Europe

Highlights Our intermediate-term timing models suggest the US dollar is broadly overvalued.  We are maintaining a modest procyclical currency stance (long NOK, GBP and SEK), but also have a portfolio hedge (short USD/JPY). Go long a basket of petrocurrencies versus the euro. Stay short the gold/silver ratio. Feature Our fundamental intermediate-term timing models (FITM) are one of the toolkits we use in currency management. These simple models enable us to time shifts in developed-market currencies using two key variables. Real Interest Rate Differentials: G10 currencies tend to move with their real rate differentials. Under interest rate parity, if one country is expected to have high interest rates versus another, its currency will rise today so as to gradually depreciate in the future and nullify the interest rate advantage. Risk factor: The ebb and flow of risk aversion affects the path of currencies, as it does their domestic capital markets. Procyclical currencies tend to perform better during risk-on periods. We use high-yield spreads and/or commodity prices as a gauge for risk. For all countries, the variables are highly statistically significant and of the expected signs. These models help us understand in which direction fundamentals are pushing the currencies we look at. These models are more useful as timing indicators on a three-to-nine month basis, as their error terms revert to zero quickly. For the most part, our models have worked like a charm. On a risk adjusted-return basis, a dynamic hedging strategy based on our models has outperformed all static hedging strategies for all investors with six different home currencies since 2001.1  The US Dollar Chart I-1USD Is Overvalued By 4.4% USD Is Overvalued By 4.4% USD Is Overvalued By 4.4% The dollar is a sell, according to the model, with a fair value that is falling much faster than the DXY index itself. Going forward, the Federal Reserve’s dovish stance should keep real interest rate differentials moving against the dollar. This will especially be the case if the authorities move to some form of yield curve control. The wildcard is how risk aversion gyrates as we navigate the volatile summer months, especially given rising geopolitical tensions and the potential for an equity market correction (Chart I-1). One of the factors holding up the dollar is that US domestic growth has been relatively strong, with the Citigroup economic surprise index at the highest level since the inception of the series. For the dollar to decline meaningfully, these positive surprises will need to be repeated abroad. On the data front this week, pending home sales rose 44.3% month-on-month in May, following a 21.8% decline the previous month. House prices are rebounding, to the tune of 4%. The ISM manufacturing index broke out to 52.6 in June from 43.1 the prior month. Job gains for the month of June came in at 4.8 million versus expectations of 3.23 million, pushing the unemployment rate down to 11.1%. These strong numbers provide a high hurdle that non-US growth will need to overcome in order for dollar weakness to continue. The Euro Chart I-2EUR/USD Is Undervalued By 3.8% EUR/USD Is Undervalued By 3.8% EUR/USD Is Undervalued By 3.8% The euro is not excessively undervalued versus the US dollar (Chart I-2). Usually, strong buy signals for the euro have been triggered at a discount of about 10% or so relative to the greenback. That said, the euro can still bounce towards 1.16, or about 3%-4% higher, to bring it back to fair value. The biggest catalyst for the euro remains that interest rate differentials with the US are quite wide and can continue to mean revert. The Treasury-bund spread peaked at 2.8%, and has since lost around 1.7%. Yet, a gap of 100 basis points remains wide by historical standards. On the data front, the CPI numbers from the euro area this week were quite instructive. German inflation came in at +0.8% versus a decline of -0.3% in Spain. In a general sense, inflation in Germany has been outperforming that in the periphery for a few months now, which is a sea-change from the historical trend in eurozone inflation, where both the core and periphery have seen CPI tied at the hip. If rising competitiveness in the periphery is a key driver, then the fair value of the Spanish “peseta” is rapidly catching up to that of the German “Deutsche mark,” which is positive for the euro. The Yen Chart I-3USD/JPY Is Overvalued By 10.3% USD/JPY Is Overvalued By 10.3% USD/JPY Is Overvalued By 10.3% The yen’s fair value has benefited tremendously from the plunge in global bond yields, making rock-bottom Japanese rates relatively attractive from a momentum standpoint (Chart I-3). This has pushed the yen to undervalued levels, supporting our tactically short USD/JPY position. The data out of Japan this week suggest that deflationary forces remain quite strong, which will continue to boost real rates and support the yen. The jobs-to-applicants ratio, a key barometer of labor market health, plunged to 1.20 in May from a cycle high of 1.63. Industrial production fell 25.9% year-on-year in May, the worst since the financial crisis. Meanwhile, the second quarter all-important Tankan survey suggests small businesses will continue to bear the brunt of the economic slowdown.  With most of the increase in the Bank of Japan’s balance sheet coming from USD swaps with the Fed rather than asset purchases, it suggests little ammunition or appetite for more stimulus. Fiscal policy remains the wild card that could help lift domestic demand.   The British Pound Chart I-4GBP/USD Is Undervalued By 5.9% GBP/USD Is Undervalued By 5.9% GBP/USD Is Undervalued By 5.9% Our model shows the pound as only slightly undervalued, putting our long cable position at risk. The drop in UK real rates since the Brexit referendum has prevented our model from flagging the pound as being much cheaper. Given the potential for added volatility this summer, we are looking to book modest profits on long cable (Chart I-4). Data out of the UK remains grim. Mortgage approvals fell to 9.3K in May, well below expectations. Consumer credit is falling much faster than during the depths of the financial crisis, suggesting all the BoE’s liquidity measures are still not filtering down to certain pockets of the economy. Meanwhile, the trend in the trade balance suggests that the pound has not yet started to reflate the economy.   The Canadian Dollar Chart I-5USD/CAD Is Overvalued By 8.1% USD/CAD Is Overvalued By 8.1% USD/CAD Is Overvalued By 8.1% The Canadian dollar is undervalued by about 8% (Chart I-5). Going forward, movements in the Canadian dollar will be largely dictated by interest rate differentials and crude oil prices, which remain supportive for now. We are going long a petrocurrency basket today, one that includes the Canadian dollar. Canadian data have been slowly improving, with housing starts up 20.2% month-on-month in May and existing home sales up 56.9% month-on-month. House prices have also remained resilient. More importantly, foreign investors have used the plunge in oil prices to deploy some fresh capital into Canadian assets. International security transactions in April stood at C$49 billion, the highest on record, and will likely continue to improve as oil prices recover.   The Swiss Franc Chart I-6USD/CHF Is Undervalued By 20.6% USD/CHF Is Undervalued By 20.6% USD/CHF Is Undervalued By 20.6% Our models suggest the Swiss franc is tactically at risk (Chart I-6). The main reason is that the franc has remained strong, despite the pickup in risk sentiment since March. Even if strength in the franc is sniffing market turbulence ahead, the yen remains a better and cheaper hedge. The Swiss National Bank continues to intervene in the foreign exchange market, but this week’s data shows that growth in sight deposits is rolling over. This is happening at a time when the economy remains weak. The June PMI came in at 41.9, well below expectations. Deflation has returned to Switzerland, with the CPI print for June at -1.3%, in line with the May number. While this is boosting real rates, the strength in the franc is an unnecessary headache for the SNB, especially against the euro.    The Australian Dollar Chart I-7AUD/USD Is Undervalued By 7.3% AUD/USD Is Undervalued By 7.3% AUD/USD Is Undervalued By 7.3% Despite the 20% rally in the Aussie dollar since March, it still remains 7%-8% cheap, according to our FITM (Chart I-7). Typical reflation indicators such as commodity prices and industrial share prices are showing nascent upturns. This suggests that so far, policy stimulus in China has been sufficient to lift commodity demand. Meanwhile, 10-year Aussie government bonds sport a positive spread vis-à-vis 10-year Treasurys. Recent data in Australia have been holding up. The private sector is slowly releveraging, the CBA manufacturing PMI went to 51.2 in June, and the trade balance continues to sport a healthy surplus, at A$8 billion for the month of May. Meanwhile, LNG is a long-term winner from China’s shift away from coal and will continue to benefit Australian terms of trade. We are currently in an LNG glut due to Covid-19, but should electricity generation in China, Japan, and other Asean countries recover to pre-crisis peaks, this will ease the glut. The New Zealand Dollar Chart I-8NZD/USD Is Overvalued By 4.9% NZD/USD Is Overvalued By 4.9% NZD/USD Is Overvalued By 4.9% Unlike the AUD, our FITM for the NZD is in expensive territory. This favors long positions in AUD/NZD (Chart I-8). The New Zealand economy will certainly benefit from having put Covid-19 mostly behind it. Both the ANZ business confidence and activity outlook indices continue to rebound strongly from their lows, with the final print for June released this week. However, the hit to tourism will still impact national income. Meanwhile, the adjustment to housing, especially given the ban to foreign purchases, will continue to constrain domestic spending, relative to its antipodean neighbor. In terms of trading, long CAD/NZD and AUD/NZD remain attractive positions. The Norwegian Krone Chart I-9USD/NOK Is Overvalued By 16.9% USD/NOK Is Overvalued By 16.9% USD/NOK Is Overvalued By 16.9% Our fundamental model for the Norwegian krone shows it as squarely undervalued. This favors long NOK positions, which we have implemented via multiple crosses in our bulletins (Chart I-9). The Norwegian economy remains closely tied to oil, and the negative oil print in April probably marked a structural bottom in prices. With inflation near the central bank’s target and our expectation for oil prices to grind higher, the Norwegian currency will likely fare better than a lot of its G10 peers. In terms of data, the unemployment rate ticked higher in April, but at 4.8%, it remains much lower than other developed economies. Our bet is that once the global economy stabilizes, the Norges Bank might find itself ahead of the pack, in any hiking cycle. The Swedish Krona Chart I-10USD/SEK Is Overvalued By 10.6% USD/SEK Is Overvalued By 10.6% USD/SEK Is Overvalued By 10.6% Like its Scandinavian counterpart, the Swedish krona is also quite cheap and is one of our favorite longs at the moment (Chart I-10). Meanwhile, since the Fed extended its USD swap lines, SEK has lagged the bounce in AUD, NZD, and NOK, suggesting some measure of catch up is due. The export-driven Swedish economy was hit hard by Covid-19, despite no widespread lockdowns being implemented. As such, the Riksbank expanded its QE program this week, boosting asset purchases from SEK 300 billion to SEK 500 billion, until June 2021. In September, it will start purchasing corporate bonds in addition to government, municipal, and mortgage bonds. While the repo rate was left unchanged at zero, interest rates on the standing loan facility were slashed 10 basis points and on weekly extraordinary loans by 20 basis points. These measures should provide sufficient liquidity to allow Sweden to recover as economies open up across the globe.     Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Please see Foreign Exchange Strategy / Global Asset Allocation Strategy Special Report titled, "Currency Hedging: Dynamic Or Static? – A Practical Guide For Global Equity Investors (Part II)", dated October 13, 2017.   Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights The cost of housing is the one item that has held up US inflation vis a vis European inflation in recent years. But as the cost of housing flips from being a strong tailwind to a strong headwind, US inflation is about to converge down to European levels and stay there. This means that US and European bond yields will also converge. If the US 30-year yield converges down to the UK 30-year yield, it would equate to a price appreciation of 15 percent. Underweight the dollar versus the most defensive European currency, the Swiss franc. Continue to favour long-duration defensive equities, technology and healthcare, whose net present values are most leveraged to a decline in the US T-bond yield. Fractal trade: long GBP/RUB. Feature Chart I-1Housing Cost Inflation Has Been Subdued In The UK... Housing Cost Inflation Has Been Subdued In The UK... Housing Cost Inflation Has Been Subdued In The UK... Chart I-2...But Running Hot In The US. What Happens Next? ...But Running Hot In The US. What Happens Next? ...But Running Hot In The US. What Happens Next? One of the biggest ongoing costs that we face is the cost of housing. Yet economists remain perplexed on how to measure this cost in a consumer price index. For people who rent their homes, the issue is straightforward – the rent paid every month captures the cost of the housing services that are consumed. But for owner occupiers, the biggest ongoing cost tends to be the mortgage interest payment. Therein lies a problem. Measuring Housing Costs Is A Challenge A consumer price index aims to measure the costs of consumption. But a mortgage interest payment measures the cost of borrowing money, rather than a cost of consumption. Therefore, capturing owner occupiers’ housing costs poses a challenge, and economists have developed several theoretical approaches to measure them (Box I-1). Box I-1The Different Methods Of Measuring Owner Occupiers’ Housing Costs Why Housing Costs Matter More Than Ever Why Housing Costs Matter More Than Ever This report focusses on the approach known as rental equivalence or ‘owners’ equivalent rent’. The reason is that rental equivalence is the approach used in the UK CPI including housing (CPIH) – though be aware that the Bank of England still targets inflation using the CPI excluding housing. Rental equivalence is also the approach used in the US CPI and PCE, and the Federal Reserve does target inflation including housing. The treatment of housing costs in inflation matters enormously. The UK versus US comparison reveals something odd. In the UK, owner occupiers’ housing inflation has been running well below overall inflation, whereas in the US it has been running hot (Chart I-1 and Chart I-2). In fact, remove the 25 percent weighting to owners’ equivalent rent from the US consumer price index – to make it comparable with Europe – and the US inflation rate would now be one of the lowest in the world at minus 1 percent! (Chart I-3). Hence, the treatment of housing costs in inflation matters enormously. Chart I-3Excluding Owners' Equivalent Rent, US Inflation Is Minus 1 Percent Excluding Owners' Equivalent Rent, US Inflation Is Minus 1 Percent Excluding Owners' Equivalent Rent, US Inflation Is Minus 1 Percent What Is Driving Housing Costs? A UK Versus US Comparison Rental equivalence uses the rent paid for an equivalent house as a proxy for the costs faced by an owner occupier. The approach answers the question: “how much rent would I have to pay to live in a home like mine?” In other words, the housing services are valued by looking at the cost of the next best alternative to owning the home, namely renting an identical or near-identical property. As rental equivalence aims to measure the cost of housing services rather than the asset value of the house, it should not be expected to move in line with house prices in the short-term. Indeed, the rent for a property is likely to be lower in relation to the house price when the monthly mortgage payment is lower. This is because a lower monthly mortgage payment makes it more affordable to own a house, pushing down the prices of rents and rental equivalence. Economists remain perplexed on how to measure housing costs in a consumer price index. In the UK, mortgages tend to have a variable interest rate linked to the Bank of England policy rate. Hence, the change in short-term mortgage rates explains the profile of housing cost inflation. For the past few years, UK owner occupiers’ housing inflation has been subdued because short-term mortgage rates have been drifting down (Chart I-4). Chart I-4UK Owner Occupiers' Housing Cost Inflation Tracks Changes In The Mortgage Rate UK Owner Occupiers' Housing Cost Inflation Tracks Changes In The Mortgage Rate UK Owner Occupiers' Housing Cost Inflation