Economy

Dear client, Next Monday, October 19, we will be hosting our quarterly webcast, “From Alpha To Omega With Anastasios”, at 10am EST; Matt Gertken, BCA’s Geopolitical Strategist will be our guest on the eve of the US Presidential Election. Our regular weekly publication will resume on Monday October 26, 2020. Kind Regards, Anastasios Highlights Portfolio Strategy Homebuilders are more than fully priced, discounting high margins as far as the eye can see and no end to demand. The specter of higher interest rates, lumber inflation, stealing demand from the future, unfriendly bankers and uncertainty with regard to a fresh stimulus package more than offset the positives, and compel us to issue a downgrade alert for the S&P homebuilding index. While the price of credit, loan growth prospects and credit quality all weigh on relative bank performance. A fiscal stimulus bill, depressed valuations and a Fed induced resumption of dividend hikes and share buybacks keep us on the sidelines in the S&P banks index.  Recent Changes There are no changes to our portfolio this week. Table 1 Feature Equities seesawed last week as President Trump returned to the White House (WH) and injected fresh volatility in markets signaling that there will be no fiscal deal prior to the elections. The SPX immediately gapped down and we cannot stress enough the importance of our newly configured Fiscal Policy Loop: fiscal hawkishness causes skittishness in markets culminating to a classic BCA riot point and then policymakers relent and fiscal dovishness restores the equity bull market (Figure 1). While we cannot rule out a slimmed-down stimulus package deal by later this month, fiscal policy- and election-related uncertainties remain elevated. The daily back-and-forth on where Congress and the WH stand with passing a new stimulus bill coupled with the prospects of a contested election that would drag on the presidential race likely into December, have caused investor fatigue. The sooner both of these uncertainties recede, the quicker the SPX will climb to fresh all-time highs (Chart 1). Figure 1The Fiscal Policy Loop Chart 1Receding Uncertainty Will Boost Stocks   We have shown in recent research, and update today, that the fourth year of presidential cycles finds the SPX ending the year on average in the green with a calendar return in the high single digits (Chart 2). Peering back in 2016 is instructive as that presidential election cycle year was in some ways similar to the current one. The economy, in particular, was fighting off a manufacturing recession that spread and infected the services sectors as the vast majority of S&P GICS1 sectors saw profit contraction and more importantly revenue declines. Chart 3 shows a number of asset classes and compares 2016 with 2020. The 10-year US Treasury yield appears poised to rebound significantly, especially if Congress passes a fresh fiscal package that aides the parts of the economy that need the stimulus checks most. Fiscal easing uncertainty remains a thorny issue across different markets and if history is an accurate guide, the SPX could glide lower into the November election before rallying into year-end. Chart 2Back Up Near The Average Profile Meanwhile, a number of investors we talk to also experience COVID-19 fatigue (Chart 4). For the better part of the last 10 months media has constantly bombarded the world with pandemic news, and rightly so. However, all this seems dystopian by now, and we cannot wait for a semblance of normality to make a comeback, which a vaccine will definitively bring about. The equity market has been indurated to this news-flow and has shaken-off the recession. When the vaccine does arrive likely next year, profits will also return back to trend, as we have been arguing for some time, because the global economy will fully reopen. Chart 32016 Versus 2020 Already, if we juxtapose leading soft economic data surprises with lagging hard economic data surprises, it is clear that a stellar profit recovery looms (second panel, Chart 5). Similarly, within soft the data universe, the ISM new orders-to-inventories ratio paints a rosy picture for an earnings recovery in 2021 (third panel, Chart 5). Even within hard economic data, a simple liquidity indicator we have used in the past comparing industrial production (IP) with M2 money stock signals that S&P profits have troughed (IP vs. M2 shown advanced, bottom panel, Chart 5) Chart 4COVID Fatigue Finally, the US Equity Strategy’s four-factor macro profit growth model has slingshot higher recently and signals that a return to $162 level of EPS in calendar 2021 is a high probability outcome (Chart 6). Netting it all out, we are in the tail end of the equity market correction and as election and fiscal policy uncertainties ebb, they will pave the way for a robust SPX rally. Chart 5Profit Recovery On Track   Chart 6EPS Model Concurs This week, we continue with our strategy of preferring beaten-down cyclicals to defensives and steer the portfolio away from another safe haven staples industry via downgrading a consumer goods subgroup to underweight. We also delve deeper into the banking industry highlighting some cracks in small commercial banks. Put Homebuilders On Downgrade Alert Homebuilders have had a monster run since the depths of the recession back in March and the question a lot of our clients are now asking is: does it make sense to chase them higher at the current juncture? The short answer is no. Before we get into the details of our analysis a brief recap of our recent residential real estate-related moves is in order. Going into the March carnage we were cyclically underweight the niche homebuilding index. Moreover, last December we had identified homebuilders as a high-conviction underweight in our annual Key Views report. We monetized relative gains of 41% and 43%, respectively from both positions and lifted exposure to a benchmark allocation. While in retrospect we should have upgraded all the way to overweight, we did manage to participate in the V-shaped housing-related returns by opting to go overweight the mega cap home improvement retail index instead. In addition, this summer we eked out another 10% return from a long homebuilders/short REITs pair trade. Homebuilders are enjoying the single family home renaissance as the pandemic has turbo-charged the work from home movement and employees are rushing to move into comfortable spaces in the suburbs as the traditional office is literally declared dead. Indeed, housing starts and permits have renormalized, the drubbing in interest rates has boosted affordability and caused a knee jerk reaction in the mortgage application purchase index, and sell-side analysts are fighting hand-over-fist to upgrade profit projections for the homebuilding group (Chart 7). The end result has been a boom in new home sales that are trouncing existing home sales, and the NAHB’s survey of prospective homebuyers continues to paint a rosy picture for additional demand for new single family homes especially given the low inventory of homes (top & third panels, Chart 8). Chart 7Housing Tailwinds Chart 8Price Concessions Generate Volume This is where all the good news ends. With respect to selling prices, homebuilders are making price concessions compared with existing homes and also in absolute terms new home prices are deflating (second & bottom panels, Chart 8). Therefore, at close to 15%, homebuilding profit margins are near all-time highs and under threat especially from a firming industry wage bill (second & third panels, Chart 9). Tack on surging lumber inflation and a profit margin squeeze is a high probability outcome (bottom panel, Chart 9). As a reminder framing lumber, on average, comprises 15% of a new single family home’s total input costs. While the NAHB survey points to brisk demand for new homes, the sister Conference Board survey shows that consumers’ appetite for a new home has crested (second & third panels, Chart 10). With consumers rushing to move to the suburbs due to the pandemic, there is an element of bringing housing demand forward. Chart 9Beware Margin Squeeze Chart 10Good News Fully Priced Worrisomely, if the economy continues to open up then interest rates should continue to back up. From all the major asset classes the 10-year Treasury yield is the one that has yet to discount a V-shaped economic recovery. The implication is that rising interest rate would dent affordability and at the margin weigh on housing demand (10-year Treasury yield shown inverted, top panel, Chart 10). Moving on to the credit backdrop, while demand for residential real estate loans has recovered, bankers refuse to extend mortgage credit (second & third panels, Chart 11). According to the latest Fed H8 weekly credit release, residential real estate loans are on the verge of contraction (bottom panel, Chart 11). Finally, the tug-of-war on the fiscal package front is also threatening to sustain the unemployment rate near double digits, which could jeopardize the housing recovery. Historically, housing starts have been near perfectly inversely correlated with the