Policy

Highlights China’s 14th Five Year Plan and broader national strategy will continue to provoke opposition from the US and the West, regardless of the US election. China’s economic blueprint will focus on self-sufficiency, “dual circulation” (import substitution), state subsidies, and high-tech advancement – all factors that will continue to provoke western ire. US political polarization creates geopolitical risks, particularly for China, which will support the dollar and US equity outperformance, depending on the election result. If Trump wins, polarization will persist, he will face gridlock at home, and he will thus continue his aggressive foreign and trade policies, with China facing disruptive consequences. The CNY, EUR, and especially TWD would suffer. If Biden wins, he could face either gridlock or full Democratic control. The former case presents a greater risk of a focus on trade and foreign policy. The latter would result in a domestically focused Washington, which gives China breathing space. The CNY and EUR would benefit, but the TWD would face limited upside. Either way, investors are likely to become over-exuberant about assets that are exposed to the US-China relationship in the event of a Biden victory. Over the long run, this is a bull trap.  Feature In the years after the 2008 financial crisis, the global news media proclaimed the rise of China and the demise of the United States as a global leader. The US’s free-wheeling democracy and capitalism led to economic collapse, partisan gridlock, and nearly a self-inflicted default on sovereign debt. Meanwhile China’s state-controlled system stimulated its economy, cracked down on the first inklings of unrest in the spring of 2011, and expanded its regional and global influence.  The conclusion is similar today in the wake of the COVID-19 crisis. The US has squandered its response to the pandemic, while partisan gridlock threatens the economic recovery. China has suppressed the virus that started within its borders and its economy is rapidly on the mend. The orgy of social unrest and political dysfunction in the US has weighed on its international image and leadership. What the past decade showed, however, is that the first narrative to take hold after a global crisis is not likely to be the final narrative. In fact, the past decade was the most difficult for China since the 1980s. The next decade will be even more challenging. The COVID-19 pandemic brought to an official conclusion the unprecedented economic boom of the past four decades (Chart 1). Though Chinese policy makers have navigated relatively well, the social and political system faces greater challenges in a new economic and international environment. Chinese potential GDP growth has now fallen to 3%, as the labor force contracts and productivity remains flat. Chart 1China Already Plucked The Long-Hanging Fruit China Already Plucked The Long-Hanging Fruit China Already Plucked The Long-Hanging Fruit China is well-situated in the short run to benefit from domestic and global economic stimulus, but over the long run its challenges are significantly underrated. China Faces Headwinds From Abroad Chinese leaders are prepared for any of the possible outcomes in the US election. With regard to US foreign and trade policy, the election is about tactics, not strategy. US grand strategy clearly dictates that Washington focus on curbing China, which is the only country that can challenge the US for global supremacy over the long run. But the US is not alone – other countries are also taking a more skeptical stance toward China’s geopolitical prominence. The result is that China will continue to emphasize self-sufficiency, a centrally guided economic model, and state-supported technological advancement in its fourteenth Five Year Plan for 2021-25 (see Appendix). This policy trajectory, combined with the key policy developments of the past decade, suggests that China’s self-sufficiency drive will continue to attract geopolitical opposition from the US and the West: Capital Controls: China tightened its capital controls aggressively during the financial turmoil of 2015-16. This emergency decision undercut the liberal reform agenda and alienated the western world on one of its critical structural demands. With China having grown its money supply from 175% to 197% of GDP since 2009, and capital flowing out again amid this year’s crisis (Chart 2), Beijing will not be able to fully liberalize its capital account anytime soon. Chart 2China's Capital Controls China's Capital Controls China's Capital Controls Chart 3China's State-Owned Enterprises Revived China's State-Owned Enterprises Revived China's State-Owned Enterprises Revived State-Owned Enterprises: The current administration has struggled with slowing trend growth and deflationary pressures. This is not an environment opportune for restructuring or liquidating inefficient state-owned enterprises (SOEs). It is the opposite of the 1990s, when SOEs were last culled. The regime has instead promised to make SOEs bigger and stronger (Chart 3). While it has pursued reforms to allow more private ownership of state assets, it has also encouraged public ownership of private assets, thus producing “mixed ownership” and a fusion of state and corporate power. The US and western countries resent this reassertion