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Highlights Our base case of a Biden win with a GOP Senate may come to pass. But the US election is not over yet. Trump still has a chance of victory by winning Pennsylvania and one other state. If the vote count does not settle the outcome clearly this week, a full-fledged contested election will emerge that may not be settled until just before December 14 (or even January). Risk-off sentiment will prevail in the interim, given the importance of the executive-legislative configuration for the pandemic response and the fiscal policy outlook. What we know is that Republicans kept the Senate, in line with our final forecast last week. This means gridlock is assured – which is positive for US stocks beyond near-term fiscal risks. Stay long JPY-USD, short CNY-USD, long stocks over bonds, long health care equipment, and long infrastructure plays. Keep dry powder for the presidential outcome, as global trade hangs in the balance. Feature The US presidential election is unsettled as we go to press, but we know that Republicans will keep control of the Senate and hence that American government will be divided or “gridlocked” for the next two years. As things stand, Democrats picked up two senate seats, Arizona and Colorado, but fell short everywhere else. They may even have lost a seat in Michigan. This leaves the balance of power at ~52-48 in favor of Republicans – which is one seat better than our final 51-49 forecast in their favor (Chart 1).1 Chart 1Our Senate Election Model Correctly Predicted Republican Control Gridlock Gridlock Table 1Gridlock Is Inevitable Regardless Of Presidential Outcome Gridlock Gridlock Gridlock is the inevitable consequence. If President Trump pulls off a victory in any two of the upper Midwestern states (Michigan, Pennsylvania, Wisconsin), then he will still face a Democrat-controlled House of Representatives. If former Vice President Joe Biden pulls off a victory in two of these states, then he will face a Republican controlled Senate (Table 1). Chart 2Gridlock More Favorable Than Sweep For Wall Street, But Fiscal Risks Abound In Short Run Gridlock More Favorable Than Sweep For Wall Street, But Fiscal Risks Abound In Short Run Gridlock More Favorable Than Sweep For Wall Street, But Fiscal Risks Abound In Short Run Historically gridlock offers more upside for the S&P 500 than a single-party sweep (Chart 2), and we agree with this expectation when it comes to the long-run impact of this election. However, we have also warned against the fiscal risks of a Biden win with a Republican Senate in the short run. The status quo Trump gridlock is reflationary at first but later problematic due to trade war. The Biden gridlock is deflationary at first but the best outcome for investors over the long run. Consider the following: Trump with Senate Republicans: Trump is a spendthrift and he and his party joined the House Democrats in blowing out the budget deficit from 2018-20. Trump’s victory will force House Speaker Nancy Pelosi to concede to a Republican-drafted ~$1-$1.5 trillion new COVID-19 fiscal relief bill right away. For the second term, Trump will push an infrastructure bill, border security, and make his tax cuts permanent. The fiscal thrust in 2021 will be flat-to-up. The budget deficit will probably end up somewhere between the Republican “high spending” scenario and the Democratic “low spending” scenario in our budget deficit projections (Chart 3). This is positive for US growth and especially corporate earnings, but it comes with a catch: Trump will be emboldened in his trade wars, which could expand beyond China to Europe or others. Tariffs and currency depreciation will weigh on global growth. Still, Trump’s second term will occur in the early stages of the business cycle and the Fed is committed not to hike rates until 2023, so the overall picture is reflationary.   Chart 3Trump Gridlock Reflationary, Biden Gridlock Deflationary Over Short Run Gridlock Gridlock Biden with Senate Republicans: Since Senate Republicans did not capitulate to large Democratic spending demands prior to the election, when their seats were at risk, they will have less incentive to do so afterwards when the president hails from the opposing party. The only way they will agree to a new fiscal stimulus in the “lame duck” session (November-December) is if the Democrats concede to their skinny proposals for the time being. But Democrats will probably insist on their demands having made electoral gains. In this case, either financial markets will sell off, forcing Republicans to capitulate, or investors will have to wait until early 2021 to receive a new fiscal bill that is uncertain in size and timing. The first battle of Biden’s presidency will be with the GOP Senate. The Republican “low spending” scenario in Chart 3 is most likely. It is not realistic that Congress will allow the baseline scenario, in which the budget deficit contracts by ~7.4% of GDP. Republican senators today are not the Tea Party House Republicans of 2010, who were rabid fiscal hawks. Still, uncertainty will weigh heavily and markets will have to fall before GOP senators wake up to the underlying risk to the economic recovery. The consolation is that beyond this 3-6 month period of negative sentiment and deflationary fiscal risk, the outlook will be fairly positive. Biden will not use broad-based unilateral tariffs the way Trump did, with the possible exception of China later in his term. And the Republican Senate will not agree to tax hikes at any point, making taxes a concern for 2023 or thereafter. This is the best of both worlds for US business sentiment and the corporate earnings outlook over the two-year period. Risk-off sentiment will prevail until the election is decided. This could be in a couple of days if the vote count is clear in Michigan, Pennsylvania, and Wisconsin. Or it could extend until just before December 14, when the Electoral College votes, if the litigation and court rulings in these critical states drag on, which we discuss below. The reason risk-off sentiment will prevail is that the US economy is burning through its remaining stimulus funds rapidly, the fiscal trajectory is unclear until the presidency is decided, Europe is going into partial lockdowns over the pandemic, and a Biden victory would imply more US lockdowns. Diagram 1 outlines the macro and market implications as we see them, depending on the presidential outcome. We never took the view that a Democratic sweep of White House and Senate would be the best outcome for the overall investment outlook, though we conceded that it was the most reflationary and bullish in the short term. But now this point is moot. Investors will have to wait another two years at minimum for the full smorgasbord of Democratic spending proposals to have a chance at passage. Diagram 1Gridlock Rules Out Massive Fiscal Boost Gridlock Gridlock Bottom Line: The presidency is indeterminate as we go to press. What is clear is that Republicans retained the Senate. Therefore gridlock will prevail. This is generally market positive, though a Biden win would weigh on risk assets in the near term until financial markets force Republican senators to capitulate to a new fiscal bill. A Controversial Election Or A Contested Election? The critical battleground states are undecided as we go to press. Trump needs to win any two of Michigan, Pennsylvania, and Wisconsin to retain the White House. The vote count will last through Wednesday and possibly beyond. The Republican and Democratic legal teams are preparing for trench warfare. Major legal challenges are highly likely and will delay the final outcome into December or even January. The first thing is to finish counting the absentee and mail-in ballots. Georgia, Michigan, Wisconsin, and Arizona are not accepting ballots after election day, so they will finish counting soon. Then all that remains is to see if any legal disputes arise that prevent the Electoral College members from being settled in these states, which is still possible. For example, Wisconsin is within a percentage point. Nevada will accept ballots by November 10 and North Carolina by November 12 as long as they are postmarked by election day. It is likely but not certain that Democrats will keep Nevada (~75% counted) while Republicans will keep North Carolina (~100% counted). Thus Pennsylvania poses the biggest risk of a contested result – and this was anticipated. The deadline to receive mailed ballots is Friday, November 6, but a legal dispute is already underway as to whether the original November 3 deadline should be reinstated.2 We will not pretend to predict the final court verdict on Pennsylvania, but it would not be surprising at all if the Supreme Court ruled that ballots received after election day cannot be accepted. The constitution grants state legislatures the sole power of choosing a state’s electors. Each state passes its own election laws. The Pennsylvania state legislature clearly stated that ballots must be returned by election day. It was a court decision that extended the deadline. The Supreme Court could easily determine that a lower court does not have the power to change the deadline. But nobody will know until the court rules. The fact that Trump appointed several of the judges has little bearing on their decisions because they serve lifetime appointments. Once election disputes rise above state vote-counting to the federal level, Trump gets a lifeline. First, the two-seat conservative leaning on the Supreme Court should produce strict readings of the law that could favor his bid. Second, the GOP’s victory in the Senate means that Democrats cannot unilaterally settle disputed electoral votes in their own favor at the joint session of Congress on January 6, which they could have done with a united Congress. Third, the Republicans are likely to have maintained a one or two-state majority of state delegations in the House of Representatives (based on results as we go to press), which means that Trump would win if the candidates failed to reach a 270-vote majority on the Electoral College or tied at 269. Note that an Electoral College tie is a distinct possibility in this election. Right now, if Trump loses in Michigan and Wisconsin, but wins Pennsylvania, and nothing else changes, then an Electoral College tie could result at 269-269 electoral votes.3 Polls … And Exit Polls Before condemning the entire profession of opinion pollsters to death it will be important to receive the verified results of the election and compare them with the final polling averages. It is clear that Trump was widely underrated yet again, but it is not yet clear that this was primarily or exclusively the fault of pollsters. Right now Trump is down by 1.8% in the nationwide popular vote, whereas he lagged by 7.2% in the average of the national polls and 2.3% in the battleground average on election day. This is a big 5.4% gap in the national poll, but in the battleground poll it is a minor 0.5% polling gap and as such merely confirms what many observers knew, that the battleground polls were the ones that really mattered due to the Electoral College. Trump’s battleground support average was 46.6% and his approval rating was 45.9% on election day, which respectively is 1.8% and 2.5% below his tentative share of the national vote at 48.4%. These gaps are within the average 3% margin of error – and normally sitting presidents outperform their polling by around 1%. State opinion polling had huge errors like the national poll. Charts 4 and 4B shows the final election polling in the critical swing states along with a “T” or “B” to mark Trump’s and Biden’s tentative vote share as we go to press. Swing state polls showed Trump staging a major rally in the final weeks of the campaign, which is what prompted us to upgrade his odds to 45%. Neither major pundits nor the mainstream media paid enough attention to this shift. Several prominent outlets denied that there was any real tightening in the polls even in late October. Chart 4APundits Overlooked Trump’s Rally In Swing State Polls In Final Weeks Pundits Overlooked Trump's Rally In Swing State Polls In Final Weeks Pundits Overlooked Trump's Rally In Swing State Polls In Final Weeks Chart 4BPundits Overlooked Trump’s Rally In Swing State Polls In Final Weeks Pundits Overlooked Trump's Rally In Swing State Polls In Final Weeks Pundits Overlooked Trump's Rally In Swing State Polls In Final Weeks What this demonstrates to us is the power of momentum in opinion polling, especially in the final week before an election when people’s attitudes harden and they bare more of their true opinions. It does not tell us that opinion polling is dead. What about the exit polls? Biden cut into Trump’s lead in key demographic groups just as the Democratic Party machinery anticipated, but it is not clear if it was enough to win the election. Trump lost ground and Democrats gained ground, relative to 2016, with white voters, old folks, and non-college-educated voters. But Trump improved his support among blacks and Hispanics, a signal point that gives the lie to much of this year’s media hype (Charts 5A and 5B). Chart 5ADemocrats Gained Ground With White, Elderly, And Non-College-Educated Voters; GOP Gained Among Blacks And Hispanics Gridlock Gridlock Chart 5BDemocrats Gained Ground With White, Elderly, And Non-College-Educated Voters; GOP Gained Among Blacks And Hispanics Gridlock Gridlock By far voters cared most about the issues, not personalities, and the biggest issue was the economy (35% of voters versus 20% on racial inequality and 17% on the coronavirus, which was apparently overrated as an issue by Democrats). The economic focus is the only explanation for Trump’s outperformance – the law and order narrative was less popular. Trump’s vote share may end up exactly equal to the number of respondents who said the economy was “good” or “excellent” (48%). Otherwise Trump’s base is well known: it consists predominantly of white people, rural people, those in the Midwest and South, those who have been fairly successful in income, and those who think America needs a “strong leader” more than a unifier with good judgment who seems to care about the average person. If Trump is defeated, the clear implication is that he failed to expand his base. If he wins, the clear implication is that Democrats suffered in the key regions for their aggressive approach to COVID lockdowns, their condoning of lawlessness, and their divisive handling of racial inequality and police brutality. With such a close vote for the White House, sweeping narratives are questionable. It is not clear yet whether liberalism or nationalism won, and at any rate the margin was thin. What is clear is that Democrats substantially disappointed in the Senate and they might even have failed to gain the White House. Given that this year witnessed a recession, pandemic, and widespread social unrest – well-attested historical signs that point to the failure of the incumbent party and recession – Democrats apparently failed to capitalize. National exit polls suggest the fault lay in their relative neglect of bread and butter in favor of the coronavirus or left-wing social theory. This is true not so much in the House of Representatives but in the presidential and senate races. If Trump wins – especially through a contested election – then US political polarization will rise due to the continued divergence of popular opinion and the constitutional system. “Peak polarization” will last another four years at least. But if Trump loses, given that Republicans held the Senate, there is room for compromise that would reduce polarization. But it is too early to say. Investment Takeaways Trade and foreign policy hinge on the presidency. Trump is favored in several of the key states at the moment and he is especially favored in a contested election process, but it is too soon to make investment recommendations on the executive branch other than that US equity outperformance is likely to continue on both of the scenarios at hand. Table 2Earnings Shock From Partial Repeal Of Trump Tax Cuts Has Been Averted Gridlock Gridlock For now we recommend investors stay long JPY-USD, short CNY-USD, long health care equipment, and overweight stocks relative to bonds. On the Senate, the key takeaway is that Biden and the Democrats will not be able to raise taxes. This is a big benefit to the sectors that faced the greatest earnings shock from a partial repeal of Trump’s Tax Cuts and Jobs Act – namely real estate, tech, health care, utilities, consumer discretionary, and financials (Table 2). A simple play on these sectoral benefits courtesy of Anastasios Avgeriou, our US equity strategist, would be to go long small caps versus large caps, i.e. S&P 600 relative to the S&P 500, but wait till the fiscal hurdle is cleared. The BCA infrastructure basket should benefit regardless, as infrastructure is one of the few areas of bipartisan agreement, especially amid a large output gap.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1 We upgraded the Republicans to favored status last week based on our quantitative Senate election model, which showed a 51% chance that Republicans would maintain control, with 51-49 votes. Our presidential model also showed Trump winning with a 51% chance, but we subjectively capped his odds at 45% due to our doubts about his ability to win Michigan given Biden’s 4% lead in head-to-head public opinion polls there. 2 It is possible that Nevada’s November 10 deadline or North Carolina’s November 12 deadline could become relevant, but we doubt it. 3 Precise Electoral College outcomes cannot be predicted due to faithless electors, i.e. electoral college members who vote differently than required based on their state’s popular vote. In 2016 there were seven faithless electors and in 2020 there could be several and they could make the difference. Material punishments may not prevent an elector from making a conscientious decision to stray from his or her state’s results in an election viewed as having historic importance.