Tracks Changes In The Mortgage Rate But in the US, mortgages tend to have fixed rates resulting in a different explanation for the profile of housing cost inflation. US owners’ equivalent rent inflation moves in lockstep with actual rent inflation. In fact, the two series are almost indistinguishable (Chart I-5). Raising the question: what drives US rent inflation? Empirically, the most important driver is the (inverted) unemployment rate – which establishes the number of people who can rent a property. Chart I-5US Owners' Equivalent Rent Tracks Actual Rent Inflation US Owners' Equivalent Rent Tracks Actual Rent Inflation US Owners' Equivalent Rent Tracks Actual Rent Inflation This leads to a crucial finding. The last three times that the US unemployment rate moved into the high single digits – in the recessions of the early 1980s, early 1990s, and 2008 – rent inflation plus owners’ equivalent rent inflation flipped from being a strong tailwind to core inflation into a very strong headwind. Given the consistent relationship in each of the last three recessions, and with US unemployment rate now running in double digits, only a brave man would bet on it being any different in the 2020 recession (Chart I-6). Chart I-6Whenever US Unemployment Surges, Shelter Inflation Flips From An Inflation Tailwind To An Inflation Headwind Whenever US Unemployment Surges, Shelter Inflation Flips From An Inflation Tailwind To An Inflation Headwind Whenever US Unemployment Surges, Shelter Inflation Flips From An Inflation Tailwind To An Inflation Headwind The combination of rent plus owners’ equivalent rent – shelter – comprises 34 percent of the US consumer price index, 42 percent of the core CPI, as well as a hefty weighting in the core PCE. It is the one item that has held up US core inflation vis a vis European core inflation in recent years (Chart I-7). But as shelter inflation flips from being a strong tailwind to a strong headwind, US inflation is about to converge down to European levels and stay there. Chart I-7Shelter Has Propped Up US Core Inflation... But For How Much Longer? Shelter Has Propped Up US Core Inflation... But For How Much Longer? Shelter Has Propped Up US Core Inflation... But For How Much Longer? The Implications Of Converging Inflation As US inflation converges down to European levels, the last few years of divergence in US bond yields from European yields will prove to be a brief aberration. Before 2016, US and European yields were joined at the hip. It is highly likely that they will soon re-join at the hip (Chart I-8 and Chart I-9). Chart I-8The Last Few Years Of Divergence Between US And European Bond Yields... The Last Few Years Of Divergence Between US And European Bond Yields... The Last Few Years Of Divergence Between US And European Bond Yields... Chart I-9...Will Prove To Be A Brief ##br##Aberration ...Will Prove To Be A Brief Aberration ...Will Prove To Be A Brief Aberration All of which reinforces three of our existing investment recommendations: Stay overweight US T-bonds versus high-quality European government bonds. In fact, if the US 30-year yield converges down to the UK 30-year yield, it would equate to a price appreciation of 15 percent. Meaning that an absolute overweight to the US long bond will also reap rewards. Turning to currencies, yield convergence should be bearish for the dollar versus European currencies. That said, the dollar has the merit of being well bid during periods of economic and financial stress which might prove to be regular occurrences in the coming year. On this basis, the best strategy is to underweight the dollar versus the most defensive European currency, the Swiss franc. If the US 30-year yield converges down to the UK 30-year yield, it would equate to a price appreciation of 15 percent. Finally, in the equity markets, continue to favour long-duration growth defensives – whose net present values are most leveraged to a decline in the US T-bond yield. This means technology and healthcare. Fractal Trading System* The rally in the Russian rouble is technically stretched and susceptible to a countertrend reversal. Accordingly, this week’s recommended trade is long GBP/RUB. Set the profit target and symmetrical stop-loss at 3 percent. Chart I-10GBP/RUB GBP/RUB GBP/RUB In other trades, long Australia versus New Zealand closed at the end of its 65 day holding period flat. The rolling 1-year win ratio now stands at 59 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.   Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading System   Cyclical Recommendations Structural Recommendations Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields   Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations  

Highlights Recommended Allocation Quarterly Portfolio Outlook: Cash Injections Versus COVID Infections Quarterly Portfolio Outlook: Cash Injections Versus COVID Infections The coronavirus pandemic is not over. Enormous fiscal and monetary stimulus will soften the blow to the global economy, but there remain significant risks to growth over the next 12 months. The P/E ratio for global equities is near a record high. This suggests that the market is pricing in a V-shaped recovery, and ignoring the risks. We can, therefore, recommend no more than a neutral position on global equities. But government bonds are even more expensive, with yields having largely hit their lower bound. Stay underweight government bonds, and hedge downside risk via cash. The US dollar is likely to depreciate further: It is expensive, US liquidity has risen faster than elsewhere, interest-rate differentials no longer favor it, and momentum has swung against it. A weakening dollar – plus accelerating Chinese credit growth – should help commodities. We raise the Materials equity sector to neutral, and put Emerging Market equities on watch to upgrade from neutral. Corporate credit selectively remains attractive where central banks are providing a backstop. We prefer A-, Baa-, and Ba-rated credits, especially in the Financials and Energy sectors. Defensive illiquid alternative assets, such as macro hedge funds, have done well this year. But investors should start to think about rotating into private equity and distressed debt, where allocations are best made mid-recession. Overview Cash Injections Vs. COVID Infections The key to where markets will move over the next six-to-nine months is (1) whether there will be a second wave of COVID-19 cases and how serious it will be, and (2) how much appetite there is among central banks and fiscal authorities to ramp up stimulus to offset the damage the global economy will suffer even without a new spike in cases. A new wave of COVID-19 in the northern hemisphere this fall and winter is probable. It is not surprising, after such a sudden stop in global activity between February and May, that economic data is beginning to return to some sort of normality. PMIs have generally recovered to around 50, and in some cases moved above it (Chart 1). Economic data has surprised enormously to the upside in the US, although it is lagging in the euro zone and Japan (Chart 2). Chart 1Data Is Rebounding Sharply Data Is Rebounding Sharply Data Is Rebounding Sharply Chart 2US Data Well Above Expectations US Data Well Above Expectations US Data Well Above Expectations     New COVID-19 cases continue to rise alarmingly in some emerging economies and in parts of the US, but in Europe and Asia the pandemic is largely over (for now) and lockdown regulations are being eased, allowing economic activity to resume (Chart 3). Nonetheless, consumers remain cautious. Even where economies have reopened, people remain reluctant to eat in restaurants, to go on vacation, or to visit shopping malls (Chart 4). While shopping and entertainment activities are now no longer 70-80% below their pre-pandemic levels, as they were in April and May, they remain down 20% or more (Chart 5). Chart 3Few COVID-19 Cases Now In Europe And Asia Few COVID-19 Cases Now In Europe And Asia Few COVID-19 Cases Now In Europe And Asia Chart 4Consumers Still Reluctant To Go Out Quarterly Portfolio Outlook: Cash Injections Versus COVID Infections Quarterly Portfolio Outlook: Cash Injections Versus COVID Infections Chart 5Spending Well Below Pre-Pandemic Levels Quarterly Portfolio Outlook: Cash Injections Versus COVID Infections Quarterly Portfolio Outlook: Cash Injections Versus COVID Infections So how big is the risk of further spikes in COVID-19 cases? Speaking on a recent BCA Research webcast, the conclusion of Professor Peter Doherty, a Nobel prize-winning immunologist connected to the University of Melbourne, was that, “It’s not unlikely we’ll see a second wave.”1 But experts can’t be sure. It seems that the virus spreads most easily when people group together indoors. That is why US states where it is hot at this time of the year, such as Arizona, have seen rising infections. This suggests that a new wave in the northern hemisphere this fall and winter is probable. Offsetting the economic damage caused by the coronavirus has been the staggering amount of liquidity injected by central banks, and huge extra fiscal spending. Major central bank balance-sheets have grown by around 5% of global GDP since March, causing a spike in broad money growth everywhere (Chart 6). Fiscal spending programs also add up to around 5% of global GDP (Chart 7), with a further 5% or so in the form of loans and guarantees. Chart 6Remarkable Growth In Money Supply... Remarkable Growth In Money Supply... Remarkable Growth In Money Supply... Chart 7...And Unprecedented Fiscal Spending Quarterly Portfolio Outlook: Cash Injections Versus COVID Infections Quarterly Portfolio Outlook: Cash Injections Versus COVID Infections   But is it enough? Considerable damage has been done by the collapse in activity. Bankruptcies are rising (Chart 8) and, with activity still down 20% in consuming-facing sectors, pressure on companies’ business models will not ease soon – particularly given evidence that banks are tightening lending conditions. Household income has been buoyed by government wage-replacement schemes, handout checks, and more generous unemployment benefits (Chart 9). But, when these run out, households will struggle if the programs are not topped up. Central banks are clearly willing to inject more liquidity if need be. But the US Congress is prevaricating on a second fiscal program, and the Merkel/Macron proposed EUR750 billion spending package in the EU is making little progress. It will probably take a wake-up call from a sinking stock market to push both to take action. Chart 8Companies Feeling The Pressure Quarterly Portfolio Outlook: Cash Injections Versus COVID Infections Quarterly Portfolio Outlook: Cash Injections Versus COVID Infections Considerable damage has been done by the collapse in activity. We lowered our recommendation for global equities to neutral from overweight in May. We are still comfortable with that position. Given the high degree of uncertainty, this is not a market in which to take bold positioning in a portfolio. When you have a high conviction, position your portfolio accordingly; but when you are unsure, stay close to benchmark. With stocks up by 36% since their bottom on March 23rd, the market is pricing in a V-shaped recovery and not, in our view, sufficiently taking into account the potential downside risks. P/E ratios for global stocks are at very stretched levels (Chart 10). Chart 9Households Dependent On Handouts More Stimulus Forthcoming? Households Dependent On Handouts More Stimulus Forthcoming? Households Dependent On Handouts Chart 10Global Equities Are Expensive... Global Equities Are Expensive... Global Equities Are Expensive...   Nonetheless, we would not bet against equities. Simply, there is no alternative. Most government bond yields are close to their effective lower bound. Gold looks overbought (in the absence of a significant spike in inflation which, while possible, is unlikely for at least 12 months). No sensible investor in, say, Germany would want to hold 10-year government bonds yielding -50 basis points. Assuming 1.5% average annual inflation over the next decade, that guarantees an 18% real loss over 10 years. The only investors who hold such positions have them because their regulators force them to. Chart 11...But They Are Cheap Against Bonds ...But They Are Cheap Against Bonds ...But They Are Cheap Against Bonds The Sharpe ratio on 10-year US Treasurys, which currently yield 70 BPs, will be 0.16 (assuming volatility of 4.5%) over the next 10 years. A simple calculation of the likely Sharpe ratio for US equities (earnings yield of 4.5% and volatility of 16%) comes to 0.28. One would need to assume a disastrous outlook for the global economy to believe that stocks will underperform bonds in the long run. Though equities are expensive, bonds are even more so. The equity risk premium in most markets is close to a record high (Chart 11). With such mathematics, it is hard for a long-term oriented investor to be underweight equities. Garry Evans, Senior Vice President Chief Global Asset Allocation Strategist garry@bcaresearch.com   What Our Clients Are Asking Chart 12Premature Opening Of The Economy Is Risky Quarterly Portfolio Outlook: Cash Injections Versus COVID Infections Quarterly Portfolio Outlook: Cash Injections Versus COVID Infections COVID-19: How Risky Is Reopening? Countries around the world are rushing to reopen their economies, claiming victory over the pandemic. It is hard to be sure whether a second wave of COVID-19 will hit. What is certain, however, is that a premature relaxation of measures is as risky as a tardy initial response. That was the lesson from our Special Report analyzing the Spanish Flu of 1918. The risk is certainly still there: Herd immunity will require around 70% of the population to get sick, and a drug or vaccine will (even in an optimistic scenario) not be available until early next year. China and South Korea, for example, after reporting only a handful of daily new cases in early May, were forced to impose new restrictions over the past few weeks as COVID-19 cases spiked again (Chart 12, panel 1). We await to see if other European countries, such as Italy, Spain, and France will be forced to follow. Some argue that even if a second wave hits, policy makers – to avoid a further hit to economic output – will favor the “Swedish model”: Relying on people’s awareness to limit the spread of the virus, without imposing additional lockdowns and restrictions. This logic, however, is risky since Sweden suffered a much higher number of infections and deaths than its neighboring countries (panel 2). The US faces a similar fate. States such as Florida, Arizona, and Texas are recording a sharp rise in new infections as lockdowns are eased. In panel 3, we show the daily number of new infections during the stay-at-home orders (the solid lines) and after they were lifted (dashed lines). To an extent, increases in infections are a function of mass testing. However, what is obvious is that the percentage of positive cases per tests conducted has started trending upwards as lockdown measures were eased (panel 4). Our base case remains that new clusters of infections will emerge. Eager citizens and rushed policy decisions will fuel further contagion. If the Swedish model is implemented, lives lost are likely to be larger than during the first wave. Chart 13W Or U, Says The OECD Quarterly Portfolio Outlook: Cash Injections Versus COVID Infections Quarterly Portfolio Outlook: Cash Injections Versus COVID Infections What Shape Will The Recovery Be: U, V, W, Or Swoosh? The National Bureau of Economic Research (NBER) Business Cycle Dating Committee has already declared that the US recession began in March. The economists’ consensus is that Q2 US GDP shrank by 35% QoQ annualized. But, after such a momentous collapse and with a moderate move back towards normalcy, it is almost mathematically certain that Q3 GDP will show positive quarter-on-quarter growth. So does this mean that the recession lasted only one quarter, i.e. a sharp V-shape? And does this matter for risk assets? The latest OECD Economic Outlook has sensible forecasts, using two “equally probable” scenarios: One in which a second wave of coronavirus infections hits before year-end, requiring new lockdowns, and one in which another major outbreak is avoided.2 The second-wave scenario would trigger a renewed decline in activity around the turn of 2020-21: a W-shape. The second scenario looks more like a U-shape or swoosh, with an initial rebound but then only a slow drawn-out recovery, with OECD GDP not returning to its Q4 2019 level before the end of 2021 (Chart 13). Chart 14Unemployment Will Take A Long Time To Come Down Unemployment Will Take A Long Time To Come Down Unemployment Will Take A Long Time To Come Down Why is it likely that, in even the absence of a renewed outbreak of the pandemic, recovery would be faltering? After an initial period in which many furloughed workers return to their jobs, and pent-up demand is fulfilled, the damage