unemployment rate and the current message is for a leveling off in residential construction activity (middle panel, Chart 12). The recent homebuilding run has pushed relative valuations from undervalued to overvalued. The relative P/S ratio trades roughly 30% above the historical mean (a three-year high), and leaves no cushion for any mishaps (bottom panel, Chart 12). Chart 11Bankers Refusing To Dole Out Loans Chart 12In Desperate Need Of Fiscal Help Netting it all out, homebuilders are more than fully priced, discounting high margins as far as the eye can see and no end to demand. The specter of higher interest rates, lumber inflation, stealing demand from the future, unfriendly bankers and uncertainty with regard to a fresh stimulus package more than offset the positives, and compel us to issue a downgrade alert for the S&P homebuilding index. Bottom Line: Stay neutral the S&P homebuilders index, but it is now on our downgrade watch list. The ticker symbols for the stocks in this index are: BLBG: S5HOME – LEN, PHM, DHI, NVR. A Few Words On Banks Pundits around the globe focus on Eurozone and pan-European banks and argue that these outfits have been value destroyers since the history of the data series in late-1986 (bottom panel, Chart 13). Similarly, US banks relative share prices peaked in the mid-1970s and have never looked back, and very recently have tumbled to fresh all-time lows whether one uses monthly, weekly or daily data (top panel, Chart 13). Meanwhile, the recent drubbing in relative share prices suggests that loan loss provisioning is not over. In fact, Q3 loan loss reserves will surpass the level hit in the GFC, and likely close in on the $300bn mark (provisions shown inverted, Chart 14). Chart 13Banks, The World Over, Are Value Destroyers Chart 14More Loan Losses Loom… Historically, loan loss provisions are the mirror image of bank net operating income and most importantly bank profits decline as provisioning increases (Chart 15). Worrisomely, the longer the new stimulus checks take to arrive, the longer it will take banks to rebound. Banks have been semi-sheltered from the recession courtesy of eviction/foreclosure moratorium as well as mortgage forbearance agreements. Absent a fresh stimulus package, the unemployment rate will remain elevated, warning that lagging non-performing loans will skyrocket (bottom panel, Chart 16). Chart 15…Which Will Weigh On Profits Chart 16Fiscal Policy Easing To The Rescue? Tack on the year-to-date more than halving in the 10-year US Treasury yield and the earnings outlook remains grim for banks (top & middle panels, Chart 17). The transmission mechanism is through net interest margins (NIMs). The fourth panel of Chart 17 highlights that the pair have been joined at the hip and all-time lows in the 10-year US Treasury yield have sank bank NIMs below 3%, which is another all-time low since the history of the FDIC data. Credit growth has crested and our loans and leases model suggests that loan growth will continue to decelerate into 2021 (second panel, Chart 17). Not only is there lack of appetite for new overall loan uptake, but bankers are stringent with extending credit to businesses and consumer alike, according to the most recent Fed Senior Loan Officer survey (Chart 18). Chart 17Credit Growth Blues Chart 18Lack Of Loan Demand And Tightening Credit Supply However, there are three significant offsets to all these stiff headwinds that prevent us from downgrading banks to an underweight stance. First, the 10-year US Treasury yield is one of the few assets that has yet to discount any economic recovery. Thus, as uncertainty lifts post the November election, the economy continues to open up and Congress and the new President manage to pass a fresh fiscal stimulus bill, all this could catalyze a catch up phase in the long bond yield. Second, valuations offer a deep enough discount to absorb a little bit of more negative news as analysts and investors alike have thrown in the towel in banks (bottom panel, Chart 19). Finally, the credible Fed’s stress test loom by year-end and assuming banks pass them with flying colors a resumption of shareholder friendly activities will boost the allure of owing banks and unwind extremely oversold conditions (middle panel, Chart 19). In sum, while the price of credit, loan growth prospects and credit quality all weigh on relative bank performance. A fiscal stimulus bill, depressed valuations and a Fed induced resumption of dividend hikes and share buybacks keep us on the sidelines in the S&P banks index. Chart 19Unloved And Under-owned Bottom Line: Stay neutral the S&P banks index, but keep it on the downgrade watch list. The ticker symbols for the stocks in this index are: BLBG: S5BANKX – JPM, BAC, C, WFC, USB, TFC, PNC, FRC, FITB, MTB, KEY, SIVB, RF, CFG, HBAN, ZION, CMA, PBCT.   Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com Current Recommendations Current Trades Strategic (10-Year) Trade Recommendations Size And Style Views July 27, 2020 Overweight cyclicals over defensives April 28, 2020  Stay neutral large over small caps June 11, 2018 Long the BCA Millennial basket  The ticker symbols are: (AAPL, AMZN, UBER, HD, LEN, MSFT, NFLX, SPOT, TSLA, V). January 22, 2018 Favor value over growth

Highlights Hopes for another round of fiscal stimulus before the election were apparently torpedoed last week, … : The White House’s 180-degree turn to abandon stimulus talks may initially have been meant as a negotiating ploy, but it pushed House leadership to dig in, and a major stimulus agreement ahead of the election appears to be slipping out of reach. … but stocks rose anyway, … : Financial markets seem to have decided that a failure to reach agreement on a stopgap stimulus measure now increases the chances for a no-holds-barred package after the new year. … and they just may be getting it right: There are some indications that households have stored up enough nuts to make it through a fourth quarter with nothing more than automatic fiscal stabilizers. If they can get by until a torrent of new stimulus is released in February, equities may well be the place to be. We Need More Stimulus … We have been talking about fiscal stimulus ever since the pandemic arrived on US shores. It and monetary accommodation are the economic tools policymakers have to combat the virus and fiscal stimulus has loomed increasingly larger given that the Fed has done nearly all it can. Our constructive view on risk assets and the economy stems from our conviction that fiscal policymakers have the power to bridge the pandemic’s economic gap and will eventually summon the will to exercise it. We have not previously delved into why the stimulus is needed, however, so we highlight the primary reasons now. Labor market hysteresis: The longer an individual is out of the work force, the greater the probability that his/her skills will erode to the point that s/he may become unemployable. If enough workers suffer this fate, America’s labor pool will be appreciably diminished. Since long-run economic growth is simply the sum of the growth of the working-age population and growth in productivity, a shrunken labor force will crimp potential economic growth. Slower economic growth would lead to weaker earnings growth and more difficulty servicing private- and public-sector debt, signaling trouble for risk assets and Treasuries. Although the unemployment rate retreated very quickly from the postwar high it established in April (Chart 1, top panel), the ranks of the long-term unemployed, defined as workers out of work for at least 27 weeks, are poised to swell. The share of the unemployed who have been out of work for at least 15 weeks is extremely high relative to its postwar history, just shy of early 2010’s 60% record (Chart 1, bottom panel). Once layoffs recede, the mass of long-term unemployed workers will eventually be whittled down, but the process did not begin for a full year after initial jobless claims peaked after the great recession (Chart 2). With claims’ four-week moving average having stalled well above its GFC peak and fresh layoff announcements from businesses in the virus’ crosshairs like Disney, Regal Cinemas and several airlines, the pipeline of the newly unemployed will remain full without additional aid. Chart 1The Unemployment Rate Is Falling, But Its Average Duration Is Rising Chart 2It Takes A While For Claims To Recede ... State and local governments, which account for over 13% of nonfarm payrolls, are also poised to swell the ranks of the unemployed. Hamstrung by balanced-budget laws, many public entities have no choice but to reduce headcount in the face of plummeting tax revenues. The difficulty of calibrating seasonal adjustment factors with this year’s shuffled school calendar may have distorted summer payroll data, but the empirical record suggests that state and local government payrolls do not bottom until well after recessions end (Chart 3). Without generous infusions of federal aid, state and local government layoffs are likely to be a lingering drag. Chart 3... And State And Local Governments Keep Shedding Workers Until They Come Way Down Self-reinforcing bankruptcies: Diminished potential long-run growth would be a drag for investors, but the most acute near-term concern is a wave of bankruptcies. In the absence of CARES Act provisions that expanded eligibility for unemployment insurance (UI) benefits, extended the period over which laid-off workers could collect UI benefits and granted the $600 weekly federal UI benefit supplement, along with various measures encouraging banks and forcing mortgage servicers to establish lender forbearance programs, consumer credit performance would have been significantly worse. Despite the pandemic shock, TransUnion reports that delinquencies across all consumer loan categories, ex-autos, have been steadily falling since March, and only auto loan delinquencies were higher (by a mere 7 basis points) in August 2020 than they were in August 2019. Bankruptcies beget bankruptcies. If policymakers can keep some creditworthy borrowers in viable industries out of the path of the falling dominoes, the economy will bounce back faster once the virus is contained.  If consumer delinquencies (Chart 4) were to rise anything close to the level implied by the unemployment rate, the effects would reverberate across the banking system and the credit markets. Reported delinquencies have been held down by forbearance measures, which have had the cosmetic effect of removing many of the most vulnerable loans from the delinquency ratios, but through the second quarter the biggest banks uniformly reported that most borrowers enrolled in their forbearance programs were making at least some payments on their loans and that a far greater share than they had expected were exiting the programs without requesting extensions. We will hear later this week if that surprisingly benevolent trend held across the third quarter, most of which unfolded after the expiration of key CARES Act provisions, but management comments in public appearances last month suggest that it did. Without another round of federal aid, state and local government layoffs will continue. Chart 4The CARES Act Worked Rising delinquencies and widening bond spreads typically sap banks’ and bond investors’ ardor for making new loans, establishing a vicious circle in which weak credit performance leads to reduced credit availability and more onerous terms. Banks have tightened lending standards on cue (Chart 5), but ultra-accommodative monetary policy and unprecedentedly generous fiscal policy have blunted tighter bank standards’ impact. The former made bond investors forget their fears, paving the way for a bonanza of investment grade and high yield issuance (Chart 6), while households’ transfer windfall supported consumer credit performance and made it possible for consumers to pay down a good chunk of their outstanding credit card balances (Chart 7). In 2020's hall of mirrors, household income rises, and personal loan delinquencies decline, despite a vicious recession. Chart 5Banks Tightened Lending Standards, ... Chart 6... But The Bond Market Welcomed Large Corporate Borrowers With Open Arms The result is that emergency policy measures have so far staved off defaults and bankruptcies by viable creditworthy borrowers but reduced credit availability could undo those victories going forward.     Chart 7Consumer Loan Balances Typically Rise At The Onset Of A Recession … But Do We Need It Right Away? Though they differ on their proposals for the ideal size and composition of a new package, mainstream economists unanimously support an additional round of stimulus. A stickier question we’ve been mulling over is when that package is needed. According to former Obama Council of Economic Advisers chairman Jason Furman, “The answer is, two months ago.”1 Furman’s formidable public policy credentials notwithstanding, financial markets do not share his sense of urgency. Given that the National Multifamily Housing Council’s Rent Tracker showed that residential rent collections haven’t missed a beat since CARES Act provisions expired in late July, markets may be on to something. September collections were a tick better than August’s and were within a percentage point of year-ago collections, while October is off to a better start than all of the last three months and has matched last year’s pace (Table 1). The rent collection data provide a real-world example of the ongoing impact of generous fiscal transfers. Despite the expiration of the federal UI supplement in July, August personal income exceeded February’s pre-pandemic level. Table 1Apartment Tenants Are Paying Their Rent Even without that key pillar of the CARES Act, households were able to add another $100 billion of savings to the $1 trillion cache they amassed from March to July over and above the savings they would otherwise have accumulated if income had grown in line with nominal trend GDP growth and the savings rate had remained constant at its pre-pandemic level. Some vulnerable households will surely suffer, but it looks to us like the aggregate savings stash may be able to see the economy through the rest of the year from a consumption perspective (Table 2). That would suggest that the salubrious effect on household wealth from consumer belt tightening and CARES Act transfers may give policymakers some extra leeway to cobble together the next round. Table 2Savings Might Be Able To Plug The Stimulus Gap Markets apparently reached that conclusion themselves, as they now seem to be rooting for the Democrats to take both the Senate and the White House. That outcome would likely postpone the next round of fiscal stimulus until February but would ultimately result in much more aid. The way that stocks swiftly shrugged off their initial disappointment over the termination of the latest stimulus talks suggests that they’re happy to forego a band-aid now for more significant assistance later. The situation is fluid, and Republicans may come around to providing immediate aid that would boost their electoral prospects, but we think markets could survive a fourth quarter without new fiscal stimulus, especially when it would increase the prospects of installing a Congress that shares the Fed's determination to err on the side of doing too much. Delayed Gratification In a now famous experiment, early childhood researchers at Stanford University seated a series of nursery school children at a table with a marshmallow, telling each child s/he could eat it, but if s/he held off until the researcher returned to the room (after an interval of several minutes), s/he would get a second marshmallow. The study’s subsequent conclusion that a child’s ability to delay gratification was an excellent predictor of his/her future success has since been questioned, but investors seem perfectly willing to forego modest stimulus now for a much richer reward in 2021. That perspective applies to the SIFI banks as well. Delaying the provision of additional support to households, businesses and state and local governments may cause a little near-term pain, but it’ll be well worth it to get a super-sized package promising much more long-term gain. The excess savings households built up across the spring and summer are large enough to cover projected consumption shortfalls, though it remains to be seen if they will be willing to part with them while the virus continues to spread. Our overweight recommendation is rooted in our conviction that extraordinary fiscal support will keep the SIFI banks’ ultimate credit losses well below market expectations. No support would force us to close out our recommendation, a skinny package now with uncertain follow-up later would undermine it, and a CARES Act sequel early next year would make it even more robust. A Democratic sweep would pave the way for Congress to match the Fed’s whatever-it-takes approach, greatly relieving the distress of consumers and small businesses as well as those who have lent to them. No one can be sure of how the election dynamics will unfold over the next three weeks, but it would be a mistake to walk away from SIFIs while the Democrats’ prospects are improving. We are therefore staying the course, further heartened by the SIFIs’ bombed-out valuations, which continue to imply gaping credit losses, and their failure to stay down in response to last week’s ostensibly bad news items. Investors would do well to heed our geopolitical strategy team’s admonition that single-party control of the White House and Capitol Hill contains risks that markets are currently overlooking, but our endorsement of the SIFIs has always been a cyclical call, not a tactical one. If Congress is eventually poised to join the Fed in a whatever-it-takes campaign, the SIFIs’ credit losses will be far smaller than feared and their stocks will have a long runway for unwinding their 2020 losses (Chart 8). Chart 8The SIFIs Would Benefit More From Supersized Stimulus Than The Overall Equity Market   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 Casselman, Ben and Tankersley, Jim, "Anxious for a Lifeline, the U.S. Economy Is Left to Sink or Swim," New York Times, accessed October 8, 2020.