Highlights Our base case of a Biden win with a GOP Senate may come to pass. But the US election is not over yet. Trump still has a chance of victory by winning Pennsylvania and one other state. If the vote count does not settle the outcome clearly this week, a full-fledged contested election will emerge that may not be settled until just before December 14 (or even January). Risk-off sentiment will prevail in the interim, given the importance of the executive-legislative configuration for the pandemic response and the fiscal policy outlook. What we know is that Republicans kept the Senate, in line with our final forecast last week. This means gridlock is assured – which is positive for US stocks beyond near-term fiscal risks. Stay long JPY-USD, short CNY-USD, long stocks over bonds, long health care equipment, and long infrastructure plays. Keep dry powder for the presidential outcome, as global trade hangs in the balance. Feature The US presidential election is unsettled as we go to press, but we know that Republicans will keep control of the Senate and hence that American government will be divided or “gridlocked” for the next two years. As things stand, Democrats picked up two senate seats, Arizona and Colorado, but fell short everywhere else. They may even have lost a seat in Michigan. This leaves the balance of power at ~52-48 in favor of Republicans – which is one seat better than our final 51-49 forecast in their favor (Chart 1).1 Chart 1Our Senate Election Model Correctly Predicted Republican Control Gridlock Gridlock Table 1Gridlock Is Inevitable Regardless Of Presidential Outcome Gridlock Gridlock Gridlock is the inevitable consequence. If President Trump pulls off a victory in any two of the upper Midwestern states (Michigan, Pennsylvania, Wisconsin), then he will still face a Democrat-controlled House of Representatives. If former Vice President Joe Biden pulls off a victory in two of these states, then he will face a Republican controlled Senate (Table 1). Chart 2Gridlock More Favorable Than Sweep For Wall Street, But Fiscal Risks Abound In Short Run Gridlock More Favorable Than Sweep For Wall Street, But Fiscal Risks Abound In Short Run Gridlock More Favorable Than Sweep For Wall Street, But Fiscal Risks Abound In Short Run Historically gridlock offers more upside for the S&P 500 than a single-party sweep (Chart 2), and we agree with this expectation when it comes to the long-run impact of this election. However, we have also warned against the fiscal risks of a Biden win with a Republican Senate in the short run. The status quo Trump gridlock is reflationary at first but later problematic due to trade war. The Biden gridlock is deflationary at first but the best outcome for investors over the long run. Consider the following: Trump with Senate Republicans: Trump is a spendthrift and he and his party joined the House Democrats in blowing out the budget deficit from 2018-20. Trump’s victory will force House Speaker Nancy Pelosi to concede to a Republican-drafted ~$1-$1.5 trillion new COVID-19 fiscal relief bill right away. For the second term, Trump will push an infrastructure bill, border security, and make his tax cuts permanent. The fiscal thrust in 2021 will be flat-to-up. The budget deficit will probably end up somewhere between the Republican “high spending” scenario and the Democratic “low spending” scenario in our budget deficit projections (Chart 3). This is positive for US growth and especially corporate earnings, but it comes with a catch: Trump will be emboldened in his trade wars, which could expand beyond China to Europe or others. Tariffs and currency depreciation will weigh on global growth. Still, Trump’s second term will occur in the early stages of the business cycle and the Fed is committed not to hike rates until 2023, so the overall picture is reflationary.   Chart 3Trump Gridlock Reflationary, Biden Gridlock Deflationary Over Short Run Gridlock Gridlock Biden with Senate Republicans: Since Senate Republicans did not capitulate to large Democratic spending demands prior to the election, when their seats were at risk, they will have less incentive to do so afterwards when the president hails from the opposing party. The only way they will agree to a new fiscal stimulus in the “lame duck” session (November-December) is if the Democrats concede to their skinny proposals for the time being. But Democrats will probably insist on their demands having made electoral gains. In this case, either financial markets will sell off, forcing Republicans to capitulate, or investors will have to wait until early 2021 to receive a new fiscal bill that is uncertain in size and timing. The first battle of Biden’s presidency will be with the GOP Senate. The Republican “low spending” scenario in Chart 3 is most likely. It is not realistic that Congress will allow the baseline scenario, in which the budget deficit contracts by ~7.4% of GDP. Republican senators today are not the Tea Party House Republicans of 2010, who were rabid fiscal hawks. Still, uncertainty will weigh heavily and markets will have to fall before GOP senators wake up to the underlying risk to the economic recovery. The consolation is that beyond this 3-6 month period of negative sentiment and deflationary fiscal risk, the outlook will be fairly positive. Biden will not use broad-based unilateral tariffs the way Trump did, with the possible exception of China later in his term. And the Republican Senate will not agree to tax hikes at any point, making taxes a concern for 2023 or thereafter. This is the best of both worlds for US business sentiment and the corporate earnings outlook over the two-year period. Risk-off sentiment will prevail until the election is decided. This could be in a couple of days if the vote count is clear in Michigan, Pennsylvania, and Wisconsin. Or it could extend until just before December 14, when the Electoral College votes, if the litigation and court rulings in these critical states drag on, which we discuss below. The reason risk-off sentiment will prevail is that the US economy is burning through its remaining stimulus funds rapidly, the fiscal trajectory is unclear until the presidency is decided, Europe is going into partial lockdowns over the pandemic, and a Biden victory would imply more US lockdowns. Diagram 1 outlines the macro and market implications as we see them, depending on the presidential outcome. We never took the view that a Democratic sweep of White House and Senate would be the best outcome for the overall investment outlook, though we conceded that it was the most reflationary and bullish in the short term. But now this point is moot. Investors will have to wait another two years at minimum for the full smorgasbord of Democratic spending proposals to have a chance at passage. Diagram 1Gridlock Rules Out Massive Fiscal Boost Gridlock Gridlock Bottom Line: The presidency is indeterminate as we go to press. What is clear is that Republicans retained the Senate. Therefore gridlock will prevail. This is generally market positive, though a Biden win would weigh on risk assets in the near term until financial markets force Republican senators to capitulate to a new fiscal bill. A Controversial Election Or A Contested Election? The critical battleground states are undecided as we go to press. Trump needs to win any two of Michigan, Pennsylvania, and Wisconsin to retain the White House. The vote count will last through Wednesday and possibly beyond. The Republican and Democratic legal teams are preparing for trench warfare. Major legal challenges are highly likely and will delay the final outcome into December or even January. The first thing is to finish counting the absentee and mail-in ballots. Georgia, Michigan, Wisconsin, and Arizona are not accepting ballots after election day, so they will finish counting soon. Then all that remains is to see if any legal disputes arise that prevent the Electoral College members from being settled in these states, which is still possible. For example, Wisconsin is within a percentage point. Nevada will accept ballots by November 10 and North Carolina by November 12 as long as they are postmarked by election day. It is likely but not certain that Democrats will keep Nevada (~75% counted) while Republicans will keep North Carolina (~100% counted). Thus Pennsylvania poses the biggest risk of a contested result – and this was anticipated. The deadline to receive mailed ballots is Friday, November 6, but a legal dispute is already underway as to whether the original November 3 deadline should be reinstated.2 We will not pretend to predict the final court verdict on Pennsylvania, but it would not be surprising at all if the Supreme Court ruled that ballots received after election day cannot be accepted. The constitution grants state legislatures the sole power of choosing a state’s electors. Each state passes its own election laws. The Pennsylvania state legislature clearly stated that ballots must be returned by election day. It was a court decision that extended the deadline. The Supreme Court could easily determine that a lower court does not have the power to change the deadline. But nobody will know until the court rules. The fact that Trump appointed several of the judges has little bearing on their decisions because they serve lifetime appointments. Once election disputes rise above state vote-counting to the federal level, Trump gets a lifeline. First, the two-seat conservative leaning on the Supreme Court should produce strict readings of the law that could favor his bid. Second, the GOP’s victory in the Senate means that Democrats cannot unilaterally settle disputed electoral votes in their own favor at the joint session of Congress on January 6, which they could have done with a united Congress. Third, the Republicans are likely to have maintained a one or two-state majority of state delegations in the House of Representatives (based on results as we go to press), which means that Trump would win if the candidates failed to reach a 270-vote majority on the Electoral College or tied at 269. Note that an Electoral College tie is a distinct possibility in this election. Right now, if Trump loses in Michigan and Wisconsin, but wins Pennsylvania, and nothing else changes, then an Electoral College tie could result at 269-269 electoral votes.3 Polls … And Exit Polls Before condemning the entire profession of opinion pollsters to death it will be important to receive the verified results of the election and compare them with the final polling averages. It is clear that Trump was widely underrated yet again, but it is not yet clear that this was primarily or exclusively the fault of pollsters. Right now Trump is down by 1.8% in the nationwide popular vote, whereas he lagged by 7.2% in the average of the national polls and 2.3% in the battleground average on election day. This is a big 5.4% gap in the national poll, but in the battleground poll it is a minor 0.5% polling gap and as such merely confirms what many observers knew, that the battleground polls were the ones that really mattered due to the Electoral College. Trump’s battleground support average was 46.6% and his approval rating was 45.9% on election day, which respectively is 1.8% and 2.5% below his tentative share of the national vote at 48.4%. These gaps are within the average 3% margin of error – and normally sitting presidents outperform their polling by around 1%. State opinion polling had huge errors like the national poll. Charts 4 and 4B shows the final election polling in the critical swing states along with a “T” or “B” to mark Trump’s and Biden’s tentative vote share as we go to press. Swing state polls showed Trump staging a major rally in the final weeks of the campaign, which is what prompted us to upgrade his odds to 45%. Neither major pundits nor the mainstream media paid enough attention to this shift. Several prominent outlets denied that there was any real tightening in the polls even in late October. Chart 4APundits Overlooked Trump’s Rally In Swing State Polls In Final Weeks Pundits Overlooked Trump's Rally In Swing State Polls In Final Weeks Pundits Overlooked Trump's Rally In Swing State Polls In Final Weeks Chart 4BPundits Overlooked Trump’s Rally In Swing State Polls In Final Weeks Pundits Overlooked Trump's Rally In Swing State Polls In Final Weeks Pundits Overlooked Trump's Rally In Swing State Polls In Final Weeks What this demonstrates to us is the power of momentum in opinion polling, especially in the final week before an election when people’s attitudes harden and they bare more of their true opinions. It does not tell us that opinion polling is dead. What about the exit polls? Biden cut into Trump’s lead in key demographic groups just as the Democratic Party machinery anticipated, but it is not clear if it was enough to win the election. Trump lost ground and Democrats gained ground, relative to 2016, with white voters, old folks, and non-college-educated voters. But Trump improved his support among blacks and Hispanics, a signal point that gives the lie to much of this year’s media hype (Charts 5A and 5B). Chart 5ADemocrats Gained Ground With White, Elderly, And Non-College-Educated Voters; GOP Gained Among Blacks And Hispanics Gridlock Gridlock Chart 5BDemocrats Gained Ground With White, Elderly, And Non-College-Educated Voters; GOP Gained Among Blacks And Hispanics Gridlock Gridlock By far voters cared most about the issues, not personalities, and the biggest issue was the economy (35% of voters versus 20% on racial inequality and 17% on the coronavirus, which was apparently overrated as an issue by Democrats). The economic focus is the only explanation for Trump’s outperformance – the law and order narrative was less popular. Trump’s vote share may end up exactly equal to the number of respondents who said the economy was “good” or “excellent” (48%). Otherwise Trump’s base is well known: it consists predominantly of white people, rural people, those in the Midwest and South, those who have been fairly successful in income, and those who think America needs a “strong leader” more than a unifier with good judgment who seems to care about the average person. If Trump is defeated, the clear implication is that he failed to expand his base. If he wins, the clear implication is that Democrats suffered in the key regions for their aggressive approach to COVID lockdowns, their condoning of lawlessness, and their divisive handling of racial inequality and police brutality. With such a close vote for the White House, sweeping narratives are questionable. It is not clear yet whether liberalism or nationalism won, and at any rate the margin was thin. What is clear is that Democrats substantially disappointed in the Senate and they might even have failed to gain the White House. Given that this year witnessed a recession, pandemic, and widespread social unrest – well-attested historical signs that point to the failure of the incumbent party and recession – Democrats apparently failed to capitalize. National exit polls suggest the fault lay in their relative neglect of bread and butter in favor of the coronavirus or left-wing social theory. This is true not so much in the House of Representatives but in the presidential and senate races. If Trump wins – especially through a contested election – then US political polarization will rise due to the continued divergence of popular opinion and the constitutional system. “Peak polarization” will last another four years at least. But if Trump loses, given that Republicans held the Senate, there is room for compromise that would reduce polarization. But it is too early to say. Investment Takeaways Trade and foreign policy hinge on the presidency. Trump is favored in several of the key states at the moment and he is especially favored in a contested election process, but it is too soon to make investment recommendations on the executive branch other than that US equity outperformance is likely to continue on both of the scenarios at hand. Table 2Earnings Shock From Partial Repeal Of Trump Tax Cuts Has Been Averted Gridlock Gridlock For now we recommend investors stay long JPY-USD, short CNY-USD, long health care equipment, and overweight stocks relative to bonds. On the Senate, the key takeaway is that Biden and the Democrats will not be able to raise taxes. This is a big benefit to the sectors that faced the greatest earnings shock from a partial repeal of Trump’s Tax Cuts and Jobs Act – namely real estate, tech, health care, utilities, consumer discretionary, and financials (Table 2). A simple play on these sectoral benefits courtesy of Anastasios Avgeriou, our US equity strategist, would be to go long small caps versus large caps, i.e. S&P 600 relative to the S&P 500, but wait till the fiscal hurdle is cleared. The BCA infrastructure basket should benefit regardless, as infrastructure is one of the few areas of bipartisan agreement, especially amid a large output gap.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1 We upgraded the Republicans to favored status last week based on our quantitative Senate election model, which showed a 51% chance that Republicans would maintain control, with 51-49 votes. Our presidential model also showed Trump winning with a 51% chance, but we subjectively capped his odds at 45% due to our doubts about his ability to win Michigan given Biden’s 4% lead in head-to-head public opinion polls there. 2 It is possible that Nevada’s November 10 deadline or North Carolina’s November 12 deadline could become relevant, but we doubt it. 3 Precise Electoral College outcomes cannot be predicted due to faithless electors, i.e. electoral college members who vote differently than required based on their state’s popular vote. In 2016 there were seven faithless electors and in 2020 there could be several and they could make the difference. Material punishments may not prevent an elector from making a conscientious decision to stray from his or her state’s results in an election viewed as having historic importance.