from the sudden stop to the global economy would kick in. Typically, unemployment rises rapidly in a recession, but recovers only over many years back to its previous low (Chart 14). This time, many firms, especially in hospitality and travel, will have gone bust. Capex plans are also likely to be delayed. Chart 15Sub-Potential Output Can Be Good For Risk Assets Sub-Potential Output Can Be Good For Risk Assets Sub-Potential Output Can Be Good For Risk Assets However, a slow recovery is not necessarily bad for risk assets. Periods when the economy is recovering but remains well below potential (such as 2009-2015) are typically non-inflationary, which allows central banks to continue accommodation (Chart 15). Is This Sharp Equity Rebound A Retail Investor Frenzy? The answer to this question is both Yes and No. From a macro fundamental perspective, the answer is No, because coordinated global reflationary policies and medical developments to fight the coronavirus have been the key drivers underpinning this equity rebound. “COVID-on” and “COVID-off” have been the main determinants for equity rotations. Chart 16Active Retail Participation Lately Retail Investors Have Driven Up Trading Volumes Active Retail Participation Lately Retail Investors Have Driven Up Trading Volumes Active Retail Participation Lately But at the individual stock level, the answer is Yes. Some of the unusual action in beaten-down stocks over the past few weeks may have its origin in an upsurge of active retail participation (Chart 16). Retail investors on their own are not large enough to influence the market direction. Many online brokerages do not charge any commission for trades, but make money by selling order flows to hedge funds. As such, the momentum set in motion by retail investors may have been amplified by fast-money pools of capital. Retail participation in some beaten-down stocks has also provided an opportunity for institutions to exit. BCA’s US Investment Strategy examined the change in institutional ownership of 12 stocks in three stressed groups between February 23 and June 14, as shown in Table 1. In the case of these stocks, retail investors have served as liquidity providers to institutional sellers seeking to exit their holdings. The redeployment of capital by institutions into large-cap and quality names may have pushed up the overall equity index level. Table 1Individuals Have Replaced Institutions Quarterly Portfolio Outlook: Cash Injections Versus COVID Infections Quarterly Portfolio Outlook: Cash Injections Versus COVID Infections How Will Inflation Behave After COVID? Some clients have asked us about the behavior of inflation following the COVID epidemic. Over the very short term, inflation could have more downside. However, this trend is likely to reverse rapidly. Headline inflation is mainly driven by changes in the oil price and not by its level. Thus, even if oil prices were to stay at current low levels, the violent recovery of crude from its April lows could bring headline inflation near pre-COVID levels by the beginning of 2021 (Chart 17, top panel). This effect could become even larger if our Commodity strategist price target of 65$/barrel on average in 2021 comes to fruition. Chart 17Rising Oil Prices And Fiscal Stimulus Will Boost Inflation Rising Oil Prices And Fiscal Stimulus Will Boost Inflation Rising Oil Prices And Fiscal Stimulus Will Boost Inflation But will this change in inflation be transitory or will it prove to be sustainable? We believe it will be the latter. The COVID crisis may have dramatically accelerated the shift to the left in US fiscal policy. Specifically, programs such as universal basic income may now be within the Overton window3 of acceptable fiscal policy, thanks to the success of the CARES Act in propping up incomes amid Depression-like levels of unemployment (middle panel). Meanwhile there is evidence that this stimulus is helping demand to recover rapidly: Data on credit and debit card trends show that consumer spending in the US has staged a furious rally, particularly among low-income groups, where spending has almost completely recovered (bottom panel). With entire industries like travel, restaurants and lodging destroyed for the foreseeable future, the political will to unwind these programs completely is likely to be very low, given that most policymakers will be queasy about an economic relapse, even after the worst of the crisis has passed. Such aggressive fiscal stimulus, coupled with extremely easy monetary policy will likely keep inflation robust on a cyclical basis. Global Economy Overview: March-May 2020 will probably prove to be the worst period for the global economy since the 1930s, as a result of the sudden stop caused by the coronavirus pandemic and government-imposed restrictions on movement. As the world slowly emerges from the pandemic, data has started to improve. But there remain many risks, and global activity is unlikely to return to its end-2019 level for at least another two years. That means that further fiscal and monetary stimulus will be required. The speed of the recovery will be partly determined by how much more aggressively central banks can act, and by how much appetite there is among fiscal authorities to continue to bail out households and companies which have suffered a catastrophic loss of income. US: The economy has shown signs of a strong rebound from the coronavirus slump in March and April. Q2 GDP probably fell around 35% quarter-on-quarter annualized, but Q3 will almost certainly show positive growth. The Economic Surprise Index (Chart 18, panel 1) has bounced to a record high, after stronger-than expected May data, for example the 16% month-on-month growth in durable goods orders, and 18% in retail sales. But the next stage of the recovery will be harder: continuing unemployment claims in late June were still 19.5 million. Bankruptcies are rising, and banks are tightening lending conditions. One key will be whether Congress can pass a further fiscal program before the emergency spending runs out in July. Euro Area: Although pandemic lockdowns ended in Europe earlier than in the US, recovery has been somewhat slower. The euro zone PMI rebounded to close to 50 in June but, given that activity had collapsed in February-May, it is surprising (since the PMI measures month-on-month change) that it is not well above 50 (Chart 19, panel 1). Fiscal and monetary stimulus, while large, has not been as aggressive as in the US. The ECB remains circumscribed (as least psychologically) by the German constitutional court’s questioning the justification for previous QE. Germany and France have agreed a EUR750 billion additional package to help the periphery, but this has still to be finalized, due to the opposition of some smaller northern EU members. Chart 18Economic Data Has Started To Surprise To The Upside... Economic Data Has Started To Surprise To The Upside... Economic Data Has Started To Surprise To The Upside... Chart 19...But From Dramatically Low Levels ...But From Dramatically Low Levels ...But From Dramatically Low Levels   Japan: Although Japan escaped relatively easily from pandemic deaths and lockdowns, its economy remains notably weak. New machinery orders in April were still falling 18% YoY, and exports in May were down 28% YoY. The poor economic performance is due to its dependence on overseas demand, distrust in the government, the lingering effects of the ill-timed consumption tax rise last October, and limited room for manoeuvre by the Bank of Japan. The government has announced fiscal stimulus equal to a barely credible 40% of GDP, but much of this is double-counting, and less than half of the household and small-company income-replacement handouts announced in March have so far been paid out. Emerging Markets: India, Brazil, and other Latin American countries are now bearing the brunt of the coronavirus pandemic. Economies throughout Emerging Markets have weakened dramatically as a result. Two factors may come to their aid, though. China is again ramping up monetary stimulus, with a notable acceleration of credit growth over the past three months. Its economy has stabilized as a result, as PMIs show (panel 3). And the US dollar has begun to depreciate, which will take pressure off EM borrowers in foreign currencies, and boost commodities prices. The biggest risk is that many EM central banks have now resorted to printing money, which could result in currency weakness and inflation at a later stage. Interest Rates: Central banks in advanced economies have lowered policy rates to their effective lower bound. It is unlikely the Fed will cut into negative territory, having seen the nefarious effects of this on the banking systems in Japan and the euro zone, and particularly due to the large money-market fund industry in the US, which is unviable with negative rates. Reported inflation everywhere, both headline and core, has fallen sharply, but this is somewhat misleading since the price of items that households in lockdown have actually been buying has risen sharply. Markets have started to sniff out the possibility of inflation once the pandemic is over, and inflation expectations have begun to rise (panel 4). For now, deflation is likely to be the bigger worry and so we do not expect long-term rates to rise much this year. But a sharp pickup in inflation is a definite risk on the 18-24 month time horizon. Global Equities Chart 20Stretched Valuation Has Earnings Growth Bottomed? Has Earnings Growth Bottomed? Valuation Concern: Global equities staged an impressive rebound of 18% in Q2 after the violent selloff in Q1, thanks to the “whatever-it-takes” support from central banks, and massive fiscal stimulus packages around the globe. Within equities, our country allocation worked well, as the US outperformed both the euro Area and Japan. Our sector performance was mixed: The overweight in Info Tech and underweight in Utilities and Real Estate generated good profits, but the overweights in Industrials and Healthcare and the underweight in Materials suffered losses. As shown in Chart 20, even before the pandemic-induced profit contraction, forward earnings were already only flattish in 2019. The sharp selloff in Q1 brought the valuation multiple back down only to the same level as at the end of 2018. Currently, this valuation measure stands at the highest level since the Great Financial Crisis after a 37% increase in Q2 2020 alone. Such a rapid multiple expansion was one of the key reasons why we downgraded equities to Neutral in May at the asset-class level. Going forward, BCA’s house view is that easy monetary policies and stimulative fiscal policies globally will help to revive economic activity, and that a weakening US dollar will give an additional boost to the global economy, especially Emerging Markets. Consequently, we upgrade global Materials to neutral from underweight and put Emerging Market equities (currently neutral) on an upgrade watch (see next page). Warming To Reflation Plays Chart 21EM On Upgrade Watch EM On Upgrade Watch EM On Upgrade Watch Taking risk where risks will most likely be rewarded has been GAA’s philosophy in portfolio construction. As equity valuation reaches an extreme level, the natural thing to do is to rotate into less expensive areas within the equity portfolio. As shown in panel 2 of Chart 21, EM equities are trading at a 31% discount to DM equities based on forward P/E, which is 2 standard deviations below the average discount of past three years. Valuation is not a good timing tool in general, but when it reaches an extreme, it’s time to pay attention and check the fundamental and technical indicators. We are putting EM on upgrade watch (from our current neutral stance, and also closing the underweight in Materials given the close correlation of the two (Chart 21, panel 1). Three factors are on our radar screen: First, reflation efforts in China. The change in China’s total social financing as a % of GDP has been on the rise and BCA’s China Investment Strategy Team expects it to increase further. This bodes well for the momentum of the EM/DM performance, which is improving, albeit still in negative territory (panel 3). Second, a weakening USD is another key driver for EM/DM and the Materials sector relative performance as shown in panel 4. According to BCA’s Foreign Exchange Strategy, the US dollar is likely to churn on recent weakness before a cyclical bear market fully unfolds.4 Last but not least, the recent surge in the number of the coronavirus infections in EM economies, especially Brazil and India, has increased the likelihood of a second wave of lockdowns. Government Bonds Chart 22Bottoming Bond Yields Bottoming Bond Yields Bottoming Bond Yields Maintain Neutral Duration. Global bond yields barely moved in Q2 as the global economy rebounded from the COVID-induced recession low (Chart 22, panel 1). The upside surprise in economic data releases implies that global bond yields will likely go up in the near term (panel 2). For the next 9-12 months, however, the upside in global bond yields might be limited given the increasing likelihood of a new set of COVID-19 lockdowns due to the recent surge in new infections globally, especially in the US, Brazil, and India. As such, a neutral duration stance is still appropriate (Chart 22). Chart 23Inflation Expectations On The Rise Inflation Expectations On The Rise Inflation Expectations On The Rise Favor Linkers Vs. Nominal Bonds. To fight off the risk of an extended recession, policymakers around the world are determined to continue to use aggressive monetary and fiscal stimulus to boost the global economy. The combined effect of extremely accommodative policy settings and the rebound in global commodity prices, especially oil prices, will push up inflation expectations (Chart 23). Higher inflation expectations will no doubt push up nominal bond yields somewhat, but according to BCA’s Global Fixed Income Strategy (GFIS), positioning for wider inflation breakevens remains the “cleaner” way to profit for the initial impact of policy reflation.5 According to GFIS valuation models, inflation-linked bonds in Canada, Italy, Germany, Australia, France, and Japan should be favored over their respective nominal bonds. Corporate Bonds Chart 24Better Value In A-rated and Baa-rated Credit Better Value In A-rated and Baa-rated Credit Better Value In A-rated and Baa-rated Credit Investment-grade: Since we moved to overweight on investment-grade credit within the fixed-income category, it has produced 8.8% in excess returns over duration-matched government bonds. We remain overweight, given that the Federal Reserve has guaranteed to rollover debt for investment-grade issuers, essentially eliminating the left tail of returns. Moreover, the Fed has begun buying both ETFs and individual bond issues, in an effort to keep financial stress contained during the pandemic. However, there are some sectors within the investment-grade space that are more attractive than others. Specifically, our Global Fixed Income Strategy team has shown that A-rated and Baa-rated bonds are more attractive than higher-rated credits (Chart 24). Meanwhile, our fixed-income strategist are overweight Energy and Financials at the sector level.6 High-yield: High-yield bonds – where we have a neutral position - have delivered 11.5% of excess return since April. We are maintaining our neutral position. At current levels, spreads no longer offer enough value to justify an overweight position, specially if one considers that defaults in junk credits could be severe, since the Fed doesn’t offer the same level of support that it provides for investment-grade issuers. Within the high-yield space, we prefer Ba-rated credit. Fallen angels (i.e. bonds which fell to junk status) are particularly attractive given that most qualify for the Fed’s corporate buying program, since issuers which held at least a Baa3 rating as of March 22 are eligible for the Fed’s lending facilities.7  Commodities Chart 25Commodity Prices Will Rise As Growth Revives Commodity Prices Will Rise As Growth Revives Commodity Prices Will Rise As Growth Revives Energy (Overweight): A near-complete lack of storage led WTI prices to go into freefall and trade at -$40 in mid-April: The largest drawdown in oil prices over the past 30 years (Chart 25, panel 1). Since then, oil prices have picked up, reaching their pre-“sudden stop” levels, as the OPEC 2.0 coalition slashed production. Nevertheless, excess supply remains a key issue. Crude inventories have been on the rise as global crude demand weakens. Year-to-date inventories have increased by over 100 million barrels, and current inventories cover over 40 days of supply (panel 2). As long as the OPEC supply cuts hold and demand picks up over the coming quarters, the excess inventories are likely to be worked off. BCA’s oil strategists expect Brent crude to rise back above $60 by year-end. Industrial Metals (Neutral): Last quarter, we flagged that industrial metals face tailwinds as fiscal packages get rolled out globally – particularly in China where infrastructure spending is expected to increase by 10% in the latter half of the year. Major industrial metals have yet to recover to their pre-pandemic levels but, as lockdown measures are lifted and activity is restored, prices are likely to start to rise strongly (panel 3). Precious Metals (Neutral): The merits of holding gold were not obvious during the first phase of the equity sell-off in February and March. Gold prices tumbled as much as 13%, along with the decline in risk assets. Since the beginning of March, however, there have been as many positive return days as there has been negative (panel 4). However, given the uncertainty regarding a second wave of the pandemic, and the rise in geopolitical tensions between the US and China, as well as between India and China, we continue to recommend holding gold as a hedge against tail risks. Currencies Chart 26Momentum For The Dollar Has Turned Negative Momentum For The Dollar Has Turned Negative Momentum For The Dollar Has Turned Negative US Dollar: The DXY has depreciated by almost 3% since the beginning of April. Currently, there are multiple forces pushing the dollar lower: first, interest-rate differentials no longer favor the dollar Second, liquidity conditions have improved substantially thanks to the unprecedented fiscal and monetary stimulus, as well as coordinated swap lines between the Fed and other central banks to keep USD funding costs contained. Third, momentum in the DXY – one of the most reliable indicators for the dollar – has turned negative (Chart 26– top & middle panel). Taking all these factors into account, we are downgrading the USD from neutral to underweight. Euro: The euro should benefit in an environment where the dollar weakens, and global growth starts to rebound. Moreover, outperformance by cyclical sectors as well as concerns about over-valuation in US markets should bring portfolio flows to the Euro area. Therefore, we are upgrading the euro from neutral to overweight. Australian dollar: Last quarter we upgraded the Australian dollar to overweight due to its attractive valuations, as well as the effect of the monetary stimulus coming out of China. This proved to be the correct approach: AUD/USD has appreciated by a staggering 13% since our upgrade – the best performance of any G10 currency versus the dollar this quarter (bottom panel). Overall, while we believe that Chinese stimulus should continue to prop up the Aussie dollar, valuations are no longer attractive with AUD/USD hovering around PPP fair value. This means that the risk-reward profile of this currency no longer warrants an overweight position. Thus, we are downgrading the AUD to neutral. Alternatives Chart 27Opportunities Will Emerge In Private Equity Opportunities Will Emerge In Private Equity Opportunities Will Emerge In Private Equity Return Enhancers: Over the past year, we have flagged that hedge funds, particularly macro funds, will outperform other risk assets during recessions and periods of high market stress. This played out as we expected: macro hedge funds’ drawdown from January to March 2020 was a mere 1.4%, whereas other hedge funds’ drawdown ranged between 9% and 19% and global equities fell as much as 35% from their February 2020 peak. (Chart 27, panel 1). However, unlike other recessions, the unprecedented sum of stimulus should place a floor under global growth. Given the time it takes to move allocations in the illiquid space, investors should prepare for new opportunities within private equity as global growth bottoms in the latter half of this year. In an earlier Special Report, we stressed that funds raised in late-cycle bull markets tend to underperform given their high entry valuations. If previous recessions are to provide any guidance, funds raised during recession years had a higher median net IRR than those raised in the latter year of the preceding bull market (panel 2). Inflation Hedges: Over the past few quarters, we have been highlighting commodity futures as a better inflation hedge relative to other assets (e.g. real estate). Within the asset class, assuming a moderate rise in inflation over the next 12-18 months as we expect, energy-related commodities should fare best (panel 3). This corroborates with our overweight stance on oil over the next 12 months (see commodities section). Volatility Dampeners: We have been favoring farmland and timberland since Q1 2016. While both have an excel track record of reducing volatility, farmland’s inelastic demand during slowdowns will be more beneficial. Investors should therefore allocate more to farmland over timberland (panel 4). Risks To Our View The risks are skewed to the downside. After such a big economic shock, damage could appear in unexpected places. Banking systems in Europe, Japan, and the Emerging Markets (but probably not the US) remain fragile. Defaults are growing in sub-investment grade debt; mortgage-backed securities are experiencing rising delinquencies; student debt and auto loans are at risk. Emerging Market borrowers, with $4 trn of foreign-currency debt, are particularly vulnerable. The length and depth of recessions and bear markets are determined by how serious are the second-round effects of a cyclical slowdown. If the current recession really lasted only from March to July, and the bear market from February to March, this will be very unusual by historical standards (Chart 28). Chart 28Can The Recession And Bear Market Really Be All Over Already? Can It Really Be Over Already? Can It Really Be Over Already? Upside surprises are not impossible. A vaccine could be developed earlier than the mid-2021 that most specialists predict. But this is unlikely since the US Food and Drug Administration will not fast-track approval given the need for proper safety testing. If economies continue to improve and newsflow generally remains positive over the coming months, more conservative investors could be sucked into the rally. Evidence suggests that the rebound in stocks since March was propelled largely by hedge funds and individual day-traders. More conservative institutions and most retail investors remain pessimistic and have so far missed the run-up (Chart 29). One key, as so often, is the direction of US dollar. Further weakness in the currency would be a positive indicator for risk assets, particularly Emerging Market equities and commodities. In this Quarterly, we have moved to bearish from neutral on the dollar (see Currency section for details). Momentum has turned negative, and both valuation and relative interest rates suggest further downside. But it should be remembered that the dollar is a safe-haven, counter-cyclical currency (Chart 30). Any rebound in the currency would not only signal that markets are entering a risk-off period, but would cause problems for Emerging Market borrowers that need to service debt in an appreciating currency. Chart 29Many Investors Are Still Pessimistic Many Investors Are Still Pessimistic Many Investors Are Still Pessimistic Chart 30Dollar Direction Is Key Dollar Direction Is Key Dollar Direction Is Key     Footnotes 1  Please see BCA Webcast, "The Way Ahead For COVID-19: An Expert's Views," available at bcaresearch.com. 2  OECD Economic Outlook, June 2020, available at https://www.oecd-ilibrary.org/economics/oecd-economic-outlook/volume-2020/issue-1_0d1d1e2e-en 3  The Overton window, named after Joseph P. Overton, is the range of policies politically acceptable to the mainstream population at a given time. It frames the range of policies that a politician can espouse without appearing extreme. 4  Please see Foreign Exchange Strategy Weekly Report, “DXY: False Breakdown Or Cyclical Bear Market?” dated June 5, 2020 available at fes.bcaresearch.com 5  Please see Global Fixed Income Strategy Weekly Report, “How To Play The Revival Of Global Inflation Expectations” dated June 23, 2020 available at gfis.bcaresearch.com 6 Please see Global Fixed Income Strategy, "Hunting For Alpha In The Global Corporate Bond Jungle," dated May 27, 2020, available at gfis.bcaresearch.com. 7  Fallen angels also outperform during economic recoveries. Please see Global Asset Allocation Special Report, "Even Fallen Angels Have A Place In Heaven," dated November 15, 2020, available at gaa.bcaresearch.com.   GAA Asset Allocation

Highlights Global Growth & Inflation: An increasing number of growth indicators worldwide are tracing out a “v”-shaped pattern from the COVID-19 recession. However, high unemployment and a lack of inflationary pressure will ensure that global monetary policies remain highly stimulative for some time. Duration:  Maintain a neutral duration stance in global fixed income portfolios, as the recent negative correlation between inflation expectations and real yields is likely to continue.  Stay overweight higher-yielding government bonds in the US, Canada and Italy versus core Europe and Japan.  Also, favor inflation-linked bonds over nominals - particularly in the US, Canada and euro area – as breakevens will continue drifting higher over the next 6-12 months. Corporate Credit: Maintain a neutral overall allocation to global spread product, focused on overweights in markets directly supported by central bank purchases (US investment grade corporates of maturities up to five years, US Ba-rated high-yield). Feature Today marks the midway point of what has already become one the most eventful years of our lifetimes. Investors have had to process multiple massive shocks: a global pandemic; a historically deep worldwide recession; and in the US, nationwide social unrest and a now politically vulnerable president.  Yet despite the severe economic shock and persistent uncertainties, financial market performance over the entire first six months of the year has not been terrible. The S&P 500 index is only down -5.5% year-to-date, while the NASDAQ index is up +10.5% over the same period. Meanwhile, the Barclays Global Aggregate benchmark fixed income index is up +3.9% so far in 2020 (in hedged US dollar terms).  In light of the magnitude of losses suffered by global equity and credit markets in February and March, those are impressive year-to-date returns. CHART OF THE WEEKA Tug Of War A Tug Of War A Tug Of War Falling government bond yields, driven lower by an aggressive easing of global monetary policies through rate cuts and quantitative easing (QE), have played a major role in driving the recovery in risk assets. With the number of global COVID-19 cases now accelerating rapidly once again, however, the odds are increasing that investors become more reluctant to drive equity and credit valuations even higher (Chart of the Week). At the halfway point of the calendar year, this is a good time to review our most trusted indicators, and current investment recommendations, for global government debt and corporate credit. Duration Allocation: A Non-Inflationary Growth Recovery – But With Higher Inflation Expectations Our current recommended overall global duration stance is NEUTRAL. Global growth has started to recover from the sharp COVID-19 recession.  Survey data like manufacturing and services purchasing managers indices (PMIs) have rapidly rebounded from the huge March/April drops, although most PMIs remain below the 50 level suggesting accelerating economic growth (Chart 2). While there is less timely “hard data” available due to reporting lags, there are signs of improvement in critical measures like US durable goods orders, which soared +15.8% in May after falling by similar amounts in both March and April.  Global realized inflation data remains very weak, however, with headline CPI flirting with deflation in most major develop economies.  Combined with still very high levels of unemployment, which will take years to return anywhere close to pre-COVID levels, the backdrop will keep central banks highly dovish for a long time. The US Federal Reserve has already signaled that the fed funds rate will remain near 0% until the end of 2022, while the Bank of Japan has said no rate hikes will happen before 2023 at the earliest. Our Global Duration Indicator, comprised of three elements - our global leading economic indicator and its diffusion index, along with the global ZEW measure of economic expectations - has already returned to pre-COVID levels (Chart 3).  This leading, directional indicator of bond yields suggests that the downward pressure on yields seen over the first half of 2020 is over.   Chart 2Growth, But Not Inflation, Is Recovering Growth, But Not Inflation, Is Recovering Growth, But Not Inflation, Is Recovering Chart 3Our Global Duration Indicator Says Bond Yields Will Bottom Out In H2/2020 Our Global Duration Indicator Says Bond Yields Will Bottom Out In H2/2020 Our Global Duration Indicator Says Bond Yields Will Bottom Out In H2/2020 However, it is far too soon to expect a big bond selloff, with nominal government bond yields now pulled in opposing directions by their real yield and inflation expectations components. As we discussed in last week’s report, our models for market-based inflation expectations indicate that breakevens derived from inflation-linked bonds are too low.1 Hyper-easy monetary policies from the Fed, ECB and other major central banks will help lift inflation expectations, especially with oil prices likely to continue rising over the next 12-18 months according to BCA’s commodity strategists.  Chart 4Higher Inflation Breakevens Should Eventually Help Steepen Yield Curves Higher Inflation Breakevens Should Eventually Help Steepen Yield Curves Higher Inflation Breakevens Should Eventually Help Steepen Yield Curves The rise in inflation breakevens already seen over the past three months in places like the US, Canada and Australia – combined with dovish forward guidance on future interest rates that has kept shorter-maturity bond yields anchored -  should have resulted in a bearish steepening of government bond yield curves.  Yet the differences between 10-year and 2-year yields across the major developed markets have gone sideways since the beginning of April, even as 10-year inflation breakevens have increased (Chart 4). This has also kept the overall level of nominal 10-year yields nearly unchanged over the same period; for example, the 10-year US Treasury yield is now at 0.64% compared to the 0.58% closing level seen back on April 1. An outcome of rising inflation expectations with stable nominal yields must mean that real bond yields have declined by nearly as much as breakeven inflation rates have increased.  That is exactly what has happened when looking at the actual real yield on 10-year inflation-linked bonds in the US, euro area, Canada, Japan, the UK and Australia. Using the US as an example, the 10-year inflation breakeven has increased +44bps since April 1, while the 10-year real yield has declined by -38bps. The decline in global real bond yields has coincided with the major central banks aggressively easing monetary policy, including large-scale purchases of government bonds.  This occurred even in countries that had not engaged in major QE programs before, like Australia and Canada. The sizes involved for the new QE purchases have been massive, given the significant increase in the size of central bank balance sheets in absolute terms and relative to GDP (Chart 5).  An outcome of rising inflation expectations with stable nominal yields must mean that real bond yields have declined by nearly as much as breakeven inflation rates have increased.   Chart 5Global QE Is Helping Drive Real Bond Yields Lower Global QE Is Helping Drive Real Bond Yields Lower Global QE Is Helping Drive Real Bond Yields Lower It is possible that the decline in real yields is due to other factors besides QE purchases, like markets pricing in structurally slower economic growth (and lower neutral interest rates) following the severe COVID-19 recession.  Or perhaps it is more fundamentally economic in nature, reflecting a surge in domestic savings at a time of falling investment spending.  The key takeaway for investors is that rising inflation expectations do not necessarily have to translate into higher nominal bond yields if the markets do not expect central banks to signal a need to tighten monetary policy in the near future, which would push real bond yields higher. For this reason, we continue to prefer structural allocations to inflation-linked bonds out of nominal government debt, rather than maintaining below-benchmark duration exposure in fixed income portfolios.  That is a position that benefits from both higher inflation breakevens and lower real yields, while still having the benefit of maintaining a neutral level of safe-haven duration exposure given the lingering uncertainties over the accelerating global spread of COVID-19. At the specific country level, we recommend overweighting inflation-linked bonds over nominals in the US, Italy and Canada where breakevens appear most cheap on our models. Bottom Line: Maintain a neutral duration stance in global fixed income portfolios, as the recent negative correlation between inflation expectations and real yields is likely to continue.  