Highlights Both public opinion polls and betting markets suggest that Joe Biden will become President, with the Democrats gaining control of the Senate and retaining the House of Representatives. Such a “blue wave” would have mixed effects on the value of the S&P 500. On the one hand, corporate taxes would rise under a Biden administration. On the other hand, trade relations with China would improve. The Democrats would also push for more fiscal stimulus, which the stock market would welcome. The odds of Republicans and Democrats agreeing on a major new stimulus deal before the November elections look increasingly slim. In a blue wave scenario, the Democrats will enact $2.5-to-$3.5 trillion in pandemic relief shortly after Inauguration Day. Joe Biden‘s platform also calls for around 3% of GDP in additional spending on infrastructure, health care, education, climate, housing, and other Democratic priorities. Unlike in late 2016, the Fed is in no mood to raise interest rates. Large-scale fiscal easing will push down the value of the US dollar, while giving bond yields a modest boost. Non-US stocks will outperform their US peers. Value stocks will outperform growth stocks. Looking further out, Republicans will move to the left on economic issues, leaving corporate America with no clear backer among the two major parties. As such, while we are constructive on equities over the next 12 months, we see grave dangers ahead later this decade. Look, Here's The Deal: Joe Biden Is In The Lead With four weeks remaining until the US presidential election, Joe Biden remains on course to become the 46th president of the United States. According to recent public opinion polls, the former vice president leads Donald Trump by 10 percentage points nationwide, and by 4 points in battleground states (Chart 1). Far fewer voters are undecided today compared to 2016. This suggests that there is less scope for President Trump to narrow his deficit in the polls. Betting markets give Biden a 68% chance of prevailing in the race for the White House (Chart 2). They also assign a 67% probability that the Democrats will take control of the Senate and 89% odds that they will retain their majority in the House of Representatives. Chart 1Opinion Polls Favor Biden ... Chart 2.... As Do Betting Markets   Mixed Impact On The S&P 500 What would the market implications of a “blue wave” be? Our sense is that the overall impact on the value of the S&P 500 would be small, largely because some negative repercussions from a Democratic sweep would be offset by positive repercussions. On the negative side, Biden has pledged to raise the corporate income tax rate from 21% to 28%, bringing it halfway back to the 35% rate that prevailed in 2017. He has also promised to introduce a minimum of 15% tax on the income that companies report in their financial statements to shareholders, raise taxes on overseas profits, and lift payroll taxes on households with annual earnings in excess of $400,000. Together, these measures would reduce S&P 500 earnings-per-share by 9%-to-10%. On the positive side, while geopolitical tensions will persist, US trade relations with China would likely improve if Joe Biden were to become the president. Biden has roundly criticized Trump’s tariffs, saying that they are “crushing farmers” and “hitting a lot of American manufacturing… choking it to within an inch of its life.”1 He has pledged to honor multilateral agreements. The World Trade Organization concluded on September 15 that Trump’s tariffs violated international trade rules. This judgement and the desire to turn the page on the Trump era could give Biden the impetus to eventually roll back some of the tariffs. In contrast, having been stricken by what he has called the “China virus,” Trump could take things personally and retaliate with a flurry of new punitive measures.  Fiscal policy would be further loosened in a blue wave scenario, an outcome that the stock market would welcome. Voters would also applaud more pandemic relief. Table 1 shows that 72% of Americans, including the majority of Republicans, support the broader contours of the $2 trillion stimulus package that President Trump has rejected. Table 1Voters Support A New $2 Trillion Coronavirus Stimulus Package By A Fairly Wide Margin At this point, the odds of Republicans and Democrats agreeing on a major new stimulus deal before the November elections look increasingly slim. If Biden wins and the Republicans lose control of the senate, the Democrats would likely enact a stimulus package worth $2.5-to-$3.5 trillion shortly after Inauguration Day on January 20. In addition to pandemic-related stimulus, Joe Biden has called for around 3% of GDP in spending on infrastructure, health care, education, climate, housing, and other Democratic priorities. Only about half of those expenditures would be matched by higher taxes, implying substantial net stimulus for the economy. A Weaker Dollar And Modestly Higher Bond Yields The greenback jumped on Tuesday after President Trump said he is breaking off negotiations with the Democrats over a new stimulus bill. This suggests that the dollar will weaken if fiscal policy is loosened. If that were to happen, it would be different from what transpired following Trump’s victory in 2016 when the dollar strengthened. Why the disconnect between now and then? The answer has to do with the outlook for monetary policy. Back then, the Fed was primed to start raising rates again – it hiked rates eight times beginning in December 2016, ultimately bringing the fed funds rate to 2.5% by end-2018 (Chart 3). This time around, the Fed is firmly on hold, with the vast majority of FOMC members expecting policy rates to stay at rock-bottom levels until at least 2023. This suggests that nominal bond yields will rise less than they did in late 2016. Since inflation expectations will likely move up in response to more stimulative fiscal policy, real yields will rise even less than nominal yields. Over the past 18 months, US real rates have fallen a lot more in relation to rates abroad than what one would have expected based on the fairly modest depreciation in the US dollar (Chart 4). If US real rates remain entrenched deep in negative territory, while the US current account deficit widens further on the back of strong domestic demand, the dollar will continue to weaken. Chart 3Trump Victory Was Followed By Rising Interest Rates Chart 4A Relatively Muted Decline In The Dollar Given The Move In Real Yield Differentials   Favor Non-US And Value Stocks Non-US stocks typically outperform their US peers when the dollar is weakening (Chart 5). This partly stems from the fact that cyclical stocks are overrepresented in stock markets outside of the United States. It also reflects the fact that cash flows denominated in say, euros or yen, are worth more in dollars if the value of the dollar declines. Chart 5A Weaker Dollar Tends To Benefit Cyclical And Non-US Stocks Financial stocks are overrepresented outside the US (Table 2). They are also overrepresented in value indices (Table 3). While a Biden administration would subject the largest US banks to additional regulatory scrutiny, the impact on their bottom lines would likely be small. US banks have been living under the shadows of the Dodd-Frank Act for over a decade. Today, banks operate more as stable utilities than as cavalier casinos. Table 2Financials Are Overrepresented In Ex-US Indexes, While Tech Dominates The US Market Table 3Financials Are Overrepresented In Value, While Tech Dominates Growth Indexes Stronger stimulus-induced growth next year will allow many banks to release some of the hefty provisions against bad loans that they built up this year, while modestly steeper yields curves will boost net interest margins. Tech stocks are overrepresented in growth indices. Better trade relations would help US tech companies, as would a weaker dollar. That said, Joe Biden’s plan to increase taxes on overseas profits would hit tech companies disproportionately hard since the tech sector derives over half its revenue from outside the United States. Stepped up antitrust enforcement and more stringent privacy rules could also weigh on tech profits. On balance, while there are many moving parts, a Democratic sweep would favor non-US equities over US equities, and value stocks over growth stocks. Trumpism Transcends Trump Chart 6Trump Targeted Socially Conservative Voters In 2016, we bucked the consensus view that Hillary Clinton would win the election. On September 30, 2016, we predicted that “Trump will win and the dollar will rally,” noting that “Trump has seen a huge (yuge?) increase in support among working-class whites. If the so-called “likely voters” backing Clinton are, in fact, less likely to turn out at the polls than those backing Trump, this could skew the final outcome in Trump's favor.”2 Right-wing populism was the $1 trillion bill lying on the sidewalk that no mainstream Republican politician seemed eager to pick up. According to the Voter Study Group, only 4% of the US electorate identified as socially liberal and fiscally conservative in 2016, compared to 29% who saw themselves as fiscally liberal and socially conservative (Chart 6). The latter group had no political home, at least until Donald Trump came along. Rather than waxing poetically about small government conservatism – as most establishment Republicans were wont to do – Trump railed against mass immigration, unfair trade deals, rising crime, never-ending wars, and what he described as out-of-control political correctness. While Trump was able to carry out parts of his protectionist agenda, most of his other actions fell well short of what he had promised. His only major legislative achievement was a massive tax cut for corporations and wealthy individuals – something that the vast majority of his base never asked for. The Rich Are Flocking To The Democratic Party How did corporations and wealthy Americans reward Trump for lowering their taxes? By shifting their allegiances towards the Democrats, that’s how. According to the Pew Research Center, households earning more than $150,000 favored Democrats by 20 percentage points during the 2018 Congressional elections, a 13-point jump from 2016. Households earning