Your feedback is important to us. Please take our client survey today. Highlights The long-term outlook for the dollar is bearish, but fresh shorts could be offside over the next one to three months. An uptick in US political uncertainty adds to our bullish dollar view over the next month. Stay short USD/JPY as a core holding for now. Beyond the near term, the Scandinavian currencies are best positioned for outperformance over the next 12 months. Silver is selling off relative to gold. Being long silver is a long-term bet that will pay handsome returns, but stand aside for now. Feature November is seasonally a good month for the dollar, and this year could well prove no exception (Chart I-1). Just a few days ago, the market consensus was that the dollar would decline irrespective of who sits in the Oval Office next year. A few days later and the market woke up to the realization that such a “heads I win, tails I win” bet rarely pans out smoothly. We have been very sympathetic to a dollar-bearish view over the long term, but as we highlighted last week, a few indicators have not passed our smell test, setting up the potential for a knee-jerk dollar rally. To add to this thesis, the rise in the greenback this week (and bloodbath in financial markets) has eerie historical echoes with the recent past. Remarkably, since the 2009 global financial crisis and the ensuing 2011 dollar bull market, the greenback has tended to stage its most powerful rallies into year-end. Chart I-2 shows that even after adjusting for the dollar uptrend over the last decade, November to January have proven to be very good months for dollar-long positions. This was particularly notable in 2009, 2011, 2014 and 2017 (Chart I-3). Chart I-1The Dollar Loves November The Dollar In A Market Reset The Dollar In A Market Reset Chart I-2The Dollar Since GFC The Dollar Since GFC The Dollar Since GFC Chart I-3The Dollar Is Oversold The Dollar Is Oversold The Dollar Is Oversold We are no technical experts, but could this time be different, especially given so many uncertainties clouding the investment outlook? And if so, what are other catalysts for a dollar bounce, other than those penned in report last week? What Could Be Different? Chart I-4The Dollar Rally Occurs In Two Phases The Dollar Rally Occurs In Two Phases The Dollar Rally Occurs In Two Phases Crises are rarely solved with one silver bullet. Historians can try to justify this over the last several centuries, but for the dollar call, it is instructive to simply re-examine the significant events we have lived through since the Great Financial Crisis. Enter 2008. The dollar rally occurred in two phases. The first phase prompted the US authorities to act by dropping interest rates, which dampened the rally and stimulated reflation. When the crisis proved bigger than the authorities expected, indiscriminate liquidation by financial market participants eventually prompted more action (Chart I-4). To be specific, the US first introduced swap lines with a select few central banks in December 2007 in response to the dollar crisis following the collapse of the housing market. These swap lines allowed foreign central banks to draw on dollar liquidity directly from the Federal Reserve and use this to provide credit to domestic concerns. However, from March to October 2008, the dollar soared by about 25%, since the swap lines did not include emerging markets. This prompted the Fed to expand its swap lines to include more developed-market participants and some emerging market countries. When the crisis proved bigger than the authorities expected, indiscriminate liquidation by financial market participants eventually prompted more action.  If we consider the situation today, we can all agree that the nature of the crisis is quite different from 2008, but the severity is as important, if not greater. However, similar to 2008, the Fed only has swap lines with 14 central banks. Moreover, the six-month original window is expiring. Granted, cross-currency basis swaps do not suggest any imminent danger (Chart I-5). Nevertheless, emerging market countries like South Africa, Turkey, India, Indonesia, and Russia do not have direct access to dollar liquidity from the Fed and are at risk to torpedo the dollar decline. Chart I-5No Funding Stresses For Now No Funding Stresses For Now No Funding Stresses For Now In short, many emerging market central banks do not have swap agreements with the US. These are countries with huge dollar liabilities that could continue to see their currencies fall, pushing up the aggregate dollar index. Developed market commodity currencies tend to be highly correlated with emerging market currencies, so this dynamic is very important for the US dollar call (Chart I-6). Meanwhile, there is a huge pool within the financial architecture unable to access funding through central bank swap lines. To be exact, around 60% of outstanding foreign exchange swaps/forwards are among non-bank financial and other institutions. Hedge funds are included in this group, and they entail a lot more credit risk than any central bank would be willing to bear. Then there is the Fed’s FIMA facility. This is a temporary repo facility for foreign and international monetary authorities (FIMA) that allows account holders to temporarily exchange their Treasury securities held with the Fed for US dollars. However, the pool of Treasury securities available to swap for US dollars has shrunk significantly. This has been on the back of slowing global trade and conscious diversification of reserves by offshore concerns (Chart I-7). Chart I-6EM And DM Currencies EM And DM Currencies EM And DM Currencies Chart I-7A Smaller Pool Of Treasurys To Sell A Smaller Pool Of Treasurys To Sell A Smaller Pool Of Treasurys To Sell The bottom line is that there is a window between a crisis and action by the Fed that could exacerbate the knee-jerk rally in the US dollar, as we have been highlighting in recent weeks. For now, there remains ample room for foreign central banks to draw on dollar liquidity (Chart I-8). As such, the dollar bounce will be an opportunity to establish fresh short positions rather than signal a renewed bull market. Chart I-8Ample Swap Liquidity Ample Swap Liquidity Ample Swap Liquidity Currency Positions US Dollar: A temporary dip in inflation expectations in the US will boost real rates and encourage flows back into US fixed-income assets. The drop in oil prices, which has been moving neck in neck with US inflation expectations, corroborates this view (Chart I-9). The DXY could easily touch 96 before consolidating gains. Chart I-9US Inflation Expectations Could Drop US Inflation Expectations Could Drop US Inflation Expectations Could Drop Euro: It remains unclear the disbursement of the funds from the pandemic emergency purchase program (PEPP). In the meantime, the European Central Bank stood pat today, confirming the narrative that Europe might be out of monetary bullets and fiscal policy is needed to revive animal spirits. This could cause air pocket for EUR/USD, which could touch 1.15 before rebounding. Yen: The yen is a perfect “heads I win, tails I don’t lose much bet.” Japan is one of the few countries offering positive real rates (Chart I-10). Switzerland also falls in that category. In a world that can temporarily dip into deflation, one might prefer to be in US dollars, but the yen and Swiss franc will also hold up nicely. Chart I-10Only In Japan And Switzerland The Dollar In A Market Reset The Dollar In A Market Reset Loonie: Our colleagues at the Daily Insights summarized the Bank Of Canada’s actions this week as technical and not fundamental (Chart I-11). With no real change in monetary policy, Canadian asset prices will remain dominated by global trends. The CAD has cyclical upside versus the USD, as we wrote about, but the current period of market tumult should push the loonie lower in the coming month or two. Chart I-11Canada Versus US Canada Versus US Canada Versus US Scandinavian currencies: The NOK and SEK have borne the brunt of the dollar decline so far and will bounce the most once reflation is back in play. We have a limit buy order on Nordic currencies should they decline further (Chart I-12). Chart I-12Dollar Seasonality The Dollar In A Market Reset The Dollar In A Market Reset Relative Value: Focus on relative value at the crosses rather than outright dollar bets. We are short the NZD/CAD, CAD/NOK and EUR/GBP as plays on relative fundamentals. EUR/GBP remains at risk of a significant selloff if we get a Brexit deal. Oil currencies: Remain long petrocurrencies versus the euro, but we are looking to use the tactical bounce in the dollar to shift to USD shorts. Silver: Short-term investors should stand aside on silver for now. The bullish thesis remains intact but volatility will rise in the short term.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com 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 positive: GDP recovered by 33.1% quarter-on-quarter on an annualized basis in Q3. The Markit Manufacturing PMI marginally increased from 53.2 to 53.3 in October. The services PMI also increased, from 54.6 to 56. The Chicago Fed National Activity Index declined from 1.11 to 0.27 in September. Initial jobless claims increased by 751K for the week ending on October 23rd. The DXY index increased by 1% this week alongside the equity market correction, impacted by the looming US elections and increasing number of COVID-19 cases. Our Geopolitical strategists have upgraded Trump’s odds of winning from 35% to 45%, though major opinion polls still favor a Biden victory. Our bias is that a Biden win will likely increase fiscal stimulus and decrease economic and trade policy uncertainties, which is bearish for the US dollar. Report Links: A Few Market Observations - October 23, 2020 Does The US Save Too Much Or Too Little? - October 16, 2020 Tail Risks In FX Markets - October 2, 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 mixed: The Markit Manufacturing PMI increased from 53.7 to 54.4 in October. However, the Services PMI declined from 48 to 46.2.  M3 money supply surged by 10.4% year-on-year in September. The Economic Sentiment Indicator was unchanged at 90.9 in October. The euro plunged by 1.4% against the US dollar this week. On Thursday, the ECB held its key interest rate unchanged at -0.5% despite re-imposed lockdown measures against surging COVID cases in Europe. However, it also hinted that there could be additional policy action and more stimulus in December should conditions worsen. 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 from Japan have been positive: The Jibun Manufacturing PMI increased from 47.7 to 48 in October. The Coincident Index rose from 78.3 to 79.2 in August. The Leading Economic Index also ticked up from 86.7 to 88.4. Retail trade fell by 8.7% year-on-year in September.  The Japanese yen depreciated by 0.3% against the US dollar this week amid market volatilities. With relatively higher real interest rates, a current account surplus and cheaper valuation, the Japanese yen is our favorite safe-haven currency. We continue to recommend holding the Japanese yen as a portfolio hedge for surfing election and COVID waves. On a separate note, the BoJ kept its interest rate on hold this Thursday. The Bank also weakened its economic forecast for this year but upgraded the economic recovery outlook. 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 mixed: Retail sales increased by 4.7% year-on-year in September. The Markit Manufacturing PMI declined from 54.1 to 53.3 in October. The services PMI fell from 56.1 to 52.3 in October. The British pound plunged by 1.5% against the US dollar this week amid broad USD strength. The latest PMI releases saw a steeper decline in the services industry. As UK’s services account for more than half of total economic output, it suggests that the pound is more exposed to second infection risks than other manufacturing-oriented economies. 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: Imports fell by 1% month-on-month in September. Exports, however, increased by 3% month-on-month. The trade surplus widened from A$2.6 billion to A$5.1 billion. Headline CPI increased by 0.7% year-on-year in Q3, up from -0.3% the previous quarter. The Australian dollar fell by 1.5% against the US dollar this week. The pickup in inflation eased the RBA’s pressure to further ease monetary policy further. The expansion in the trade account surplus also bodes well for the Australian dollar in a reflationary environment. 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 negative:  Exports fell from NZ$4.4 billion to NZ$4 billion in September while imports expanded from NZ$4.7 billion to NZ$5 billion. The trade deficit therefore widened from NZ$282 million to NZ$1,013 million. The ANZ Business Confidence Index rose to -15.7 from -28.5 in October. The New Zealand dollar fell by 1.2% against the US dollar this week. The ANZ Activity Outlook Report said that “there was a mix of ups and downs” in recent developments and warned against higher economic and unemployment risks once the cushioning impact of the wage subsidy fades. 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: Building permits increased by 17% month-on-month in September. The Canadian dollar plunged by 1.7% against the US dollar this week. Crude oil prices dropped by 12% this week amid worries about the second infection wave and prolonged travel restrictions, which represent a headwind for the Canadian dollar. On Wednesday, the Bank of Canada announced that it would keep interest rates on hold at 0.25% and maintain such low policy rates until the inflation objective is achieved. Moreover, the Bank is recalibrating the QE program to shift purchases towards longer-term bonds, which have a more direct influence on the borrowing rates for household and businesses. 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 negative: The ZEW Expectations Index plunged from 26.2 to 2.3 in October. Total sight deposits increased from CHF 705.1 billion to CHF 706.9 billion for the week ending on October 23rd. While the Swiss franc depreciated by 1% against the US dollar this week, it increased by 0.5% against the euro, which brings it close to our limit buy price of 1.06. An expensive currency is likely to impede growth for a small open economy like Switzerland, suggesting the SNB will step up its currency intervention. Prepare to go long EUR/CHF.  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 Recent data from Norway have been positive: Retail sales increased by 0.3% month-on-month in September. The Norwegian krone plunged by 3.4% against the US dollar this week, making it the worst performing G10 currency. Despite recent market volatilities, we continue to favor the Norwegian krone in the long run based on its cheap valuation and a brighter energy outlook in the post-vaccine world. We are looking to rebuy the Nordic currencies on weakness. 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 positive: The trade balance shifted from a deficit of SEK 2.1 billion to a surplus of SEK 2.6 billion in September. Consumer confidence increased from 88.4 to 90 in October. Retail sales increased by 3.9% year-on-year in September. PPI fell by 4.2% year-on-year in September. The Swedish krona decreased by 1.9% against the US dollar this week. While COVID cases have been resurging in Sweden, Sweden’s services is lower, as a % of GDP, than other major euro area countries and therefore less exposed to the risk of a second wave. We continue to recommend the Swedish krona from a cyclical perspective. 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