Stay overweight higher-yielding government bonds in the US, Canada and Italy versus core Europe and Japan.  Also, favor inflation-linked bonds over nominals - particularly in the US, Canada and euro area – as breakevens will continue drifting higher over the next 6-12 months. Corporate Credit Allocation: Keep Buying What The Central Banks Are Buying Our current recommended overall stance on global corporate credit is NEUTRAL. The same reflationary arguments underlying our recommended inflation-linked bond positions also help support our views on global corporate debt.  Aggressively easy monetary policies, combined with some recovery in global economic growth, will help minimize the risk premium on corporate debt.  Yield-starved investors will continue to have no choice but to look to corporate bond markets for income over the next 6-12 months. The same reflationary arguments under-lying our recommended inflation-linked bond positions also help support our views on global corporate debt.   The combined growth rate of the balance sheets for the major central banks (the Fed, ECB, Bank of Japan and Bank of England) has been a reliable leading indicator of excess returns for global investment grade and high-yield debt since the 2008 financial crisis (Chart 6). With that combined balance sheet now expanding at a 34% year-over-year pace after the ramp up of global QE, this suggests continued support for global corporate outperformance versus government bonds over the next year. Corporate debt is also benefitting from direct central bank purchases by the Fed, ECB and Bank of England. Unsurprisingly, the 2020 peak in US investment grade and high-yield corporate spreads occurred on March 20, literally the last trading day before the Fed announced its corporate bond purchase programs (Chart 7).  Chart 6Global QE Will Continue To Support Risk Assets Global QE Will Continue To Support Risk Assets Global QE Will Continue To Support Risk Assets Chart 7The Fed Has Removed The 'Left Tail' Risk Of US Credit The Fed Has Removed The 'Left Tail' Risk Of US Credit The Fed Has Removed The 'Left Tail' Risk Of US Credit   The Fed’s announced plan for its corporate bond buying was to have it focused on shorter maturity (1-5 year) investment grade credit.  Later, the Fed allowed the programs to buy high-yield ETFs while also allowing “fallen angel” debt of investment grade credits downgrade to junk to be held within the programs.  Since that announcement in late March, risk premiums for US corporate debt across all credit tiers and maturities have narrowed.  However, the limits of that broad-based spread tightening may have now been reached, as some of the dislocations in US corporate bond markets created by the global market rout in February and early March have now been corrected.  Chart 8Relative US Corporate Spread Relationships Have Normalized Relative US Corporate Spread Relationships Have Normalized Relative US Corporate Spread Relationships Have Normalized For example, the spread on the Bloomberg Barclays 1-5 year US investment grade index – a proxy for the universe of bonds the Fed is buying – has moved from a level 25bps above that of the 5-10 year US investment grade index, seen before the Fed announced its purchase programs, to 53bps below the longer maturity index (Chart 8, top panel). This is a more normal “slope” for that spread maturity curve relationship, in line with levels seen over the past decade. This suggests that additional spread tightening in US investment grade corporates may be more widespread across all maturities, even with the Fed still focusing its own purchases on shorter-maturity bonds. A similar dynamic is evident in the US high-yield universe.  The spread between the riskier B-rated and Caa-rated credit tiers to Ba-rated names has narrowed since late March to the lower bound of a rising trend channel in place since mid-2018 (bottom panel).  The market appears to be pricing in a structurally rising risk premium between lower-rated junk and higher-rated US high-yield debt – likely a sign of a US credit cycle that was already maturing before COVID-19. The implication going forward is that additional outperformance of lower-rated US junk bonds will be difficult to achieve. The market appears to be pricing in a structurally rising risk premium between lower-rated junk and higher-rated US high-yield debt – likely a sign of a US credit cycle that was already maturing before COVID-19.  European corporate debt has also been witnessing similar trends to those seen in the US.  Euro area investment grade corporate spreads have tightened alongside US spreads since the March 20 peak, but that trend has now stabilized given the recent uptick in market volatility measures like the VIX and VStoxx index (Chart 9).  The spread tightening in euro area high yield has also stalled, with spreads seeing a slight uptick alongside the recent increase in market volatility (Chart 10). Chart 9Global IG Spread Tightening Has Stalled Global IG Spread Tightening Has Stalled Global IG Spread Tightening Has Stalled Chart 10Have Global HY Spreads Bottomed? Have Global HY Spreads Bottomed? Have Global HY Spreads Bottomed? Given the renewed uncertainty over the accelerating number of global COVID-19 cases, hitting large US population areas in the US southern states and across the emerging economies, it will be difficult for global market volatility and credit spreads to return to even the recent lows, much less the pre-COVID levels. Thus, we continue to recommend a “selective” approach to global corporate bond allocations, based on valuations, while maintaining a neutral exposure to credit versus government bonds. Our preferred method for evaluating the attractiveness of credit spreads is to look at 12-month breakeven spreads, or the amount of spread widening that would make corporate bond returns equal to duration-matched government debt over a one-year horizon.  We compare those breakeven spreads to their own history to determine if the current level of credit spreads offer value, while adjusting for the underlying spread volatility backdrop. In the US, the 12-month breakeven spread for investment grade corporates is now less attractive than was the case back in March, now sitting at the long-run median level (Chart 11, top panel). The 12-month breakeven for US high-yield is much more attractive, sitting near the highest readings dating back to the mid-1990s (bottom panel).  Of course, this approach only looks at spreads relative to their volatility and does not incorporate credit risk, which is an obvious risk after the recent collapse in US economic growth. In other words, high-yield needs to offer very high 12-month breakeven spreads to be attractive in the current environment. In the euro area, 12-month breakevens for high-yield are only at long-run median levels, while the breakevens for investment grade are a bit more attractive sitting at the 65th percentile of its own history (Chart 12). Chart 11US Corporate Breakeven Spreads: HY Looks Attractive, But Beware Defaults US Corporate Breakeven Spreads: HY Looks Attractive, But Beware Defaults US Corporate Breakeven Spreads: HY Looks Attractive, But Beware Defaults Chart 12European Corporate Breakeven Spreads: Now At Median Levels European Corporate Breakeven Spreads: Now At Median Levels European Corporate Breakeven Spreads: Now At Median Levels Importantly, 12-month breakeven spreads in both the US and euro area, for investment grade and high-yield, have not fallen into the lower quartile rankings, even after the sharp tightening of spreads since late March. This is a sign the current rally in global corporates has more room to run, strictly from a spread compression perspective.  For high-yield credit, however, the risk of default losses coming after a short, but intense, recession must be factored into any assessment of valuation. Chart 13Default-Adjusted HY Spreads In The US & Europe Are Unattractive Default-Adjusted HY Spreads In The US & Europe Are Unattractive Default-Adjusted HY Spreads In The US & Europe Are Unattractive Looking at default-adjusted spreads – spread in excess of realized and expected credit losses – shows that the current level of junk spreads on both sides of the Atlantic offers little-to-no compensation for credit losses (Chart 13).  Default-adjusted spreads are already well below long-run median levels, but if a typical 10-12% recessionary default rate is applied, expected credit losses over the next twelve months will exceed the current level of spreads, thus ensuring negative excess returns on allocations to junk bonds versus government bonds. Tying it all together, our valuation metrics for corporates suggest the following recommended allocations: Overweight US investment grade corporates, but focused on the 1-5 year maturity range that is supported by Fed purchases Overweight US Ba-rated high-yield (also eligible for Fed holdings), while underweighting lower-rated B- and Caa-rated junk Neutral allocation to euro area investment grade Underweight euro area high-yield across all credit tiers This allocation is in line with our current allocations within our model bond portfolio, which are on pages 13-14. Bottom Line: Maintain a neutral overall allocation to global spread product, focused on overweights in markets directly supported by central bank purchases (US investment grade corporates of maturities up to five years, US Ba-rated high-yield).   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com   Footnotes 1  Please see BCA Research Global Fixed Income Strategy Weekly Report, “How To Play The Revival Of Global Inflation Expectations”, dated June 23, 2020, available at gfis.bcaresearch.com Recommendations Contagion Vs. Reflation: The Battle Of 2020 Rages On Contagion Vs. Reflation: The Battle Of 2020 Rages On Contagion Vs. Reflation: The Battle Of 2020 Rages On Contagion Vs. Reflation: The Battle Of 2020 Rages On Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Economic shocks in recent decades have led to surges in nationalism and the COVID-19 crisis is unlikely to be different. Nationalism adds to the structural challenges facing globalization, which is already in retreat. Investors face at least a 35% chance that President Trump will be reelected and energize a nationalist and protectionist agenda that is globally disruptive. China is also indulging in nationalism as trend growth slows, raising the probability of a clash with the US even if Trump does not win. US-China economic decoupling will present opportunities as well as risks – primarily for India and Southeast Asia. Feature Since the Great Recession, investors have watched the US dollar and US equities outperform their peers in the face of a destabilizing world order (Chart 1). Chart 1US Outperformance Amid Global Disorder US Outperformance Amid Global Disorder US Outperformance Amid Global Disorder Global and American economic policy uncertainty has surged to the highest levels on record. Investors face political and geopolitical power struggles, trade wars, a global pandemic and recession, and social unrest.  How will these risks shape up in the wake of COVID-19? First, massive monetary and fiscal stimulus ensure a global recovery but they also remove some of the economic limitations on countries that are witnessing a surge in nationalism.  Second, nationalism creates a precarious environment for globalization – namely the wave of “hyper-globalization” since 2000. Nationalism and de-globalization do not depend on the United States alone but rather have shifted to the East, which means that geopolitical risks will remain elevated even if the US presidential election sees a restoration of the more dovish Democratic Party.  Economic Shocks Fuel Nationalism’s Revival Nationalism is the idea that the political state should be made up of a single ethnic or cultural community. While many disasters have resulted from this idea, it is responsible for the modern nation-state and it has enabled democracies to take shape across Europe, the Americas, and beyond. Industrialization is also more feasible under nationalism because cultural conformity helps labor competitiveness.1  At the end of the Cold War, transnational communist ideology collapsed and democratic liberalism grew complacent. Each successive economic shock or major crisis has led to a surge in nationalism to fill the ideological gaps that were exposed. For instance, various nationalists and populists emerged from the financial crises of the late 1990s. Russian President Vladimir Putin sought to restore Russia to greatness in its own and other peoples’ eyes (Chart 2). Not every Russian adventure has mattered for investors, but taken together they have undermined the stability of the global system and raised barriers to exchange. The invasion of Crimea in 2014 and the interference in the US election in 2016 helped to fuel the rise in policy uncertainty, risk premiums in Russian assets, and safe havens over the past decade. The September 11, 2001 terrorist attacks in the United States created a surge in American nationalism (Chart 3). This surge has since collapsed, but while it lasted the US destabilized the Middle East and provided Russia and China with the opportunity to pursue a nationalist path of their own. Investors who went long oil and short the US dollar at this time could have done worse. Chart 2The Resurgence Of Russian Nationalism Nationalism And Globalization After COVID-19 Nationalism And Globalization After COVID-19 Chart 3USA: From Nationalism To Anti-Nationalism Nationalism And Globalization After COVID-19 Nationalism And Globalization After COVID-19 The 2008 crisis spawned new waves of nationalist feeling in countries such as China, Japan, the UK, and India (Chart 4). Conservatives of the majority cultural group rose to power, including in China, where provincial grassroots members of the elite reasserted the Communist Party’s centrality. Japan and India became excellent equity investment opportunities in their respective spheres, while the UK and China saw their currencies weaken.  The rising number of wars and conflicts across the world since 2008 reflects the shift toward nationalism, whether among minority groups seeking autonomy or nation-states seeking living space (Chart 5). Chart 4Nationalist Trends Since The Great Recession Nationalism And Globalization After COVID-19 Nationalism And Globalization After COVID-19 Chart 5World Conflicts Rise After Major Crises Nationalism And Globalization After COVID-19 Nationalism And Globalization After COVID-19 COVID-19 is the latest economic shock that will feed a new round of nationalism. At least 750 million people are extremely vulnerable across the world, mostly concentrated in the shatter belt from Libya to Turkey, Iran, Pakistan, and India.2 Instability will generate emigration and conflict. Once again the global oil supply will be at risk from Middle Eastern instability and the dollar will eventually fall due to gargantuan budget and trade deficits. Today’s shock will differ, however, in the way it knocks against globalization, a process that has already begun to slow. Specifically, this crisis threatens to generate instability in East Asia – the workshop of the world – due to the strategic conflict between the US and China. This conflict will play out in the form of “proxy battles” in Greater China and the East Asian periphery. The dollar’s recent weakness is a telling sign of the future to come. In the short run, however, political and geopolitical risks are acute and will support safe havens. Globalization In Retreat Nationalism is not necessarily at odds with globalization. Historically there are many cases in which nationalism undergirds a foreign policy that favors trade and eschews military intervention. This is the default setting of maritime powers such as the British and Dutch. Prior to WWII it was the American setting, and after WWII it was the Japanese. Over the past thirty years, however, the rise of nationalism has generally worked against global trade, peace, and order. That’s because after WWII most of the world accepted internationalist ideals and institutions promoted by the United States that encouraged free markets and free trade. Serious challenges to that US-led system are necessarily challenges to global trade. This is true even if they originate in the United States. Globalization has occurred in waves continuously since the sixteenth century. It is not a light matter to suggest that it is experiencing a reversal. Yet the best historical evidence suggests that global imports, as a share of global output, have hit a major top (Chart 6).3 The line in this chart will fall further in 2020. American household deleveraging, China’s secular slowdown, and the 2014 drop in oil and commodities have had a pervasive impact on the export contribution to global growth.   