between $30,000 and $149,999 favored Democrats by only 6 points in 2018. The only other income group that strongly favored Democrats were those earning less than $30,000 per year (Table 4). Table 4Democratic Candidates Had Wide Advantages Among The Highest-And-Lowest Income Voters Chart 7Democratic Districts Have Fared Better Over The Past Decade Other data tell a similar story. Median household income in Democratic congressional districts rose by 13% between 2008 and 2017. It fell by 4% in Republican districts. Today, on average, Republican districts have a median income that is 13% below Democratic districts (Chart 7). Campaign donations have shifted towards the Democrats. The latest monthly fundraising data shows that the Biden campaign received three times more large-dollar contributions in total than the Trump campaign. The nation’s CEOs have not been immune from this transformation. Seventy-seven percent of the business leaders surveyed by the Yale School of Management on September 23 said they would be voting for Joe Biden.3   As elites desert the Republican Party, will the Democratic Party start championing lower taxes and less regulation? That seems unlikely. According to the Voter Study Group, higher-income Democrats are actually more likely to support raising taxes on families earning more than $200,000 per year than lower-income Democrats (83% versus 79%). Among Republicans, the opposite is true: 45% of lower-income Republicans are in favor of raising taxes, compared to only 23% of higher-income Republicans.4  There used to be a time when companies tried to steer clear of the political limelight. This is starting to change. As the relative purchasing power of Democratic voters has risen, many companies have become emboldened to adopt overtly political stances on a variety of hot-button social and cultural issues, even if those stances alienate many conservative customers.  What does this imply for investors? If big business abandons conservative voters, conservative voters will abandon big business. Corporate America will be left with no clear backer among the two major parties. Over the long haul, this is likely to be bad news for equity investors. As such, while we are constructive on equities over the next 12 months, we see grave dangers ahead later this decade.   Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1  “Biden Takes On ‘Trump’s Tariffs’,” The Wall Street Journal, June 12, 2019. 2 Please see Global Investment Strategy Special Report, “Three (New) Controversial Calls,” dated September 30, 2016. 3 “CEO Caucus Survey: Business Leaders Fault Trump Administration on COVID and China,” Yale School of Management, September 24, 2020. 4 Lee Drutman, Vanessa Williamson, Felicia Wong, “On the Money: How Americans’ Economic Views Define — and Defy — Party Lines,” votersstudygroup.org, June 2019. Global Investment Strategy View Matrix Current MacroQuant Model Scores

Highlights President Trump is waffling on fiscal relief. Our constraints-based framework still points to a deal, but the odds have clearly fallen. US and global stocks have rallied despite the fiscal failure. Markets evidently believe stimulus is coming regardless, particularly if Democrats win a blue sweep – our base case election scenario. However, our quantitative election model has boosted Republican odds, flagging a major risk to the blue sweep scenario. Moreover a blue sweep will remove checks and balances on the new administration and thus bring negative surprises that the market is underrating. We maintain our tactical risk-off positioning on the expectation of another leg of election-related volatility. Over a 12-month time horizon we remain invested in reflation plays. Feature Financial markets came around to our “blue sweep” base case for the US election this week. Betting markets shifted sharply after the first presidential debate (Chart 1). Support for Biden surged in national opinion polls while Trump dropped off, albeit to a lesser extent in swing states. Worryingly for the White House, the few polls taken since Trump took ill with COVID-19 on October 2 do not show a sympathy bounce for the president (Chart 2). Chart 1Consensus Forms Around ‘Blue Sweep’ Base Case Chart 2Trump Takes A Dive With Little Time On Clock In a very dangerous turn for the president’s re-election chances, Trump discontinued negotiations with House Democrats over a fiscal relief bill, promising to pass a large new stimulus after the election. Partially walking back those comments, he said he would sign any targeted stimulus bills that Congress sends him in the meantime (such as a new round of $1,200 rebates for households). House Speaker Nancy Pelosi shot down the option of a skinny bill, as we have argued she would. Now they are going back and forth. While the S&P 500 rallied on the news, other reflation trades like US cyclicals, oil, and silver show the risk of premature fiscal tightening (Chart 3). Investors may have to wait until late January until getting a new infusion of government support. Chart 3Lack Of Stimulus Still A Risk To Reflation Trades Chart 4Market Rally Not Based On Blue Sweep Odds True, a fiscal deal could be passed in the lame duck session in November or December, but Republican Senators unwilling to pony up around $500 billion to bail out blue states – when they face a possible wipeout in a historic election – will be even less willing if they lose the election. They will be more hawkish since they will want to pin deficits on the Democrats in future. If Republicans retain control of the Senate despite the latest news – which is possible, especially given the Democratic candidate’s new vulnerability in the North Carolina race due to a sex scandal – then investors have two years of fiscal hawkishness to contend with. Diagram 1 highlights the market implications of this Senate risk. Diagram 1Scenarios For US Election Outcomes And Market Impacts So we need to look elsewhere to explain why the market rallied when odds of a fiscal deal fell. The above reasoning leaves us with the following options: The economy is recovering so robustly that new fiscal stimulus is unnecessary. This is not the view of Federal Reserve Chairman Jay Powell, who all but pleaded for Congress to conclude a deal to secure the recovery, or of other mainstream economists. Stimulus is coming regardless of election outcome. Congress will be forced to support the country during a slump. Debt monetization is the relevant point, even if there is a month-or-two delay in stimulus. Financial markets are cheering the higher odds of a Democratic clean sweep of Congress and the White House since it implies fiscal largesse. The market may already have discounted some of the impending tax hikes over the past month. The second explanation is the best but the third is rapidly becoming the new consensus on Wall Street. Chart 4 suggests there is no connection between the S&P rally and the odds of a blue sweep. With the Fed pursuing “maximum employment” and average inflation targeting, it makes sense that the real mover in the macro landscape has become fiscal policy. Hence the outcome that produces the most proactive fiscal policy is positive for financial markets. A blue sweep is verification of the shift toward debt monetization, which is missing from option two above. The problem is that a blue sweep also brings downside risks. Domestic policy uncertainty will only fall temporarily after the election if there is a blue sweep. Checks and balances will vanish. Eventually Democrats will become overweening in their policy agenda, delivering negative surprises to financial markets. A “New Deal”-style policy agenda would weigh on the corporate earnings outlook. For example, Democrats have refused to forswear removing the filibuster or stacking the Supreme Court, both of which would lie in their power and either of which would enable them to pass an ambitious “New Deal”-style policy agenda that would bring unforeseen consequences – largely in the direction of wealth redistribution away from corporations. Table 1What EPS Hit To Expect? Redistribution would start to correct US social and economic imbalances, improve middle class spending power, and boost consumption – but it would first weigh on the corporate earnings outlook. Net profit growth, which grew by 16% above what was otherwise expected due to the Trump tax cuts (Chart 5), could suffer more than the expected 11% one-off contraction (Table 1), as our US equity strategist Anastasios Avgeriou has shown. Chart 5Partial Repeal Of Trump Tax Cut Bad For Earnings New proposals will also emerge that the market is not taking account of. To take just the latest example, former Fed Chair Janet Yellen recently stated that the US could adopt a $40 per ton tax on carbon emissions under a Biden administration.1This proposal is not part of Biden’s official plan, hence not priced by markets along with Biden’s expected tax hikes (Table 2). But control of the Senate would make it a real option given Biden’s ambitious climate goals. Table 2Biden Needs Senate To Raise Taxes Consumer confidence in the US will suffer from political polarization. Recall that in 2016, the economy was in fine shape but Republicans did not believe it, weighing down the average until President Trump won the election. Today the economy is in a slump but Republicans may not recognize the bad news until President Trump loses. Democrats, for their part, will suddenly abandon their doom and gloom if Biden wins the election. Applying a comparable partisan shock to consumer confidence for 2021 would suggest that overall confidence will be lackluster (Chart 6). At least this is true until the passage of new stimulus and an advancing recovery outweigh the partisan effect. Chart 6Biden Will Not Recreate Trump Confidence Boost A similar case can be made that small business sentiment will worsen in a blue sweep scenario. Fear of higher regulation and taxes will spike and weigh on animal spirits (Chart 7). Historically the first year after an election sees smaller equity upside and larger downside with unified government as opposed to divided government (Chart 8). If this time is different it is because of the sea change in the US to embrace debt monetization. But that sea change occurred under a