Your feedback is important to us. Please take our client survey today. Highlights Mounting populism has created a structural tailwind behind inflation. The risk that inflation accelerates quickly is greater than the market appreciates. Monetary dynamics strongly influence consumer prices when inflation is stationary. The Federal Reserve’s back-door monetization of debt is inflationary. Financial assets do not embed a sufficiently large risk premium against higher inflation. The long-term, real returns of equities are likely to be poor. Small cap stocks and commodities offer cheap protection against higher inflation. Feature The equity market is extremely vulnerable to positive inflation surprises. The expectation of an extended period of low interest rates and extraordinarily easy monetary policy is the crucial justification for the S&P 500’s exceptionally elevated multiples. Anything that could threaten this policy set up would create a danger for stocks. Whether the mean of inflation in a given period is stationary will determine the influence that money has on inflation. The problem for the S&P 500 is that investors assign a much-too-small probability to the inflation risk, especially as structural and political forces point to an elevated chance that inflation will reach 3% to 5% within the next 10 years. There is also a non-trivial probability that inflation begins rising significantly faster than the market anticipates, even if it is not BCA Research’s base case. The dichotomy between the low odds of a quick turnaround in inflation embedded in financial asset prices and the inflationary threat created by monetary and fiscal choices is too large. It will force market participants to assign a greater inflation risk premium in bonds and stocks to protect against this eventuality. This process could precipitate painful corrections in both bond and equity prices. The good news is that inflation protection remains cheap. Three Stages Of Inflation The staggering recent increase in money supply and the extraordinary fiscal stimulus rolled out this year raise two questions: Are we exiting the recent period of low and stable inflation that has prevailed? Is inflation becoming a threat to financial asset prices? Major turning points in inflation provide context to assess the risk of an impending threat of increased inflation. From a statistical perspective, three phases in inflation dynamics have defined the past 100 years (Chart I-1): Chart I-1Three Stages Of Inflation Three Stages Of Inflation Three Stages Of Inflation 1922 to 1965: Inflation gyrated violently from as low as -12.1% to as high as 11.9% in response to various shocks such as the Great Depression or World War II. Nonetheless, inflation’s mean was stationary or trendless. 1965 to 1998: A period of great upheaval when inflation trended strongly, moving up until 1980 and then down until 1998. 1998 to present: Inflation has been stable, flatlining between 0.6% and 2.9%. Chart I-2More Often Than Not, Money Matters More Often Than Not, Money Matters More Often Than Not, Money Matters Empirically speaking, whether the mean of inflation in a given period is stationary will determine the influence that money has on inflation. The era of stationary inflation from 1922 to 1965 saw M2 closely correlated with changes in US consumer prices, but the link was severed from 1965 to 1998 when inflation trended strongly (Chart I-2, top and bottom panel). When inflation stabilized again from 1998 to 2020, M2 growth again explained gyrations in consumer prices (Chart I-2, bottom panel). Why did inflation behave differently from 1965 to 1998 compared with other episodes in the past 100 years? The defining factor of the pre-1965 era was an adherence to the gold standard. The gold standard created a hard anchor on prices because its rigidity made monetary policy credible, which produced stable inflation expectations. The velocity of money was also steady. Consequently, using the Fisher formulation of the equation of exchange (Price*Output = Money*Velocity or PY=MV), inflation became a direct derivative of the money supply. Various shocks such as a war or a depression would impact the rate of expansion of money, leading to a nearly linear effect on prices. When we examine unstable inflation from 1965 to 1998, it helps if we split the period into two subsamples: 1965 to 1977 and 1977 to 1998. The first interval generated accelerating inflation due to a multitude of factors. In the mid-1960s, slack in the US economy disappeared while demand became excessive as a result of the federal government’s increased spending from The Great Society programs and the Vietnam War. Additionally, by 1965, the gold standard was under attack. The US current account disappeared between 1965 and 1969. Worried by the deteriorating US balance of payment dynamics, French President De Gaulle sent his navy to repatriate France’s gold at the New York Fed. Other countries followed suit. The continued pressure on the US balance of payments, along with the need for easier monetary policy following the 1970 recession, lead to the 1971 Smithsonian Agreement whereby President Nixon unpegged the dollar from gold, effectively killing the gold standard. Any semblance of monetary rectitude disappeared and inflation expectations began to drift up. The oil shock of 1973 fueled the inflationary dynamics and pushed inflation higher through the rest of the decade. The developments outside of monetary policy reinforced downward pressure on inflation expectations created by the Fed’s orthodoxy. The second interval began in 1977, three years before inflation peaked. This date marks the implementation of the Federal Reserve Reform Act, which modified the Fed’s mandate from only targeting full employment to full employment and stable inflation. At first, the Act had little practical impact until Paul Volker became Fed chair in 1979 and began to combat inflation. Prior to 1977, the unemployment rate was below NAIRU (the unemployment rate consistent with full employment) most of the time, the economy overheated and ultimately, inflation trended up (Chart I-3). However, since 1977, the unemployment rate has mostly been above NAIRU and the labor market has predominantly experienced excess slack. Consequently, inflation expectations re-anchored to the downside and realized inflation collapsed. Chart I-3The Effect Of The Federal Reserve Reform Act Of 1977 The Effect Of The Federal Reserve Reform Act Of 1977 The Effect Of The Federal Reserve Reform Act Of 1977 Chart I-4The Monetarist Fed: 1977 to 1998 The Monetarist Fed: 1977 to 1998 The Monetarist Fed: 1977 to 1998 The relationship between short rates and money supply provides another way to appreciate the change in monetary policy after 1977. The Fed opted for a monetarist approach (officially and unofficially) when it had to combat high realized and expected inflation. During most of the past 100 years, money supply changes and short rates were either negatively correlated or not linked at all (Chart I-4, top and second panel); however, they began to move together from 1979 to 1998 (Chart I-4, bottom panel). The Fed boosted rates to preempt the inflationary impact of faster money supply expansion, which curtailed the link between prices and M2. Between 1977 and 1998, major structural forces also pushed down inflation and severed the bond between money supply and CPI. Starting with President Reagan, a period of aggressive deregulation and union-busting increased competition and removed some pricing power from labor.1 Most importantly, the rapid widening in globalization resulted in international trade representing an ever-climbing portion of global GDP. By adding more people to the global network of supply chains, globalization further entrenched the loss of workers’ pricing power, which caused wages to lag productivity and decline as a share of national income (Chart I-5). The developments outside of monetary policy reinforced downward pressure on inflation expectations created by the Fed’s orthodoxy. In the final phase from 1998 to 2020, the stabilization of inflation reunited prices and money supply. Inflation flattened due to several factors. By 1998, 70% of the global population lived in a capitalist system (compared to market shares only 28% in 1977). Thus, most of the expansion of the global labor supply was completed. China entered the WTO only in 2001, but it had been exerting its deflationary influence for many years by stealing market share away from newly industrialized Asian economies. Additionally, following the Asian Crisis of 1997, many Asian economies (including China and Japan) elected to build large dollar FX reserves to contain their currencies versus the USD, and subsidize economic activity. This process created some stability in global goods prices and slowed the USD’s depreciation started in 2002. In response to these influences, inflation expectations stabilized in the late 1990s, creating an anchor for realized inflation (Chart I-6). Thanks to this steadiness in inflation expectations, the Phillips curve (the inverse link between wages and the unemployment rate) flattened. The economy entered a feedback loop where consistent inflation rates begat stable wages, which in turn created more stability in aggregate prices. Fluctuations in the rate of inflation became directly linked to changes in the output gap and thus, variations in demand. Importantly, the flat Phillips curve and the well-anchored inflation expectations freed the Fed to maintain easier policy during expansions and allow money supply to expand in line with money demand. Chart I-5Expanding Globalization Robbed Labor Of Its Bargaining Power Expanding Globalization Robbed Labor Of Its Bargaining Power Expanding Globalization Robbed Labor Of Its Bargaining Power Chart I-6The Anchoring Of Inflation Expectations The Anchoring Of Inflation Expectations The Anchoring Of Inflation Expectations   Bottom Line: The correlation between inflation and M2 growth since 1998 is as relevant as it was from 1922 to 1965. What The Future Holds Structurally, inflation will likely trend higher. The Median Voter Theory (MVT), developed by Anthony Downs and upheld by our Geopolitical Strategy service as the key constraint on global and US policymakers, is at the heart of our position. Over the past 40 years, income and wealth inequalities have soared worldwide, especially in the US and the UK, which have both embraced ‘laissez-faire’ capitalism enthusiastically. Moreover, these countries also suffer from pronounced levels of intergenerational social immobility.2 The effect of these aforementioned trends has become so pervasive that life expectancy for a large swath of the US population is decreasing (Chart I-7). The shift by median voters to the left on economic matters will force greater fiscal profligacy and regulatory rigidity. This policy mix will add a secular drift to inflation. In response to widening inequalities, voter preferences have shifted to the left on economic matters and toward populism. Brexit and the election of President Trump both fit this pattern because they represent the repudiation of the prevalent neoliberal discourse that pushed toward more globalization, more immigration and more deregulation. Moreover, voters in the UK and the US increasingly doubt the benefits of free trade (Chart I-8). Chart I-7Inequalities Are Physically Hurting Many US Voters November 2020 November 2020 Chart I-8Free Trade Is Out… November 2020 November 2020   Attitudes toward the government’s role in the economy have also changed. Voters in the US are much more open than they were 10 or 20 years ago to a greater involvement of the public sector in the economy. Additionally, support toward socialism has become more widespread among various demographic groups (Chart I-9). The MVT posits that politicians who want to access or remain in power must cater to voter preferences. Hence, when compared with the Great Financial Crisis, the swift fiscal policy easing that accompanied the COVID-19 recession illustrates the understanding by politicians that spending is popular, especially in times of crisis (Chart I-10). Chart I-9…But State Intervention Is In November 2020 November 2020 Chart I-10Politicians Deliver What Voters Want November 2020 November 2020   Greater government spending and larger fiscal deficits are used to achieve faster nominal growth. When the output gap is negative, public spending helps the economy and may even increase national savings. However, if profligacy continues after the economy has reached full employment, it generates excess demand relative to aggregate supply and puts downward pressure on the national savings rate. This is inflationary. To redistribute income toward the middle class, populists aim to diminish competition in the economy. They reregulate the economy, which indirectly protects workers. They also limit global trade flows as much as possible. Free trade is good for the economy, but it puts downward pressure on the price of goods relative to services. Therefore, to remain competitive domestic goods producers must compress their labor costs, which either hurts wages for middle-class workers or destroys the number of manufacturing jobs with high wages. Undoing this process raises labor costs and undermines a major deflationary influence on the economy. Tax policy is another tool to force a redistribution of income and wealth toward the middle class. We should expect increased taxes on higher-income households. This process puts more money in the pockets of a middle class whose marginal propensity to consume is around 95% to 99% compared with 50% to 60% for households at the top of the income distribution. Re-shuffling the composition of national income toward the middle class will boost demand and puts upward pressure on consumer prices. Central banks are not immune to the preference of the median voter. As we showed earlier, the Fed Reform Act of 1977 had a meaningful impact on inflation, but only after Volcker took the helm of the FOMC. Given the damages wrought by high inflation in the 1970s, the median voter wanted to see less inflation, which enabled Volcker’s hawkish shift. As Marko Papic argued in a recent BCA Research webcast,3 a minority of voters (and policymakers) remember the pain created by inflation, but everyone is aware of the difficulties created by low nominal growth. Moreover, the Fed is still a creature of Congress and the median voter’s preferences greatly affect the legislative body’s decisions. Consequently, the Fed’s policy stance will likely become structurally looser in response to indirect voter pressure. Inflation accelerates when the Fed expands money supply faster than the federal government sucks in liquidity via its deficit. The Fed’s recent adoption of an average inflation mandate fits within this paradigm. According to its new strategy, the Fed will start tightening policy after the unemployment gap has closed and inflation is above 2%. This is reminiscent of the model prior to 1977 (when full employment conditions were paramount), which generated a significant inflation upside. Bottom Line: The shift by median voters to the left on economic matters will force greater fiscal profligacy and regulatory rigidity. It will also contribute to a more dovish bias by central banks. This policy mix will add a secular drift to inflation. What About Now? Markets may be failing to recognize the risk that inflation will rise sooner rather than later. Low yields, subpar inflation expectations, dovish central bank pricing and the valuation premium of growth relative to value stocks already reflect the strong deflationary force created by a deeply negative output gap. Thus, a quicker-than-expected recovery in inflation threatens the financial markets. Our structural inflation view is not the source of this danger. The hidden, near-term inflationary risk arises because we are still in an environment where broad money matters because inflation remains stationary. M2 is expanding at 23.7%, its fastest rate on record. If relationships of the past 20-plus years hold, then this is a warning sign for inflation. The catalyst to crystalize the structural inflationary pressures created by economic populism may be the loose monetary and fiscal conditions caused by the COVID-19 recession. Chart I-11The Real Near-term Inflation Risk The Real Near-term Inflation Risk The Real Near-term Inflation Risk This view may seem simplistic in light of the current large output gap, but when fiscal policy is included in the assessment, the picture becomes clearer. Since 1998, the gap between the expansion of M2 and the issuance of debt to the public by the federal government has explained inflation better than broad money alone (Chart I-11). Inflation accelerates when the Fed expands money supply faster than the federal government sucks in liquidity via its deficit. However, inflation decelerates when the Fed expands the money supply slower than the public sector pulls in private funds. In other words, if the Fed eases monetary conditions enough to finance the deficit, then debt monetization occurs, the private sector is not crowded out and demand gets a massive boost. This point is crucial and feeds the stronger economic recovery compared with the one post-GFC. In 2009 and 2010, the private sector was