Chart 6Globalization Hits A Major Top Globalization Hits A Major Top Globalization Hits A Major Top The next upswing of the business cycle will prompt an increase in trade in 2021. Global fiscal stimulus this year amounts to 8% of GDP and counting. But will the import-to-GDP  ratio surpass previous highs? Probably not anytime soon. It is impossible to recreate America’s consumption boom and China’s production boom of the 1980s-2000s with public debt alone. Global trend growth is slowing. Isn’t globalization proceeding in services, if not goods? The world is more interconnected than ever, with nearly half of the population using the Internet – almost 30% in Sub-Saharan Africa. One in every two people uses a smartphone. Eventually the pandemic will be mitigated and global travel will resume. Nevertheless, the global services trade is also facing headwinds. And it requires even more political will to break down barriers for services than it does for goods (Chart 7). The desire of nations to control and patrol cyber space has resulted in separate Internets for authoritarian states like Russia and China. Even democracies are turning to censorship and content controls to protect their ideologies.  Chart 7Both Goods And Services Face Headwinds Both Goods And Services Face Headwinds Both Goods And Services Face Headwinds Political demands to protect workers and industries are gaining ground. Policymakers in China and Russia have already shifted back toward import substitution; now the US and EU are joining them, at least when it comes to strategic sectors (health, defense). Nationalists and populists across the emerging world will follow their lead. Regional and wealth inequalities are driving populations to be more skeptical of globalization. GDP per capita has not grown as fast as GDP itself, a simple indication of how globalization does not benefit everyone equally even though it increases growth overall (Chart 8). Inequality is a factor not only because of relatively well-off workers in the developed world who resent losing their job or earning less than their neighbors. Inequality is also rife in the developing world where opportunities to work, earn higher wages, borrow, enter markets, and innovate are lacking. Over the past decade, emerging countries like Brazil, Indonesia, Mexico, and South Africa have seen growing skepticism about whether foreign openness creates jobs or lifts wages.4  Immigration is probably the clearest indication of the break from globalization. The United States and especially the European Union have faced an influx of refugees and immigrants across their southern borders and have resorted to hard-nosed tactics to put a stop to it (Chart 9). Chart 8Global Inequality Fuels Protectionism Nationalism And Globalization After COVID-19 Nationalism And Globalization After COVID-19 Chart 9US And EU Crack Down On Immigration Nationalism And Globalization After COVID-19 Nationalism And Globalization After COVID-19 There is zero chance that these tough tactics will come to an end anytime soon in Europe, where the political establishment has discovered a winning combination with voters by promoting European integration yet tightening control of borders. This combination has kept populists at bay in France, Italy, the Netherlands, Spain, and Germany. A degree of nationalism has been co-opted by the transnational European project. In the US, extreme polarization could cause a major change in immigration policy, depending on the election later this year. But note that the Obama administration was relatively hawkish on the border and the next president will face sky-high unemployment, which discourages flinging open the gates.  Reduced immigration will weigh on potential GDP growth and drive up the wage bill for domestic corporations. If nationalism continues to rise and to hinder the movement of people, goods, capital, and ideas, then it will reduce the market’s expectations of future earnings. American Nationalism Still A Risk  The United States is experiencing a “Civil War Lite” that may take anywhere from one-to-five years to resolve. The November 3 presidential election will have a major impact on the direction of nationalism and globalization over the coming presidential term. If President Trump is reelected – which we peg at 35% odds – then American nationalism and protectionism will gain a new lease on life. Other nations will follow the US’s lead. If Trump fails, then nationalism will likely be driven by external forces, but protectionism will persist in some form. Chart 10Trump Is Not Yet Down For The Count Nationalism And Globalization After COVID-19 Nationalism And Globalization After COVID-19 Investors should not write Trump off. If the election were held today, Trump would lose, but the election is still four months away. His national approval rating has troughed at a higher level than previous troughs. His disapproval rating has spiked but has not yet cleared its early 2019 peak (Chart 10).5 This is despite an unprecedented deluge of bad news: universal condemnation from Democrats and the media, high-profile defections from fellow Republicans and cabinet members, stunning defeats at the Supreme Court, and scathing rebukes from top US army officers. If Trump’s odds are 35% then this translates to a 35% chance that the United States will continue pursuing globally disruptive “America First” foreign and trade policies in the 2020-24 period.    First Trump will attempt to pass a Reciprocal Trade Act to equalize tariffs with all trading partners. Assuming Democrats block it in the House of Representatives, he will still have sweeping executive authority to levy tariffs. He will launch the next round in the trade war with China to secure a “Phase Two” trade deal, which will be tougher because it will be focused on structural reforms. He could also open new fronts against the European Union, Mexico, and other trade surplus countries. By contrast, these risks will melt away if Biden is elected. Biden would restore the Obama administration’s approach of trade favoritism toward strategic allies and partners, such as Europe and the members of the Trans-Pacific Partnership, but only occasional use of tariffs. Biden would work with international organizations like the World Trade Organization. His foreign policy would also open up trade with pariah states like Iran, reducing the tail-risk of a war to almost zero.  Biden would be tougher on China than Presidents Obama or Bill Clinton, as the consensus in Washington is now hawkish and Biden would need to keep the blue-collar voters he won back from Trump. He may keep Trump’s tariffs in place as negotiating leverage. But he is less likely to expand these tariffs – and there is zero chance he will use them against Europe. At the same time, it will take a year or more to court the allies and put together a "coalition of the willing" to pressure China on structural reforms and liberalization. China would get a reprieve – and so would financial markets. Thus investors have a roughly 65% chance of seeing US policy “normalize” into an internationalist (not nationalist) approach that reduces the US contribution to trade policy uncertainty and geopolitical risk over the next few years at minimum. But there are still four months to go before the election; these odds can change, and equity market volatility will come first. Moreover a mellower US would still need to react to nationalism in Asia. European Nationalism Not A Risk (Yet) European nationalism has reemerged in recent years but has greatly disappointed the prophets of doom who expected it to lead to the breakup of the European Union. The southern European states suffered the most from COVID-19 but many of them have made their decision regarding nationalism and the supra-national EU. Greece underwent a depression yet remained in the union. Italians could easily elect the right-wing anti-establishment League to head a government in the not-too-distant future. But there is no appetite for an Italian exit. Brexit is the grand exception. If Trump wins, then the UK and British Prime Minister Boris Johnson will be seen as the vanguard of the revival of nationalism in the West. If Trump loses, English nationalism will appear an isolated case that is constrained by its own logic given the response of Scottish nationalism (Chart 11). The trend in the British Isles would become increasingly remote from the trends in continental Europe and the United States. The majority of Europeans identify both as Europeans and as their home nationality, including majorities in countries like Greece, Italy, France, and Austria where visions of life outside the union are the most robust (Chart 12). Even the Catalonians are focused on options other than independence, which has fallen to 36% support. Eastern European nationalists play a careful balancing game of posturing against Brussels yet never drifting so far as to let Russia devour them. Chart 11English Versus Scottish Nationalism English Versus Scottish Nationalism English Versus Scottish Nationalism Chart 12European Nationalism Is Limited (For Now) European Nationalism Is Limited (For Now) European Nationalism Is Limited (For Now) Europeans have embraced the EU as a multi-ethnic confederation that requires dual allegiances and prioritizes the European project. COVID-19 has so far reinforced this trend, showing solidarity as the predominant force, and much more promptly than during the 2011 crisis. It will take a different kind of crisis to reverse this trend of deeper integration. European nationalists would benefit from another economic crash, a new refugee wave from the Middle East, or conflict with Turkish nationalism. The latter is already burning brightly and will eventually flame out, but not before causing a regional crisis of some kind. European policymakers are containing nationalism by co-opting some of its demands. The EU is taking steps to guard against globalization, particularly on immigration and Chinese mercantilism. The lack of nationalist uprisings in Europe do not overthrow the contention that globalization is slowing down. Europe can become more integrated at home while maintaining the higher barriers against globalization that it has always maintained relative to the UK and United States. Chinese Nationalism The Biggest Risk The nationalist risk to globalization is most significant in East Asia and the Pacific, where Chinese nationalism continues the ascent that began with the Great Recession. China’s slowdown in growth rates has weakened the Communist Party’s confidence in the long-term viability of single-party rule. The result has been a shift in the party line to promote ideology and quality of life improvements to compensate for slower income gains. Xi Jinping’s governing philosophy consists of nationalist territorial gains, promoting “the China Dream” for the middle class, and projecting ambitious goals of global influence by 2035 and 2049. The result has been a clash between mainland Chinese and peripheral Chinese territories – especially Hong Kong and Taiwan (Chart 13). The turn away from Chinese identity in these areas runs up against their economic interest. It is largely a reaction to the surge in mainland nationalist sentiment, which cannot be observed directly due to the absence of reliable opinion polling. Chart 13Chinese Nationalism On The Mainland, Anti-Nationalism In Periphery Nationalism And Globalization After COVID-19 Nationalism And Globalization After COVID-19 The conflict over identity in Greater China is perhaps the world’s greatest geopolitical risk. While Hong Kong has no conceivable alternative to Beijing’s supremacy, Taiwan does. The US is interested in reviving its technological and defense relationship with Taiwan now that it seeks to counterbalance China. Chart 14Taiwan: Epicenter Of US-China Cold War Nationalism And Globalization After COVID-19 Nationalism And Globalization After COVID-19 Beijing may be faced with a technology cordon imposed by the United States, and yet have the option of circumventing this cordon via Taiwan’s advanced semiconductor manufacturing. Taiwan’s “Silicon Shield” used to be its security guarantee. Now that the US is tightening export controls and sanctions on China, Beijing has a greater need to confiscate that shield. This makes Taiwan the epicenter of the US-China struggle, as we have highlighted since 2016. The risk of a fourth Taiwan Strait crisis is as pertinent in the short run as it is over the long run, given that the US and China have already intensified their saber-rattling in the Strait (Chart 14), including in the wake of COVID-19 specifically. China’s secular slowdown is prompting it to encroach on the borders of all of its neighbors simultaneously, creating a nascent balance-of-power alliance ranging from India to Australia to Japan. If China fails to curb its nationalism, then eventually US political polarization will decline as the country unites in the face of a peer competitor. If American divisions persist, they could drive the US to instigate conflict with China. Thus a failure of either side to restrain itself is a major geopolitical risk. The US and China ultimately face mutually assured destruction in the event of conflict, but they can have a clash in the near term before they learn their limits. The Cold War provides many occasions of such a learning process – from the Berlin airlift to the Cuban missile crisis. Such crises typically present buying opportunities for financial markets, but the consequences could be more far reaching if the Asian manufacturing supply chain is permanently damaged or if the shifting of supply chains out of China is too rapid. Globalization will also suffer as a result of currency wars. The US has not been successful in driving the dollar down, a key demand of the US-China trade war. It is much harder to force China to reform its labor and wage policies than it is to force it to appreciate its currency. But unlike Japan in 1985, China will not commit to unilateral appreciation for fear of American economic sabotage.   Punitive measures will remain an American tool. Contrary to popular belief, the US is not attempting to eliminate its trade deficit. It is attempting to reduce overreliance on China. Status quo globalization is intolerable for US strategy. But autarky is intolerable for US corporations. The compromise is globalization-ex-China, i.e., economic decoupling. Investment Implications Chart 15Favor International Stocks As Growth Revives Favor International Stocks As Growth Revives Favor International Stocks As Growth Revives US stock market capitalization now makes up 58% of global capitalization (Chart 15), reflecting the strength and innovation of American companies as well as a worldwide flight to safety during a decade of rising policy uncertainty and geopolitical risk. The revival of global growth amid this year’s gargantuan stimulus will prompt a major rotation out of US equities and into international and emerging market equities over the long run. As mentioned, the US greenback would also trend downward. However, there will be little clarity on the pace of nationalism and the fate of globalization until the US election is decided. Moreover the fate of globalization does not depend entirely on the United States. It mostly depends on countries in the east – Russia, China, and India, all of which are increasingly nationalistic.  A miscalculation over Taiwan, North Korea, the East China Sea, the South China Sea, trade, or technology could ignite into tariffs, sanctions, boycotts, embargoes, saber-rattling, proxy battles, and potentially even direct conflict. These risks are elevated in the short run but will persist in the long run. As the US decouples from China it will have to deepen relations with other trading partners. The trade deficit will not go away but will be redistributed to Asian allies. Southeast Asian nations and India – whose own nationalism has created a shift in favor of economic development – will be the long-run beneficiaries.   Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com   Footnotes 1  Ernest Gellner, Nations and Nationalism (Ithaca, NY: Cornell University Press, 1983). 2  Neli Esipova, Julie Ray, and Ying Han, “750 Million Struggling To Meet Basic Needs With No Safety Net,” Gallup News, June 16, 2020. 3 Christopher Chase-Dunn et al, “The Development of World-Systems,” Sociology of Development 1 (2015), pp. 149-172; and Chase-Dunn, Yukio Kawano, Benjamin Brewer, “Trade globalization since 1795: waves of integration in the world-system,” American Sociological Review 65 (2000), pp. 77-95. 4 Bruce Stokes, “Americans, Like Many In Other Advanced Economies, Not Convinced Of Trade’s Benefits,” September 26, 2018. 5 In other words, the mishandling of COVID-19 and the historic George Floyd protests of June 2020 have not taken as great of a toll on Trump’s national approval, thus far, as the Ukraine scandal last October, the government shutdown in January-February 2019, the near-failure to pass tax cuts in December 2017, or the Charlottesville incident in August 2017. This is surprising and points once more to Trump’s very solid political base, which could serve as a springboard for a comeback over the next four months.