Republican administration and is likely to persist due to the output gap. Chart 7SMEs Will Fear Blue Wave Chart 8Stock Market Profile Fits Divided Government, Which Has More Upside A Republican Senate under a Biden presidency would bring higher fiscal risk, but the truth is that neither trade war risks nor corporate taxes would go up, yet Republicans would eventually have to concede to spending bills (just as Democrats did under Trump). Hence divided government is not as negative as it is made out to be as it contains mostly known quantities, whereas a blue sweep would lead the US in a redistributionist direction that is initially disruptive. Relative to divided government, it would be positive for aggregate demand but negative for corporate earnings. Bottom Line: US and global equities will rise over the coming 12 months on the back of eventual US stimulus and ongoing global stimulus. A blue sweep is our base case election outcome but it brings mixed results. Global equities would benefit more than US equities which will face a spike in taxes and regulation. US equities will still rise but they face more upside under a divided government in which Republicans halt tax hikes. Supreme Court Confirmation Looms Of course, a blue sweep outcome is not guaranteed. Indeed the fact that it is now consensus makes us nervous, as there are still 26 days until the election. Our quantitative election model gives the Republicans a 49% chance of winning the White House on the back of the V-shaped recovery in the states, which delivers Florida to the Republican camp, leaving Trump with 259 Electoral College votes (Chart 9). This probability is well above our subjective 35% judgment and the new market consensus on Trump’s odds. Chart 9Quant Election Model Gives Trump 259 Electoral College Votes And 49% Odds Of Victory Trump’s decision to break off the fiscal talks probably sealed his doom, but we would still maintain that a correct reading of the various political and economic constraints point toward a fiscal deal. Hence there is still some chance that a deal will be snatched from the jaws of defeat. At that point we would upgrade Trump’s chances to something closer to our election model. But it would not be bullish, as the market would need to price a higher risk of trade war. Subjectively Trump has a 35% chance of re-election, but our quant model flags a risk to this view. The market also must contend with COVID-19 risks (Charts 10A and 10B). Stimulus is necessary to prevent COVID-19 risks from hitting the market, as more distancing will be necessary in states where cases are rising. Chart 10ACOVID-19 Cases Rising Chart 10BCOVID-19 Hits Swing States The reason President Trump cut short the fiscal talks was to ensure that they would not interfere with the Senate’s ability to confirm his Supreme Court nominee Amy Coney Barrett. The confirmation hearings will go up for a floor vote in the Senate sometime around October 23, ensuring a massive constitutional brawl just ahead of the election. The dollar has more upside if Trump wins. Chart 11Risk: Trump Comeback Boosts The Greenback We do not expect this showdown to change the game, since boosting turnout among Trump’s conservative base will be insufficient in an election fought in the face of major national shocks that affect the median voter (pandemic, recession, social unrest). This election is already going to be a high turnout election – preliminary information suggests it could be the highest since 1908 at 65% of eligible voters2 — which means that Republicans will suffer from the leftward tilt of the median voter. However, if Trump’s polling improves between now and then – and if mFarkets inexplicably rally all month despite the withdrawal of fiscal support – then we could be surprised. Our quantitative model provides a basis for believing that Republicans are now underrated. This implies that the dollar has more upside in the near term as the risk of a contested election and/or a Trump second term, and hence another shock to the US political system and global trading system, must still be guarded against (Chart 11). Investment Takeaways The market faces near-term downside risk and volatility until the US fiscal support is restored. This is particularly the case as long as COVID-19 cases are not subdued. The rising odds of a blue sweep, our base case, is not sufficient to dampen volatility over the coming month. Depending on the election results, volatility will subside in November or January at the latest. Not only is a contested election a non-negligible risk – based on our quant model’s reading – but also President Trump will remain in office till January 20 and could easily dish out some negative surprises, particularly on China relations. Hence we are maintaining our tactical risk-off and safe-haven trades: long US treasuries, Japanese yen, US health care equipment stocks (which will outperform the overall sector amid the Democratic regulatory threat), and EUR-GBP volatility. Over the 12-month time frame, we have little doubt that the US adoption of debt monetization, in keeping with Chinese and global stimulus, will push equities and risky assets higher. The reflation trade remains the core of our strategic portfolio. Global stocks should outperform under a Biden presidency. Biden will be positive for global trade ex-China, as both US electoral politics and grand strategy will drive any administration to take a hard line on China, though Biden will not wield tariffs like Trump.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1 See Matthew Green, "U.S. could adopt carbon tax under a Biden presidency, ex-Fed Chair Yellen says," Reuters, October 8, 2020, reuters.com; see also Group of Thirty, "Mainstreaming The Transition To A Net-Zero Economy," October 2020, group30.org. 2 See John Whitesides, "More than 4 million Americans have already voted, suggesting record turnout," Reuters, October 6, 2020, reuters.com.

Highlights US market risks stem from both the lack of fiscal stimulus before the new president assumes office in late January. Risk-off moves in US financial markets will weigh on EM. China’s stimulus has peaked and the country has begun a destocking phase in commodities inventories. These factors could add to investor worries reinforcing the pullback in commodities prices and EM currencies.  The key risks to our strategy are that financial markets might look through the lack of US fiscal stimulus in the next several months and ignore the commodity destocking cycle in China. This will be the case if investors instead focus on the US and China’s benign growth outlook over the next nine months. In that regard, we are positive too. Hence, the difficulty is to navigate markets in the near-term. If EM risk assets and currencies prove resilient in the short term, we will upgrade our stance sooner than later. Feature Global risk assets are vulnerable as US Republicans and Democrats have failed to agree on a new round of fiscal stimulus. The odds of enacting significant stimulus legislation – including income support for the unemployed – before the new president assumes office in late January are low. Global risk assets will suffer due to their dependence on continuous government stimulus. The rally since late March has created an air pocket, somewhat disconnecting risk asset prices from their fundamentals. In particular, the gaps between share prices and corporate earnings and between corporate spreads and projected corporate default rates have widened dramatically (Chart I-1). We do not mean that corporate earnings will not recover. Our point is that share prices have risen too far, too fast. Absent a large fiscal stimulus package in the US, risk asset prices will likely experience a meaningful setback. These gaps have been sustained by hopes of continuous fiscal and monetary stimulus. However, absent a large fiscal stimulus package in the US, risk asset prices will likely experience a meaningful setback. We continue recommending EM investors maintain a defensive positioning for now. Asset allocators should remain neutral on EM equities and credit within their respective global portfolios. In the near term, EM currencies will depreciate against the US dollar. We continue shorting a basket of EM currencies versus the euro, CHF and JPY. These DM currencies are likely to experience some, but not substantial, downside versus the greenback. Elevated Expectations Economic growth expectations are rather elevated and investor sentiment is complacent: The Global ZEW expectations index – based on a survey of analysts from banks, insurance companies and finance departments from the corporate sector – is close to an all-time high (Chart I-2). This implies that investors’ and analysts’ growth expectations are substantially inflated.   Chart I-1The Rally Has Been Too Fast, And Gone Too Far Chart I-2Investor Expectations Are Very Elevated   The very low level of the SKEW for US stocks signifies investor complacency (Chart I-3). A low SKEW reading means investors are not pricing in tail risks. Further, the rally since March lows has been reinforced by the substantial speculative trading activities of retail investors. Finally, investors’ net long positions in copper are at their previous cyclical highs (Chart I-4). Chart I-3Low SKEW Signifies That Investors Are Not Ready For Tail Risks Chart I-4Investors Are Very Long Copper   Peak Stimulus? China is approaching peak stimulus. Chart I-5 shows that the projected bond issuance by central and local governments will decline in the coming months. Besides, the loan approval index of the PBoC banking survey has rolled over decisively (Chart I-6). Chart I-5Peak Fiscal Stimulus In China? Chart I-6Peak Credit Growth In China?   A combination of less government bond issuance and less loan origination by banks implies that the credit impulse will roll over in the coming months. This does not mean that the mainland economy will weaken in the coming months. The credit and fiscal spending as well as broad money impulses lead the economy by about nine months (Chart I-7). Therefore, even if the credit and fiscal spending impulse rolls over later this year, the economy will continue improving at least until next spring. Therefore, from a cyclical perspective, we remain positive on China’s business cycle. China’s peak stimulus and destocking phase in commodities could add to investor worries. That said, China-related financial markets have already rallied quite a bit and are likely to experience a pullback as US equity and credit markets sell off. Additionally, after having stockpiled commodities since spring, China has probably entered a commodity destocking cycle. Even though final demand in China will be firming, resource prices will likely relapse in the near term due to diminished mainland imports.  In the US, the massive fiscal stimulus from the CARES Act has led to a surge in household income amidst the worst collapse in economic activity since the Great Depression and the massive layoffs that accompanied it. Government transfers during recessions are typically devised to moderate income decline but not lead to a boom in income as has occurred in the US this year (Chart I-8). Chart I-7China's Business Cycle Will Continue Improving Chart I-8US Household Income Surged Amid Economic Collapse Chart I-9Credit Standards At US Banks Are Tight Without renewed fiscal transfers to households, personal income will erode and consumer spending will weaken. Further, state and local governments are retrenching as their revenue streams have evaporated. Finally, bank lending standards have tightened dramatically (Chart I-9). Crucially, the majority of investors are long risk assets because of expectations of recurring fiscal stimulus and the Federal Reserve’s implicit put on stocks and corporate credit. If one of these two pillars – in this case fiscal stimulus – fades away, some investors might throw in the towel. In EM excluding China, Korea and Taiwan, economic activity is rebounding post lockdowns. However, these economies are also approaching peak stimulus at a time when the level of economic activity in many countries remains very low. In addition, hit by a wave of defaults, banks in these economies are not in a position to originate new loans. Thereby, the transmission mechanism of monetary policy is partially broken. Their central banks’ stimulus have not been fully transmitted to the real economies.  Bottom Line: Risks to the rally in US equities stem from both the lack of fiscal stimulus and political uncertainty following a possibly contested presidential election. Risk-off moves in US financial markets will weigh on EM. China’s peak stimulus and destocking phase in commodities could add to investor worries, reinforcing the pullback in commodities and EM risk assets.  Indicator Review A number of indicators point to downside in EM risk assets and currencies. The advance-decline line for EM equities is below zero stocks (Chart I-10). This points to poor equity breadth in the EM universe. Chart I-10Poor Breadth In EM Equities Chart I-11A Warning Signal For EM Stocks The cross rate of the Swedish koruna versus the Swiss franc (de-trended) has been a good coincident indicator for EM share prices and it points to a selloff (Chart I-11). The implied volatility index for EM currencies is rising (shown inverted in the chart), pointing to a relapse in EM exchange rates versus the US dollar (Chart I-12, top panel). Chart I-12Red Flags For EM Equities And Currencies Chart I-13Are Commodities In A Soft Spot? Platinum prices are gapping down. This rings alarm bells for EM currencies as the two are strongly correlated (Chart I-12, bottom panel).  Chinese steel rebar futures, global steel stocks and Glencore’s share price – a global bellwether for commodities – have all begun relapsing, even before Trump’s withdrawal from the fiscal stimulus talks (Chart I-13). Also, the latter has failed to break above its 200-day moving average. The same is true for oil prices. We read such a technical configuration as a telltale sign that these commodity plays have not entered a bull market and remain vulnerable. In emerging Asia, high-yield corporate credit’s relative performance versus investment-grade corporates has rolled over at its previous highs (Chart I-14). In the past several years, the failure to break above this technical resistance level was followed by a material selloff in EM credit and equity markets. Bottom Line: The majority of indicators for EM risk assets and currencies are presently flashing red. Investment Considerations The rally in share prices and drop in the US dollar yesterday following Trump’s cancellation of stimulus talks is puzzling. We expect the market to realize that the odds of considerable fiscal stimulus with meaningful income support for the unemployed is low until the new president assumes office in late January. We believe large and recurring US fiscal stimulus packages are very likely following the elections, favoring reflation and inflation strategies in the medium and long run, and weighing on the US dollar. That was the basis upon which we turned bearish on the US dollar on July 9 and upgraded EM stocks from underweight to neutral on July 30. However, in the near term, the lack of fiscal stimulus favors the deflation trade: a bet on lower growth and lower inflation. If EM risk assets and currencies prove resilient in the near term, we will upgrade our stance sooner than later. If the markets agree with our assessment that US growth will meaningfully disappoint without fiscal stimulus, not only will global share prices drop but also US inflation expectations will decline, US real rates will rise and the US dollar will rebound (Chart I-15). This would produce a bearish cocktail for EM currencies, credit markets and stocks in the near term. Chart I-14A Message From Emerging Asian Credit Markets Chart I-15A Reset In US Inflation Expectations, Real Rates And US Dollar Is Overdue   The key risks to our strategy are that financial markets might look through the lack of US fiscal stimulus in the next several months and ignore the commodity destocking cycle in China. It will be the case if investors focus on the US and China’s benign growth outlook over the next nine months. In that regard, we are positive too. Hence, the difficulty is to navigate markets in the near-term. If EM risk assets and currencies prove resilient in the near term, we will upgrade our stance sooner than later. Stay tuned. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Strategy For Philippine Markets xChart II-1Philippine Equities: Relative & Absolute Performance Our underweight stance on Philippine stocks has played out well as this bourse has massively underperformed the EM equity benchmark (Chart II-1, top panel). Notably, in absolute terms, Philippine share prices look disconcerting as they have stalled at their long-term moving average (Chart II-1, bottom panel). We continue to recommend an underweight position in this bourse for dedicated EM portfolios and a cautious stance for absolute-return investors. In terms of the currency market, our short position on the Philippine peso has not played out as the exchange rate has been very resilient. We are removing the PHP from our short EM currency basket by closing the short PHP/long the euro, CHF and JPY trade with a 1% loss. The key reason for the peso’s strength has been the rapidly improving current account balance (Chart II-2). The latter has moved into a surplus due to the collapse in domestic demand and imports as well as ballooning remittances. In brief, the balance of payment surplus has been so large that the currency appreciated against the US dollar even though the central bank accumulated large amounts of foreign exchange reserves.   Such strong remittance inflows are probably due to returning expatriate Filipino workers from Gulf countries, bringing their entire savings with them. If so, such remittance inflow will not reoccur. Nevertheless, the trade and current account deficits are unlikely to widen rapidly because imports will stay subdued - due to weak domestic demand - and exports will be supported by electronics exports (Chart II-3). The latter make up 57% of total goods exports. Chart II-2Current Account Balance Is In Surplus Chart II-3Philippine Exports Are Recovering Commercial banks in the Philippines have tightened their lending standards meaningfully. On domestic demand, the post lockdown recovery will be moderate and slow and corporate profits will disappoint: Chart II-4Decelerating Bank Loan Growth The country has not been handling the pandemic well. The health system is showing signs of stress and the authorities have been forced to continuously roll out new lockdowns and social distancing measures. This will prevent a strong revival in business activity in an economy where consumer spending represents 70% of GDP. The Philippine government has unleashed  fiscal stimulus packages of about 4% of GDP to counter the pandemic-induced recession. With the fiscal year nearing its end, the cyclical growth outlook will depend on next year’s budget. Next year’s government spending will likely be 5% higher than the original 2020 budget, i.e., excluding extraordinary stimulus measures from both 2020 and 2021 budgets. Therefore, the 2021 budget is unlikely to be enough to support growth materially. Besides, even though the government is trying to roll out more stimulus for next year, its concerns about the size of budget deficit and its financing will limit stimulus. Crucially, bank loan growth is decelerating sharply (Chart II-4). Commercial banks will be reluctant to originate much new credit in this weak growth environment. In brief, the negative credit impulse will offset the fiscal stimulus. The Philippine central bank has been very aggressive in its measures. It has unleashed an unprecedented QE program – buying government bonds en masse – and has also injected liquidity into the banking system and cut its policy rate by 175 basis points (Chart II-5). Yet, the monetary transmission mechanism has been broken in the Philippines and the monetary easing has not benefited the real economy. In particular, commercial banks in the Philippines have tightened their lending standards meaningfully. In turn, banks’ lending rates have not dropped.  