deleveraging and commercial banks were retrenching their lending. Neither the demand for nor the supply of credit was ample. Therefore, the Fed’s rapid balance sheet expansion had a limited impact on broad money. Instead, it skewed the composition of M2 toward commercial bank excess reserves at the Fed and away from private-sector deposits. Broad money was not rising quickly enough to fully finance the government and real interest rates did not fall as far as they should have. The economy suffered. A virtuous cycle has emerged, one which creates more inflation risks than are priced in. Nowadays, broad money responds much better to the Fed’s intervention because the balance sheets of the nonfinancial private sector are much healthier than in 2008 and deleveraging is absent. This mitigates the tightening credit standards of commercial banks. As Chart I-12 illustrates, household net worth is more robust than it was 12 years ago, debt-servicing costs account for a much narrower slice of disposable income and the government’s aggressive actions have bolstered household finances. Moreover, the majority of job losses have been concentrated in low-income jobs, thus, above-average earners have kept their incomes. Under these conditions, households have taken advantage of record low mortgage rates to purchase real estate, which is contributing to growth in the residential sector (Chart I-13, top two panels). Meanwhile, the rapid rebound in businesses’ capex intentions (which even small firms exhibit) and in core capital goods orders indicates that animal spirits are much more vigorous than anyone expected this past spring (Chart I-13, bottom two panels). At that time, the dominant narrative posited that firms were tapping their credit lines to set aside cash. Chart I-12Robust Household Balance Sheets = No Liquidity Trap Robust Household Balance Sheets = No Liquidity Trap Robust Household Balance Sheets = No Liquidity Trap Chart I-13Housing And Capex Are In The Driver's Seat Housing And Capex Are In The Driver's Seat Housing And Capex Are In The Driver's Seat   Chart I-14Unlike In 2008/09, Real Rates Have Collapsed Unlike In 2008/09, Real Rates Have Collapsed Unlike In 2008/09, Real Rates Have Collapsed Thanks to these more favorable balance sheet dynamics, the Fed’s injection of liquidity is boosting M2 enough to finance the Treasury’s issuance. Hence, real interest rates are much lower than in 2009/10 even if the economy is recovering much more quickly (Chart I-14). Policymakers are not crowding out the private sector. A virtuous cycle has emerged, one which creates more inflation risks than are priced in. A counterargument is that technology is too deflationary for the above dynamics to matter. The reality is that technology is always a deflationary force. The expansion of the capital stock has always been about providing each worker with access to newer and better technology to boost productivity. The current low level of productivity gains suggests that the dominant discourse exaggerates the economic advances from new technologies. Thus, inflation stationarity and the interplay between monetary and fiscal policy still matters to CPI. Investors should monitor factors that would indicate if the upside risk to near-term inflation described above is morphing into reality. Doing so would seriously damage financial asset prices made vulnerable to higher inflation by prohibitive valuations. We propose tracking the following variables: The household savings rate. If savings normalize faster because consumer confidence firms, then spending will accelerate, profits will rise more quickly and money will expand further, all of which will bring back inflation sooner. A Blue Sweep in the US presidential election. If the Democrats take control of both the executive and legislative branches, then they will expand stimulating policies that will bolster demand. This, too, would boost profits and broad money supply, which would be inflationary. The velocity of money. An increase in money velocity, which remains depressed, would accentuate the impact of rapid money growth. It would also suggest that animal spirits are strengthening, which will further encourage economic transactions. A weak dollar. The dollar is set to weaken because of savings dynamics and the global recovery. A runaway decline in the USD would indicate that the interplay between monetary and fiscal policy is debasing money, unleashing an inflationary spiral.  Bottom Line: The probability that inflation returns quickly is much more meaningful than financial markets appreciate because of the interplay between money growth, fiscal deficits and robust private-sector balance sheets. This dissonance will create a substantial risk for asset prices next year. Investment Implications The most important implication of the analysis above is that investors should consider inflation protection in all asset classes. However, this protection is cheap to acquire because investors are focusing on deflation, not inflation. Chart I-15Inflation Protection Remains Cheap Inflation Protection Remains Cheap Inflation Protection Remains Cheap Bonds Our bond strategists recently moved to a below-benchmark duration in fixed-income portfolios in light of the economic recovery and the increasing probability of a Blue Wave on November 3, an argument highlighted in the Section II Special Report written by our colleagues Rob Robis and Ryan Swift. The Fed’s new average-inflation target, coupled with the global economic recovery, should put upward pressure on inflation breakeven rates, which are still well below 2.3%-2.5% normally associated with stable inflation near 2% (Chart I-15). The underestimated upward risk to inflation further favors climbing yields. Beyond lifting inflation breakeven rates, this risk would also raise inflation uncertainty, which warrants a greater term premium and a steeper yield curve (Chart I-16). Additionally, higher inflation would occur lockstep with declining savings. The recent surge in excess savings was a primary driver of the collapse in yields; its reversal would push up long-term interest rates (Chart I-17). Chart I-16Rising Inflation Uncertainty Will Steepen The Yield Curve Rising Inflation Uncertainty Will Steepen The Yield Curve Rising Inflation Uncertainty Will Steepen The Yield Curve Chart I-17Excess Savings Will Fall And Yields Will Rise Excess Savings Will Fall And Yields Will Rise Excess Savings Will Fall And Yields Will Rise   The Dollar The US dollar is the major currency most exposed to growing populism because of the extraordinary income inequalities observed in the US. Moreover, a generous combined monetary and fiscal policy setting in the US has eroded the dollar’s appeal as the country’s trade deficit widens (it normally narrows during a recession) in response to pronounced national dissaving (Chart I-18, left panel). Furthermore, US broad money growth stands far above that of other major economies (Chart I-18, right panel). Compared with other major central banks, the Fed is more guilty of financing the public-sector’s debt binge. Debt monetization creates a real risk to a stable USD. Chart I-18AFalling Savings And The Fed's Generosity Will Tank The Greenback November 2020 November 2020 Chart I-18BFalling Savings And The Fed’s Generosity Will Tank The Greenback November 2020 November 2020   The expanding global recovery creates an additional problem for the countercyclical dollar. China’s role is particularly important in this regard as the nation’s domestic economic activity will improve further in response to the lagged impact of a rapid climb in total social financing (Chart I-19, top panel). Sturdy Chinese demand results in climbing global industrial production, which will hurt the greenback. Likewise, China’s healthy recovery has lifted interest rate differentials in favor of the yuan (Chart I-19, bottom panel). A strong CNY flatters China’s purchasing power abroad and diminishes deflationary pressures around the world. This combination should stimulate the global manufacturing sector, which benefits foreign economies more than it does the US.  Investors should consider inflation protection in all asset classes. Equities BCA Research still prefers global equities to bonds on a cyclical basis. The early innings of a pickup in inflation would solidify this bias. Our Adjusted Equity Risk Premium, which accounts for the expected growth rate of earnings and the non-stationarity of the traditional ERP, shows a solid valuation cushion in favor of stocks (Chart I-20). Moreover, forward earnings for the S&P 500 have upside, judging by the gap between the Backlog of Orders and the Customer Inventories components of the ISM Manufacturing survey (Chart I-21). Chart I-19China's Robust Growth Hurts The Dollar China's Robust Growth Hurts The Dollar China's Robust Growth Hurts The Dollar Chart I-20The Adjusted ERP Still Favors Stocks The Adjusted ERP Still Favors Stocks The Adjusted ERP Still Favors Stocks   We also continue to overweight cyclical sectors over defensive ones. The existence of greater inflation risk than the market believes confirms this view. Cyclicals would outperform if investors priced in quicker inflation because they would also bid down the dollar and push up inflation breakeven rates (Chart I-22). These relationships exist because industrials and materials enjoy greater pricing power in an inflationary environment and financials would benefit from a steeper yield curve. An outperformance of deep cyclicals relative to defensive equities should result in an underperformance of US shares relative to the rest of the world. Chart I-21Earnings Revisions Have Upside Earnings Revisions Have Upside Earnings Revisions Have Upside Chart I-22Deep Cyclicals Will Like The Brand New World Deep Cyclicals Will Like The Brand New World Deep Cyclicals Will Like The Brand New World   The long-term outlook for real stock returns is poor, despite a positive six- to nine-month view. Higher inflation will force a greater upside in yields. However, the current extraordinary market multiples can only be justified if one believes that yields will stay depressed for many more years. Thus, inflation would likely prompt a de-rating of equities. Furthermore, our structural inflation view rests on the imposition of populist economic policies. A move backward in globalization and redistributionist policies would lift the share of wages in national income, which would compress extraordinarily wide profit margins (Chart I-23). Therefore, real long-term profits will probably suffer. Paradoxically, nominal stock prices may still eke out positive nominal gains, but that will be a consequence of the money illusion created by higher inflation. Chart I-23Populism Threatens Profit Margins Populism Threatens Profit Margins Populism Threatens Profit Margins BCA Research still prefers global equities to bonds on a cyclical basis. Investors should continue to overweight equities versus bonds, despite pronounced hurdles to long-term, real returns in stocks. Historically, periods of transition from low inflation to higher inflation have allowed stocks to outperform bonds, even if equities generate negative real returns (Table I-1). The exceptionally low real yields and thin inflation protection offered by government bonds increases the likelihood that history will be repeated. Table I-1Rising Inflation: Equities Beat Bonds November 2020 November 2020 A size bias may offer some protection against higher inflation both in the near and long term. We have been positive on small cap equities since September and our US Equity Strategy service upgraded the Russell 2000 to overweight this week.4 A bump in railroad freight volumes augurs well for the domestic economy to which small caps are very sensitive. Additionally, stronger railroad freight volumes also indicate net rating upgrades for junk bonds, which decreases the riskiness of a highly levered small cap sector (Chart I-24). Moreover, small cap stocks are positively linked to major trends produced by higher inflation, such as a weaker dollar and higher commodity prices (Chart I-25). Small firms also enjoy rising consumer confidence, a variable targeted by populist politicians (Chart I-26). Therefore, the potential for a re-rating of the Russell 2000 relative to the S&P 500 is elevated, especially if investors reassess the likelihood of higher inflation.  Chart I-24Small-Cap Stocks Are Set To Shine Small-Cap Stocks Are Set To Shine Small-Cap Stocks Are Set To Shine Chart I-25Small-Cap Will Enjoy Higher Inflation... Small-Cap Will Enjoy Higher Inflation... Small-Cap Will Enjoy Higher Inflation... Chart I-26...And Populists ...And Populists ...And Populists Commodities BCA Research remains positive on the prices of natural resources on a cyclical basis even if there is more risk of a near-term correction for this asset class. Commodities are highly sensitive to a global industrial cycle that offers significant upside and to China in particular. Moreover, commodities are high-beta plays on a weaker dollar and higher inflation expectations (Chart I-27). Natural resources will benefit from economic populism because it lifts demand for cyclical spending. Moreover, commodities are natural hedges against the risk of higher inflation. In this context, it makes sense to allocate more funds to resource stocks to protect an equity portfolio against inflation. Investors worried about the near-term outlook for commodities should rotate out of copper into crude. Copper has withstood the COVID-19 shock much better than Brent despite the strong cyclicality of both natural resources. Following this move, net speculative positions and sentiment measures for copper are toward the top of their ranges of the past 15 years. Meanwhile, the opposite is true for oil. Since 2005, increases in the Brent-to-copper ratio have followed declines to the current levels in the relative Composite Sentiment Indicator (Chart I-28), which includes sentiment and positioning measures for both commodities. Chart I-27Commodities Remain Efficient Inflation Hedges Commodities Remain Efficient Inflation Hedges Commodities Remain Efficient Inflation Hedges Chart I-28A Contrarian Tactical Trade: Buy Brent / Sell Copper A Contrarian Tactical Trade: Buy Brent / Sell Copper A Contrarian Tactical Trade: Buy Brent / Sell Copper   Fundamentals also point in that direction. After collapsing in recent months, global inventories of copper are beginning to climb relative to Brent. Moreover, oil production has dropped significantly relative to copper. Oil demand fell even more dramatically than that of copper, but the gap between production and demand growth is moving in favor of crude. Real long-term profits will probably suffer. This trade is agnostic to the direction of the business cycle. Copper prices embed a much more optimistic take toward global economic activity than Brent. Therefore, copper is more vulnerable to a negative economic upset than oil and less likely to benefit from a positive economic surprise. Mathieu Savary Vice President The Bank Credit Analyst October 29, 2020 Next Report: November 30, 2020   II. Beware The Bond-Bearish Blue Sweep US Election & Duration: We estimate that there is an 72% probability of a US election result that will give a lift to US Treasury yields via increased fiscal stimulus. Those are strong enough odds to justify a move to a below-benchmark cyclical US duration stance on a 6-12 month horizon. US Treasuries: We anticipate a moderate bear market in US Treasuries to unfold during the next 6-12 months. In addition to below-benchmark portfolio duration, investors should overweight TIPS versus nominal Treasuries, hold nominal and real yield curve steepeners, and hold inflation curve flatteners. Non-US Country Allocation: Within global government bond portfolios, downgrade the US to underweight. Favor countries that have lower sensitivity to rising US Treasury yields with central banks that are likely to be more dovish than the Fed in the next few years. That means increasing allocations to core Europe and Japan, while reducing exposure to Canada and Australia. Stay neutral on the UK given the near-term uncertainties over the final Brexit outcome. With the US presidential election just two weeks away, public opinion polls continue to show that Joe Biden is the favorite to win the White House. However, the odds of a “Blue Sweep” - combining a Biden victory with the Democratic Party winning control of both the US Senate and House of