Dear Client, This week, we are publishing a Special Report on the geopolitical implications of COVID-19 from Matt Gertken, BCA Research’s Chief Geopolitical Strategist. Matt discusses the rise of nationalism with each successive global crisis and the negative implications for globalization. I hope you find his report insightful. Next week, we will publish our quarterly Strategy Outlook. Best regards, Peter Berezin, Chief Global Strategist Highlights Economic shocks in recent decades have led to surges in nationalism and the COVID-19 crisis is unlikely to be different. Nationalism adds to the structural challenges facing globalization, which is already in retreat. Investors face at least a 35% chance that President Trump will be reelected and energize a nationalist and protectionist agenda that is globally disruptive. China is also indulging in nationalism as trend growth slows, raising the probability of a clash with the US even if Trump does not win. US-China economic decoupling will present opportunities as well as risks – primarily for India and Southeast Asia. Feature Since the Great Recession, investors have watched the US dollar and US equities outperform their peers in the face of a destabilizing world order (Chart 1). Chart 1US Outperformance Amid Global Disorder US Outperformance Amid Global Disorder US Outperformance Amid Global Disorder Global and American economic policy uncertainty has surged to the highest levels on record. Investors face political and geopolitical power struggles, trade wars, a global pandemic and recession, and social unrest.  How will these risks shape up in the wake of COVID-19? First, massive monetary and fiscal stimulus ensure a global recovery but they also remove some of the economic limitations on countries that are witnessing a surge in nationalism.  Second, nationalism creates a precarious environment for globalization – namely the wave of “hyper-globalization” since 2000. Nationalism and de-globalization do not depend on the United States alone but rather have shifted to the East, which means that geopolitical risks will remain elevated even if the US presidential election sees a restoration of the more dovish Democratic Party.  Economic Shocks Fuel Nationalism’s Revival Nationalism is the idea that the political state should be made up of a single ethnic or cultural community. While many disasters have resulted from this idea, it is responsible for the modern nation-state and it has enabled democracies to take shape across Europe, the Americas, and beyond. Industrialization is also more feasible under nationalism because cultural conformity helps labor competitiveness.1  At the end of the Cold War, transnational communist ideology collapsed and democratic liberalism grew complacent. Each successive economic shock or major crisis has led to a surge in nationalism to fill the ideological gaps that were exposed. For instance, various nationalists and populists emerged from the financial crises of the late 1990s. Russian President Vladimir Putin sought to restore Russia to greatness in its own and other peoples’ eyes (Chart 2). Not every Russian adventure has mattered for investors, but taken together they have undermined the stability of the global system and raised barriers to exchange. The invasion of Crimea in 2014 and the interference in the US election in 2016 helped to fuel the rise in policy uncertainty, risk premiums in Russian assets, and safe havens over the past decade. The September 11, 2001 terrorist attacks in the United States created a surge in American nationalism (Chart 3). This surge has since collapsed, but while it lasted the US destabilized the Middle East and provided Russia and China with the opportunity to pursue a nationalist path of their own. Investors who went long oil and short the US dollar at this time could have done worse. Chart 2The Resurgence Of Russian Nationalism Nationalism And Globalization After COVID-19 Nationalism And Globalization After COVID-19 Chart 3USA: From Nationalism To Anti-Nationalism Nationalism And Globalization After COVID-19 Nationalism And Globalization After COVID-19 The 2008 crisis spawned new waves of nationalist feeling in countries such as China, Japan, the UK, and India (Chart 4). Conservatives of the majority cultural group rose to power, including in China, where provincial grassroots members of the elite reasserted the Communist Party’s centrality. Japan and India became excellent equity investment opportunities in their respective spheres, while the UK and China saw their currencies weaken.  The rising number of wars and conflicts across the world since 2008 reflects the shift toward nationalism, whether among minority groups seeking autonomy or nation-states seeking living space (Chart 5). Chart 4Nationalist Trends Since The Great Recession Nationalism And Globalization After COVID-19 Nationalism And Globalization After COVID-19 Chart 5World Conflicts Rise After Major Crises Nationalism And Globalization After COVID-19 Nationalism And Globalization After COVID-19 COVID-19 is the latest economic shock that will feed a new round of nationalism. At least 750 million people are extremely vulnerable across the world, mostly concentrated in the shatter belt from Libya to Turkey, Iran, Pakistan, and India.2 Instability will generate emigration and conflict. Once again the global oil supply will be at risk from Middle Eastern instability and the dollar will eventually fall due to gargantuan budget and trade deficits. Today’s shock will differ, however, in the way it knocks against globalization, a process that has already begun to slow. Specifically, this crisis threatens to generate instability in East Asia – the workshop of the world – due to the strategic conflict between the US and China. This conflict will play out in the form of “proxy battles” in Greater China and the East Asian periphery. The dollar’s recent weakness is a telling sign of the future to come. In the short run, however, political and geopolitical risks are acute and will support safe havens. Globalization In Retreat Nationalism is not necessarily at odds with globalization. Historically there are many cases in which nationalism undergirds a foreign policy that favors trade and eschews military intervention. This is the default setting of maritime powers such as the British and Dutch. Prior to WWII it was the American setting, and after WWII it was the Japanese. Over the past thirty years, however, the rise of nationalism has generally worked against global trade, peace, and order. That’s because after WWII most of the world accepted internationalist ideals and institutions promoted by the United States that encouraged free markets and free trade. Serious challenges to that US-led system are necessarily challenges to global trade. This is true even if they originate in the United States. Globalization has occurred in waves continuously since the sixteenth century. It is not a light matter to suggest that it is experiencing a reversal. Yet the best historical evidence suggests that global imports, as a share of global output, have hit a major top (Chart 6).3 The line in this chart will fall further in 2020. American household deleveraging, China’s secular slowdown, and the 2014 drop in oil and commodities have had a pervasive impact on the export contribution to global growth.   Chart 6Globalization Hits A Major Top Globalization Hits A Major Top Globalization Hits A Major Top The next upswing of the business cycle will prompt an increase in trade in 2021. Global fiscal stimulus this year amounts to 8% of GDP and counting. But will the import-to-GDP  ratio surpass previous highs? Probably not anytime soon. It is impossible to recreate America’s consumption boom and China’s production boom of the 1980s-2000s with public debt alone. Global trend growth is slowing. Isn’t globalization proceeding in services, if not goods? The world is more interconnected than ever, with nearly half of the population using the Internet – almost 30% in Sub-Saharan Africa. One in every two people uses a smartphone. Eventually the pandemic will be mitigated and global travel will resume. Nevertheless, the global services trade is also facing headwinds. And it requires even more political will to break down barriers for services than it does for goods (Chart 7). The desire of nations to control and patrol cyber space has resulted in separate Internets for authoritarian states like Russia and China. Even democracies are turning to censorship and content controls to protect their ideologies.  Chart 7Both Goods And Services Face Headwinds Both Goods And Services Face Headwinds Both Goods And Services Face Headwinds Political demands to protect workers and industries are gaining ground. Policymakers in China and Russia have already shifted back toward import substitution; now the US and EU are joining them, at least when it comes to strategic sectors (health, defense). Nationalists and populists across the emerging world will follow their lead. Regional and wealth inequalities are driving populations to be more skeptical of globalization. GDP per capita has not grown as fast as GDP itself, a simple indication of how globalization does not benefit everyone equally even though it increases growth overall (Chart 8). Inequality is a factor not only because of relatively well-off workers in the developed world who resent losing their job or earning less than their neighbors. Inequality is also rife in the developing world where opportunities to work, earn higher wages, borrow, enter markets, and innovate are lacking. Over the past decade, emerging countries like Brazil, Indonesia, Mexico, and South Africa have seen growing skepticism about whether foreign openness creates jobs or lifts wages.4  Immigration is probably the clearest indication of the break from globalization. The United States and especially the European Union have faced an influx of refugees and immigrants across their southern borders and have resorted to hard-nosed tactics to put a stop to it (Chart 9). Chart 8Global Inequality Fuels Protectionism Nationalism And Globalization After COVID-19 Nationalism And Globalization After COVID-19 Chart 9US And EU Crack Down On Immigration Nationalism And Globalization After COVID-19 Nationalism And Globalization After COVID-19 There is zero chance that these tough tactics will come to an end anytime soon in Europe, where the political establishment has discovered a winning combination with voters by promoting European integration yet tightening control of borders. This combination has kept populists at bay in France, Italy, the Netherlands, Spain, and Germany. A degree of nationalism has been co-opted by the transnational European project. In the US, extreme polarization could cause a major change in immigration policy, depending on the election later this year. But note that the Obama administration was relatively hawkish on the border and the next president will face sky-high unemployment, which discourages flinging open the gates.  Reduced immigration will weigh on potential GDP growth and drive up the wage bill for domestic corporations. If nationalism continues to rise and to hinder the movement of people, goods, capital, and ideas, then it will reduce the market’s expectations of future earnings. American Nationalism Still A Risk  The United States is experiencing a “Civil War Lite” that may take anywhere from one-to-five years to resolve. The November 3 presidential election will have a major impact on the direction of nationalism and globalization over the coming presidential term. If President Trump is reelected – which we peg at 35% odds – then American nationalism and protectionism will gain a new lease on life. Other nations will follow the US’s lead. If Trump fails, then nationalism will likely be driven by external forces, but protectionism will persist in some form. Chart 10Trump Is Not Yet Down For The Count Nationalism And Globalization After COVID-19 Nationalism And Globalization After COVID-19 Investors should not write Trump off. If the election were held today, Trump would lose, but the election is still four months away. His national approval rating has troughed at a higher level than previous troughs. His disapproval rating has spiked but has not yet cleared its early 2019 peak (Chart 10).5 This is despite an unprecedented deluge of bad news: universal condemnation from Democrats and the media, high-profile defections from fellow Republicans and cabinet members, stunning defeats at the Supreme Court, and scathing rebukes from top US army officers. If Trump’s odds are 35% then this translates to a 35% chance that the United States will continue pursuing globally disruptive “America First” foreign and trade policies in the 2020-24 period.    First Trump will attempt to pass a Reciprocal Trade Act to equalize tariffs with all trading partners. Assuming Democrats block it in the House of Representatives, he will still have sweeping executive authority to levy tariffs. He will launch the next round in the trade war with China to secure a “Phase Two” trade deal, which will be tougher because it will be focused on structural reforms. He could also open new fronts against the European Union, Mexico, and other trade surplus countries. By contrast, these risks will melt away if Biden is elected. Biden would restore the Obama administration’s approach of trade favoritism toward strategic allies and partners, such as Europe and the members of the Trans-Pacific Partnership, but only occasional use of tariffs. Biden would work with international organizations like the World Trade Organization. His foreign policy would also open up trade with pariah states like Iran, reducing the tail-risk of a war to almost zero.  Biden would be tougher on China than Presidents Obama or Bill Clinton, as the consensus in Washington is now hawkish and Biden would need to keep the blue-collar voters he won back from Trump. He may keep Trump’s tariffs in place as negotiating leverage. But he is less likely to expand these tariffs – and there is zero chance he will use them against Europe. At the same time, it will take a year or more to court the allies and put together a "coalition of the willing" to pressure China on structural reforms and liberalization. China would get a reprieve – and so would financial markets. Thus investors have a roughly 65% chance of seeing US policy “normalize” into an internationalist (not nationalist) approach that reduces the US contribution to trade policy uncertainty and geopolitical risk over the next few years at minimum. But there are still four months to go before the election; these odds can change, and equity market volatility will come first. Moreover a mellower US would still need to react to nationalism in Asia. European Nationalism Not A Risk (Yet) European nationalism has reemerged in recent years but has greatly disappointed the prophets of doom who expected it to lead to the breakup of the European Union. The southern European states suffered the most from COVID-19 but many of them have made their decision regarding nationalism and the supra-national EU. Greece underwent a depression yet remained in the union. Italians could easily elect the right-wing anti-establishment League to head a government in the not-too-distant future. But there is no appetite for an Italian exit. Brexit is the grand exception. If Trump wins, then the UK and British Prime Minister Boris Johnson will be seen as the vanguard of the revival of nationalism in the West. If Trump loses, English nationalism will appear an isolated case that is constrained by its own logic given the response of Scottish nationalism (Chart 11). The trend in the British Isles would become increasingly remote from the trends in continental Europe and the United States. The majority of Europeans identify both as Europeans and as their home nationality, including majorities in countries like Greece, Italy, France, and Austria where visions of life outside the union are the most robust (Chart 12). Even the Catalonians are focused on options other than independence, which has fallen to 36% support. Eastern European nationalists play a careful balancing game of posturing against Brussels yet never drifting so far as to let Russia devour them. Chart 11English Versus Scottish Nationalism English Versus Scottish Nationalism English Versus Scottish Nationalism Chart 12European Nationalism Is Limited (For Now) European Nationalism Is Limited (For Now) European Nationalism Is Limited (For Now) Europeans have embraced the EU as a multi-ethnic confederation that requires dual allegiances and prioritizes the European project. COVID-19 has so far reinforced this trend, showing solidarity as the predominant force, and much more promptly than during the 2011 crisis. It will take a different kind of crisis to reverse this trend of deeper integration. European nationalists would benefit from another economic crash, a new refugee wave from the Middle East, or conflict with Turkish nationalism. The latter is already burning brightly and will eventually flame out, but not before causing a regional crisis of some kind. European policymakers are containing nationalism by co-opting some of its demands. The EU is taking steps to guard against globalization, particularly on immigration and Chinese mercantilism. The lack of nationalist uprisings in Europe do not overthrow the contention that globalization is slowing down. Europe can become more integrated at home while maintaining the higher barriers against globalization that it has always maintained relative to the UK and United States. Chinese Nationalism The Biggest Risk The nationalist risk to globalization is most significant in East Asia and the Pacific, where Chinese nationalism continues the ascent that began with the Great Recession. China’s slowdown in growth rates has weakened the Communist Party’s confidence in the long-term viability of single-party rule. The result has been a