As with many other EMs, this is occurring because Philippine banks want to protect or increase their net interest rate margins at a time when they are witnessing mounting non-performing loans, rising provisions, and tanking profits (Chart II-6). Chart II-5Philippine: Central Bank Is Doing QE Chart II-6Banks Are Facing Mounting NPLs   Bottom Line: Continue underweighting Philippine stocks in an EM equity portfolio. Within this bourse, we are taking profit on the short position in property stocks. This recommendation has generated a 10% gain since its initiation on November 1, 2018. As to fixed-income markets, consistent with our view change on the currency we are upgrading Philippine sovereign credit from underweight to overweight and domestic bonds from underweight to neutral. Ayman Kawtharani Editor/Strategist ayman@bcaresearch.com   Footnotes Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights Long-term investors who can tolerate volatility should buy SEK/USD for a potential 20 percent upside. Short-term investors who cannot tolerate volatility should buy CHF/USD. The dollar’s short-term moves are a perfect mirror-image of the global stock market. US and euro area long-duration bond yields will ultimately converge… …and the euro area’s huge trade surplus with the US will vanish. Fractal trade: Underweight European retailers versus market. Feature Chart of the WeekSEK/USD Is 20 Percent Undervalued Relative To The Sweden/US Bond Yield Differential The demand for a foreign currency serves one of four purposes: To buy goods and services denominated in the foreign currency. To buy long-term investments denominated in the foreign currency, also known as foreign direct investment (FDI). To buy shorter-term financial investments like bonds and equities denominated in the foreign currency, also known as portfolio flows.1 To buy currency reserves denominated in the foreign currency. What Sets The Broad Level Of EUR/USD? Looking at the euro, three of the four components of demand tend to change relatively slowly. The net foreign demand for euro area goods and services is not particularly volatile. Neither is FDI. Demand for euro reserves also tends not to suffer wild gyrations, except at the rare moment that a currency peg starts or ends.  All of which means that the usual driver of demand for euros are portfolio flows (Chart I-2). Chart I-2Euro Area Portfolio Flows Have A High Amplitude Portfolio flows are of two main types: fixed income and equity. However, in the euro area, fixed income portfolio flows usually have the much higher amplitude (Chart I-3). The reason is that most savings are invested in fixed income assets. For example, German households hold 80 percent of their assets in fixed income, cash, or close proxies. This explains why the stock of government fixed income securities in the euro area is almost twice as large as the market capitalisation of all the euro area’s stock markets (Chart I-4). Chart I-3Euro Area Fixed Income Portfolio Flows Have A Higher Amplitude Than Equity Flows... Chart I-4...Because Euro Area Fixed Income Is The Dominant Asset-Class What causes fixed income flows to flood out of the euro area one moment and back in the next? The answer is the expected change in interest rates. The main issue is not the exact timing of short-term interest rate changes. Instead, it is the so-called terminal rate: the average interest rate over the very long term, proxied by the long-duration bond yield. Fixed income investors gravitate to the bonds with the highest potential returns adjusted for currency hedging costs or likely currency moves. In the euro area, fixed income portfolio flows have a higher amplitude than equity flows. When the expected interest rate in the euro area declines relative to that in the US, it diminishes any further price upside of euro area bonds compared with that of US T-bonds. Hence, fixed income investors shift out of the less attractive euro area bonds into US T-bonds. The outflow continues until it has depressed EUR/USD to a level where the potential upside to the exchange rate becomes symmetrically more attractive. At this new lower level for EUR/USD, the fixed income portfolio outflow stops because a new equilibrium has been established. International fixed income investors have less upside from the euro area bond price, but they now have symmetrically more upside from the cheaper EUR/USD – and the two factors cancel out. Chart I-5 provides powerful evidence of this dynamic. For the past 15 years, the broad territory in which EUR/USD trades has been a close function of the euro area/US long-duration bond yield spread.3 A zero yield spread equates to EUR/USD in the broad territory of 1.35 with every +/-100 bps equal to +/- 15 cents. Hence, the current yield spread of -100 bps equates to EUR/USD trading in the broad territory of 1.20. Chart I-5The Euro Area/US Bond Yield Differential Sets EUR/USD... Interestingly, the euro area/US trade imbalance is also a close function of the bond yield spread. This confirms that the euro area’s massive trade surplus with the US is the direct result of the massive imbalance in relative monetary policy – which depressed EUR/USD and boosted the euro area’s relative competitiveness. Put simply, at a narrower (and more normal) bond yield spread, the euro area’s trade surplus with the US would largely vanish (Chart I-6). Chart I-6...And Thereby It Sets The Euro Area/US Trade Imbalance The Euro Area/US Yield Spread Is Likely To Narrow Further The long-term evolution of EUR/USD – as well as the associated trade imbalance – hinges on the long-term evolution of the euro area/US long-duration bond yield spread. Will this spread widen or narrow? At a narrower bond yield spread, the euro area’s trade surplus with the US would largely vanish. From the euro area side, the answer is easy. The spread cannot widen, it can only narrow. With the ECB policy interest rate already expected to be stuck at its lower bound indefinitely, down is not an option. From the US side, the spread could go either way, at least mathematically. However, it is our high conviction view that in the long term it will narrow. The Federal Reserve’s recent strategic review has made its reaction function blatantly asymmetric. The central bank has told us that it will be thick-skinned to reflationary shocks, but trigger-happy to the slightest further deflationary shock. Hence, when the slightest further deflationary shock comes – and sooner or later it will – US long-duration bond yields will converge with those in the UK and Japan in one of two ways. Either the Fed will follow the Bank of England in a volte-face about adding negative interest rate policy into its toolbox. Or the Fed will follow the Bank of Japan in formally implementing yield curve control (Chart I-7).   Chart I-7The US Bond Yield Will Converge With The Others Buy SEK/USD For The Long Term, Buy CHF/USD For The Short Term Other European economies also exhibit the same strong link between their exchange rates with the dollar and their bond yield spreads with the US. In the case of Sweden, there is an attractive opportunity. SEK/USD is still about 20 percent undervalued relative to the long-term relationship with the Sweden/US bond yield spread. Hence, the long-term case for owning SEK/USD does not even require the yield spread to narrow from where it stands today. Of course, if the spread did narrow by a further 50 bps, the potential upside would approach 30 percent (Chart of the Week). SEK/USD is still about 20 percent undervalued relative to the long-term relationship with the Sweden/US bond yield spread.  Nevertheless, for short-term investors, there is an important caveat. While fixed income portfolio flows drive the long-term values of European currencies versus the dollar, equity portfolio flows become dominant in periods of market stress. During such dislocations, equity flows tend to flee to perceived haven assets and markets, many of which are denominated in dollars. As a result, the dollar rallies. The compelling proof is that over the past year, the dollar has traded as a perfect mirror-image of the global stock market (Chart I-8). Chart I-8The Dollar In 2020 = A Perfect Mirror-Image Of The Stock Market In Europe, the haven currency is the Swiss franc. Hence, while SEK/USD fell by 10 percent during this year’s market turbulence, CHF/USD remained unperturbed. Furthermore, CHF/USD is also undervalued relative to its relationship with the Switzerland/US bond yield spread.4 Albeit, the undervaluation is more modest, at around 6 percent (Chart I-9). Chart I-9CHF/USD Is Modestly Undervalued Relative To The Switzerland/US Bond Yield Differential The conclusion is that long-term investors who can tolerate volatility should buy SEK/USD for its greater upside. Whereas short-term investors who cannot tolerate volatility should buy CHF/USD for its greater safety. Fractal Trading System* This week we note that the recent strong outperformance of European retailers is vulnerable to a trend reversal, and especially so if the pandemic resurges. Accordingly, the recommended trade is underweight European retailers versus the market (which can be implemented as EXH8 versus Euro Stoxx 600). The profit target and symmetrical stop-loss is set at 4.2 percent. Chart I-10European Retailers Vs. Market The rolling 1-year win ratio now stands at 56 percent. When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated  December 11, 2014, available at eis.bcaresearch.com. Footnotes 1 In this discussion, portfolio flows include short-term speculative flows. 2 For example, when the Swiss National Bank broke the franc’s peg with the euro in early 2015, it abruptly stopped buying euro reserves. 3 The euro area bond yield is the issue-weighted average of the euro area’s constituent sovereign bond yields. A good approximation of the euro area’s issue-weighted average is the French bond yield.   Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading System   Cyclical Recommendations Structural Recommendations Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart I-1Indicators To Watch - Bond Yields Chart I-2Indicators To Watch - Bond Yields Chart I-3Indicators To Watch - Bond Yields Chart I-4Indicators To Watch - Bond Yields   Interest Rate Chart I-5Indicators To Watch - Interest Rate Expectations Chart I-6Indicators To Watch - Interest Rate Expectations Chart I-7Indicators To Watch - Interest Rate Expectations Chart I-8Indicators To Watch - Interest Rate Expectations