Representatives - have increased since the end of September according to online prediction markets. US Treasury yields have also moved higher over that same period (Chart II-1), which we interpret as the bond market becoming more sensitive to the likelihood of a major increase in US government spending under single-party Democratic control. Chart II-1A Blue Sweep Is Bond Bearish A Blue Sweep Is Bond Bearish A Blue Sweep Is Bond Bearish Table II-1A Comparison Of The Candidates' Budget Proposals November 2020 November 2020 According to a recent analysis done by the Committee for a Responsible Federal Budget, President Trump’s formal policy proposals would increase US federal debt by $4.95 trillion between 2021 and 2030, while Biden’s plan would increase the debt by $5.60 trillion (Table II-1).5 While those are both massive fiscal stimulus plans, there is a stark difference in the policy mix of their proposals that matters for the future path of US bond yields. Under Biden, spending is projected to increase by a cumulative $11.1 trillion, partially offset by $5.8 trillion in revenue increases and savings with the former vice-president calling for tax hikes on corporations and high-income earners. On the other hand, Trump’s plan includes $5.45 trillion of spending increases and tax cuts over the next decade, offset by $0.75 trillion in savings. Conclusion: Biden would increase spending by over twice that of a re-elected Trump, with much of that spending expected to be front-loaded in the early part of his first term. Outright spending is more reflationary than tax cuts because it puts more money in the pockets of consumers (spenders) relative to producers (savers). The Biden plan would be more stimulating for overall activity even if the increase in debt is about the same. Chart II-2The Biden Platform Is Highly Stimulative The Biden Platform Is Highly Stimulative The Biden Platform Is Highly Stimulative Another analysis of the Biden and Trump platforms was conducted by Moody’s in September, based on estimates of how much of each candidate’s promises could be successfully implemented under different combinations of White House and Congressional control.6 The stimulus figures were run through the Moody’s US economic model, which is similar to the budget scoring model of the US Congressional Budget Office, to produce a year-by-year path for the US economy over the next decade (Chart II-2). Moody’s concluded that the US economy would return to full employment in the second half of 2022 under a President Biden – especially if the Democrats win the Senate - compared to the first half of 2024 under a re-elected President Trump. Such a rapid closing of the deep US output gap that opened up because of the COVID-19 recession would likely trigger a reassessment of the Fed’s current highly dovish policy stance. At the moment, the US overnight index swap (OIS) curve discounts one full 25bp Fed hike by late 2023/early 2024, and two full hikes by late 2024/early 2025 (Chart II-3). This pricing of the future path of interest rates has occurred even with the Fed promising to keep the funds rate anchored near 0% until at least the end of 2023. The likelihood of some form of increased fiscal spending after the election will cause the bond market to challenge the Fed’s current forward guidance even more, putting upward pressure on Treasury yields. Chart II-3US Fiscal Stimulus Will Pull Forward Fed Liftoff US Fiscal Stimulus Will Pull Forward Fed Liftoff US Fiscal Stimulus Will Pull Forward Fed Liftoff Our colleagues at BCA Geopolitical Strategy see a Blue Sweep as the most likely outcome of the US election, although their forecasting models suggest that the race for control of the Senate will be much closer than the Biden vs Trump battle (there is little chance that control of the House of Representatives would switch back to the Republicans).7 Their scenarios for each of the White House/Senate combinations, along with their own estimated probability for each, are the following: Biden wins in a Democratic sweep: BCA probability = 27%. The US economy will benefit from higher odds of unfettered fiscal stimulus in 2021, although financial markets will simultaneously have to adjust for the negative shock to US corporate earnings from higher taxes and regulation. Government bond yields should rise on the generally reflationary agenda. Trump wins with a Republican Senate: BCA probability = 23%. In this status quo scenario, a re-elected President Trump would still face opposition from House Democrats on most domestic economic issues, forcing him to tilt towards more protectionist foreign and trade policies in his second term. Fiscal stimulus would be easy to agree, though not as large as under a Democratic sweep. US Treasury yields would rise, but would later prove volatile due to the risk to the cyclical recovery from a global trade war, as Trump’s tariffs will not be limited to China and could even affect the European Union. Biden wins with the Senate staying Republican: BCA probability = 28%. This is ultimately the most positive outcome for financial markets - reduced odds of a full-blown trade war with China, combined with no new tax hikes. Bond yields would drift upward over time, but not during the occasional fiscal battles that would ensue between the Democratic president and Republican senators. The first such battle would start right after the election. Treasuries would remain well bid until financial market pressures forced a Senate compromise with the new president sometime in H1 2021. Trump wins with a Democratic Senate: BCA probability = 22%. This is the least likely scenario but one that could produce a big positive fiscal impulse. Trump is a big spender and will veto tax hikes, but will approve populist spending on areas where he agrees. The Democratic Senate would not resist Trump’s tough stance on China, however, thus keeping the risk of US-China trade skirmishes elevated. This is neutral-to-bearish for US Treasuries, depending on the size of any bipartisan stimulus measures and Trump’s trade actions. The key takeaway is that the combined probability of scenarios that will put upward pressure on US Treasury yields is 72%, versus a 28% probability of a more bond-neutral outcome. That is a bond-bearish skew worth positioning for by reducing US duration exposure now, ahead of the November 3 election. Of this 72%, 45 percentage points come from scenarios in which President Trump would remain in power. Hence his trade wars would eventually undercut his reflationary fiscal policy. This would become the key risk to the short duration view after the initial market response. Bottom Line: The most likely scenarios for the US election will give a cyclical lift to US Treasury yields via increased fiscal stimulus. This justifies a move to a below-benchmark US duration stance on a 6-12 month horizon. If Trump is re-elected, the timing of Trump’s likely return to using broad-based tariffs will have to be monitored closely. A Moderate Bear Market While our anticipated Blue Sweep election outcome will lead to a large amount of fiscal spending in 2021 and beyond, we anticipate only a modest increase in bond yields during the next 6-12 months. In terms of strategy, our recommended reduction in portfolio duration reflects the fact that fiscal largesse meaningfully reduces the risk of another significant downleg in bond yields and strengthens our conviction in a moderate bear market scenario for bonds. This does raise the question of how large an increase in US Treasury yields we expect during the next 6-12 months. We turn to this question now. Chart II-4Less Election-Day Upside Than In 2016 Less Election-Day Upside Than In 2016 Less Election-Day Upside Than In 2016 Not Like 2016 First, we do not expect a massive election night bond rout like we saw in 2016 (Chart II-4). For one thing, the Fed was much more eager to tighten policy in 2016 than it is today, and it did deliver a rate hike one month after the Republicans won the House, Senate and White House (Chart II-4, bottom panel). This time around, the Fed has made it clear that it will wait until inflation is running above its 2% target before lifting rates off the zero bound and will not respond directly to expectations for greater fiscal stimulus. Second, 2016’s election result was mostly unanticipated. This led to a dramatic adjustment in market prices once the results came in. The PredictIt betting market odds of a “Red Sweep” by the Republicans in 2016 were only 16% the night before the election. As of today, the betting markets are priced for a 58% chance of a Blue Sweep in 2020. Unlike in 2016, bonds are presumably already partially priced for the most bond-bearish election outcome. A Slow Return To Equilibrium To more directly answer the question of how high bond yields can rise, survey estimates of the long-run (or equilibrium) federal funds rate provide a useful starting point. In a world where the economy is growing at an above-trend pace and inflation is expected to move towards the Fed’s target, it is logical for long-maturity Treasury yields to settle near estimates of the long-run fed funds rate. Indeed, this theory is borne out empirically. During the last two periods of robust global economic growth (2017/18 & 2013/14), the 5-year/5-year forward Treasury yield peaked around levels consistent with long-run fed funds rate estimates (Chart II-5). As of today, the median estimates of the long-run fed funds rate from the New York Fed’s Survey of Market Participants and Survey of Primary Dealers are 2% and 2.25%, respectively. In other words, a complete re-convergence to these equilibrium levels would impart 80 – 100 bps of upward pressure to the 5-year/5-year forward Treasury yield. We expect this re-convergence to play out eventually, but probably not within the next 6-12 months. In both prior periods when the 5-year/5-year forward Treasury yield reached these equilibrium levels, the Fed’s reaction function was much more hawkish. The Fed was hiking rates throughout 2017 & 2018 (Chart II-5, panel 4), and the market moved quickly to price in rate hikes in 2013 (Chart II-5, bottom panel). The Fed’s new dovish messaging will ensure that the market reacts less quickly this time around. Also, continued curve steepening will mean that the 5-year/5-year forward yield’s 80 – 100 bps of upside will translate into significantly less upside for the benchmark 10-year yield. The 10-year yield and 5-year/5-year forward yield peaked at similar levels in 2017/18 when the Fed was lifting rates and the yield curve was flat (Chart II-6). But, the 10-year peaked far below the 5-year/5-year yield in 2013/14 when the Fed stayed on hold and the curve steepened. Chart II-5How High For Treasury Yields? How High For Treasury Yields? How High For Treasury Yields? Chart II-6Less Upside In 10yr Than In 5y5y Less Upside In 10yr Than In 5y5y Less Upside In 10yr Than In 5y5y   The next bear move in bonds will look much more like 2013/14. The Fed will keep a firm grip over the front-end of the curve, leading to curve steepening and less upside in the 10-year Treasury yield than in the 5-year/5-year forward. In addition to shifting to a below-benchmark duration stance, investors should maintain exposure to nominal yield curve steepeners. Specifically, we recommend buying the 5-year note versus a duration-matched barbell consisting of the 2-year and 10-year notes (Chart II-6, bottom panel).8 TIPS Versus Nominals We have seen that a full re-convergence to “equilibrium” implies 80 – 100 bps of upside in the 5-year/5-year forward nominal Treasury yield. Bringing TIPS into the equation, we have also observed that long-maturity (5-year/5-year forward and 10-year) TIPS breakeven inflation rates tend to settle into a range of 2.3 – 2.5 percent when inflation is well-anchored and close to the Fed’s target (Chart II-7). The additional fiscal stimulus that will follow a Blue Sweep election makes it much more likely that the economic recovery will stay on course, leading to an eventual return of inflation to target and of long-maturity TIPS breakeven inflation rates to a 2.3 – 2.5 percent range. However, as with nominal yields, this re-convergence will be a long process whose pace will be dictated by the actual inflation data. To underscore that point, consider that our Adaptive Expectations Model of the 10-year TIPS breakeven inflation rate – a model that is driven by trends in the actual inflation data – has the 10-year breakeven rate as close to fair value (Chart II-8).9 This fair value will rise only slowly over time, alongside increases in actual inflation. Chart II-7Overweight TIPS Versus Nominals Overweight TIPS Versus Nominals Overweight TIPS Versus Nominals Chart II-8Real Yields Have Likely Bottomed Real Yields Have Likely Bottomed Real Yields Have Likely Bottomed   All in all, we continue to recommend an overweight allocation to TIPS versus nominal Treasuries. TIPS breakeven inflation rates will move higher during the next 6-12 months, but are unlikely to reach our 2.3 – 2.5 percent target range within that timeframe. TIPS In Absolute Terms As stated above, we expect nominal yields to increase more than real yields during the next 6-12 months, but what about the absolute direction of real (aka TIPS) yields? Here, our sense is that real yields have also bottomed. If we consider the extreme scenario where the 5-year/5-year forward nominal yield returns to its equilibrium level and where long-maturity TIPS breakeven inflation rates return to our target range, it implies about 80 bps of upside in the nominal yield and 40 bps of upside in the breakeven. This means that the 5-year/5-year real yield has about 40 bps of upside in a complete “return to equilibrium” scenario. While we don’t expect this “return to equilibrium” to be completed within the next 6-12 months, the process is probably underway. The only way for real yields to keep falling in this reflationary world is for the Fed to become increasingly dovish, even as growth improves and inflation rises. After its recent shift to an average inflation target, our best guess is that Fed rate guidance won’t get any more dovish from here. Real yields fell sharply this year as the market priced in this change in the Fed’s reaction function, but the late-August announcement of the Fed’s new framework will probably mark the bottom in real yields (Chart II-8, bottom panel).10 Chart II-9Own Inflation Curve Flatteners And Real Curve Steepeners Own Inflation Curve Flatteners And Real Curve Steepeners Own Inflation Curve Flatteners And Real Curve Steepeners Two More Curve Trades In addition to moving to below-benchmark duration, maintaining nominal yield curve steepeners and staying overweight TIPS versus nominal Treasuries, there are two additional trades that investors should consider in order to profit from the reflationary economic environment. The first is inflation curve flatteners. The cost of short-maturity inflation protection is below the cost of long-maturity inflation protection, meaning that it has further to run as inflation returns to the Fed’s target (Chart II-9). In addition, if the Fed eventually succeeds in achieving a temporary overshoot of its inflation target, then we should expect the inflation curve to invert. Real yield curve steepeners are in some ways the mirror image of inflation curve flatteners. Assuming no change in nominal yields, the real yield curve will steepen as the inflation curve flattens. But what makes real yield curve steepeners look even more attractive is that increases in nominal yields during the next 6-12 months will be concentrated in long-maturities. This will impart even more steepening pressure to the real yield curve. Investors should continue to hold inflation curve flatteners and real yield curve steepeners. Bottom Line: We anticipate a moderate bear market in US Treasuries to unfold during the next 6-12 months. In addition to below-benchmark portfolio duration, investors should overweight TIPS versus nominal Treasuries, hold nominal and real yield curve steepeners, and hold inflation curve flatteners. Non-US Government Bonds: Reduce Exposure To US Treasuries The mildly bearish case for US Treasuries that we have laid out above not only matters for our recommended duration stance, but also for our suggested country allocation within global government bond portfolios. Simply put, the risk of rising bond yields is much higher in the US than elsewhere, both for the immediate post-election period but also over the medium-term. Thus, the immediate obvious portfolio decision is to downgrade US Treasuries to underweight. The move higher in US Treasury yields that we expect is strictly related to spillovers from likely US fiscal stimulus. While other countries in the developed world are contemplating the need for additional fiscal measures, particularly in Europe where there is a renewed surge in coronavirus infections and growing economic restrictions, no country is facing as sharp a policy choice as the US with its upcoming election. We can say with a fair degree of certainty that the US will have a relatively more stimulative fiscal policy stance than other developed economies over at least the next couple of years. This implies a higher relative growth trajectory for the US that hurts Treasuries more on the margin than non-US government debt. In addition, the likely path of relative monetary policy responses are more bearish for US Treasuries. As described above, the scope of the US stimulus will cause bond investors to further question the Fed’s commitment to keeping the funds rate unchanged for the next few years. That also applies to the Fed’s other policy tools, like asset purchases. The Fed is far less likely to continue buying US Treasuries at the same aggressive pace it has for the past eight months if there is less need for monetary stimulus because of more fiscal stimulus. Chart II-10The Fed Will Gladly Trade Less QE For More Fiscal Stimulus November 2020 November 2020 According to the IMF, the Fed has purchased 57% of all US Treasuries issued since late February of this year, in sharp contrast to the ECB and Bank of Japan that have purchased over 70% of euro area government bonds and JGBs issued (Chart II-10). If US Treasury yields are rising because of improving US growth expectations, fueled by fiscal stimulus, the Fed will likely tolerate such a move and buy an even lower share of Treasuries issued – particularly if the higher bond yields do not cause a selloff in US equity markets that can tighten financial conditions and threaten the growth outlook. The fact that US equities have ignored the rise in Treasury yields seen since the end of September may be a sign that both bond and stock investors are starting to focus on a faster trajectory for US growth. In terms of country allocation, beyond downgrading US Treasuries to underweight, we recommend upgrading exposure to countries that are less sensitive to changes in US Treasury yields (i.e. countries with a lower yield beta to changes in US yields). In Chart II-11, we show the rolling beta of changes in 10-year government bond yields outside the US to changes in 10-year US Treasury yields. This is a variation of the “global yield beta” concept that we have discussed in the BCA Research bond publications in recent years. Here, we modify the idea to look at which countries are more or less correlated to US yields, specifically. A few points stand out from the chart: Chart II-11Reduce Exposure To Bond Markets More Correlated To UST Yields Reduce Exposure To Bond Markets More Correlated To UST Yields Reduce Exposure To Bond Markets More Correlated To UST Yields All countries have a “US yield beta” of less than 1, suggesting that Treasuries are a consistent outperformer when US yields fall and vice versa. This suggests moving to underweight the US when US yields are rising is typically a winning strategy in a portfolio context. The list of higher beta countries includes Canada, Australia, New Zealand, the UK and Germany; although Canada stands out as having the highest yield beta in this group. The list of lower beta countries includes France, Italy, Spain, and Japan. In Chart II-12, we show what we call the “upside yield beta” that is estimated only using data for periods when Treasury yields are rising. This gives a sense of which countries are more likely to outperform or underperform during a period of rising Treasury yields, as we expect to unfold after the election. From this perspective, the “safer” lower US upside yield beta group includes the UK, France, Germany and Japan. The riskier higher US upside yield beta group includes Canada, Australia, New Zealand, Italy and Spain. Chart II-12Favor Bond Markets Less Correlated to RISING UST Yields Favor Bond Markets Less Correlated to RISING UST Yields Favor Bond Markets Less Correlated to RISING UST Yields Spain and Italy are less likely to behave like typical high-beta countries as US yields rise, however, because the ECB is likely to remain an aggressive buyer of their government bonds as part of their asset purchase programs over the next 6-12 months. We also do not recommend trading UK Gilts off their yield beta to US Treasuries in the immediate future, given the uncertainties over the negotiations over a final Brexit deal. Both sets of US yield betas suggest higher-beta Canada, Australia and New Zealand are more at risk of relative underperformance versus lower-beta France, Germany and Japan. In terms of government bond country allocation, we recommend reducing exposure to the former group and increasing allocations to the latter group. Bottom Line: Within global government bond portfolios, downgrade the US to underweight. Favor countries that have lower sensitivity to rising US Treasury yields, especially those with central banks that are likely to be more dovish than the Fed in the next few years. That means increasing allocations to core Europe and Japan, while reducing exposure to “higher-beta” Canada and Australia.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Ryan Swift US Bond Strategist rswift@bcaresearch.com III. Indicators And Reference Charts The S&P 500 is experiencing its second correction in the past two months. The market looks even more fragile than it did in September. COVID-19 is heating up fast enough that lockdowns are re-emerging globally, the odds of an imminent fiscal deal have cratered to a near-zero chance, and investors are paying more attention to the growing risk of gridlock in Washington where a Biden Presidency and a Republican Senate majority would result in temporary fiscal paralysis. In this context, the decline in the momentum of the BCA Monetary Indicator, the elevated reading of our Speculation Indicator and the overvaluation of the stock market create the perfect cocktail for a dangerous few weeks. The longer we live in uncertainty regarding the elections’ result, the worse the market will fare. Short-term indicators confirm that equities are likely to remain under downward pressure in the coming weeks. Both the proportion of NYSE stocks above their 30-week and 10-week moving averages are still deteriorating after forming negative divergences with the S&P 500. They are also nowhere near levels consistent with a solid floor under the market. Moreover, our Intermediate Equity Indicator and the S&P 500 as a deviation from its 200-day moving average have rolled-over after reaching extremely overbought levels. Finally, both the poor performance of EM stocks as well as the underperformance of the Baltic Dry index and global chemical stocks relative to bond prices and the VIX indicate that cyclical assets could suffer from a wave of growth disappointment. Despite these short-term headwinds, the main pillar supporting the rally remains intact: global monetary conditions are highly accommodative. Moreover, the economic and financial risks created by the tepidity of fiscal support in recent months is self-limiting. As the economy progressively teeters toward a second leg of the recession, the pressure will rise for policymakers to spend generously once again to support their nations. Our cyclical indicators confirm the positive backdrop for stocks. Our Monetary Indicator remains at the top of its pre-COVID-19 distribution, which will put a natural floor under stocks, even if its recent deterioration is consistent with a market correction. Moreover, our Revealed Preference Indicator continues to flash a buy signal for stocks. Additionally, the BCA Composite Sentiment Indicator stands toward the middle of its historical distribution and the VIX has not hit the extremely compressed levels that normally precede major cyclical tops in the S&P 500. When weighing the short-term negative forces against the cyclical positives, we expect the S&P 500 to find a floor between 3000 and 3100. At this level, the froth highlighted by our Speculation Indicator will have dissipated.  The bond market’s dynamics are interesting. Despite the violent sell-off in equities, Treasury yields are not declining much. Bonds are too expensive and with short-term rates near their lower bound, Treasurys are losing their ability to hedge equity risk in portfolios. Moreover, the bond market seems to understand that any recession will encourage additional fiscal profligacy, which puts a floor under yields. These dynamics suggest that once equities stabilize, yields could start rising meaningfully. Finally, the dollar continues its sideways correction. However, as risk aversion rises and global growth deteriorates, the dollar is likely to catch further upside in the near term, especially as it has not fully worked out this summer’s oversold conditions. Moreover, the dollar is a momentum currency. Thus, once its start to turn around, its rally is likely to be more powerful than most expect, which will put additional downward pressures on commodity prices. Consequently, it is too early to start selling the USD again or to bottom fish natural resources. EQUITIES: Chart III-1US Equity Indicators US Equity Indicators US Equity Indicators Chart III-2Willingness To Pay For Risk Willingness To Pay For Risk Willingness To Pay For Risk Chart III-3US Equity Sentiment Indicators US Equity Sentiment Indicators US Equity Sentiment Indicators   Chart III-4Revealed Preference Indicator Revealed Preference Indicator Revealed Preference Indicator Chart III-5US Stock Market Valuation US Stock Market Valuation US Stock Market Valuation Chart III-6US Earnings US Earnings US Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance   FIXED INCOME: Chart III-9US Treasurys And Valuations US Treasurys And Valuations US Treasurys And Valuations Chart III-10Yield Curve Slopes Yield Curve Slopes Yield Curve Slopes Chart III-11Selected US Bond Yields Selected US Bond Yields Selected US Bond Yields Chart III-1210-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components Chart III-13US Corporate Bonds And Health Monitor US Corporate Bonds And Health Monitor US Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Global Bonds: Developed Markets Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets Global Bonds: Emerging Markets Global Bonds: Emerging Markets   CURRENCIES: Chart III-16US Dollar And PPP US Dollar And PPP US Dollar And PPP Chart III-17US Dollar And Indicator US Dollar And Indicator US Dollar And Indicator Chart III-18US Dollar Fundamentals US Dollar Fundamentals US Dollar Fundamentals Chart III-19Japanese Yen Technicals Japanese Yen Technicals Japanese Yen Technicals Chart III-20Euro Technicals Euro Technicals Euro Technicals Chart III-21Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart III-22Euro/Pound Technicals Euro/Pound Technicals Euro/Pound Technicals   COMMODITIES: Chart III-23Broad Commodity Indicators Broad Commodity Indicators Broad Commodity Indicators Chart III-24Commodity Prices Commodity Prices Commodity Prices Chart III-25Commodity Prices Commodity Prices Commodity Prices Chart III-26Commodity Sentiment Commodity Sentiment Commodity Sentiment Chart III-27Speculative Positioning Speculative Positioning Speculative Positioning   ECONOMY: Chart III-28US And Global Macro Backdrop US And Global Macro Backdrop US And Global Macro Backdrop Chart III-29US Macro Snapshot US Macro Snapshot US Macro Snapshot Chart III-30US Growth Outlook US Growth Outlook US Growth Outlook Chart III-31US Cyclical Spending US Cyclical Spending US Cyclical Spending Chart III-32US Labor Market US Labor Market US Labor Market Chart III-33US Consumption US Consumption US Consumption Chart III-34US Housing US Housing US Housing Chart III-35US Debt And Deleveraging US Debt And Deleveraging US Debt And Deleveraging   Chart III-36US Financial Conditions US Financial Conditions US Financial Conditions Chart III-37Global Economic Snapshot: Europe Global Economic Snapshot: Europe Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Global Economic Snapshot: China Global Economic Snapshot: China   Mathieu Savary Vice President The Bank Credit Analyst   Footnotes 1 Please see The Bank Credit Analyst Special Report "Labor Strikes Back," dated February 27, 2020, available at bca.bcaresearch.com 2 High odds of staying in the income decile of your parents. 3 Please see Geopolitical Strategy Webcast "Geopolitical Alpha In 2020-21," dated October 21, 2020. Marko also recently published a book "Geopolitical Alpha." 4 Please see US Equity Strategy Weekly Report "Vigilantes Gone Missing?" dated October 26, 2020, available at uses.bcaresearch.com 5 http://www.crfb.org/papers/cost-trump-and-biden-campaign-plans 6 https://www.moodysanalytics.com/-/media/article/2020/the-macroeconomic-consequences-trump-vs-biden.pdf 7 Please see BCA Research Geopolitical Strategy Special Report, “Introducing Our Quantitative US Senate Election Model”, dated October 16, 2020, available at gps.bcaresearch.com 8 For more details on this recommended steepener trade please see US Bond Strategy Weekly Report, “Positioning For Reflation And Avoiding Deflation”, dated August 11, 2020, available at usbs.bcaresearch.com 9 For more details on our Adaptive Expectations Model please see US Bond Strategy Weekly Report, “How Are Inflation Expectations Adapting?”, dated February 11, 2020, available at usbs.bcaresearch.com 10 For a detailed look at the implications of the Fed’s policy shift please see US Bond Strategy / Global Fixed Income Strategy Special Report, “A New Dawn For US Monetary Policy”, dated September 1, 2020, available at usbs.bcaresearch.com

Your feedback is important to us. Please take our client survey today. Highlights The dollar remains at risk of a countertrend bounce in the near term. The DXY could rise to 94-96 before working off oversold conditions. Nonetheless, the long-term outlook for the greenback remains bearish. The Scandinavian currencies are best positioned for outperformance over the next 12 months. Stay short USD/JPY as a core holding for now. Remain long silver relative to gold. Sterling volatility will remain elevated in the near term, but short EUR/GBP positions should provide handsome gains over the longer term. Feature The US election is just a week away. The market consensus is that a “blue wave” will usher in significant fiscal stimulus which will boost stock prices, buffet bond yields and drive down the dollar. The rationale behind these anticipated market moves is that the Democrats have been more aggressive in their demand for bigger government. Fiscal spending will widen the US twin deficits as aggregate demand rises. In anticipation of higher inflation, foreign bond investors are likely to continue fleeing the US market, driving down the dollar in the process. Fiscal spending will widen the US twin deficits as aggregate demand rises. We sympathize with this view, but it is unlikely to pan out smoothly. More specifically, a number of indicators suggest that the dollar is at risk of a countertrend bounce. This could lead to an air pocket for dollar-short positions in the near term. Our bet is that the DXY could rise to 94-96 before working off oversold conditions. The Case For A Countertrend Bounce A number of indicators suggest that conditions may be ripe for a countertrend bounce in the dollar. The velocity of money (V) is collapsing around the world (Chart I-1A and Chart I-1B). At a minimum, this suggests that realized inflation is bound to remain tame in the very near term. The dollar is a countercyclical currency, and tends to do well when global inflation is decelerating. In the case of the US, a temporary dip in inflation expectations will boost real rates, and encourage flows back into US fixed-income assets. In a general sense, V can be viewed as the interest rate required by the underlying economy (the neutral rate), since it is measured using economic variables. Once economic agents start to increase the turnover of money in the system as activity improves, it is an endogenous sign that the economy has escaped a liquidity trap and can handle higher rates. Chart I-1ADownside Risks To US Inflation Downside Risks To