shift in the party line to promote ideology and quality of life improvements to compensate for slower income gains. Xi Jinping’s governing philosophy consists of nationalist territorial gains, promoting “the China Dream” for the middle class, and projecting ambitious goals of global influence by 2035 and 2049. The result has been a clash between mainland Chinese and peripheral Chinese territories – especially Hong Kong and Taiwan (Chart 13). The turn away from Chinese identity in these areas runs up against their economic interest. It is largely a reaction to the surge in mainland nationalist sentiment, which cannot be observed directly due to the absence of reliable opinion polling. Chart 13Chinese Nationalism On The Mainland, Anti-Nationalism In Periphery Nationalism And Globalization After COVID-19 Nationalism And Globalization After COVID-19 The conflict over identity in Greater China is perhaps the world’s greatest geopolitical risk. While Hong Kong has no conceivable alternative to Beijing’s supremacy, Taiwan does. The US is interested in reviving its technological and defense relationship with Taiwan now that it seeks to counterbalance China. Chart 14Taiwan: Epicenter Of US-China Cold War Nationalism And Globalization After COVID-19 Nationalism And Globalization After COVID-19 Beijing may be faced with a technology cordon imposed by the United States, and yet have the option of circumventing this cordon via Taiwan’s advanced semiconductor manufacturing. Taiwan’s “Silicon Shield” used to be its security guarantee. Now that the US is tightening export controls and sanctions on China, Beijing has a greater need to confiscate that shield. This makes Taiwan the epicenter of the US-China struggle, as we have highlighted since 2016. The risk of a fourth Taiwan Strait crisis is as pertinent in the short run as it is over the long run, given that the US and China have already intensified their saber-rattling in the Strait (Chart 14), including in the wake of COVID-19 specifically. China’s secular slowdown is prompting it to encroach on the borders of all of its neighbors simultaneously, creating a nascent balance-of-power alliance ranging from India to Australia to Japan. If China fails to curb its nationalism, then eventually US political polarization will decline as the country unites in the face of a peer competitor. If American divisions persist, they could drive the US to instigate conflict with China. Thus a failure of either side to restrain itself is a major geopolitical risk. The US and China ultimately face mutually assured destruction in the event of conflict, but they can have a clash in the near term before they learn their limits. The Cold War provides many occasions of such a learning process – from the Berlin airlift to the Cuban missile crisis. Such crises typically present buying opportunities for financial markets, but the consequences could be more far reaching if the Asian manufacturing supply chain is permanently damaged or if the shifting of supply chains out of China is too rapid. Globalization will also suffer as a result of currency wars. The US has not been successful in driving the dollar down, a key demand of the US-China trade war. It is much harder to force China to reform its labor and wage policies than it is to force it to appreciate its currency. But unlike Japan in 1985, China will not commit to unilateral appreciation for fear of American economic sabotage.   Punitive measures will remain an American tool. Contrary to popular belief, the US is not attempting to eliminate its trade deficit. It is attempting to reduce overreliance on China. Status quo globalization is intolerable for US strategy. But autarky is intolerable for US corporations. The compromise is globalization-ex-China, i.e., economic decoupling. Investment Implications Chart 15Favor International Stocks As Growth Revives Favor International Stocks As Growth Revives Favor International Stocks As Growth Revives US stock market capitalization now makes up 58% of global capitalization (Chart 15), reflecting the strength and innovation of American companies as well as a worldwide flight to safety during a decade of rising policy uncertainty and geopolitical risk. The revival of global growth amid this year’s gargantuan stimulus will prompt a major rotation out of US equities and into international and emerging market equities over the long run. As mentioned, the US greenback would also trend downward. However, there will be little clarity on the pace of nationalism and the fate of globalization until the US election is decided. Moreover the fate of globalization does not depend entirely on the United States. It mostly depends on countries in the east – Russia, China, and India, all of which are increasingly nationalistic.  A miscalculation over Taiwan, North Korea, the East China Sea, the South China Sea, trade, or technology could ignite into tariffs, sanctions, boycotts, embargoes, saber-rattling, proxy battles, and potentially even direct conflict. These risks are elevated in the short run but will persist in the long run. As the US decouples from China it will have to deepen relations with other trading partners. The trade deficit will not go away but will be redistributed to Asian allies. Southeast Asian nations and India – whose own nationalism has created a shift in favor of economic development – will be the long-run beneficiaries.   Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com   Footnotes 1  Ernest Gellner, Nations and Nationalism (Ithaca, NY: Cornell University Press, 1983). 2  Neli Esipova, Julie Ray, and Ying Han, “750 Million Struggling To Meet Basic Needs With No Safety Net,” Gallup News, June 16, 2020. 3 Christopher Chase-Dunn et al, “The Development of World-Systems,” Sociology of Development 1 (2015), pp. 149-172; and Chase-Dunn, Yukio Kawano, Benjamin Brewer, “Trade globalization since 1795: waves of integration in the world-system,” American Sociological Review 65 (2000), pp. 77-95. 4 Bruce Stokes, “Americans, Like Many In Other Advanced Economies, Not Convinced Of Trade’s Benefits,” September 26, 2018. 5 In other words, the mishandling of COVID-19 and the historic George Floyd protests of June 2020 have not taken as great of a toll on Trump’s national approval, thus far, as the Ukraine scandal last October, the government shutdown in January-February 2019, the near-failure to pass tax cuts in December 2017, or the Charlottesville incident in August 2017. This is surprising and points once more to Trump’s very solid political base, which could serve as a springboard for a comeback over the next four months.

Highlights The economic performance of Sweden, which did not have a lockdown, has been almost as bad as Denmark, which did have a lockdown. This proves that the current recession is not ‘man-made’, it is ‘pandemic-made’. While the pandemic remains in play, investors should maintain a defensive bias to their portfolios: favouring US T-bonds in bond portfolios, and technology and healthcare in equity portfolios. The technology sector has become defensive, largely because it has flipped from hardware dominance to software dominance. A new recommendation is to overweight technology-heavy Netherlands. Fractal trade: short AUD/CHF. Feature Chart I-IASweden: Avoiding A Lockdown Did Not Prevent A Slump In Consumption... Sweden: Avoiding A Lockdown Did Not Prevent A Slump In Consumption... Sweden: Avoiding A Lockdown Did Not Prevent A Slump In Consumption... Chart I-1B...But Led To Many More ##br##Infections ...But Led To Many More Infections ...But Led To Many More Infections Sweden and Denmark are neighbours. They speak near-identical languages and share a broadly similar culture and demographic. Yet the two countries have followed completely different strategies to halt the coronavirus pandemic. Sweden chose not to impose a lockdown. Instead, it opted for a ‘trust based’ approach, relying on its citizens to act sensibly and appropriately. Whereas Denmark imposed one of Europe’s earliest and most draconian lockdowns. The contrasting approaches of Sweden and neighbouring Denmark provide us with the closest thing to a controlled experiment on pandemic strategies. The Recession Is Not ‘Man-Made’, It Is ‘Pandemic-Made’ The surprising thing is that the economic performance of Sweden, which did not have a lockdown, has been almost as bad as Denmark, which did. This year, the unemployment rates in both economies have surged by 2 percentage points (albeit the latest data is for May in Sweden and April in Denmark). Furthermore, high-frequency measures of consumption show that Sweden suffered almost as severe a contraction as Denmark (Chart of the Week and Chart I-2). Chart I-2Unemployment Has Surged In Both No-Lockdown Sweden And Lockdown Denmark Unemployment Has Surged In Both No-Lockdown Sweden And Lockdown Denmark Unemployment Has Surged In Both No-Lockdown Sweden And Lockdown Denmark This surprising result challenges the popular view that this global recession is man-made. This view argues that without the government-imposed lockdowns, the global economy would not have entered a tailspin. But if this view is right, then why did consumption crash in Sweden? The simple answer is that in a pandemic, most people will change their behaviour to avoid catching the virus. The cautious behaviour is voluntary, irrespective of whether there is no lockdown, as in Sweden, or there is a lockdown, as in Denmark. People will shun public transport, shopping, and other crowded places, and even think twice about letting their children go to school. In a pandemic, the majority of people will change their behaviour even without a lockdown. But if the cautious behaviour is voluntary, then why impose a lockdown? The answer is that without a lockdown, the majority will behave sensibly to avoid catching the virus, but a minority will take a ‘devil may care’ attitude. In the pandemic, this is critical because less than 10 percent of infected people are responsible for creating 90 percent of all coronavirus infections. If this tiny minority of so-called ‘super-spreaders’ is left unchecked, then the pandemic will let rip. All of which brings us back to Sweden versus Denmark.  As a result of not imposing a mandatory lockdown to rein in its super-spreaders, Sweden now has one of the world’s worst coronavirus infection and mortality rates, four times higher than Denmark (Chart I-3, Chart I-4, Chart I-5). Chart I-3No-Lockdown Sweden Has Suffered Many More Deaths Than Lockdown Denmark No-Lockdown Sweden Has Suffered Many More Deaths Than Lockdown Denmark No-Lockdown Sweden Has Suffered Many More Deaths Than Lockdown Denmark Chart I-4Avoiding A Lockdown Meant More Infections… Who’s Right On The Pandemic – Sweden Or Denmark? Who’s Right On The Pandemic – Sweden Or Denmark? Chart I-5…And More ##br##Deaths Who’s Right On The Pandemic – Sweden Or Denmark? Who’s Right On The Pandemic – Sweden Or Denmark? Put simply, containing the pandemic depends on reining in a minority of super-spreaders. Which explains why no-lockdown Sweden suffered a much worse outbreak of the disease than lockdown Denmark. In contrast, the economy depends on the behaviour of the majority. In a pandemic the majority will voluntarily exercise caution. Which explains why no-lockdown Sweden and lockdown Denmark suffered similar contractions in consumption. Looking ahead, will the widespread adoption of face masks and plexiglass screens change the public’s cautious behaviour? To a certain extent, yes – it will permit essential activities and let people take calculated risks. That said, if you are forced to wear a mask on public transport and in the shops, and you have to spread out in restaurants while being served by a masked waiter, then – rightly or wrongly – you are getting a strong signal: the danger is still out there. Meaning that many people will continue to shun discretionary activities and spending. The upshot is that while the pandemic remains in play, investors should maintain a defensive bias to their portfolios. Explaining Why Technology Is Now Defensive A defensive bias to your portfolio now requires an exposure to technology – because in 2020 the tech sector is behaving like a classic defensive. Its relative performance is correlating positively with the bond price, like other classic defensive sectors such as healthcare (Chart I-6 and Chart I-7). Chart I-6In 2020, Tech Is Behaving Like A Defensive... In 2020, Tech Is Behaving Like A Defensive... In 2020, Tech Is Behaving Like A Defensive... Chart I-7...Like Healthcare ...Like Healthcare ...Like Healthcare The behaviour of the technology sector in the current recession contrasts with its performance in the global financial crisis of 2008. Back then, it behaved like a classic cyclical – its relative performance correlated negatively with the bond price (Chart I-8). Begging the question: why has the tech sector’s behaviour flipped from cyclical to defensive? Chart I-8In 2008, Tech Behaved Like A Cyclical In 2008, Tech Behaved Like A Cyclical In 2008, Tech Behaved Like A Cyclical The main reason is that the tech sector’s composition has flipped from hardware dominance to software dominance. In 2008, the sector market cap had a 65:35 tilt to technology hardware. But today, it is the mirror-image: a 65:35 tilt to computer and software services (Chart I-9). Chart I-9Tech Is More Defensive Now Because It Is Dominated By Software Tech Is More Defensive Now Because It Is Dominated By Software Tech Is More Defensive Now Because It Is Dominated By Software Computer and software services have many defensive characteristics suited to the current environment: For many companies, enterprise software is now business critical. It is a must-have rather than a like-to-have. Computer and software services use a subscription-based revenue model, minimising the dependency on discretionary spending. Computer and software services are helping firms to cut costs through automation and back-office efficiencies as well as facilitating the boom in ‘working from home’. The sector is cash rich. Despite these defensive characteristics, there remains a lingering worry: is the tech sector overvalued? The Rally In Growth Defensives Is Not A Mania  Some people fear that the recent run-up in stock markets does not make sense, other than as a ‘Robin Hood’ day-trader fuelled mania. After all, the pandemic is still very much in play, and so are other geopolitical risks, so how can some stock prices be near all-time highs? Yet the recent run-up in growth defensives such as tech and healthcare does make sense. Their valuations have moved in near-perfect lockstep with the bond yield, implying that the rally is based on fundamentals (Chart I-10). Chart I-10Tech And Healthcare Valuations Are Tracking The Bond Yield Tech And Healthcare Valuations Are Tracking The Bond Yield Tech And Healthcare Valuations Are Tracking The Bond Yield Simply put, if the 10-year T-bond is going to deliver a pitiful 0.7 percent a year over the next decade, then the prospective return from growth defensives must also compress. It would be absurd to expect these stocks to be priced for high single digit returns. Since late 2018, the decline in growth defensives’ forward earnings yield has broadly tracked the 250bps decline in the 10-year T-bond yield. Given that the forward earnings yield correlates well with the 10-year prospective return, the depressed bond yield is depressing the prospective return from growth defensives – as it should. Tech and healthcare valuations have moved in near-perfect lockstep with the bond yield. But with the pandemic and geopolitical risks menacing in the background, shouldn’t the gap between the prospective return on stocks and bonds – the equity risk premium – be larger? This is open to debate. When bond yields approach the lower bound, the appeal of owning bonds also diminishes because bond prices have limited upside. Nevertheless, the gap between the tech and healthcare forward earnings yield and the bond yield has gone up this year and is much larger than in 2018 (Chart I-11). This suggests that valuations are taking some account of the pandemic and other risks. Moreover, in a longer-term perspective the current gap between the tech and healthcare forward earnings yield and the bond yield, at +4 percent, hardly indicates a mania. In the true mania of 2000, the gap stood at -4 percent! (Chart I-12) Chart I-11The Equity Risk Premium Has Risen In 2020 The Equity Risk Premium Has Risen In 2020 The Equity Risk Premium Has Risen In 2020 Chart I-12Tech And Health Care Valuations Are Not In A Mania Tech And Health Care Valuations Are Not In A Mania Tech And Health Care Valuations Are Not In A Mania In summary, until the pandemic is conquered, investors should maintain a defensive bias to their portfolios. Bond investors should overweight US T-bonds versus core European bonds. Equity investors should overweight the growth defensives, technology and healthcare, which implies overweighting the technology-heavy US versus Europe. A new recommendation is to overweight technology-heavy Netherlands. Stay overweight healthcare-heavy Switzerland, and bank-light France and Germany (albeit expect a technical 5 percent underperformance of Germany versus the UK in the coming weeks). And stay underweight bank-heavy Austria. Fractal Trading System* The AUD is technically overbought and vulnerable to a tactical reversal. Accordingly, this week’s recommended trade is short AUD/CHF, with a profit target and symmetrical stop-loss set at 4.2 percent. The rolling 1-year win ratio now stands at 63 percent. Chart I-13AUD/CHF AUD/CHF AUD/CHF When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated  December 11, 2014, available at eis.bcaresearch.com.   Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading System   Cyclical Recommendations Structural Recommendations Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields   Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations