Geopolitics

Highlights The great political surprises of 2016 are approaching key deadlines on November 3 and December 31. Investors should not let Brexit take their eye off the US election. Globalization will retreat faster under Trump regardless of what happens in the United Kingdom. The market is starting to price several clear risks: a failure to extend fiscal relief in the US (25% chance); a surprise Trump tariff move (40%); a contested election (20%); or a failure of the UK and EU to seal a deal (35%). Trump is unlikely to pull off a landslide like Boris Johnson in December 2019. The backdrop has darkened and Biden is an acceptable alternative for voters, unlike Jeremy Corbyn. Go long GBP-USD at the 1.25 mark; go long GBP-EUR volatility. Feature The end game is approaching for the two great political shocks of 2016 – Brexit and Trump. November 3 is the US election and December 31 is the deadline for an UK-EU trade deal. Investor sentiment is starting to show some cracks for various reasons, some technical (Chart 1). But we do not believe near-term volatility and risk-off sentiment have fully run their course yet. Either the US election cycle or the UK’s brinkmanship with the EU, or both, will agitate markets as the deadlines approach. The former is a much weightier factor. Chart 1Market Starts To Price Bevy Of Near-Term Risks ... But Cyclical View Still Constructive Market Starts To Price Bevy Of Near-Term Risks ... But Cyclical View Still Constructive Market Starts To Price Bevy Of Near-Term Risks ... But Cyclical View Still Constructive The risks in play are a failure to extend fiscal relief in the US (25% chance); a conflict between Trump and one of America’s foreign rivals such as China, whether due to Trump’s reelection or lame duck status (40%); a contested election (20%); or a failure of the UK and EU to seal a deal, setting back their economic recovery (35%). Maybe all of these risks will dissipate by mid-November, but maybe not. The market has not discounted any of them fully. So investors should buy insurance now. Vox Populi Is The Biggest Constraint For global investors Brexit is far less consequential than President Trump’s “America First” policy but the UK does punch above its economic weight in financial markets (Chart 2). Chart 2Brexit: Why Should We Care? UK Punches Above Its Economic Weight In Financial Markets Brexit: Why Should We Care? UK Punches Above Its Economic Weight In Financial Markets Brexit: Why Should We Care? UK Punches Above Its Economic Weight In Financial Markets Geopolitical analysis teaches that limitations on policymakers should be the starting point of analysis. For democracies, the biggest constraint of all is the vox populi – the voice of the people, or popular will. The Brexit movement faced a vociferous “Resistance” that won over the media and financial market consensus until reality struck in the general election of December 12, in which the Conservative Party won a historic victory. Chart 3Joe Biden Is Not Jeremy Corbyn The End-Game For Trump And Brexit The End-Game For Trump And Brexit The election vindicated Prime Minister Boris Johnson’s brinkmanship and “hard Brexit” terms, while once again chastening the elites and experts – including an innovative Supreme Court. Johnson’s single-party majority, combined with COVID-19 and the surge in domestic economic stimulus, have increased the odds that the UK will choose sovereignty over the economy and walk away from trade talks. Trump’s supporters show the same enthusiasm as Brexiteers and the same scorn for conventional wisdom and opinion polls. Will they be similarly vindicated? Beyond any knee-jerk equity rally, that would entail a “Phase Two” trade war with China – and possibly a new trade war with Europe or a global trade war. However, Trump faces much worse odds than Boris Johnson did. First, Johnson’s snap election took place at the top of the business cycle, back when a novel coronavirus was just starting to be discovered in Wuhan, China. This is how Harry Truman won his surprise victory in 1948, in defiance of all the opinion polls. Had Truman run in 1949, after a deep recession, the story would have gone differently – which is a problem for both Trump and the near-term equity market. Second, the political alternative was not acceptable in the United Kingdom but it is in the United States. Johnson led Jeremy Corbyn, a far-left rival for the premiership, by around 15%-20% in the polls. The Conservative Party itself led the Labour Party by 10%. By contrast, former Vice President Joe Biden is a center-left Democrat who has many flaws but is not out of the mainstream. He leads President Trump in the polling, as do Democrats over Republicans, though only by single digits. There is no contest between Biden and Corbyn (Chart 3). Trump might still win, but an American version of the UK landslide in 2019 is unlikely. Trump will lose the popular vote even if he wins the Electoral College, and Republicans have a very slim chance of winning the House of Representatives. The implication for financial markets is doubly negative, at least in the near term: there is about a 35% chance that the UK will leave without a deal and about a 35% chance that Trump will win. He could also kick China in the interim period if he loses. Won’t stocks cheer a Trump comeback and victory? Perhaps, but a data-dependent approach suggests that a “blue sweep” is still the base case, and that would be a good trigger for a full equity correction. Nor would a Trump win be positive for long-term equity returns in the final analysis. Trump is reflationary, but a larger trade war would hamper the global economic recovery and thus keep earnings suppressed. There is a 35% chance that Trump will win re-election. Trump is unlikely to win the national vox populi, like Brexit did, but he obviously can win the popular vote in the critical regions – the Sun Belt and the Rust Belt. If he does, the revolution in the global system will be confirmed: the retreat of globalization will accelerate. If he does not, then Brexit alone cannot confirm de-globalization; rather the UK will face even more pressure to make concessions and get a trade deal. Trump’s Path To Victory Chart 4Sitting Presidents Win Half The Time If Recession Ends In H1 Sitting Presidents Win Half The Time If Recession Ends In H1 Sitting Presidents Win Half The Time If Recession Ends In H1 We may well be forced to upgrade Trump’s odds of winning if his comeback gains momentum. Our subjective odds of a Trump win come from the historical record – incumbent parties only retain the White House amid recessions five out of 13 times in American history – but there are some important exceptions. First, the longest-serving American president, Franklin Delano Roosevelt, served during the Great Depression. So obviously a bad economy does not always disqualify a president. Nevertheless FDR got lucky with the timing of the fluctuations and he was personally popular, unlike President Trump. Second, an incumbent president wins 50% of the time if the recession ends before the election – namely in 1900, 1904, and 1924 (contrasted with defeats in 1888, 1912, and 1980). Today’s market performance looks similar to these cases, though premature fiscal tightening is now jeopardizing Trump’s bid (Chart 4). Assuming new stimulus passes, it is extremely beneficial for President Trump that COVID-19 cases are subsiding (Chart 5). Chart 5COVID-19 Subsides In Nick Of Time For Trump? The End-Game For Trump And Brexit The End-Game For Trump And Brexit Chart 6Even Approval Of Trump’s Pandemic Response Improving The End-Game For Trump And Brexit The End-Game For Trump And Brexit His approval rating on handling COVID-19 is somewhat recovering at the moment (Chart 6). Trump’s “law and order” message is also benefiting him amid the rise in vandalism, rioting, and homicide, judging by his improvement in national approval rating across almost all demographic groups, including many that are otherwise averse to Trump. Finally, Trump’s Abraham Accords – a potentially major peace deal between Israel and an expanding list of Arab states – could give his image another boost (Table 1). Foreign policy will not decide the election but these peace deals should not be underrated because they underscore a more important argument for voters: that the US should withdraw from its endless foreign wars and pursue peace and prosperity instead. If Trump’s typically weak approval rating on foreign policy starts to rise then his comeback gains breadth. Table 1The Abraham Accords Give Boost To Trump Image As Peacemaker The End-Game For Trump And Brexit The End-Game For Trump And Brexit We will upgrade our 35% odds of Trump’s re-election if Congress passes a new fiscal relief package, assuming Trump’s polling continues to improve. Our quantitative model is now giving Trump a 45% chance, which is in line with the consensus view but well above our subjective odds (Chart 7). We will upgrade our view if Congress passes a new fiscal relief package, assuming Trump’s polling continues to improve. Chart 7Quantitative US Election Model Puts Trump Win At 45% Odds The End-Game For Trump And Brexit The End-Game For Trump And Brexit Chart 8Stimulus Hiccups Cause Market To Sell Stimulus Hiccups Cause Market To Sell Stimulus Hiccups Cause Market To Sell The stock market does not perform well during periods in which fiscal cliff negotiations are prolonged – the failure of the Emergency Economic Stabilization Act in 2008 is one thing, but today’s impasse is more reminiscent of the debt ceiling crises of 2011 and 2013. Trump is now directly pressuring Senate Republicans to capitulate to House Democratic spending demands. If Republican senators abandon him, market turmoil will undercut his argument that he is the best man to revive the economy and he will lose the election (Chart 8). We do not think they will – and House Speaker Nancy Pelosi’s pledge to keep the House in session until a deal is passed is very positive news – but until the deal is sealed the market is vulnerable. As mentioned above we give a 25% chance of a failure to pass any stimulus bill in September or October. The next chance for stimulus will be in late January or February. Trump stands for growth at all costs, which will be received well by equity markets, other things being equal. But a Trump victory implies more trade war and that the GOP will retain the Senate, creating a steeper fiscal cliff next year – so any relief rally will be short-lived. Meanwhile a Trump defeat raises the risk he will take aggressive actions on the way out to cement his legacy as the Man Who Confronted China, and bind the Biden administration to decoupling policy. This is not a favorable outlook for investor sentiment or the economic recovery over the next few months. Brexit: The Three Kingdoms Will Force A Trade Deal Chart 9Sterling Will Fall Before It Bounces Back On A Deal Sterling Will Fall Before It Bounces Back On A Deal Sterling Will Fall Before It Bounces Back On A Deal In December 2016 we pointed to the three kingdoms – England, Ireland, and Scotland – as the origin of the geopolitical and constitutional crisis that would arise from the Brexit referendum and act as a powerful bar against a no-deal Brexit. That framework remains salient today as the risk of no-deal escalates due to quarrels over Northern Ireland Protocol, which was agreed in October 2019 as part of the formal Withdrawal Agreement that made Brexit happen on January 31, 2020. The implication is that the pound has not bottomed yet, though we see a buying opportunity around the corner (Chart 9). No one should doubt that the UK could walk away from the EU without a deal this December: The Tories’ single-party majority gives them the raw capability to push through plans they decide on – and raises the risk that they will overreach. The tariff shock of a no-deal exit is frequently exaggerated. The UK would suffer a tariff shock of about 1.38% of GDP, larger than what the US suffered in its tariff-war with China but hardly a death knell (Table 2). (The costs of losing single-market access would grow over time, however.) Table 2A No-Trade-Deal Brexit Would Create A Minimum Tariff Shock Of 1.4% Of GDP The End-Game For Trump And Brexit The End-Game For Trump And Brexit COVID-19 has supplanted the worst-case outcome of a no-deal exit by producing a much worse recession than anyone feared. The US is using the disruption to decouple from China and the UK could do the same with the EU. The result of COVID-19 is massive domestic stimulus that raises the UK’s and Europe’s threshold for pain. Any failure of trade talks would spur more stimulus. The Bank of England still has some bond-buying ammunition left and parliament, again, is undivided. Given that Boris Johnson has until 2024 before the next election, there is theoretically time for his personal and party approval ratings to improve as the economy recovers from the pandemic and any messy Brexit (Chart 10). Chart 10Bojo Has Until 2024 To Recover From Crises The End-Game For Trump And Brexit The End-Game For Trump And Brexit Chart 11UK Would Face WTO-Level Tariffs If No Deal The End-Game For Trump And Brexit The End-Game For Trump And Brexit The UK’s position in the quarrel over Ireland is rational – but so is the EU’s. If the trade talks collapse, the UK will need to remove any regulatory or customs divisions with Northern Ireland. Yet in preparing to do so it vitiates trust with the EU and makes a trade deal less likely. However, weighing all these points up, an UK-EU trade deal is still the most likely outcome (65% chance), as the economic and political costs are crystal clear while the benefits of a hard break are not so clear. Allow us to explain. Northern Ireland is the latest cause of tensions, although it was inevitable that tensions would arise ahead of the end-of-year deadline for a trade deal. Westminster has proposed an Internal Market Bill, which has passed with solid majorities in two readings in parliament, to reclaim aspects of sovereignty over Northern Ireland that were traded away to clinch the Withdrawal Agreement last year. The Johnson government’s position should be seen as a negotiating tactic to build leverage in the talks but also as a real fallback position if the talks fail. The House of Lords could delay the bill by a year, meaning that it may not take effect until end of 2021 – but a trade deal would make it moot. The Northern Ireland Protocol solved the riddle of how to preserve the integrity of the EU’s single market after Brexit yet avoid a return to a hard customs border with the Republic of Ireland. Customs checks were removed with the Good Friday (or Belfast) Agreement in 1998, which ended the Troubles between the two Irelands. The Protocol introduces a pseudo-customs border on the Irish Sea, requiring declarations on exports to Great Britain and EU oversight of UK state aid for Northern Irish firms, so that Northern Ireland can stay in the EU customs area while the UK can leave and still preserve a semblance of its own customs area in Northern Ireland. If the UK and EU get a trade deal, then all trade is tariff-free and the Protocol becomes redundant. Also, the Protocol enables a Joint Committee to review disputes over exports to Northern Ireland that are “at risk” of making their way into the EU without duties. The Protocol is supposed to operate even if the UK and EU fail to get a trade deal. Yet it is politically untenable for the UK to subject trade within its own country to EU rules or duties, or allow the EU to supervise state corporate subsidies across the UK, if no deal is agreed. The UK is more likely to violate the treaty to preserve its internal integrity. As Northern Ireland Secretary Brandon Lewis admitted, “Yes, this [Internal Market Bill] does break international law in a very specific and limited way.” While the EU’s threat to slap tariffs on British food exports to Northern Ireland is the proximate trigger of the Internal Market Bill, another key reason for the UK’s aggressive shift is the issue of state aid. All governments are extending emergency aid to major corporations to keep them from insolvency amid the recession. This will be the case for some time and it is even more true of the EU than of the United Kingdom. However, under the Protocol, the EU would be able to penalize companies in Great Britain that receive subsidies if goods or firms in Northern Ireland can be shown to benefit. Northern Ireland is supposed to operate within the EU’s standards on state aid. London obviously bristles at this backdoor for letting in EU regulation, not least because, in the event that a trade deal is not reached, it will need to pump the country full of state aid to compensate for the shock of seeing exports to the EU rise by 3% across the board according to Most Favored Nation status under the World Trade Organization (Chart 11). An UK-EU trade deal is the most likely outcome. As Dhaval Joshi of BCA’s European Investment Strategy points out, Boris needs to keep his own Tories under his heel (Chart 12). The Internal Market Bill provoked a backlash among 30 moderates. If that number rises to 40 Johnson loses his majority. This is a problem that he is seeking to address by giving parliament a veto over any future uses of the bill that would violate international law (this is an acceptable compromise because he has a majority). But a failure to drive a hard bargain with the EU would cause a much bigger rebellion among hard Brexit Conservative MPs and threaten his job. Chart 12Bojo Must Balance Hard Brexit Tories The End-Game For Trump And Brexit The End-Game For Trump And Brexit Geopolitics is about might, not right – the UK can assert its sovereignty and violate these international agreements, while the EU can then apply punitive tariffs, non-tariff barriers, and sanctions under the Withdrawal Agreement. Brexit is a power-political struggle that could devolve into a trade war. Obviously that would be a very bad outcome for the market, particularly for the UK, which is overmatched (Chart 13). But this risk is also a key limitation on the UK that will prevent this worst-case outcome. Indeed, despite all of the above, our base case is still that the UK and EU will get a deal. First, the economy will clearly suffer without a deal. After all, the US-China tariffs produced a negative effect for these two economies in 2019 and the impact on the UK would be bigger than that on the US (Chart 14). Chart 13The Brick Wall The UK Cannot Avoid The Brick Wall The UK Cannot Avoid The Brick Wall The UK Cannot Avoid Chart 14UK Faces Trade Shock If No Deal UK Faces Trade Shock If No Deal UK Faces Trade Shock If No Deal Second, the public doesn’t support a no-deal exit (Chart 15). Northern Ireland itself voted against Brexit in the referendum and as such would rather see an agreement that groups the UK and the EU under a single zero-tariff free trade agreement. Third, Boris faces a rebellion in Scotland if he pursues a hard break. The Scottish National Party would revive ahead of Scottish elections in May 2021 and demand a second independence referendum (Chart 16). The Irish Sea is a natural division that makes a more intrusive customs presence more supportable than otherwise. A little more paperwork is an acceptable cost to keep the United Kingdom from falling apart. Scotland is much more likely to go independent than Ireland is to unite. Chart 15Only 25% Think 'No Deal' A Good Outcome The End-Game For Trump And Brexit The End-Game For Trump And Brexit Boris is now prime minister, not just party leader, and he will ultimately have to decide whether he wants to be the last prime minister of a United Kingdom. Assuming Boris is at least focused on the next election, he will have to decide if he wants the rest of his premiership to be consumed with a self-inflicted double-dip recession and democratic revolt in Scotland, or a recovery on the back of a functional if uninspiring trade deal enabling him to head off the Scottish threat and save the union. Chart 16No Deal' Would Boost Scottish Independence Movement No Deal' Would Boost Scottish Independence Movement No Deal' Would Boost Scottish Independence Movement Obviously the final deal may not be clinched until the eleventh hour. The October 15 deadline can be delayed but talks must conclude in November or December in time to be ratified by the EU member states by December 31. US Election Drives Geopolitics, But Not The Brexit Outcome One factor that will not play much of a role in the UK’s decision-making is the US election. It is true that the Johnson government would benefit from President Trump’s reelection. But the EU is a much bigger market for the UK and the UK’s best strategy is to focus on its national interest regardless of what the US does. The US election may not be decided in mid-December in time for the UK to agree to a deal that can be ratified by year’s end anyway. Moreover the UK’s best strategy is to conclude a deal with the EU first, and then pursue a deal with the United States. This is because President Trump will be inclined to sign at least an executive deal, while a congressional deal requires support from the Democrats, which is only possible if Northern Ireland is resolved without hard border checks. Because the EU makes up such a larger share of British trade, an American deal does not give the UK much leverage in negotiating with the EU, but an EU deal does give the UK greater leverage in negotiating with the US. As Diagrams 1 and 2 show, this strategic logic holds even if the UK knows the outcome of the US election ahead of time: the scenarios with the least benefit and the greatest cost would still be scenarios involving no deal with the European Union. Diagrams 1 & 2United Kingdom Wants An EU Trade Deal (Regardless Of Trump/Biden) The End-Game For Trump And Brexit The End-Game For Trump And Brexit Diagram 3 boils all of this down to a single decision tree. First, the diagram shows that the economic costs are not prohibitive and therefore the risk of a no-deal exit is substantial – we would say 35%. Second, it shows that the risks of the negotiation are skewed to the downside. Third, it highlights that the UK will settle its affairs directly with the EU and not hinge its actions on the US election cycle. Diagram 3No-Deal Brexit Cost Not Prohibitive, But Best Strategy Is To Get A Deal The End-Game For Trump And Brexit The End-Game For Trump And Brexit Clearly the best strategy and best outcome involve seeking a trade deal with the EU, and hence it is our base case. This means an opportunity to buy the pound and domestic-oriented British equities, and turn neutral on gilts, is just around the corner. Investment Takeaways The GBP-EUR is the best measure of the market’s sensitivity to Brexit risks, so it should fall in the near term and rally sharply after resolution. However, the US election complicates things. The euro’s response is fairly binary: it is one of the biggest winners if Biden wins and one of the biggest losers if Trump wins. Hence GBP-EUR volatility will rise in the coming months (Chart 17). We recommend going long 1-month implied volatility contracts for October and November. The pound sterling, by contrast, will ultimately rise regardless of US election result, since the UK will pursue a trade deal out of its own national interest. Trump is less negative for the US dollar than Biden and a comeback and victory will drive a counter-trend dollar bounce. However, in the medium term we expect the dollar to fall regardless due to debt monetization and global growth recovery. Thus we recommend going long GBP-USD on a strategic basis when political risks peak over the next two-to-three months and GBP-USD falls to around 1.25, as recommended by our Foreign Exchange Strategist Chester Ntonifor (Chart 18). Chart 17EUR-GBP Volatility Will Rise EUR-GBP Volatility Will Rise EUR-GBP Volatility Will Rise Sterling bears are forgetting that the sound defeat of Corbyn ruled out a sharp left-wing turn in domestic economic policy (higher taxes), while the Tories have made a clear turn against fiscal austerity. Therefore the worst-case scenario is a failure to agree to a trade deal by the end of this year. But that is not the base case and the risk will be priced within a month or two. Chart 18Pound Will Rally After Deal Concluded In November Or December Pound Will Rally After Deal Concluded In November Or December Pound Will Rally After Deal Concluded In November Or December Chart 19Yes, China Is Opening The Taps Yes, China Is Opening The Taps Yes, China Is Opening The Taps We remain tactically cautious and defensive even though the US fiscal negotiations are improving. The market is underrating too many clear and concrete risks to sentiment and the corporate earnings outlook, so the current bout of volatility can continue until there is greater clarity on US fiscal spending, the US election cycle, associated geopolitical risks, and the Brexit showdown. Book gains on long Brent trade for a return of 69.7%. We initiated this trade on March 27 in our “No Depression” report, which marked our shift to a strategic risk-on positioning. We remain bullish on oil prices and commodities on the back of global stimulus and our assessment that the OPEC 3.0 cartel will maintain discipline overall, but the next three-to-six months are crowded with downside risk. Cyclically, we see a global economic recovery deepening and broadening. China’s stimulus is surprising to the upside, as we have long written and the latest credit numbers bear this view out (Chart 19), which is critical for global reflation.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com

Feature Investors are increasingly concerned that the US presidential election this year will fail to produce a legitimate result, leading to an escalation in political instability and uncertainty. In this report we hold a Q&A session that we hope will serve as your concise and definitive guide to a contested US election – by which we mean an election that is not decided by the popular vote or Electoral College but requires the intervention of the US Congress or Supreme Court to determine the final outcome. As always, this report draws on the best academic work on the subject, but is not limited to academic conclusions. We apply our geopolitical method and macroeconomic perspective to determine the likeliest scenarios and financial market impacts.  The takeaway? Most likely the election result will be decisive, as incumbent presidents tend to lose amid recessions. However, with President Trump staging a comeback, a contested election is possible and investors would be wise to prepare for volatility over the next two-to-four months at minimum.         Chart 1Trump At Disadvantage In Popular Opinion The Definitive Guide To Contested US Elections The Definitive Guide To Contested US Elections A good rule of thumb: Trump is at a disadvantage in raw popular opinion (Chart 1), so anything that directs the election decision away from the popular vote and toward constitutional procedures should be seen as a lifeline for Trump, and hence a recipe for a bigger trade war and prolonged US equity outperformance. How Is The US President Elected? The US elects presidents by means of electors, private citizens appointed by each of the 50 states to vote on their population’s behalf, i.e. the Electoral College. The popular vote, or canvass, has been the prevailing method of choosing each state’s electors since the 1840s. The vote is held and tallied by the election authorities of the states on the first Tuesday after the first Monday of November (e.g. November 3, 2020). Each state has different laws on how to hold elections and appoint a slate of electors loyal to the winning candidate in the state. The constitution grants state legislatures the power to appoint the electors. This could become a source of controversy in a contested election.1 Generally the state’s secretary of state approves the popular tally which then determines which slate of electors is appointed. The state governor certifies the names of the electors and the numbers of votes received, signs the letter and applies the state seal, and then sends multiple copies to various authorities for surety.2  If disputes arise over a state’s election results, the state will ideally resolve them by December 8 (Table 1), six days before the electors meet to fill out their ballots for the president and vice-president. Electors meet in the state capital on the first Monday after the second Wednesday of December (e.g. Monday, December 14, 2020) and cast their vote. They send certificates of their vote to the President of the United States Senate in Washington, DC, who is also the nation’s vice president, currently Mike Pence.  Table 1Calendar Of US Election 2020 The Definitive Guide To Contested US Elections The Definitive Guide To Contested US Elections On January 6 of the New Year (2021), the President of the Senate presides over a special joint session of the new Congress, which itself convenes on January 3. He presents the states’ electoral votes to Congress alphabetically. The votes are counted, with Congress employing official tellers to record the sums.3  If any disputes are raised against any state’s electoral votes, the two houses of Congress must agree in order to disqualify those votes. If the two houses disagree, the votes will be counted. The Senate President, as the constitutional keeper of the electoral returns and presiding officer of the joint session, has some influence, which is another potential source of controversy. When the count is done, the tellers hand their results to the Senate President, who reads them off. Usually the leading candidate captures an absolute majority of the Electoral College (270/538 votes), so the next president is crystal clear and the whole ceremony is finished in half an hour. Alas, not always. What Electoral Results Can Be Ruled Out In 2020? Before getting into contested elections, it is important to address what is highly unlikely to occur in 2020. First, President Trump will not win the popular vote. Chart 2Trump Highly Unlikely To Win Popular Vote The Definitive Guide To Contested US Elections The Definitive Guide To Contested US Elections Trump won 46% of the popular vote in 2016, trailing Hillary Clinton by 2.9 million votes. Since 2017, Trump’s national approval rating has never risen above 50% in the average of polls. His disapproval rating is almost always higher than his approval (Chart 2). Thus if Trump wins the election it will be through his Electoral College strategy, as in 2016 – or through a contested election. The US has split the popular and Electoral College vote on five occasions, yielding a historical probability of 9%. The fifth time was President Trump’s victory in 2016; he would be the first president to do so twice. This is possible because the regional and demographic factors behind Trump’s win four years ago are still largely intact. Currently our quantitative election model gives Trump a 45% chance of winning the election (Chart 3). This is in line with the consensus view, as online betting markets put Trump’s odds at 43%. However, online gamblers put the odds of the next president losing the popular vote in a range of 27%-31%, which implies that his odds are lower given his low popularity (Chart 4). Chart 3Our Quant Election Model Gives Trump 45% Chance Of Victory The Definitive Guide To Contested US Elections The Definitive Guide To Contested US Elections Chart 4Trump Odds Weighed Down By Low Chance Of Popular Win The Definitive Guide To Contested US Elections The Definitive Guide To Contested US Elections Subjectively, we are sticking with our 35% chance of Trump winning, which falls in the middle of this range. What is clear is that Trump has a much greater chance than the historical 9% probability of winning without the popular vote.  There is nothing illegitimate about an Electoral College victory – far from it, it is the constitutional way in which the presidency is won. Nevertheless a victory without a popular mandate deprives the new administration of political capital. A second-term Trump is likely to be stymied at home and more inclined to act unilaterally abroad, a downside risk to global equity markets. Second, Republicans will not reclaim a majority of the House of Representatives. Chart 5Republicans Highly Unlikely To Win House Of Representatives The Definitive Guide To Contested US Elections The Definitive Guide To Contested US Elections To do so, the GOP would have to retain all Republican-leaning seats (yielding 186) plus all “toss up” seats (totaling 214) and then four additional Democratic-leaning seats. Yet there are only two Democratic-leaning seats that do not benefit from the incumbent advantage (Chart 5).4 The re-election rate in the House and Senate is around 85-95%. Neither the state of the economy nor Trump’s approval rating suggest that Republicans are capable of such a big victory in the House (Chart 6). Chart 6Trump An Albatross For House Republicans The Definitive Guide To Contested US Elections The Definitive Guide To Contested US Elections Third, Democrats are unlikely to win a majority of the state delegations in the House of Representatives. Currently, Republicans have a majority on 26 of the 50 delegations of lawmakers that the states send to the US House of Representatives. Democrats control 23 state delegations, while Pennsylvania is neutral. If the presidential election is close, then the balance of power among the state delegations will most likely stay the same. Republicans are likely to retain 25 state delegations, whereas Democrats would have to win all five toss-up delegations plus Florida merely to tie the Republicans with 25 delegations (Table 2). This is a tall order. Table 2Democrats Unlikely To Win Majority Of State Delegations In House Of Representatives The Definitive Guide To Contested US Elections The Definitive Guide To Contested US Elections The Republicans’ state-by-state House majority would prove critical in a contested election, as we will see. Otherwise it doesn’t matter much. What Is A Contested Election? Chart 7Extreme Political Polarization Means Election Disputes Will Rage The Definitive Guide To Contested US Elections The Definitive Guide To Contested US Elections The 2020 election will inevitably see legal challenges, vote recounts, and procedural problems. Partisanship is at extreme levels, meaning that the two parties will do anything to win (Chart 7). The unprecedented large-scale adoption of mail-in voting due to the COVID-19 pandemic also ensures that recounts and legal disputes will abound.5 Neither candidate is likely to concede defeat quickly or easily. While President Trump is explicit about his reluctance to concede, there is zero chance that Joe Biden will bow out quietly like Al Gore did in the 2000 dispute.   However, investors should distinguish a contested election, in which the resolution of disputes will determine the final outcome, from a controversial election, in which the final outcome is known but the defeated candidate refuses to concede. Either could be market-relevant, but the first scenario is the primary concern as it yields the powers of the presidency. The rest is aftermath. The bedrock principle of US presidential succession is as follows: Constitutionally, if the Electoral College vote falls short of a clear majority (270 out of 538), the House of Representatives chooses the president on a majority vote, with each state receiving only one vote. Similarly, the Senate chooses the vice president.6 President Trump is favored to win in this scenario. As mentioned, Republicans may well hold 26 of the 50 state delegations in the House. A clear majority on either side removes any risk of indecision: the next president will be chosen on a party-line vote of the states. For Democrats to choose the president in the House, they need a landslide victory. This is possible, but then it would imply that President Trump has been soundly beaten in the presidential race. A contested election presupposes a close national race that is likely to result in the status quo balance of power among the states in Congress, and hence an advantage for Trump if the House chooses the president. Map 1 illustrates the fundamental shift in American political power if the House of Representatives votes on a state-by-state basis to resolve a contested election. It alters the geography of each state according to the voting age population, the Electoral College representation from 2016, and an equal weighting in which each state gets the same number of votes, as in the House’s contested election procedure. The Electoral College is not nearly as distortive of the popular will as is often made out. However, the red states greatly increase their prominence in an equal weighting (just as in the US Senate). Map 1Trump Disfavored In Popular Vote, But Favored If Contested Election Decided In House Of Representatives The Definitive Guide To Contested US Elections The Definitive Guide To Contested US Elections The fundamental takeaway is that President Trump is disfavored when it comes to the popular vote in the states, but if the election is contested and shifts to the House of Representatives, he has a lifeline. Yet if Democrats win the Senate in the election, this lifeline will be cut off. Moreover, the Supreme Court is a wild card, as discussed below.  