US Inflation Downside Risks To US Inflation Chart I-1BDownside Risks To Euro Area Inflation Downside Risks To Euro Area Inflation Downside Risks To Euro Area Inflation ​​​​The balance sheet impulse of the Federal Reserve could peak soon, relative to a few other countries (Chart I-2). This will especially be the case if other G10 countries step up the pace of their quantitative easing. This is already occurring in Canada and could soon happen in Australia. Remarkably, long-term US interest rates have started rising faster compared to its G10 peers. This was bound to happen as we stepped into a world of competitive devaluations. For most of the post-2008 period, the EUR/USD exchange rate oscillated with the relative balance sheet impulse between the Fed and the European Central Bank. The story in Japan was similar after the Fukushima crisis in 2011 and the subsequent adoption of Abenomics. In short, central bank QE becomes an important driver at the lower bound, since it is the key signaling mechanism on the future path of interest rates. Chart I-2The Dollar And Balance Sheet Impulse The Dollar And Balance Sheet Impulse The Dollar And Balance Sheet Impulse Currencies are about relative growth trends. Remarkably, relative growth tends to play a crucial role in currency dynamics even over the short term. For example, the upside growth surprise between the euro area and the US has started to reverse after a sharp V-shaped recovery (Chart I-3). Correspondingly, the euro has been consolidating its gains since August. On a broader scale, the OECD leading economic indicator for the US has picked up relative to its G10 peers (Chart I-4). Chart I-3EUR/USD And Relative Growth EUR/USD And Relative Growth EUR/USD And Relative Growth Chart I-4The Dollar And Relative Growth The Dollar And Relative Growth The Dollar And Relative Growth The exchange rate that best signals whether we are in a reflationary/deflationary environment is the AUD/JPY rate (Chart I-5). The AUD/JPY cross has consistently bottomed at the key support zone of 72-74. This defensive line notably held during the European debt crisis, China’s industrial recession, and the global trade war. This Maginot Line was clearly breached during the March drawdown, but we have since re-entered the safe zone. In recent trading sessions, however, AUD/JPY has been edging lower and could soon punch below the 74 level. Inflows into US equities are rising sharply (Chart I-6). Currencies tend to move in sync with the relative performance of their equity bourses. Correspondingly, non-US equity markets have relapsed relative to the US. Similarly, cyclical stocks have been underperforming defensive ones of late. The dollar tends to weaken when non-US equity markets, with a much higher concentration of cyclical stocks in their bourses, are outperforming. This is usually a clear sign that the marginal dollar is rotating outside of the US. Speculators are very short the dollar. Whenever the percentage of leveraged funds and overall speculators that are short the dollar is at or below 20%, a meaningful rally ensues (Chart I-7). Chart I-5AUD/JPY: Watch The 72-24 Zone AUD/JPY: Watch The 72-24 Zone AUD/JPY: Watch The 72-24 Zone Chart I-6Strong Inflows Into US Equities Strong Inflows Into US Equities Strong Inflows Into US Equities Chart I-7Many Dollar Bears Many Dollar Bears Many Dollar Bears In a nutshell, the market has been ignoring clear bullish signals for the dollar such as the drop in money velocity and the relapse of global interest rates relative to the US. Meanwhile, the consensus is overwhelmingly bearish on the dollar, which could make any bounce or advance go much further than most expect. The catalyst in the near term could be a market reset, given uncertainty around the US presidential elections, the resurgence in COVID-19 cases and Brexit. Meanwhile, unless animal spirits are rekindled by an invisible hand, perhaps in the form of a vaccine, then the outperformance of cyclical stocks, which is needed to boost the aggregate market index higher, is not a sure bet. Similarly, the outperformance of non-US stocks, specifically those in Europe and Japan, is also needed to confirm the dollar bear market remains intact. Positive Catalysts Chart I-8Lumber Versus Copper Lumber Versus Copper Lumber Versus Copper Despite our concerns of a near-term bounce in the dollar, there are still many signs that it will not be a durable one. Therefore, investors should use any dollar rally to establish fresh short positions. Lumber has started to underperform Dr. Copper. Lumber benefits greatly from a pickup in housing activity in the US and is very closely correlated to US domestic variables, while copper is strongly linked to Chinese and global industrial cycles. The dollar also tends to underperform higher-beta currencies when lumber is underperforming copper, as is the case now (Chart I-8). Similarly, the copper-to-gold ratio has bottomed and is heading higher from deeply oversold levels. Together with the stabilization in government bond yields, it signifies that the liquidity-to-growth transmission mechanism might be working. This is usually dollar bearish, as rising global growth leads to capital outflows from the US (Chart I-9). The gold/silver ratio (GSR) has rolled over following the recent bounce (Chart I-10). The GSR provides important information on the battleground between easing financial conditions and a pickup in economic (or manufacturing) activity. Gold benefits from plentiful liquidity and very low real rates, while silver benefits from rising industrial demand. Therefore, the GSR usually peaks as we exit a recession. The bond-to-gold ratio, as measured by the ratio of the US bond ETF (TLT)-to-gold ETF (GLD) remains below the key technical level of 0.90, which is bearish for the dollar (Chart I-11). The ratio measures the shift in confidence between the dollar and alternatives to the fiat reserve currency. The upside for the 10-year Treasury is much more capped than the upside is for gold, suggesting that this confidence measure will remain dollar bearish for the near future. Finally, currency volatility is high, suggesting that currency traders are no longer complacent. Usually, high volatility signals a more balanced and healthy market rotation. Over the last three episodes where volatility rose from these oversold levels, the dollar has benefitted (Chart I-12). Should volatility drop from current levels, especially in early 2021, pro-cyclical currencies will benefit. Chart I-9The Copper/Gold Ratio Leads The Dollar The Copper/Gold Ratio Leads The Dollar The Copper/Gold Ratio Leads The Dollar Chart I-10The Gold/Silver Ratio Has Relapsed The Gold/Silver Ratio Has Relapsed The Gold/Silver Ratio Has Relapsed Chart I-11Watch The Bond-To-Gold Ratio Watch The Bond-To-Gold Ratio Watch The Bond-To-Gold Ratio Chart I-12Currency Volatility Is Rolling Over Currency Volatility Is Rolling Over Currency Volatility Is Rolling Over In summary, many cyclical drivers still point to a lower ultimate resting spot for the dollar. Nonetheless, the character of any equity shakeout over the coming weeks will be worth monitoring. If cyclical and value stocks that are already at historically bombed-out levels start to outperform, it will signal an equity market leadership change – something that is required for the dollar bear market to resume. Investment Implications Chart I-13Sell EUR/GBP Sell EUR/GBP Sell EUR/GBP Chart I-14Place Stops On Short GSR At 80 Place Stops On Short GSR At 80 Place Stops On Short GSR At 80 The investment implications are straightforward. Maintain a basket of the cheapest currencies, together with some safe-havens. Also, focus on trades at the crosses. Specifically: Stay long the Japanese yen, which sports an attractive real rate relative to the US. Focus on relative value at the crosses rather than outright dollar bets. We are short the NZD/CAD and EUR/GBP as a play on relative fundamentals. We also went short CAD/NOK a fortnight ago. EUR/GBP is at risk of a significant selloff if we get a Brexit deal (Chart I-13). We already have limit orders on a few currencies, including a Nordic currency basket, AUD/NZD and EUR/CHF. We are long petrocurrencies versus the euro, and will use any tactical bounce in the dollar to shift to USD shorts. Remain short gold/long silver with a target of 50, but tighten the stop loss to 80 (Chart I-14).   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com 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 in the US have been positive: The preliminary Michigan consumer sentiment index climbed up from 80.4 to 81.2 in October. Retail sales increased by 1.9% month-on-month in September. This was a significant beat, relative to expectations of a 0.8% rise. Housing starts increased by 1.9% month-on-month in September. Building permits also increased by 5.2% month-on-month, overtaking pre-pandemic levels. Initial jobless claims increased by 787K for the week ending on October 16th. Claims have consistently come under 1000K since August 28. The DXY index fell by 0.8% this week. It remains evident from incoming data that the US economy is holding up well, relative to its trading partners. Bond yields have also moved in favor of the US dollar. While this could catalyze a countertrend bounce in the DXY, our bias is that it is not likely to be a durable one.   Report Links: Does The US Save Too Much Or Too Little? - October 16, 2020 Tail Risks In FX Markets - October 2, 2020 The Message From Dollar Sentiment And Technical Indicators - Sept. 25, 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 in the euro area have been positive: The seasonally adjusted trade surplus increased from €19.3 billion to €21.9 billion in August. This lifted the current account balance from €16.95 billion to €19.94 billion. Both headline and core inflation remained unchanged at -0.3% and 0.2% year-on-year, respectively, in September. Consumer confidence has been rolling over, but much better than you would expect given the resurgence in COVID-19 cases in Europe. The euro increased by 0.7% against the US dollar this week. The critical barometer for the euro outlook is the economic impact from the second wave of the pandemic. During an interview this week, ECB president Christine Lagarde said that the recovery could be “running out of steam.” Economic surprise indices in Europe are also rolling over, relative to the US. This sets the euro up for some indigestion before the bull market resumes. 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 from Japan have been mixed: The adjusted trade surplus significantly widened from ¥248 billion to ¥675 billion in September. Exports fell by 4.9% year-on-year in September, up from a 14.8% decrease the previous month. Imports continued to fall by 17.2% year-on-year. The Japanese yen appreciated by 0.7% against the US dollar this week. Sluggish imports reflect weakness in Japanese domestic demand, which is putting upward pressure on real rates. Meanwhile, Suga-san’s push to continue pressuring telecoms to drop prices does not bode well for the BoJ’s inflation target. As such, the yen remains a very attractive currency when real rates are compared across the G10. 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 in the UK have been robust: Rightmove house prices surged by 5.5% year-on-year in October. Headline inflation increased from 0.2% to 0.5% year-on-year in September. Core inflation also ticked up from 0.9% to 1.3% year-on-year. CBI trends continue to improve in terms of both orders, selling prices and business optimism. The British pound increased by 0.7% against the US dollar this week. Sterling action will continue to be dictated by the evolution of Brexit. The UK public sector has no choice but to step in as a spender of last resort amid the twin economic and health crises. In fact, net borrowing surged to £35 billion from £29 billion in September, which was more elevated than expected. Rising public debt has pushed Moody’s to downgrade the UK’s sovereign credit rating, warning that Britain “effectively has no fiscal anchor.” That said, positive action on the pound this week reflects the market’s laser focus on the terms of the UK’s withdrawal from the EU, and nothing else. 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 soft: The Westpac Leading Index declined from 0.49 to 0.22 in September.  Retail sales declined by 1.5% month-on-month in September. The Australian dollar appreciated by 0.4% against the US dollar this week. The RBA meeting minutes released this week implied further easing from the central bank, which might include further rate cuts and some expansion in its QE program. Interestingly, softness in the AUD, particularly against the NZD is setting the stage for a nice entry point. AUD/NZD slipped by 0.7% on the dovish RBA minutes. Over the longer-term, our fundamentally bullish bias on the AUD is based on strong relative terms of trade, and a currency that remains undervalued. 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 There has been scant data from New Zealand this week: NZIER business confidence fell by 40% quarter-on-quarter in Q3. Credit card spending fell by 9.9% year-on-year in September, but is a marked improvement from the 48.6% drop earlier this year. The New Zealand dollar surged by 1% against the US dollar this week. Prime minister Jacina Ardern’s election sweep over the weekend has boosted confidence on a more fluid government in New Zealand. That said, our updated PPP models shows that the New Zealand dollar is currently close to its fair value, while other major DM currencies, with the exception of the US dollar, are significantly undervalued. While NZD could rise against the US dollar in the near term, it should underperform at the crosses. We are short on NZD/CAD in our portfolio and it’s 2.5% in the money. 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: Headline inflation jumped from 0.1% to 0.5% year-on-year in September. Most measures of core inflation have held steady, but still came in below the midpoint of the BoC’s 1-3% band. The core median CPI came in at 1.9%, similar to last month, in line with expectations. Retail sales continued to increase by 0.4% month-on-month in September, but came in below the expected 1.1% rise. Teranet/National Bank House Prices increased by 6.7% year-on-year in September. The Canadian dollar appreciated by 0.3% against the US dollar this week. The most important release for Canada this week was the Business Outlook Survey, which showed a notable improvement in Quebec, Alberta, and the other Prairies. The pickup in September’s inflation figures also lowered the possibility of further rate cuts when the BoC meets next week. We remain positive on the CAD, expecting it to touch 82 cents versus the dollar over a cyclical horizon. 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: Exports increased from CHF 16.7 billion to CHF 18.7 billion in September and imports increased from CHF 13 billion to CHF 15.4 billion. As such, the trade surplus slightly narrowed from CHF 3.5 billion to CHF 3.3 billion. The Swiss franc increased by 0.2% against the US dollar this week. Since the March 19 lows, the franc has appreciated by nearly 10% against the US dollar. The unwanted strength in the Swiss franc has been a headache for the SNB. We believe the intervention from the SNB will limit how far the franc can rise, compared to other G10 currencies. 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 Recent data from Norway have been negative: The unemployment rate rose from 5.2% to 5.3% in August. The participation rate dropped by 0.4% to 70.9% in Q3 compared with the same quarter last year. On a positive note, industrial confidence continues to rebound. The Norwegian krone soared by 1.2% against the US dollar this week. As we frequently highlight in our publications, the Norwegian krone is poised to benefit most from a weaker USD. Moreover, our PPP model shows that at 30% below its fair value, the krone is still the most undervalued DM currency. 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 There has been no significant data release from Sweden this week. The Swedish krona fell by 0.6% against the US dollar this week. Reuters polls now suggest that the Swedish economy is expected to shrink by only 4% in 2020, rather than by 5% as was previously forecast. The Swedish krona is one of the cheapest currencies in the G10 and will benefit from a post-pandemic recovery. 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