What Can We Learn From Past Contested Elections? Chart 8US Contested Elections Often Coincide With Deflationary Economy The Definitive Guide To Contested US Elections The Definitive Guide To Contested US Elections The US has witnessed four contested elections under our definition. Most of them occurred amid deflationary economic trends, which would fit with today’s environment (Chart 8). Each episode can be described as a “stolen election,” depending on one’s point of view.  The key lessons for today are as follows: 1800 – “The Revolution” – Vice President Thomas Jefferson, as Senate President, chose to count the electoral votes from Georgia even though they lacked the governor’s signature and failed to meet federal requirements. This gave him a majority of the electoral votes, which ultimately led to his election.7 If he had rejected these votes, the outgoing House of Representatives would have chosen his rival candidate, John Adams, as president. Takeaway: The vice president has the constitutional authority to present the electoral votes for counting and to oversee the joint session of Congress. If Congress is divided, and the vice president has a decision as to whether to present a certain set of electoral votes, then the vice president could tip the election in his own party’s favor. Also noteworthy: the presence or absence of a governor’s signature on a state’s electoral votes is not definitive. 1824 – “The Corrupt Bargain” – Andrew Jackson lost the election despite winning both the popular vote and the Electoral College vote. With a hung vote in the college, the House of Representatives decided the election among the top three candidates. The Speaker of the House threw his weight behind John Quincy Adams, who then nominated the speaker as the secretary of state in his new administration. Takeaway: Washington insiders can determine the outcome arbitrarily if they control the House of Representatives. A hung Electoral College, or tie, throws the election to the House and thus favors Trump. 1876 – “The Stolen Election” – Democrat Samuel Tilden won the popular vote and the most electoral votes, at 184, while Republican Rutherford Hayes won 165 electoral votes. Tilden was one vote shy of an Electoral College majority (185), while Hayes fell 20 votes shy. Republican control of four states led to an alternative set of Republican electoral votes being sent to Washington. Congress then had to choose between the rival electoral slates. To resolve the dispute, Congress created a special bipartisan committee. The tiebreaking member of the committee was disqualified by a fluke, leading to a replacement who voted on party lines, awarding all 20 disputed electoral votes to Hayes, who thus won the presidency. Simultaneously lawmakers negotiated a grand compromise to ensure Congress would not filibuster the committee’s decision: Hayes would withdraw federal troops from the South, which had been occupied since the Civil War. Takeaway: A party can use control of states to send an alternate set of electoral returns to Washington, muddying the electoral counting process and throwing the election into Congress’s hands. Also, Congress is supreme and can create special mechanisms to resolve electoral disputes. Political solutions are essential when constitutional mechanisms fail.   2000 – Bush versus Gore – Contested election results in Florida led Democrat Al Gore to withdraw his concession to Republican George W. Bush. The Gore legal team convinced the Florida Supreme Court to allow several recounts, including a statewide recount. The Florida legislature, along with Florida Governor Jeb Bush, prepared to certify Jeb’s brother’s victory and send electoral votes to Washington. The US Supreme Court intervened, halting a statewide recount, on the basis of the equal protection clause of the fourteenth amendment and in rejection of the Florida court’s novel recount scheme. Takeaway: The Supreme Court can and will intervene in a state election dispute if it is becoming a legal morass. Previously the states settled disputes themselves, or the US Congress settled disputes in Washington. Though the Supreme Court claimed that its ruling did not set a precedent, the clear precedent is that the Supreme Court will intervene if there is a power vacuum. Each of these contested elections sparked extreme partisan controversy.8 In two of them, both the popular and electoral results were thrown out the window. The lesson is that the House of Representatives is definitive. Unless, of course, the Supreme Court preempts it. Since both the Constitution and statutory history point to Congress, not the Supreme Court, as the arbiter of presidential elections, it is unlikely that the Supreme Court would overrule the House if the House makes its decision first. But it is still possible, and this is a major source of uncertainty for 2020 or future elections. To fix the various problems that have arisen over the years, Washington has passed several laws, such as the twelfth amendment (1804) and the Electoral Count Act (1887). But fundamental disagreements can still emerge: namely over the constitutional power of the state legislatures to appoint electors, the value of the governor’s signature on his or her state’s electoral votes, and whether the President of the Senate has a substantive or merely ceremonial role. Any of these factors could result in confusion and controversy in 2020-21. How Will States Settle Disputes? On the state level, prior to the joint session of Congress to count the electoral votes on January 6, a range of shenanigans could occur, and the states may never actually settle their disputes. States are supposed to settle any internal recounts or disputes by December 8, 2020 for “safe harbor” status. This status urges, but does not require, the US Congress to accept the state’s final determination of its own electoral votes. If a state fails of this status, Congress may still count its votes, but it has a freer hand to do as it pleases. Thus each party will attempt through judicial or legislative actions to rush and achieve safe harbor status if it believes it won the popular vote count, and will attempt to delay and deprive the state of that status if not. If the legislature and governor agree, then this will be no problem. If they do not agree, the risk emerges that a state battle could escalate all the way to Washington. States with Republican governors, and a Republican or at least a divided legislature, could ensure that Republican electoral votes are sent to Washington in the event of a dispute. This is particularly important in the case of Arizona and Florida, but it also applies to Georgia, Iowa, Ohio, and Texas in 2020. The same goes for Democrats, although there are fewer swing states that fit this description (e.g. Minnesota), as Table 3 shows. Table 3Swing States: Balance Of Legislative And Executive Power The Definitive Guide To Contested US Elections The Definitive Guide To Contested US Elections The reason for this is that the Electoral Count Act of 1887 instructs Congress to favor the electoral votes with the governor’s signature if there is any dispute about which results to accept when the US Congress holds the final count. If the governor is not opposed by his own legislature, then his certified results will be the ones that go to Congress.    However, states with a unified legislature, either Republican or Democratic, could conceivably send electoral votes of their choice regardless of what the state governor does – and this is relevant for several of the most important swing states in 2020, specifically Republican legislatures under Democratic governors in Pennsylvania, Wisconsin, Michigan, and North Carolina, and Democratic legislatures under Republican governors, as in New Hampshire. The constitution endows state legislatures with the power to appoint electors, so legislatures could attempt to override their governors – or even their state supreme courts. Indeed, Florida’s legislature and governor were prepared to send Republican electoral votes to Washington regardless of the Florida high court’s actions in the year 2000. How Will Congress Count The Votes? Republicans will not have unified control of the federal legislature and executive, as noted above. Hence Republican congressmen and senators will not be able to pick and choose which electoral votes to accept at their discretion when the votes are counted on January 6, 2021. House Democrats would prevent them from rejecting any state’s electoral votes for arbitrary reasons.  On the other hand, the Democrats are quite likely to pick up the Senate, and a united Democratic Congress would have the power to pick and choose electoral votes at its discretion. The Democrats could disqualify the electoral votes of a state that voted for Trump in the event of a dispute, tipping the scales in Biden’s favor, during the electoral counting process. For example, say President Trump wins 270 electoral votes and Biden wins 268 – a likely scenario if Trump wins all the 2016 states but loses Pennsylvania and Michigan. Ostensibly President Trump would be re-elected. But the Democratic House and Senate could disqualify the 10 electoral votes of Wisconsin due to any disputes in that state over its popular vote or electors. Trump’s votes would fall to 260 while Biden would retain his original 268. A unified Congress could simultaneously decide to disqualify Wisconsin’s electors from the 538 total of appointed electors, saying the electors were not legally appointed, bringing the total denominator of electors to 528, thus giving Biden a three-vote margin of victory (majority: 265/528). Biden would become the president. If Congress is divided then this kind of manipulation is not possible. Either a bipartisan agreement would determine whether to count a state’s votes – which would be credible and legitimate – or a bipartisan disagreement would lead to the disputed electoral votes being counted. Chart 9Democrats Likely To Win Senate, Hence Congress – Huge Perk In Electoral Count The Definitive Guide To Contested US Elections The Definitive Guide To Contested US Elections Hence the makeup of the Senate on January 3, which may not be wholly complete at that time, is of great consequence. Democrats are structurally favored to win the Senate this year. They have 12 seats up for re-election versus 23 for Republicans, and only two of their seats are at risk whereas 10 are at risk for Republicans (Chart 9). We expect Democrats to take the Senate, but in a close presidential race the Senate could tie at 50-50. If Republicans retain the Senate, then Vice President Mike Pence could take on a substantive role in counting the Electoral College votes, rather than a merely ceremonial role of presenting the electoral returns to the joint session. If a state sends questionable electoral returns, or more than one set of returns, Pence could conceivably choose which results to present to Congress. A unified Congress could override him but a divided Congress might not. There is precedent for a vice president making a decision on electoral counting that affects the outcome in his own favor, as noted above. While modern scholars tend to highlight the conflict of interest here, the constitution could be read as giving the vice president this advantage so as to more speedily settle any disputes.9 The Electoral Count Act of 1887 says that when in doubt, Congress should accept the electoral votes certified by a state’s governor. But this position was controversial at the time and may not be constitutional. The vice president could assert his own authority to present the legitimate votes to Congress to be counted. It is not clear that a conservative-leaning Supreme Court would contradict him, since neither the constitution nor the Electoral Count Act envisions the court as arbitrating these kinds of disputes. Thus it is conceivable that a situation could arise in which a critical swing state sends two sets of returns and Vice President Pence chooses the electors in favor of himself and President Trump, with a Republican Senate preventing the Democratic House from doing anything about it. A strict constructionist Supreme Court would likely defer to whatever happens in Congress. However, the court could be activist, given that Chief Justice John Roberts is a well-known swing player. It could interpose in a way that precludes any actions deemed entirely arbitrary or lacking a plausible basis in the facts of the state’s election results and laws. As we saw, the court will be inclined to fill a power vacuum. The takeaway is that a unified Congress could count the electoral votes in such a way as to secure a Biden win, while a divided Congress could count the electoral votes in such a way as to give President Trump a lifeline in a disputed election. The Supreme Court is a wild card. What About An Electoral College Tie Or Faithless Electors? A contested election, using the narrow definition, would occur due to an Electoral College tie at 269-269 or any other anomalies that prevent either candidate from reaching a 270-vote majority. Again, the House of Representatives would decide on a state-by-state basis, likely favoring Trump. For example, some electoral votes could be disqualified, a third party candidate could split the vote, or “faithless electors” could vote contrary to their state’s popular choice.10  An electoral tie is not a negligible risk in 2020 – there are 68 possible combinations, and many of them are plausible.11 In 2016, 11 states had a margin of victory less than 5%. Take two equally realistic examples. If Trump lost Pennsylvania and Michigan (likely) as well as Nebraska’s second district (Omaha/suburbs, which President Obama won) then he would tie Biden at 269. Or, if Trump lost Pennsylvania, Michigan, and Arizona (which leaned Democratic in 2018), yet gained Minnesota (the epicenter of the crisis over race and law enforcement), a tie would occur. In a near-tie, a few wayward electors could deprive either candidate of a win. This is far more likely to happen to Trump than Biden. Table 4Range Of Electoral College Votes, 2020 The Definitive Guide To Contested US Elections The Definitive Guide To Contested US Elections The current combinations of truly competitive states suggest that the Democrats have a lock on 268-319 electoral votes while Republicans only have a lock on 169-219 electoral votes (Table 4). Trump is widely expected to lose both Pennsylvania and Michigan, which alone cut him down to 270 votes; the loss of a single vote from there would deprive him of a majority. By contrast, Biden would hit 278 votes at minimum by picking off a single Republican state in addition to Pennsylvania and Michigan. It is more likely that Trump would lose one or two faithless electors than that Biden would lose nine or ten. So it is more likely that faithless electors would deprive Trump of a win than Biden. But then the House of Representatives would have to resolve the impasse, and would likely favor Trump. What Is The Line Of Succession If The House Fails To Choose A President? What happens if a contested election goes to the House but the state delegations tie at 25-25? Then the House must continue voting over and over until one of the presidential candidates gets the majority. A single lawmaker in a critical state could swing the balance. That lawmaker could be swayed by conscience, bribes, or chance. In 1824, a critical lawmaker from New York changed his vote at the last minute because he found a ballot with John Q. Adams’s name on it and believed it was a sign from God. In 1876, the tiebreaking Supreme Court judge in the congressional commission delegated to work out a compromise solution was disqualified after it was found he had won a simultaneous race for a seat in the Senate.12 The House would eventually decide, but if the state delegations are evenly split, the voting could continue through January 20, Inauguration Day. The vice president would take over at that time. The vice president is chosen by a majority vote of the Senate. If Democrats take the Senate, they would choose California Senator Kamala Harris as the vice president, and she would act as president until the House made its choice. If the Senate vote also split at 50-50 on the new vice president, then the Speaker of the House, who is likely still to be California Representative Nancy Pelosi, would serve as acting president under the statutory line of presidential succession (Table 5). Table 5US Line Of Succession If Presidency Vacant The Definitive Guide To Contested US Elections The Definitive Guide To Contested US Elections Obviously both the House and the Senate would be under immense pressure to make a decision, so the power vacuum would not last more than a couple of months at most. The US would not be without a leader. However, its leader would be an interim leader with limited ability to make major policy changes or act proactively at home or abroad. It might be a good time for China to stage a surprise attack on Taiwan, or for other revisionist powers like Russia, Iran, or Turkey to make aggressive moves, while the global policeman is asleep at the wheel.13  What Is The “Blue Shift” And Does It Matter? The scholar Edward Foley has called attention to the phenomenon of the “Blue Shift” as a possible pretext for President Trump to contest the election result. The blue shift is the emerging tendency for US election tallies to change significantly after election day as a result of absentee and mail-in ballots that arrive after in-person ballots are counted.14  In 2018, the Arizona senate election went from Republican, as of the tally on November 6 to Democratic as of November 12 as a result of the blue shift. This produced whiplash for Republican supporters who thought they had won (Table 6).  Table 6“ Blue Shift” Means Vote Count Leans Democratic As Late Votes Arrive The Definitive Guide To Contested US Elections The Definitive Guide To Contested US Elections Will COVID-19 exacerbate the blue shift in 2020? While Republicans are less fearful of the virus and Democrats more enthusiastic about mail-in voting, the pandemic’s effect will be for more people in general to vote by mail, which should reduce the Democratic skew relative to previous elections. Still, there will be some Democratic skew which opens the possibility that an election that looks like a Republican win in the wee hours of November 4 could later fall to the Democrats. Foley entertains a scenario in which President Trump disputes the election on the basis of this apparent, but not real, shift in the election results. However, a blue shift would not prevent state-level election boards from correctly tallying and certifying the result. Trump can always cry foul, but only a small group of Republican supporters will believe him if the results are duly and transparently verified by a bipartisan consensus among the branches of state government. This scenario is thus governed by the points made above regarding the role of state legislatures: if a swing state’s legislature genuinely disagrees with the state’s election board or governor, then it could send its own set of electoral votes to Washington. If Republicans control the Senate, then this alternate set of electoral votes could be accepted. What Happens After A Contested Election? The constitutional power to count the Electoral College votes, and to determine the election if the college is indecisive, lies with Congress (and/or the Supreme Court). The rest is just the wailing and gnashing of teeth.  This wailing and gnashing could still prove market-relevant, however. If the defeated candidate has enough popular support, he would reduce the effectiveness of the new administration. If President Trump is re-elected on any of the technicalities above, he will face an unprecedented popular opposition and social unrest, likely fanned by Biden and a unified Democratic Party. Trump’s administration would be weak at home and would only have influence abroad, creating downside for global risk assets. Polarization is extreme – the two parties will do anything to win the White House. Chart 10Republicans Will Drop Trump Like Nixon If He Loses The Definitive Guide To Contested US Elections The Definitive Guide To Contested US Elections By contrast, if President Trump loses and refuses to concede, then he will actually reduce policy uncertainty in the United States. Trump’s support among Republicans is premised on his ability to win and drive through their favored policies; his support will plummet if he loses, just as Richard Nixon’s plummeted after the Watergate tapes were revealed (Chart 10). Trump could create an alt-right social media empire and serve as a gadfly, or he could lead a “rump” of the Republican Party to break away. Either way, he would divide and weaken the Republicans relative to the now-ruling Democrats, which would eventually lead to greater policy certainty. Without steady opposition, Democrats would achieve more of their agenda. This would increase risks for certain equity sectors (health care, energy), but would actually reduce polarization as the Democratic majority would more easily cooperate with moderate Republicans.  The latter scenario would be hugely important. Trump could hobble the Republicans for years. This would pave the way for a Democratic ascendancy. Such an ascendancy is already possible based on trends in age, demographics, and ideology, but a serious split in the Republican Party would ensure that it comes to pass. The negative side-effect is that the populist fringe would be more likely to become disaffected or radicalized. Implications For The Long Run The advanced democracies have seen a period of relative peace and prosperity since World War II that kept their electoral disputes limited. They have sought to use multilateral institutions to promote free and fair elections across the rest of the world. But globalization has disrupted their internal political balances, particularly in the United States, making them vulnerable to governance and electoral failures usually associated with emerging and frontier markets (Table 7). Table 7Worldwide Contested Elections Rarely End Peacefully The Definitive Guide To Contested US Elections The Definitive Guide To Contested US Elections Even prior to COVID-19 the US had reached historic levels of political polarization. The downward spiral of partisanship began when the Soviet Union collapsed and the country no longer faced a common external enemy. The Democrats and Republicans rapidly descended into a fratricidal battle over what they thought would be world supremacy. Today polarization is exploding into open power struggle, with President Trump preemptively casting doubt on the legitimacy of the election and his challenger suggesting that the US military will have to remove him from office if he defies the election result (with prominent generals explicitly contemplating “collective action” to remove Trump).15 Social unrest is morphing into ideological and political violence in the streets. There is ample fuel for unrest and violence to intensify. The party that comes out on top of the 2020 election will have significant influence over the future, including taxing and spending, trade and foreign policy, Supreme Court picks, redistricting after the 2020 census, the fate of the Senate filibuster, and the debate over statehood for Washington, DC. If President Trump wins, it will either be narrowly, through the Electoral College, or through a contested election settled in the House of Representatives. It will prevent a new consensus forming on fiscal policy and the redistribution of wealth. The same goes for a Biden win with Republicans keeping the Senate. As such, polarization will increase for a few more years, before the next generation’s leftward political shift overtakes the Republicans.  Nevertheless, while domestic policy will swing on the Senate, the next president will mostly be important in shaping US policy toward the rest of the world. In this respect, it is notable that Biden and Trump are both competing to see who is more mercantilist and protectionist. The US’s secular competition with China is likely to help cultivate national consensus on a range of policies in the coming decade. And if the Democrats win with a clean sweep – which we still see as the most likely outcome – the painful process of forming a new consensus on taxing and spending will begin in 2021. The US will have witnessed a sea change in fiscal policy as well as trade policy. Partisanship will remain high, but a strong Democratic majority on taxing and spending, combined with Democrats flagrantly coopting Trump’s stance on trade and China, looks to us like the seeds of a new national policy consensus that will reduce US political polarization over the long run. A Trump victory on a technicality will lead to a weak government and trade war. A Biden victory will have popular support and lead to higher taxes. Chart 11Stock Market Will Sell Off Amid Contested Election, As In Past The Definitive Guide To Contested US Elections The Definitive Guide To Contested US Elections Unfortunately, this year and the next few years will still see polarization at extremes.  It goes without saying that the US election cycle in 2020-21 will bring surprises and likely induce financial market volatility, beyond what has been seen. Judging by history, a full-fledged contested election will likely lead to a substantial equity pullback (Chart 11) – especially in a recessionary context, as in the case of the 1876 “Stolen Election.”   Beyond that, Trump’s re-election would pose a major trade war risk for global assets, a boon for continued US equity outperformance relative to the world. Biden would reduce global risks, while hiking domestic risks due to higher taxes and regulation, thus encouraging the opposite effect.   Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com     Footnotes 1    See Article II, Section I of the US Constitution.  2   See “Electoral College Instructions To State Officials,” National Archives and Records Administration, Office of the Federal Register, available at archives.gov. 3   See Article II, i and Amendment XII of the Constitution. There is some disagreement about what the constitution says regarding who does the counting. But a miscounting of the results, if the results are clear, is not credible. The vice president cannot deliberately miscount the vote, nor could Congress. However, if the results are not clear, disagreements could emerge in which the vice president could have a decisive impact. See Stephen A. Siegel, “The Conscientious Congressman’s Guide To The Electoral Count Act of 1887,” Florida Law Review 56 (2004), floridalawreview.com. Throughout this report we are highly indebted to Siegel’s authoritative study. 4   See Cook Political Report, “2020 House Race Ratings,” August 21, 2020, cookpolitical.com.  5   See for example Anna Baringer et al, “Voting by Mail and Ballot Rejection: Lessons from Florida for Elections in the Age of the Coronavirus,” University of Florida Election Science Group, August 20, 2020, electionscience.clas.ufl.edu. 6   See Amendment XII of the Constitution. 7   See Siegel, “The Conscientious Congressman’s Guide.” For the historical details in this section, see Paul F. Boller, Jr., Presidential Campaigns: From George Washington To George W. Bush (Oxford: OUP, 1984 [2004]). The House had to vote between Jefferson and his vice presidential candidate, Aaron Burr, who had the same number of electoral votes. At that time the president and vice president were not treated separately. Jefferson ultimately won when a handful of state delegations in the House abstained after several rounds of voting. Subsequently the twelfth amendment to the constitution was passed so that presidents and vice presidents were chosen separately, avoiding an Electoral College tie between two members of the same party ticket. 8   In 1800, Thomas Jefferson warned of civil war. In 1824, Andrew Jackson fumed that the will of the people had been cheated and plotted revenge, which he got in 1828. In 1876, Washington sent federal troops to monitor state election boards and some southern states threatened to rise up again. In 2000, a debatable court intervention fueled a left-wing backlash and a vicious spiral of polarization that continues to this day. 9   Here and elsewhere in this report we are indebted to Edward B. Foley, “Preparing for a Disputed Presidential Election: An Exercise in Election Risk Assessment and Management,” Loyola University Chicago Law Journal 51:2 (2019), lawecommons.luc.edu. 10  Regarding “faithless electors,” the Supreme Court this year unanimously upheld the ability of states to punish electors who break their pledge. But faithless electors are still possible, and could conceivably deprive an Electoral College winner of his victory. The 2016 election saw seven electors deviate from their party (out of 10 who tried), abnormally high. The extreme political environment is likely to produce defectors. See “Supreme Court Clarifies Rules for Electoral College: States May Restrict Faithless Electors,” Congressional Research Service, July 10, 2020, crsreports.congress.gov. 11   See “Electoral College Tie Finder,” 270 To Win, www.270towin.com. 12  See Boller, Presidential Campaigns. 13  See Admiral James A. Winnefeld and Michael J. Morell, "The War That Never Was?" US Naval Institute Proceedings 146: 8 (August 2020), usni.org. 14  See Foley, “Preparing for a Disputed Presidential Election.” This trend began with electoral reforms that made absentee balloting easier in 2002, but it is also a broader trend. Republicans tend to vote in person; those who vote through mail skew Democratic. Therefore the initial results favor Republicans, while the final results bring in a rush of ballots favoring Democrats. 15  See Brittany Bernstein, “Mattis Told Then-DNI Coats They May Be Forced to Take ‘Collective Action’ against ‘Unfit’ Trump, According to New Woodward Book,” National Review Online, September 9, 2020, nationalreview.com.

Highlights Portfolio Strategy We are introducing a structurally constructive US equity market view with an SPX 7000 target for year 2028 on the back of peak cycle EPS of $310 and peak cycle P/E multiple of 23. The reopening of the global economy is enticing us to recommend a trade going long a basket of 14 laggard “back to work” stocks versus a basket of 14 high-flying “COVID-19 winners.” While we maintain a cyclical and secular bullish outlook on the broad market, a short-term correction due to technical and (geo) political reasons is likely in the cards. In the last segment of the Weekly Report we identify five technical reasons, in no particular order. A playable short-term pullback is in order. Recent Changes Go long a basket of 14 “back to work” stocks versus a basket of 14 COVID-19 proof stocks. Table 1 SPX 7000 SPX 7000 Feature Our structural target is neither a joke nor a marketing ploy. And yes, it really does read SPX 7000! This is our S&P 500 target for the year 2028. A new business cycle has commenced and with it a fresh bull market. Our secular US equity market view is bullish. Our readers can fault us for our optimistic view on the world. But we live by the Buffett maxim that “there are no short sellers in the Forbes Billionaires list.” What gives us confidence in this prima facie hyperbolic market view? The Fed’s explicit acceptance that it is ready to incur inflation risk, cementing the fed funds rate near the zero-lower bound for as long as the eye see. In the last cycle, it took the Fed seven years to lift the fed funds rate from zero, a move that ended being judged as premature and forced the Yellen-led Fed to pause for another year (bottom panel, Chart 1). Seven years.  As such, there is a good chance the Fed will stay put until the year 2028, another election year. Even if it ultimately raises interest rates faster due to an overheated economy goosed up on the sweet nectar of fiscal largesse, it is highly likely to be behind the curve. Before we move on to justifying our target, some observations on ZIRP are in order. Chart 1Prolonged ZIRP Neither Eliminates Corrections… Prolonged ZIRP Neither Eliminates Corrections… Prolonged ZIRP Neither Eliminates Corrections… First, the Fed’s unorthodox monetary policy (QE and ZIRP) in the last cycle did not prevent stock market corrections, including a near 20% fall in 2011 (top panel, Chart 1). In other words, we do not expect smooth sailing or a 45-degree angle line in the SPX heading to 2028. Rather, an era of volatility with a plethora of sizable corrections is upon us, but the path of least resistance will be higher. Make no mistake, we are in a “buy the dip” market now. Similar to 2008-2015, there will be a lot of fits and starts and a number of mini economic cycles will develop. Chart 2 highlights that the ISM oscillated violently during the ZIRP years and so did equity momentum and the 10-year Treasury yield. Granted, the Fed managed to suppress economic volatility as real GDP averaged ~2%/annum in the aftermath of the GFC, but mini economic cycles and profit growth scares did not disappear (top panel, Chart 3). Importantly, while the 10-year Treasury yield moved with the ebbs and flows of the ISM manufacturing survey’s readings, it remained in a downtrend and every bond market selloff proved a buying opportunity in the era of ZIRP (third panel, Chart 2). What the Fed failed to generate was inflation – of either the CPI or PCE deflator variety. In fact, the Fed has not seen core PCE price inflation overshoot 2.5% since the early 1990s (bottom panel, Chart 3). Chart 2...Nor Mini Economic Cycles ...Nor Mini Economic Cycles ...Nor Mini Economic Cycles Chart 3“Lowflation”/Disinflation Has Been The Story Of The Past 30 years “Lowflation”/Disinflation Has Been The Story Of The Past 30 years “Lowflation”/Disinflation Has Been The Story Of The Past 30 years Another feature of the ZIRP years in the last cycle was that early on easy monetary policy coincided with easy fiscal policy, as was warranted for the first few years post the GFC. Subsequently, fiscal thrust increased starting in 2016 counterbalancing the Fed’s interest rate hikes. Despite all that fiscal easing, real GDP growth peaked at 3% in 2018 before decelerating last year, raising a question mark about the long-term health of the US economy, a question to be answered in a future Special Report. Frequent readers of US Equity Strategy know our long-held view that the two primary equity market drivers have been easy fiscal and monetary policies since the March carnage. Looking ahead, the Fed has cemented the view that easy monetary policy will stay with us for quite some time. While the jury is still out on fiscal policy, it appears at the moment that profligacy has staying power as no party in Washington is campaigning on austerity or worrying about paying down the debt (save for the lone voice of the Kentucky Senator Rand Paul). The Buenos Aires Consensus is a paradigm shift, and the most important long-term consequence will be higher inflation. The US has abandoned the guardrails on populism established by the Washington Consensus – countercyclical fiscal policy, independent central banking, free trade, laissez-faire economic policy – and has adopted something… different. A new Consensus. These are extremely potent macro forces and given that there is a lag between the time both easy monetary and loose fiscal policies hit the economy, their effects will be long lasting. Especially given that they are now synchronized – unlike for large periods of the previous cycle – and undertaken at a much greater order of magnitude than after the GFC. With that macro backdrop in mind, let us circle back to our 7000 SPX target. A fresh bull market has commenced and we consider the breakout above the previous cycle’s highs as its starting point. In August, the SPX surpassed the February 19, 2020 highs, giving birth to the new bull market. Using empirical evidence since the late-1950s we conclude that, on average, the SPX doubles from its breakout point (Table 2). This gives us the SPX 7000 reading before the new bull is slayed in the plaza de toros of economic cycles. While this qualitative analysis is enticing, ultimately earnings have to deliver in order to justify the equity market’s appreciation. Put differently, easy fiscal and monetary policies the world over will deliver EPS inflation. Table 2 SPX 7000 SPX 7000 On the quantitative EPS front, we first turn to the reconstructed S&P 500 earnings back to the late-1920s. On average, EPS have grown by 7.5%/annum, effectively doubling every decade (Chart 4). Chart 4Average Annual EPS Growth Since 1920s = 7.5% Average Annual EPS Growth Since 1920s = 7.5% Average Annual EPS Growth Since 1920s = 7.5% More recently, using I/B/E/S data, there have been four distinct EPS growth periods over the past four decades with different durations. From trough-to-peak, EPS have enjoyed an average CAGR of over 10% (top panel, Chart 5). Chart 5EPS Can Double In Next Eight Years EPS Can Double In Next Eight Years EPS Can Double In Next Eight Years The current trough in forward EPS stands just shy of $140. Applying the average CAGR until 2028 results in a $310 EPS figure. This is our starting point of our EPS sensitivity analysis. Assigning the current forward multiple equates to an SPX terminal value of over 7000. Table 3 showcases different EPS and forward P/E multiple permutations with the grey shaded area representing our tight range of peak cycle multiples and peak EPS estimates. Table 3SPX EPS & Multiple Sensitivity SPX 7000 SPX 7000 With regard to what is currently priced in by sell side analysts, the 5-year forward EPS growth rate – the longest duration estimate available – is near a trough reading of 10%. The historical mean is 12% since 1985, with a range of 19% near the dotcom bubble peak and a trough of 9% at the depths of the 2016 manufacturing recession (bottom panel, Chart 5). A few words on presidential cycles are relevant given our structural bullish equity market view.  We first noticed Tables 4 & 5 in the WSJ in late-2016 and we have corrected some minor mistakes and updated them filling in the gaps. Drawdowns are frequent during term presidencies1 dating back to Hoover. Table 4Every Presidency Experiences Drawdowns SPX 7000 SPX 7000 Table 5S&P 500 Returns During Presidential Terms SPX 7000 SPX 7000 What is truly remarkable, however, is that since the late-1920s only three term presidencies ended up in the red. What the WSJ article did not mention was that in all three market declines GOP presidents were at the helm and had taken over at/or near all-time highs in the SPX! This represents a risk to our SPX 7000 view. If President Trump wins the upcoming election, given the recent modest recovery in the polling, he could meet the same fate as his Republican predecessors. Our sister Geopolitical Strategy service still assigns 35% probability for the incumbent to remain in office, a solid figure that suggests the race remains close. Importantly, while we believe a transition to a Democratic president will be tumultuous as we have been cautioning investors recently, a Biden presidency along with the possibility of a “Blue Wave” will bode well for the long-term prospects of the US equity market, if history at least rhymes. BCA’s Geopolitical strategist Matt Gertken assigns 65% odds to a Biden win and 55% to a Blue trifecta. Finally, on a technical note, the recent megaphone formation has stirred a lot of debate among technical analysts in the blogosphere and is eerily reminiscent of a similar formation that lasted from 1965 until 1975. Typically, these megaphone formations get resolved/completed by a diamond formation (Chart 6). Chart 6Of Megaphones And Diamonds Of Megaphones And Diamonds Of Megaphones And Diamonds While this points to a selloff in the broad equity market in the near-term, which is in accordance with our tactically cautious view (please see the last section of this Weekly Report), it is very bullish for the long-term, as equities catapult higher from such a diamond base formation (Chart 7). In other words, odds are much higher that the SPX will hit 7000 first, before it ever revisits 2200. Adding it all up, we are introducing a structurally constructive US equity market view with an SPX 7000 target for year 2028 on the back of peak cycle EPS of $310 and peak cycle P/E multiple of 23. Chart 7Diamond Base Is Long Term Bullish Diamond Base Is Long Term Bullish Diamond Base Is Long Term Bullish This week we recommend a basket of 14 stocks to play the “back to work” reopening of the global economy versus a basket of 14 "COVID-19 winners". We also reiterate our view not to chase the broad equity market higher in the short-term and back it up with five key technical reasons. “Back To Work” Versus “Stay At Home” Today we recommend buying a basket of 14 stocks levered to the economic reopening and the “back to work” theme, at the expense of a basket of 14 “COVID-19 winners” stocks. There is no question that we are in a V-shaped economic recovery, partly due to arithmetic, i.e. base effects. The severe blow to the economy that the pandemic-induced shutdowns inflicted is reversing violently. Easy monetary and loose fiscal policy have been a tonic and are allowing enough time for the economy to heal and stand on its own two feet. Chart 8 shows a number of economic variables that are in this V-shaped recovery. Our sense is that there will be a rotation out of mostly high-flying tech titans and select health care COVID-19 beneficiaries and into laggard stocks that would benefit from the reopening of the global economy. The transition to these stocks will be anything but smooth, however, it is a necessary precondition for the continuation of the rally late in the year post the election and into 2021. Clearly, the "COVID-19 winners" have stolen demand from the future. Now that the working-from-home setup is nearly complete for most workers, the pendulum is likely to swing in the opposite direction. In other words, at the margin, employees will slowly start to return to work and the economic reopening should serve as a catalyst for this rotation. Chart 8V-Shapes Galore V-Shapes Galore V-Shapes Galore Chart 9Buy "Back To Work" Stocks Buy “Back To Work” Stocks Buy “Back To Work” Stocks Importantly, a definitive vaccine breakthrough will assist some of the beaten down stocks and sectors that at some point were priced for bankruptcy. We remain hopeful that such positive news will soon hit the tape. As a result, this will unleash a stream of bargain hunters out of the woodwork in favor of “back to work” equities and send short sellers reeling. Ultimately, the violent recovery in relative earnings forecasted by the sling shot recovery in the ISM manufacturing survey and most of its subcomponents will boost the “back to work” basket at the expense of the “COVID-19 winners” (Chart 9). For the “back to work” basket we have selected two airlines, two hotels, two oil producers, two restaurant operators, two capital goods manufacturers, two credit card companies, an automobile manufacturer, and a steel producer. In contrast, the “COVID-19 winners” basket that we first created in mid-March currently includes: a bankruptcy consultant, a software company that enables remote access, three grocers, a tele-medicine company, two biotech giants, a Big Pharma company, the biggest online store in the US, an online streaming service company, a teleconferencing company, and finally two household/cleaning products leaders. Bottom Line: Go long a basket of 14 “back to work” stocks at the expense of 14 “COVID-19 winners” equities. The ticker symbols for the stocks in the US Equity Strategy “back to work” basket are: LUV, DAL, MAR, HLT, CVX, EOG, SBUX, MCD, CAT, HON, AXP, COF, NUE, GM. The ticker symbols for the US Equity Strategy “COVID-19 winner” basket are: TDOC, FCN, ZM, CTXS, JNJ, AMGN, REGN, CLX, RBGLY, WMT, COST, KR, NFLX, AMZN. Five Reasons Not To Chase Equities In the Near-Term Over the past weeks, we have been cautioning investors not to chase the equity market higher as the risk/reward trade-off at current levels is tilted to the downside. While we maintain a 9-12 month bullish view on the broad market, a short-term correction due to technical and/or (geo) political reasons is likely in the cards. Consequently, patient investors will be rewarded with a compelling entry point likely in the coming months. Below are five reasons, in no particular order, arguing that a playable short-term pullback is in order: Reason #1: The 200-day Moving Average Moving averages are a perfect tool to put the speed of any rally in perspective and to highlight extreme investor optimism. Chart 10 shows standardized SPX and Nasdaq 100 (NDX) price ratios with respect to their 200-day moving averages. If we look at the current cycle, whenever both the SPX and NDX crossed above the one standard deviation (std) line, a sizable pullback was quick to follow. While NDX has been well above its 1 std line for some time, last week’s price action finally pushed the SPX into the overstretched column. The implication is that a correction is looming. Chart 10Overstretched Overstretched Overstretched Reason #2: Monthly Moving Averages For the second reason, we look at the concept of price deviations from the moving average through a different lens – Bollinger bands (BBs). A traditional (20,2) BB includes a 20-period moving average of the price, as well as 20-period 2-standard standard deviation lines. While it can be plotted on any time frame, we use monthly data as set ups in longer time frames (i.e. monthly) dictate the behavior of the shorter (i.e. daily) time frames. Chart 11 shows the S&P 500 together with its (20,2) BBs on a monthly time frame. Whenever the market spikes above the 2 std line, a sizable correction ensues. Currently, the market is squarely above the 2 std line, which has historically been a precursor to a 5-10% drawdown. Chart 11Too Far Too Fast SPX 7000 SPX 7000 Reason #3: Growth/Value Staying on the topics of extreme rallies, Chart 12 shows the year-over-year growth rate in the S&P growth / S&P value share price ratio. In the entire history of the data, never has it printed a jaw-dropping 34% growth rate, not even after the depths of GFC or to the lead up to the dotcom March 2000 peak. Such a pace is clearly not sustainable and since growth stocks are dominated by FAANG-like companies that have done all of the heavy lifting year-to-date, a reset in the S&P growth / S&P value ratio will weigh on the overall market. A selloff in the bond market will likely serve as a catalyst to boost the allure of beaten down value stocks at the expense of overvalued tech titans. Chart 12In Need Of A Breather In Need Of A Breather In Need Of A Breather Reason #4: Options/Volatility Markets Option and related volatility market movements reveal some vulnerabilities in the broad equity market. More specifically, the VIX and the VXN which by construction are inversely correlated with the S&P 500 and NASDAQ 100, respectively, serve as an excellent timing tool. We look at the 20-day moving correlation of those respective variables, and similarly to Reason #1, a reliable sell signal is given once both (VIX, SPX) and (VXN, NDX) 20-day moving correlations shoot into positive territory (Chart 13). While the (VXN, NDX) correlation has been going haywire over the past quarter as likely single stock call option buying has been heavily hedged by NDX put buying, the (VIX, SPX) moving correlation only slingshot higher at the end of last week - finally producing a decisive sell signal. Again, similarly to Reason #2, each sell signal resulted into a sizable correlation in the SPX, warning that a 5-10% pullback – the sixth since the March lows – is inevitable in the coming weeks. Chart 13Unsustainable Correlation Unsustainable Correlation Unsustainable Correlation   Reason #5: Bad Breadth Tech stocks have clearly been the work horse behind this rally pushing markets into uncharted territory in a very short period of time since the March lows. However, and as we highlighted in our previous research, it is only a handful of tech titans that propelled the markets to all-time highs. Overconcentration of returns in just a few tickers is not healthy, and a reset is only a question of time. Chart 14 highlights that today only 58% of NASDAQ Composite stocks are trading above their respective 50-day moving average, which stands in marked contrast to the all-time highs in the NASDAQ Composite. Such a divergence is unsustainable and typically gets resolved by a snap back in equity prices. While Chart 14 cannot be used as a precise timing tool, it has been consistently leading the NASDAQ Composite especially at peaks, cautioning that a healthy pullback is forthcoming. Chart 14Bad Breadth Bad Breadth Bad Breadth Bottom Line: While we maintain a cyclical and structural stance in the broad equity market, the shorter-term risk/reward trade-off is tilted to the downside, and presents a playable opportunity.   Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com     Footnotes 1     By term presidencies we are referring to the different duration of Presidents staying in office.   Current Recommendations Current Trades Strategic (10-Year) Trade Recommendations Drilling Deeper Into Earnings Drilling Deeper Into Earnings Size And Style Views July 27, 2020 Overweight cyclicals over defensives April 28, 2020  Stay neutral large over small caps June 11, 2018 Long the BCA Millennial basket  The ticker symbols are: (AAPL, AMZN, UBER, HD, LEN, MSFT, NFLX, SPOT, TSLA, V). January 22, 2018 Favor value over growth

Highlights Abenomics was working – prior to trade war and COVID-19 – and it will remain Japan’s economic policy setting, albeit in a new guise. This is true even if a dark horse candidate wins the Liberal Democratic Party’s leadership race. Japan’s strategic alliance with the United States is based on a shared interest to balance China’s rise and will not change regardless of the 2020 and 2021 elections. Abe failed to make peace with Russia, but Russo-Japanese relations remain the bellwether of a revolution in Russian policy toward China. We are far from that now. Stay long JPY-USD. The yen’s safe haven properties will buoy it during the coming three-to-six months of extreme political risk. The dollar is set to fall in the medium term due to US debt monetization, twin deficits, and global growth recovery. Feature Japanese equities have rallied despite trailing their American and global counterparts (Chart 1). Yet the good news for markets is now coinciding with the emergence of political uncertainty, as Prime Minister Shinzo Abe, now the longest-serving in Japan’s history, announced he will step down due to illness. Abe’s departure marks the end of a chapter in the country’s modern history and raises questions about the future of “Abenomics,” the eponymous economic policy consisting of ultra-dovish monetary policy, accommodative fiscal policy, and neoliberal structural reforms aimed at lifting productivity and growth. Chart 1Japan's Rally Trails Global Counterparts Japan's Rally Trails Global Counterparts Japan's Rally Trails Global Counterparts Chart 2… As Longest-Serving Prime Minister Steps Down Abenomics Will Smell As Sweet By Any Other Name Abenomics Will Smell As Sweet By Any Other Name Japanese leaders rarely last as long as Abe so the market will likely have to familiarize itself with more churn in top-level government policies going forward (Chart 2). But will the churn change the secular direction? No. Abenomics: A Concise Post-Mortem Chart 3Population And Workforce Decline Population And Workforce Decline Population And Workforce Decline The driver of Abenomics was not Abe, or his central bank Governor Haruhiko Kuroda, or even the long-dominant Liberal Democratic Party. It was geopolitics – an accumulation of social, political, economic, and strategic pressures demanding that the ruling elite shake up decades-long policies in pursuit of the national interest. Everyone knows that Japan’s population is aging and shrinking, but the key to understanding the Abe era is the recognition that the 2008 global financial crisis coincided almost exactly with the peak in Japan’s total population. This came 18 years after the working age population’s peak in the very year of Japan’s own financial crisis (Chart 3). The first crisis triggered Japan’s slide into price deflation; the second crisis threatened the permanent entrenchment of deflation along with a series of existential threats to the wellbeing of the nation. The driver of Abenomics was geopolitics, not Abe. First came global recession in 2008. Next the institutional ruling party – Liberal Democrats – fell from power for the first substantial period of time in modern memory in 2009. Then China fully emerged as a great power, brandishing its new foreign policy assertiveness and igniting a maritime-territorial clash and minor trade war from 2010 (Chart 4). Japan’s decline reached its nadir with a literal nuclear meltdown, following the devastating Tohoku earthquake and tsunami in 2011. The country’s strategic import dependency combined its ongoing financial instability, as shuttered nuclear plants required a surge in high-priced energy imports that wiped away Japan’s all-important current account surplus (Chart 5). Chart 4Geopolitical Status Anxiety Geopolitical Status Anxiety Geopolitical Status Anxiety Chart 5Nuclear Meltdown And Resource Anxiety Nuclear Meltdown And Resource Anxiety Nuclear Meltdown And Resource Anxiety The Liberal Democrats returned to power in a sweeping election victory after this ill-fated experiment with opposition rule. Party leader Shinzo Abe was relatively popular and willing to oversee a drastic overhaul of stale policies. Abenomics was never going to solve all of Japan’s deep structural challenges – population decline, massive debt, overregulation, lifetime employment. But its critics failed to recognize that the country had hit rock-bottom and policymakers had no choice but to stimulate, reform, and open up the economy. Otherwise they would go straight back into the political wilderness at the next election.1 Abenomics was about as successful as an overhyped political policy program can be: The economic boom drew in workers from all parts of society, particularly women, whose participation rate soared (Chart 6). Abe flung open the doors to immigration in a traditionally xenophobic country, attracting Chinese, Vietnamese, and Filipinos to live and work in Japan (Chart 7). Chart 6Abe Got People To Work Abe Got People To Work Abe Got People To Work Chart 7Abe Broke The Taboo On Immigration Abenomics Will Smell As Sweet By Any Other Name Abenomics Will Smell As Sweet By Any Other Name Kuroda at the Bank of Japan flew into action with aggressive asset purchases, triggering a sharp devaluation of the yen (Chart 8). Nominal GDP growth and core CPI trends both improved, critical to easing debt burdens, lowering real rates, stimulating economic activity, and shaking off the deflationary mindset (Chart 9). Chart 8Abe Kicked The BoJ Into Action Abe Kicked The BoJ Into Action Abe Kicked The BoJ Into Action Chart 9Abe Combatted Deflation Abe Combatted Deflation Abe Combatted Deflation Stagnant wages finally started to grow, with an extremely tight labor market (Chart 10). This was all the more remarkable due to the simultaneous surge in foreign workers. Corporate investment stabilized and turned upward, finally overcoming the long decline since 1990 (Chart 11). Chart 10Wage Growth Improved (Until Trade War, Pandemic) Wage Growth Improved (Until Trade War, Pandemic) Wage Growth Improved (Until Trade War, Pandemic) Chart 11Abe Revived Corporate Investment Abe Revived Corporate Investment Abe Revived Corporate Investment Abe also opened the door to foreign trade, taking on powerful vested interests, including his own party’s base, to join the Trans-Pacific Partnership (TPP) along with the United States in a bid to create an advanced new trade framework that sidestepped China. Chart 12Abe Opened The Doors, A Bonus With Or Without Trade War Abenomics Will Smell As Sweet By Any Other Name Abenomics Will Smell As Sweet By Any Other Name When US President Donald Trump pulled out of the bloc in accordance with his protectionist campaign promises, Abe led the charge in preserving it. Japan stands to benefit from opening up these markets whether the US-China trade war continues or not (Chart 12). This was generally effective leadership, but none of it happened by sheer force of personality. It happened because Japan glimpsed the specter of national failure in 2011 under the combined weight of internal malaise and external domination. Economic revival was as much about shoring up Japan’s national security as it was about improving Japanese lives and livelihoods. Abenomics was the economic component of a broader national revival. The goal was to become a “normal” nation, capable of self-defense and independent policy, and a pro-active world power at that. China’s rise and a distracted US will pressure Japan to maintain Abe’s policies. The drivers of Japan’s political earthquake in 2011 are not spent. COVID-19 dashed many of Abe’s gains in the fight against deflation. China’s rise is a greater challenge than ever before. The US is even more divided and distracted. The next prime minister would not be able to change course even if he wanted to do so. Suganomics, Kishidanomics … Ishibanomics? Chart 13Still No Alternative To Institutional Ruling Party Still No Alternative To Institutional Ruling Party Still No Alternative To Institutional Ruling Party The Liberal Democrats and their longtime coalition partners, New Komeito, have not only lost about 5% of popular support since their triumphant comeback in 2012, standing at 40% support today – and with some improvement since 2017. More importantly, their nearest rivals all poll under 5% of the popular vote (Chart 13). There is no political competition as yet. The ruling party will choose a new leader with little fanfare. Abe’s Chief Cabinet Secretary and chosen successor Yoshihide Suga is the frontrunner as we go to press. Political uncertainty, such as it is in Japan, will emerge ahead of the September 2021 election. Abe’s retirement and the aftermath of the global recession create an opening for disgruntled factions and opposition parties to challenge the ruling party. It will not succeed but it will portend a less predictable period in the absence of a unifying figure like Abe. In fact, Abe’s influence peaked in July 2019 when he lost a single-party super-majority in the House of Councillors, the upper house of parliament (Chart 14). The 2021 election now raises the prospect of additional erosion of support. Chart 14US-Japan Alliance Versus China Will Persist Abenomics Will Smell As Sweet By Any Other Name Abenomics Will Smell As Sweet By Any Other Name Opposition is particularly likely if Suga attempts to achieve Abe’s major unfinished task: the revision of Article Nine of the constitution to countenance Japan’s de facto armed forces and right to self-defense. At very least Suga will mark the return of the “revolving door,” in which weak prime ministers come and go in rapid succession. The top candidates for the leadership race lack differentiation: the leading contenders are dovish on monetary and fiscal policy, hawkish on national security and foreign policy, just like Shinzo Abe (Table 1). The exception is former Defense Minister Shigeru Ishiba, but a close examination of his statements and actions suggests that he does not pose a real risk to the policy status quo (Box 1 at bottom). Should Ishiba rise to power, now or later, we would be buyers of any risk premium in financial markets on his account. Table 1The Return Of The Revolving Door Abenomics Will Smell As Sweet By Any Other Name Abenomics Will Smell As Sweet By Any Other Name The prime minister over the 2021-22 period will have the occasion to appoint up to four members of the Bank of Japan’s Policy Board (Table 2). Theoretically, the appointment of neutral or less dovish candidates could lead to a 5-4 majority on the board by 2023. But this is very unlikely. Table 2Dovish BoJ Is Here To Stay Abenomics Will Smell As Sweet By Any Other Name Abenomics Will Smell As Sweet By Any Other Name First, it would require all vacant seats to be filled with members who hold hawkish views, which would mark a sharp departure from the current thinking both within the BoJ and the LDP. Second, Kuroda is still governor and could hold that post until 2028. Third, Japan’s economic demands will still require easy monetary policy, as the population will still be shrinking and the country’s vast debt pile will remain a burden. Fiscal austerity is impossible. There is no reason to expect Abe’s successors to be fiscal hawks either. Abe proved to be more of a hawk than expected, by going forward with statutory increases to the consumption tax rate. These are now complete, at 10%, with no future tax hikes scheduled. If Abe managed to create small positive surprises in fiscal thrust throughout his term despite this effort at fiscal consolidation, then his successor should be able to do so in the wake of COVID-19 without any consolidation as yet on the books (Chart 15). Chart 15Despite Mistakes, Fiscal Thrust Surprised To Upside Abenomics Will Smell As Sweet By Any Other Name Abenomics Will Smell As Sweet By Any Other Name Chart 16Fiscal Austerity Impossible Abenomics Will Smell As Sweet By Any Other Name Abenomics Will Smell As Sweet By Any Other Name Fiscal austerity is impossible as nearly 60% of the budget is dedicated to social spending for the graying and shrinking society as well as interest payments on the national debt – leaders will continue to avail themselves of the ancient imperial practice of tokusei, or debt forgiveness, rather than draconian spending cuts or tax increases that would drag down the economy and hence increase the debt even faster (Chart 16). Of course, the major failure of Abenomics will still dog Abe’s successors over the long run: the inability to lift Japanese productivity. Despite Abe’s attempts to shake up the labor market, spark corporate investment, reform corporate governance, and open up the economy to foreign trade, productivity has still declined, underperforming both the EU and the UK (Chart 17). Japan will continue to depend heavily on foreign demand, especially Chinese demand. In the short term this is positive, since China’s deleveraging campaign and the COVID-19 shock are giving way to another major bout of Chinese fiscal and credit stimulus. China will be forced to keep stimulating to cope with its secular slowdown and manufacturing dislocation. Japan is still a cyclical economy and stands to benefit (Chart 18). Chart 17No Quick Fix For Poor Productivity No Quick Fix For Poor Productivity No Quick Fix For Poor Productivity Chart 18Chinese Stimulus Will Be Steady Chinese Stimulus Will Be Steady Chinese Stimulus Will Be Steady In the long run, however, Japan’s future darkens considerably when its own demographic decline and deflationary tendencies are coupled with China’s inheritance of these same trends. The Communist Party is doubling down on import substitution and foreign policy assertiveness, ensuring that trade and strategic conflict with the US will escalate over time. Japan will remain allied with the United States, out of its own strategic interest, but will pay the price in periodic headwinds to growth. Its ability to relocate manufacturing to Japan is limited in all but the most sophisticated of industries. It will have to embrace ever more unorthodox monetary and fiscal policy while investing heavily in new technologies and emerging markets ex-China in search of growth. Geopolitically speaking, Shinzo Abe helped the United States formulate its new strategic plan of promoting a “free and open Indo-Pacific” and the spirit of this policy will outlive Abe and President Trump. The US’s “pivot to Asia” began under the Democratic Party, which will rejoin the Trans-Pacific Partnership, with a few tweaks, if it returns to power. The US and Japan are both interested in forming a grand coalition of nations surrounding China to contain its ambitions, whether military, political, or technological. China would be naïve not to see the quadrilateral security dialogue between these countries and India and Australia as the blueprint of a naval alliance designed to contain it. The Taiwan Strait, the South and East China Seas, Vietnam, the Philippines, and the Korean Peninsula will become the sites of “proxy battles” as the US and Japan strive to contain China. Japan will retain its safe haven status – in both the geopolitical and financial sense – while other countries will see a higher geopolitical risk premium. Japanese and Korean trade tensions will persist, unless the US takes a leadership role in strengthening the trilateral relationship. Russia has chosen to throw in its lot with China, which will not change anytime soon. But if Abe’s successor is able to get peace negotiations back on track, in pursuit of another of Abe’s major unfinished initiatives, then this would serve as an important bellwether of Russia’s own fear of China’s growing power. Investment Takeaways Chart 19Japanese Stocks Look Attractive... Japanese Stocks Look Attractive... Japanese Stocks Look Attractive... Japanese equities are exceedingly cheap and hence attractive over the long run, given that a new global business cycle is beginning and governments around the world are committed to providing as much support as they are able. At a dividend yield of less than 2.5%, the real return on Japanese stocks over the next ten years could be 20% (Chart 19). However, over the next three-to-six months, the world faces extreme uncertainty over the US election and rapidly deteriorating US-China relations. The Japanese economy is slowing and monetary policy, at the zero lower bound, will play a marginal role. The yen is set to appreciate as a safe-haven in this environment (Chart 20), and until there is a total divergence of the inverse correlation of the yen and Japanese equities, the latter will struggle to outperform those of other developed markets on a sustained basis. Chart 20... But Yen Rally Will Continue ... But Yen Rally Will Continue ... But Yen Rally Will Continue Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Box 1: Ishiba Is Not A Real Risk To The Policy Status Quo Shigeru Ishiba, while not favored to succeed Abe in the short run, is a compelling Japanese politician and one of the few Liberal Democratic leadership candidates who would mark a change with Abe, as Table 1 above indicates. If Ishiba looks to become prime minister, now or later, he would create some financial market jitters primarily because he would not symbolize seamless policy continuity. He is a major rival of Abe and has publicly criticized Abenomics, including in his 2018 book.2 He is reputed to be a hawk on monetary and fiscal policy. However, a close look at his record shows that he is not ideological and would not revolutionize Japanese national policy once in office. Ishiba is a careful and rational thinker and an institutional and establishment LDP politician. Both Ishiba and his father (Jiro Ishiba) were scions of the Tanaka/Takeshita factions whose base was agriculture, construction industry, defense industry, and the postal service.3 His is not the background of a radical fiscal hawk. One of Ishiba’s major concerns is generating growth outside of the major cities, but he does not take a slash and burn approach to the central government budget. For example, at a forum on Abenomics, the director of the Japanese Civilization Institute spoke with Ishiba in his capacity as Minister of Regional Revitalization. The moderator gave Ishiba the opportunity to denounce excess government spending and promote central spending cuts, saying, “Maybe you must arrange fiscal discipline more appropriately. Then, you can supply that money to regional areas.” Ishiba responded drily, “But I think regional areas must make their own money too.” The yen could rally on a bout of political uncertainty if Ishiba at any time looks likely to become LDP leader and he criticizes excessively easy economic policies. But, as we noted above in the report above, the BoJ Policy Board, not the prime minister’s office, will set monetary policy – and Ishiba would struggle to stack the board with hawks due to institutional resistance. Moreover in the wake of a global recession, the next prime minister will not have much ability to drive parliament into budget cuts or tax hikes. Ishiba would more likely seek to pursue deregulation. If he insisted on austerity, the economy would slump and his premiership would be ruined. Chances are he would listen to his advisers. The one policy that concerns Ishiba above all is national defense and security. Ishiba previously served as defense minister and was known for his hawkish tone, particularly over disputes in the East China Sea and domestic protests against the country’s new security law. More recently he differed with Abe’s constitutional revision – not over the need to normalize Japan’s self-defense forces, but because Abe tried to avoid an explicit mention of Japan’s right to maintain armed forces. If anything, Ishiba would be inclined to increase military spending. Yet his foreign policy is not a risk to the markets, beyond rhetoric, as he is also more willing to engage China than some other LDP leaders. Footnotes 1 In truth, something of a national awakening had already begun in the early 2000s under Prime Minister Junichiro Koizumi. This is reflected in the improvement of the fertility rate from 2005. But it fell to Abe to pick up where Koizumi had left off, fighting deflation and strengthening Japan’s international position. 2 See "Abe’s rival to declare bid to become Japan’s next leader," Nikkei, July 13, 2018, asia.nikkei.com. See a campaign synopsis at ishiba.com. 3 See Jojin V. John, "Developments in Japanese Politics: LDP Presidential Election and the Future of Prime Minister Shinzo Abe," Indian Council of World Affairs, August 29, 2018, icwa.in

Recommended Allocation Monthly Portfolio Update: Can Monetary Policy Alone Propel The Market? Monthly Portfolio Update: Can Monetary Policy Alone Propel The Market? Chart 1Only Internet Stocks Have Kept On Rising Only Internet Stocks Have Kept On Rising Only Internet Stocks Have Kept On Rising It has been a very strange bull market. Although global equities are up 52% since their bottom on March 23rd, the rally has been limited largely to internet-related stocks. Excluding the three sectors (IT, Consumer Discretionary, and Communications) which house the internet names, equities have moved only sideways since May (Chart 1). Moreover, the rally comes amid sporadic serious new outbreaks of COVID-19 cases, most recently in Europe (Chart 2). Fears of the pandemic and much-reduced business activity in leisure-related industries have caused consumer confidence to diverge from the stock market in an unprecedented way (Chart 3).  Chart 2New Outbreaks Of COVID-19 In Europe New Outbreaks Of COVID-19 In Europe New Outbreaks Of COVID-19 In Europe Chart 3Why Are Stocks Rising When Consumers Are So Wary? Why Are Stocks Rising When Consumers Are So Wary? Why Are Stocks Rising When Consumers Are So Wary? The only explanation for these phenomena is the unprecedented amount of monetary stimulus, which is causing excess liquidity to flow into risk assets. Since March, the balance-sheets of major central banks have increased by $7 trillion (Chart 4), and M2 money supply growth has soared (Chart 5). Chart 4Central Banks Have Grown Their Balance-Sheets... Central Banks Have Grown Their Balance-Sheets... Central Banks Have Grown Their Balance-Sheets... Chart 5...Leading To A Big Rise in Money Growth ...Leading To A Big Rise in Money Growth ...Leading To A Big Rise in Money Growth Moreover, the Fed’s new strategic framework announced in late August represents a commitment to keep monetary policy loose even when the economy begins to overheat. The Fed will (1) target 2% inflation on average over time which means that, after a period of low inflation, it will “aim to achieve inflation moderately above 2 percent for some time”; and (2) treat its employment mandate as asymmetrical, so that when employment is below potential the Fed will be accommodative, but that a rise in employment above its “maximum level” will not necessarily trigger tightening. Historically the Fed has raised rates when unemployment approached its natural rate (Chart 6). The new policy implies it will no longer do so. The aim of the policy is to raise inflation expectations which have become unanchored, with headline PCE inflation above the Fed’s 2% target for only 14 out of 102 months since the target was introduced in February 2012 (Chart 6, panel 3).  Chart 6The Fed's Behavior Will Be Different In Future The Fed's Behavior Will Be Different In Future The Fed's Behavior Will Be Different In Future Chart 7More Permanent Job Losses To Come More Permanent Job Losses To Come More Permanent Job Losses To Come This commitment to easier monetary policy for longer will certainly help risk assets. But will it be enough? The global economic environment remains weak. Permanent job losses continue to increase, as workers initially put on furlough or dismissed temporarily, are fired (Chart 7). A second wave of COVID-19 cases in the Northern Hemisphere winter would worsen the situation. While central banks everywhere remain committed to aggressive policy, fiscal policy decision-makers are getting cold feet, with the UK’s wage-replacement scheme due to end in October, and government support in the US set to decline absent a big new fiscal package agreed by Congress (Chart 8). Credit risks are beginning to emerge, with bankruptcies surging (Chart 9), and mortgage delinquencies starting to rise (Chart 10). As a result, banks are becoming significantly more reluctant to lend (Chart 11). Chart 8Fiscal Support Is Starting To Slide Fiscal Support Is Starting To Slide Fiscal Support Is Starting To Slide   Chart 9Bankruptcies Are Surging… Monthly Portfolio Update: Can Monetary Policy Alone Propel The Market? Monthly Portfolio Update: Can Monetary Policy Alone Propel The Market?   Chart 10...Along With Mortgage Delinquencies ...Along With Mortgage Delinquencies ...Along With Mortgage Delinquencies Chart 11Banks Turning Increasingly Cautious Banks Turning Increasingly Cautious Banks Turning Increasingly Cautious To those concerns, we should add political risk ahead of the US presidential election. President Trump is probably not as far behind as the 7-percentage point gap in opinion polls suggests: After the Republican National Convention, online betting sites give him a 46% probability of being reelected (Chart 12). Over the next two months, he could be aggressive in foreign policy, particularly towards China. A disputed election is not unlikely. Investors might be wise to hedge against that possibility: BCA Research’s Geopolitical service recommends buying December VIX futures, which are still cheaply priced, and selling January VIX futures (Chart 13). 1 Chart 12Trump Could Still Pull It Off Trump Could Still Pull It Off Trump Could Still Pull It Off   Chart 13Hedge Against A Disputed Election Result Monthly Portfolio Update: Can Monetary Policy Alone Propel The Market? Monthly Portfolio Update: Can Monetary Policy Alone Propel The Market? Given the power of monetary stimulus, we are reluctant to bet against equities – not least since the yield on fixed-incomes assets is so low. Nonetheless, we see the risk of a sharp correction over the coming six months, driven by a second pandemic wave, a renewed downturn in the global economy, or political events. We continue to recommend, therefore, only a neutral position on global equities. We would hold a large overweight in cash, to keep powder dry for when a better buying opportunity for risk assets arises. But a warning: The long-run return from all asset classes will be poor. The global bond index is unlikely to produce a nominal return much above zero over the coming decade. While equities look more attractive, our valuation indicator points to a nominal annual return of only around 3% (Chart 14). For the US, valuation suggests a return of zero. Investors will need to become more realistic about their return assumptions. The 7% annual return still assumed by the average US pension fund might have made sense when the yield on BBB-rated corporate bonds was 8%, but it no longer does when it has fallen to 2.3% (Chart 15). Chart 14Long-Term Equity Returns Will Be Poor Long-Term Equity Returns Will Be Poor Long-Term Equity Returns Will Be Poor Chart 15Investors' Return Assumptions Are Unrealistic Investors' Return Assumptions Are Unrealistic Investors' Return Assumptions Are Unrealistic   Chart 16Value Sectors' Profits Have Been Terrible Value Sectors' Profits Have Been Terrible Value Sectors' Profits Have Been Terrible Equities: The most vigorous debate among BCA Research strategists currently is over whether growth stocks will continue to outperform, or whether value will take over leadership. The Global Asset Allocation service is on the side of growth. The poor performance of value stocks (concentrated in Financials, Energy, and Materials) is explained by the structural decline in their profits for the past 12 years (Chart 16). With the yield curve unlikely to steepen and non-performing loans set to rise, we do not see Financials’ earnings recovering. China’s economic shifts represent a long-term headwind for Materials. Internet stocks are expensively valued, but we do not see them underperforming until (1) their earnings’ growth slows sharply, (2) regulation on them is significantly tightened, or (3) long-term bond yields rise, lowering the NPV of their future earnings. This view drives our Overweight on US equities versus Europe and Japan. US stocks have continued to outperform even in the risk-on rally since March (Chart 17). We are a little more enthusiastic (with a Neutral recommendation) about Emerging Market stocks, which are very cheaply valued (Chart 18). Chart 17US Stocks Have Outperformed Even In A Risk-On Market US Stocks Have Outperformed Even In A Risk-On Market US Stocks Have Outperformed Even In A Risk-On Market   Chart 18EM Stocks Are Cheap EM Stocks Are Cheap EM Stocks Are Cheap   Chart 19Short USD Is Now A Consensus Trade Monthly Portfolio Update: Can Monetary Policy Alone Propel The Market? Monthly Portfolio Update: Can Monetary Policy Alone Propel The Market? Currencies: The US dollar has depreciated by 10% since mid-March. Over the next 12 months, the trend for the USD is likely to continue to be down. The new Fed policy emphasizes that real rates will stay low, and US inflation will probably be higher than in other developed economies. Nonetheless, short-USD/long-euro positions have become consensus (Chart 19) and, given the safe-haven nature of the dollar, a period of risk-off could push the dollar back up temporarily. Chart 20IG Spreads Are No Longer Attractive Investment Grade Breakeven Spreads IG Spreads Are No Longer Attractive Investment Grade Breakeven Spreads IG Spreads Are No Longer Attractive Fixed Income: We don’t expect to see a sustained rise in nominal US Treasury yields, despite the Fed’s new monetary policy framework. The Fed has an implicit yield curve control policy, and would react if yields showed signs of rising significantly. TIPS breakevens should eventually rise further to reflect the likelihood of higher inflation in the longer term, though the recent sharp rise in inflation (core CPI rose by 0.6% month-on-month in July, the largest increase since 1991) will likely subside and so the upside for breakeven yields might be limited over the next six months. We are becoming a little more cautious on credit. Investment-grade spreads are now close to historic lows and so returns are likely to be limited (Chart 20). We lower our recommendation to Neutral. Ba-rated bonds still offer attractive yields and are supported by Fed purchases. But we would not go further down the credit curve, and so stay Neutral on high yield. This by definition means that we must also be Neutral within fixed income on government bonds, which is compatible with our view that rates will not rise much. Note, though, that we remain Underweight the fixed-income asset class overall, but no longer have a preference for spread product within it. One exception is EM dollar-denominated debt, both sovereign and corporate, which offers spreads that are attractive in a world of low returns from fixed income. Chart 21Crude Prices Can Rise Further As Demand Recovers Crude Prices Can Rise Further As Demand Recovers Crude Prices Can Rise Further As Demand Recovers Commodities: Industrial metals prices have further to run up, as China continues its credit stimulus, which should lead to a rise in infrastructure investment and increased imports of commodities. The outlook for crude oil will be dominated by the demand side: OPEC forecasts demand destruction this year of 9 million barrels per day (compared to consensus expectations of 8 million) and so will be cautious about loosening its supply constraints. Demand should be boosted by increased driving, as people avoid using public transport for commuting and airlines for vacations. Based on a robust demand forecast (Chart 21), BCA Research’s energy strategists see Brent crude stable at around current levels through to the end of 2020 but averaging $65 a barrel next year. Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com   Footnotes 1  Please see Geopolitical Strategy Special Report, “What Is The Risk Of A Contested US Election?” dated July 27, 2020. GAA Asset Allocation  

Highlights President Trump is making a comeback in our quantitative election model. An upgrade from our 35% odds of a Trump win is on the horizon, pending a fiscal relief bill.  The Fed’s pursuit of “maximum employment,” the necessities of the pandemic response, fiscal largesse, a US shift toward protectionism, and the strategic need to counter China will pervade either candidate’s presidency. A Democratic “clean sweep” would add insult to injury for value stocks, but these stocks don’t have much more downside relative to growth stocks. Trump’s tariffs, or Biden’s taxes, will hit the outperformance of Big Tech, as will the recovery of inflation expectations. Feature More than at any time in recent US history, voters believe that the 2020 election is definitive in charting two distinct courses for the country (Chart 1). No doubt 2020 is an epic election with far-reaching implications. However, from an investment point of view, a Trump and a Biden administration have more in common than consensus holds. Chart 1An Epic Choice About The US’s Future Trump Versus Biden: Tariffs Versus Taxes Trump Versus Biden: Tariffs Versus Taxes The US political parties have finalized their policy platforms, giving investors greater clarity about what policies the parties will try to implement over the next four years.1 While the presidential pick is critical for American foreign and trade policy, the Senate is just as important as the president for US equity sectors. The only dramatic changes would come if the Democrats achieved a clean sweep of government – yet this result is likely as things stand today (Chart 2). Investors should prepare. It would prolong the suffering of value stocks relative to growth stocks by hitting the US health care and energy sectors hard. Chart 2“Blue Wave” Still The Likeliest Scenario Trump Versus Biden: Tariffs Versus Taxes Trump Versus Biden: Tariffs Versus Taxes The State Of Play A “Blue Wave” is still the likeliest outcome – and that’s where the stark policy differences emerge. The race is tightening. Our quantitative election model looks at state leading indicators, margins of victory in 2016, the range of the president’s approval rating, and a “time for change” variable that gives the incumbent party an advantage if it has not been in the White House for eight years. The model now shows Florida as a toss-up state with a 50% chance of flipping back into the Republican fold (Chart 3). Chart 3Florida Now 50/50 In Our Election Quant Model – 45% Chance Of Trump Win Trump Versus Biden: Tariffs Versus Taxes Trump Versus Biden: Tariffs Versus Taxes As long as the economy continues recovering between now and November 3, Florida should flip and Trump should go from 230 Electoral College votes to 259. One other state – plus one of the stray electoral votes from either Nebraska or Maine, which Trump is like to get – would deliver him the Oval Office again. The model says that Trump has a 45% chance of victory, up from 42% last month. Subjectively, we are more pessimistic than the model. Pandemic, recession, and social unrest have taken a toll on voters and unemployment is nearly three times as high as when Trump’s approval rating peaked in March. Consumer confidence is weak, albeit making an effort to trough. Voters take their cue from the jobs market more than the stock market, although the stock rally is certainly helpful for the incumbent. We await the completion of a new fiscal relief bill in Congress before upgrading Trump to closer to our model’s odds and the market consensus of 45%. Another Social Lockdown? COVID-19 subsiding in the US a boon for Trump in final two months of campaign. The first concern for the next president is COVID-19. On the surface Trump and Biden are diametrically opposed. President Trump is obviously disinclined to impose a new round of lockdowns and the Republican platform calls for normalizing the economy in 2021. By contrast, the Democrats claim they will contain the virus even at a high economic cost. Biden says he will be willing to shut down the entire US economy again if scientists deem it necessary.2 There is apparently political will for new draconian lockdowns – but it is not likely to be sustained after the election unless the next wave of the virus is overwhelming (Chart 4). Biden will need to be cognizant of the economy if he is to succeed. Chart 4Biden Has Some Support For Another Lockdown Trump Versus Biden: Tariffs Versus Taxes Trump Versus Biden: Tariffs Versus Taxes However, it is doubtful that Trump would refuse to lock down the economy in his second term if his advisers told him it was necessary. After all, it is Trump, not Biden, who implemented the lockdowns this year. Arguably he reopened the economy too soon with the election in mind. But if that is true, then it isn’t an issue for his second term, since he can’t run for president a third time. This is a theme we often come back to: reelection removes a critical impediment to Trump’s policies in a second term as opposed to his first. Bottom Line: The coronavirus outbreak and the country’s top experts will decide if new lockdowns are warranted, regardless of president, but the bar for a complete shutdown is high. COVID-19 is subsiding in both the US and in countries like Sweden that never imposed draconian lockdowns (Chart 5). Still, given that the equity market has recovered to pre-COVID highs, investors would be wise to hedge against a bad outcome this winter. Chart 5Pandemic Subsiding In US And ‘Laissez-Faire’ Sweden Trump Versus Biden: Tariffs Versus Taxes Trump Versus Biden: Tariffs Versus Taxes Maximum Employment The monetary policy backdrop will be ultra-dovish regardless of the presidency. The Fed is now pursuing average inflation targeting and “maximum employment,” according to Fed Chairman Jay Powell, speaking virtually on August 27 at the Kansas City Fed’s annual Jackson Hole summit. This means that if Trump wins, he will not have to fight running battles with Powell over rate hikes. The monetary backdrop for either president will be more reminiscent of that faced by President Obama from 2009-12 – extremely accommodative. It is possible that Trump’s “growth at all costs” attitude could lead to speculative bubbles that the Fed would need to prick. Already the NASDAQ 100 is off the charts. Elements of froth reminiscent of the dotcom bubble era are mushrooming (Chart 6). Nobody has any idea yet how the Fed will square its maximum employment mission with the need to prevent financial instability, but it will err on the side of low rates. Chart 6Frothy NDX Frothy NDX Frothy NDX Chart 7The Mother Of All V-Shapes The Mother Of All V-Shapes The Mother Of All V-Shapes Biden will be more likely to tamp down financial excesses through executive orders – or to deter excesses through taxes if he controls the Senate. But there is no reason the executive branch would be more vigilant than the Fed itself. Higher inflation will push real rates down and weaken the dollar almost regardless of who wins the presidency. Trump’s trade wars – and any major conflict with China – would tend to prop up the greenback relative to Biden’s less hawkish, more multilateral, approach. But either way the combination of debt monetization, twin deficits, and global economic recovery spells downside for the dollar. This in turn spells upside for the S&P500 and inflation-friendly (or deflation-unfriendly) equity sectors in the longer run (Chart 7). Fiscal Largesse The next president will struggle with a massive fiscal hangover resembling late 1940s. The Fed’s new strategy ensures that fiscal policy will prove the driving factor in the US macro outlook. Regardless of who wins the election, the budget deficit will fall from its extreme heights amid the COVID-19 crisis over the next four years (Chart 8). If government spending falls faster than private activity recovers, overall demand will shrink and the economy will be foisted back into recession. Chart 8Budget Deficit Will Decrease As Economy Normalizes Budget Deficit Will Decrease As Economy Normalizes Budget Deficit Will Decrease As Economy Normalizes The deep 1948-49 recession occurred because of the government’s climbing down from wartime levels of spending (Chart 9). Premature fiscal tightening would jeopardize the 2021 recovery. Yet neither candidate is a fiscal hawk. Trump is a big spender; Biden is a Democrat. The House Democrats will control the purse strings. Republican senators, the only hawkish actors left, are not all that hawkish in practice. They agreed with Trump and the Democrats in passing bipartisan spending blowouts from 2017-20. They will likely conclude another such deal just before the election. Chart 9Sharp Deficit Correction Would Jeopardize Recovery Sharp Deficit Correction Would Jeopardize Recovery Sharp Deficit Correction Would Jeopardize Recovery So Trump would maintain high levels of spending without raising taxes; Biden would spend even more, albeit with higher taxes. Table 1Biden Would Raise $4 Trillion In Revenue Over Ten Years Trump Versus Biden: Tariffs Versus Taxes Trump Versus Biden: Tariffs Versus Taxes On paper, Biden would add a net ~$2 trillion to the US budget deficit over ten years, as shown in Tables 1 and 2. But these are loose costings. Nobody knows anything until actual legislation is produced. The risk to spending levels lies to the upside until the employment-to-population ratio improves (Chart 10). Trump’s net effect on the deficit is even harder to estimate because the Republican Party platform is so vague. What we know is that Trump couldn’t care less about deficits. Back of the envelope, if Congress permanently cut the employee side of the payroll tax for workers who earn less than $8,000 per month, as Trump has suggested, the deficit would increase by roughly $4.8 trillion over ten years.3 Table 2Biden Would Spend $6 Trillion In Programs Over Ten Years Trump Versus Biden: Tariffs Versus Taxes Trump Versus Biden: Tariffs Versus Taxes   Chart 10Massive Labor Slack Will Encourage Government Spending Massive Labor Slack Will Encourage Government Spending Massive Labor Slack Will Encourage Government Spending House Democrats will hardly agree to any major new tax cuts – and certainly not gigantic ones that would “raid Social Security.” This accusation will be popular and Trump will want to avoid it during the campaign as well – his 2020 platform does not explicitly mention the payroll tax. Many of Trump’s other proposals would focus on extending the Tax Cut and Jobs Act. For example, it is possible that Trump could extend the full expensing of companies’ depreciation costs for capital purchases, set to expire in 2022 and 2026, to the tune of $419 billion over ten years.4 Thus the overall contribution of government spending to GDP growth will be higher than in the recent past. This trend was established prior to COVID (Chart 11). The rise of populism supports this prediction, as Trump has always insisted he will never cut mandatory (entitlement) spending – a major change to Republican orthodoxy now enshrined in its policy platform. Chart 11Government Role To Increase In America Government Role To Increase In America Government Role To Increase In America Chart 12No Cuts To Defense Likely Either No Cuts To Defense Likely Either No Cuts To Defense Likely Either Meanwhile Biden is not only rejecting spending cuts but also coopting the profligate spending agenda of the left wing of his party. Practically speaking, social spending cannot be cut by Trump – and yet Biden cannot cut defense spending much either, since competition with Russia and China is growing (Chart 12). The common thread in both party platforms is fiscal largesse at a time of monetary dovishness, i.e. reflation. Other Common Denominators Market is overrating Biden’s China friendliness. Both Trump and Biden promise to build infrastructure, energize domestic manufacturing, and lower pharmaceutical prices. The two candidates are competing vociferously over who will bring more American manufacturing jobs home. President Trump won the Republican nomination in 2016 partly because he stole the Democrats’ thunder on “fair trade” over “free trade.” Biden’s agenda is effusive on these Trump (and Bernie Sanders) themes – his party sees an existential risk in the Rust Belt if it cannot steal that thunder back. The manufacturing agenda centers on China-bashing. China runs the largest trade surplus with the US, it has a negative image in the public eye, and it has alarmed the military-industrial complex by rising to the status of a peer strategic competitor over the technologies of tomorrow. Where Trump once spoke of a “border adjustment tax,” or a Reciprocal Trade Act, Biden speaks openly of a carbon border tax: “the Biden Administration will impose carbon adjustment fees or quotas on carbon-intensive goods from countries that are failing to meet their climate and environmental obligations.”5 China’s coal-guzzling economy would obviously be the prime target. It is true that Biden will seek to engage China and reset the relationship. He will probably maintain Trump’s tariff levels or even slap a token new tariff, but he will then settle down for a two-track policy of dialogue with China and coalition-building with the democracies. The result may be a reprieve from strategic tensions for a year or so. Investors are exaggerating Biden’s positive impact on China relations, judging by the correlation of China-exposed US equities with the Democrats’ odds of winning. The truth is that Biden will maintain the Obama administration’s “Pivot to Asia,” which was about countering China. The secular power struggle will persist and China-exposed stocks, especially tech, will be the victims (Chart 13). Chart 13Market Over-Optimistic About Biden Vis-à-Vis China Market Over-Optimistic About Biden Vis-à-Vis China Market Over-Optimistic About Biden Vis-à-Vis China Senate election will likely tip with White House – but checks and balances are best for equities. Control of the Senate will determine whether the big differences between the two candidates materialize. Biden can’t raise taxes without the Senate; Trump can’t wage trade wars of choice as Congress is supreme over commerce and could take his magic tariff wand away from him. Trump can use executive orders to pare back immigration, but he cannot force the House Democrats to approve a southern border wall. In fact, he dropped “the Wall” from his agenda this time around. (It didn’t help that former Trump adviser Steve Bannon has been arrested for allegedly scamming people out of their money to pay for a wall.) Biden will be far looser on immigration than Trump and the reviving economy will attract foreign workers. But the Obama administration showed that during times of high unemployment, even Democrats have a limit to the influx they will allow (Chart 14). Meanwhile Biden can use executive orders to impose aspects of his version of the Green New Deal, but he cannot pass carbon pricing laws or other sweeping climate policy if Republican Senators are there to stop him. For this reason, a divided government is likely to produce three cheers from the markets. The single most market-positive scenario is Biden plus a Republican Senate, which suggests a moderation of the trade war and yet no new taxes. Second best would be Trump with a Democratic Congress that would clip his wings on tariffs, but enable him to veto any anti-market laws. The stock market’s performance to date is more reminiscent of a “gridlock” election outcome, in which the two parties split the executive and legislative branches of government in some way, as opposed to a unified single-party government (Chart 15). Chart 14Immigration Faces Limits Even Under Democrats Trump Versus Biden: Tariffs Versus Taxes Trump Versus Biden: Tariffs Versus Taxes Chart 15Stock Market Expects Gridlock? Stock Market Expects Gridlock? Stock Market Expects Gridlock? Investors should not be complacent, however, because the political polling so far suggests that the Senate race is on a knife’s edge. The balance of power will tilt whichever way the heavily nationalized, heavily polarized White House race tilts (Chart 16). A “blue sweep” is still a fairly high probability. Indeed a Biden win will most likely produce a Democratic sweep while a Trump win will produce the status quo. Chart 16Tight Senate Races Will Turn On White House Race Trump Versus Biden: Tariffs Versus Taxes Trump Versus Biden: Tariffs Versus Taxes Biden’s Agenda After A Blue Sweep Democrats would remove the filibuster – another big difference in outcomes. Biden is more likely to benefit from Democratic control of Congress if he wins. He is also more likely to rely on his top advisers and the party apparatus. Hence the Democratic platform matters more than the Republican platform in this cycle. Investors should set as their base case that a new president will largely succeed in passing his top one or two priorities. Less conviction is warranted after the initial rush of policymaking, as political capital will fall and the economic context will change. But in the honeymoon period, a president can get a lot done, especially if his party controls Congress. Investors would have been wrong to bet against George W. Bush’s Economic Growth and Tax Relief Act (2001), Barack Obama’s Affordable Care Act (2009), or Trump’s Tax Cut and Jobs Act (2017). Yet they could never have known that COVID-19 would strike in Trump’s fourth year and overturn the very best macroeconomic forecasts. Critically, if Democrats take the Senate, our base case is that they will remove the filibuster, i.e. the use of debate to block legislation. Biden has suggested that he would look at doing so. President Obama recently linked it to racist Jim Crow laws of the late nineteenth and early twentieth centuries, making it hard for party members to defend keeping the filibuster. Senate minority leader Charles Schumer (D, NY) has signaled a willingness to change the Senate rules if he becomes majority leader. Removing the filibuster would change the game of US lawmaking, enabling the Senate to pass laws with a simple majority of 51 votes – i.e. 50 plus a Democratic vice president. This is entirely within reach. While a handful of moderate Democratic senators may oppose such a dramatic move at first, the Democratic Party leadership will corral its members once it faces the reality of the 60-vote requirement blocking its agenda. The party will remember the last time it took power after a national crisis, in 2009, and the frustrations that the filibuster caused despite having at that time a much stronger Senate majority than it can possibly have in 2021. Populism is rife in the US and it is all about shattering norms. Moreover, the filibuster has already been eroding over the past two administrations (vide judicial appointments). Revoking it would enable Democrats to pass a lot more ambitious legislation, and many more laws, than in previous administrations. This is important because Biden’s agenda is more left-wing than some investors realize given his history as a traditional Democrat. In order to solidify the increasingly powerful progressive faction of his party, symbolized by Vermont Senator Bernie Sanders, Biden created task forces to merge his agenda with that of Sanders. Sanders and his fellow progressive Senator Elizabeth Warren of Massachusetts have much more influence in the party than their 35% share of the Democratic primary vote implies. The youth wing of the party shares their enthusiasm for Big Government. Here are the key structural changes that matter to investors: Offering public health insurance – A public health option will benefit from government subsidies and thus outcompete private options, reducing their pricing power. The lowest income earners will be enrolled in the program automatically, rapidly boosting its size (Chart 17). Enabling Medicare to negotiate drug prices – Medicare’s drug spending is equivalent to almost 45% of Big Pharma’s total sales. Enabling this government program to bargain with companies over prices will push down prices substantially. However, the sector’s performance is not really tied to election dynamics because President Trump is also pledging to cap drug prices – it is an effect of populism (Chart 18). Doubling the federal minimum wage – The wage will rise from $7.25 to $15 per hour, hitting low margin franchises and small businesses alike. Chart 17Health Care Gives Back Gains After Biden Nomination Health Care Gives Back Gains After Biden Nomination Health Care Gives Back Gains After Biden Nomination Chart 18Big Pharma Faces Onslaught From Both Parties Big Pharma Faces Onslaught From Both Parties Big Pharma Faces Onslaught From Both Parties Eliminating carbon emissions from power generation by 2035 – Countries are already rapidly shifting from coal to natural gas, but the Biden agenda would attempt to move rapidly away from fossil fuels completely (Chart 19). If legislation passes it will revolutionize the energy sector. Prohibiting “right to work” laws – This is only one example of a sweeping pro-labor agenda that would involve an extensive regulatory push and possibly new laws. New laws would prevent states from passing “right to work” laws that give workers more freedoms to eschew labor unions. The removal of the filibuster makes this possible. Moreover Biden will be aggressive in using executive orders to implement a pro-labor agenda, going further than Bill Clinton or Barack Obama attempted to do in recognition of the party’s shift to the left of the political spectrum. Chart 19Blue Sweep Would Bring Climate Policy Onslaught Trump Versus Biden: Tariffs Versus Taxes Trump Versus Biden: Tariffs Versus Taxes Subsidizing college tuition and low-income housing. US housing subsidies currently make up 25% of domestic private investment in housing and Biden’s government would roll out a significant expansion of these programs. Granting Washington, DC statehood – This is unlikely to happen as two-thirds of Americans are against it. But without the filibuster, Democrats could conceivably railroad it through. Trump’s Agenda Trump’s signature is tariffs – and globally exposed stocks know it. If Trump wins, his domestic legislative agenda will be stymied, other than laws directly aimed at fighting the pandemic and reviving the economy. As mentioned, Trump is unlikely to pass a law building a wall on the southern border. It is conceivable that Trump could pass a comprehensive immigration reform bill with House Democrats, but that is not a priority on the platform and Trump would have to pivot toward compromise. That would depend on Democrats winning the Senate or forcing him to negotiate with the House. Hence a Trump second term will mostly focus on foreign and trade policy. The Republican platform is aggressive on economic decoupling from China, which is ranked third behind tax cuts and pandemic stockpiles.6 Trump, vindicated on protectionism, would likely go after other trade surplus nations. The Chinese could offer some concessions, producing a Phase Two deal early in his second term to avoid sweeping tariffs and encourage him to wage trade war against Europe (Chart 20). Chart 20Trump = Global Trade War Trump = Global Trade War Trump = Global Trade War Trump’s foreign policy would consist of reducing US commitments abroad. Withdrawing from Afghanistan and other scattered conflicts is hardly a game changer. Shifting some forces back from Germany and especially South Korea is far more consequential. It will create power vacuums. But the US is not likely to abandon the allies wholesale. Chart 21Defense Stocks Will Get Wind In Sails Defense Stocks Will Get Wind In Sails Defense Stocks Will Get Wind In Sails Trump has moderated his positions on NATO and other defense priorities over his first term. It is possible he could revert back to his original preferences in a second term, however, so global power vacuums and geopolitical multipolarity will remain a major source of risk for global investors. He will probably also succeed in maintaining large defense spending, despite a Democratic House, given the reality of great power struggle with China and Russia. Geopolitical multipolarity means that defense stocks will continue to enjoy a tailwind from demand both at home and abroad (Chart 21). Investment Takeaways Energy sector struggles most under Democrats. Biden and Trump are both offering reflationary agendas. Where the two agendas diverge most notably, the impacts are largely market-negative – Trump via tariffs, Biden via taxes. The current signals from the market suggest that growth stocks benefit more from a Democratic clean sweep than value stocks (bottom panel, Chart 22). However, the general collapse in value stocks versus growth suggests that there is not much more downside even if the Democrats win (top panel, Chart 22), especially if the 10-year yield rises, as we have been writing in recent research: a selloff in the bond market is the last QE5 puzzle-piece to fall into place. Fed policy, fiscal largess, and the dollar’s decline will support a global cyclical recovery and downtrodden value stocks regardless of the president. The difference is that Biden would slow their relative recovery by piling regulatory burdens on energy as well as health care, which in the US context are a value play. As a reminder, and contrary to popular belief, health care stocks are the largest constituent of the S&P value index with a market cap weight of 21%.7 Trump’s populist “growth at any cost” and deregulatory agenda would persist in a second term and clearly favor value. Yet, if his trade wars get out of hand, they would also weigh on the recovery of these stocks. The difference is that tech stocks are not priced for a Phase Two trade war. If Trump wins it will be a rude awakening. Not to mention that Trump and populist Republicans will seek to target the tech sector for what is increasingly flagrant favoritism in political and cultural debates. Democrats are much more clearly aligned with tech. While they have ambitions of reining in the tech giants as part of the progressive drive against corporate power writ large, Joe Biden will struggle to take on Big O&G, Big Pharma, Big Insurance, and Big Tech at the same time in a single four-year term. The logical conclusion is that he will spare Silicon Valley, which maintained a powerful alliance with the Obama administration. He cannot afford to betray his progressive base when it comes to climate policy, so the Obama alliance with domestic O&G producers will suffer. Tech will face regulatory risks but they will not be existential. Chart 22Not Much Downside Left For Value Stocks Not Much Downside Left For Value Stocks Not Much Downside Left For Value Stocks The fact that the final version of the Democratic Party platform did not contain a section on removing federal subsidies for fossil fuels is merely rhetorical.8 The one clear market reaction from this election cycle is the energy sector’s abhorrence of Democratic policies (Chart 23). The difference is that energy is priced for it whereas tech is priced for perfection. Chart 23Energy Sector Loses From Blue Sweep Energy Sector Loses From Blue Sweep Energy Sector Loses From Blue Sweep     Matt Gertken Geopolitical Strategist mattg@bcaresearch.com Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com     Footnotes 1     In this report we work from the latest policy platforms available. See “Trump Campaign Announces President Trump’s 2nd Term Agenda: Fighting For You!” Trump Campaign, donaldjtrump.com  ; and the draft “2020 Democratic Party Platform” Democratic National Committee, demconvention.com. 2     Bill Barrow, “Biden Says he’d shut down economy if scientists recommended,” Associated Press, August 23, 2020, abcnews.go.com. 3    See Seth Hanlon and Christian E. Weller, “Trump’s Plan To Defund Social Security,” Center for American Progress, August 12, 2020, americanprogress.org; “The 2020 Annual Report Of The Board Of Trustrees Of The Federal Old-Age And Survivors Insurance And Federal Disability Insurance Trust Funds,” Social Security Administration, April 22, 2020, ssa.gov. 4    Erica York, “Details And Analysis Of The CREATE JOBS Act,” Tax Foundation, July 30, 2020, taxfoundation.org. 5    See “The Biden Plan For A Clean Energy Revolution And Environmental Justice,” Biden Campaign, joebiden.com. 6    A Democratic Congress could take back the constitutional power over commerce that it delegated to the president back in the 1960s-70s, limiting Trump’s ability to wage trade war. If Republicans hold the Senate, they still might restrain Trump’s protectionism, as they did with his threatened Mexico tariffs in early 2019, but they would not do so until he has already taken a major disruptive action.    7     See “S&P 500 Value,” S&P Dow Jones Indices, spglobal.com. 8    Andrew Prokop, “The Democratic Platform, Explained,” Vox, August 18, 2020, vox.com.