of state-backed economic power, notwithstanding the fact that all countries are increasing state support amid the collapse in global demand. Notably, China will likely resist cutting manufacturing capacity any faster than it will already be cut due to the global recession and foreign protectionism, meaning that stimulus-fueled overcapacity will continue to be a problem for foreign competitors. Chart 4The Tech Race Continues The Tech Race Continues The Tech Race Continues The Tech Race: Beijing is continuing a frantic dash to upgrade its science and technology capabilities in order to lift total factor productivity, which is essential to maintaining growth in the coming decades in the post-export-industrial phase. Expenditures on research and development are skyrocketing, now rivaling the United States. True, R&D spending is flattening out as a percentage of GDP, but this is likely temporary — even faster R&D spending will probably become an official target for the next five years (Chart 4). The full weight of the political system is being thrown behind the goal of creating a “Great Leap Forward” in advanced and emerging technologies. Western countries are increasingly sensitive to China’s advances in semiconductor manufacturing, artificial intelligence, new vehicles, new energy, new materials, and computing. The new strategy of “dual circulation” will consist of import substitution, especially for critical tech goods, and will incorporate programs like “Made in China 2025” as well as “new infrastructure” that are high tech and have become targets of the West. The US and others are openly adopting export controls and reducing supply chain dependency on China. Beijing will struggle to maintain its rapid innovation drive without inviting more punitive measures from the West. Chart 5US Fears China’s Military Rise Is China Afraid Of Big Bad Biden? Is China Afraid Of Big Bad Biden? Military Spending: China adopted a more assertive foreign policy in the mid-2000s and intensified this approach after 2012. Military spending has risen along with economic heft and western experts have long believed that China spends considerably more than it lets on. If we assume that China began to spend 3.75% of GDP per year after its strategic break with the US – a reasonable number in keeping with Russia’s long-term average – then China is narrowing the defense spending gap with the US more rapidly than is widely believed (Chart 5). Given the US’s giant defense spending, this is a continual source of distrust. Bear in mind that China’s defense and security aims are more limited than those of the US, at least in the short run. While the US must maintain the ability to project power globally, China need only grow its regional sphere of influence. Regionalism: While the Xi administration consolidates power within the Communist Party and central government in Beijing, it is also consolidating Beijing’s authority within Greater China. This includes efforts to bring to heel wayward provinces and regions such as Xinjiang, Tibet, Hong Kong, and Taiwan. Much of this is a fait accompli that western governments can do little about. Even in Hong Kong, public opinion is showing signs of resignation to the new legislative powers that Beijing has asserted. However, Taiwan is the clear outlier. Public opinion has shifted sharply against mainland China. Given that Taiwan is the epicenter of the new cold war with the US, both for reasons of political legitimacy as well as technological capability, a fourth Taiwan Strait crisis is looming (Chart 6). China has economic leverage to use first, but if this fails then a military confrontation cannot be ruled out. The above points do not hinge on the US election outcome or other cyclical factors, and highlight that geopolitical tensions will persist, particularly with the United States. The US’s adoption of a confrontational rather than cooperative posture toward China is a paradigm shift in international relations. Unlike Washington’s crackdown on Japanese trade in the 1980s, the US and China do not have an underlying trust or sense of shared security interests. Beijing’s willingness to increase US imports or appreciate its currency arbitrarily, to suit the shifting demands of US administrations, have substantial limits. Economic decoupling will continue in an environment of strategic insecurity (Chart 7). Chart 6Struggles In Greater China Is China Afraid Of Big Bad Biden? Is China Afraid Of Big Bad Biden? Chart 7US Redistributes Trade Deficit US Redistributes Trade Deficit US Redistributes Trade Deficit   President Trump’s biggest mistake in pursuing his trade war with China lies in his failure to build a grand alliance, or coalition of the willing, among likeminded liberal democracies. This would have amplified his leverage over China in making demands for structural reform and opening up. But this point can be overstated. China’s international image has collapsed, in Europe and Asia as well as in North America, despite the Trump administration’s diplomatic failures. Much of this effect stems from COVID-19, but that does not mean it is less grave. If the US courts allies in the trade conflict with China, it will find governments willing to cooperate (Chart 8). Chart 8China’s Image Suffers Under Trump Is China Afraid Of Big Bad Biden? Is China Afraid Of Big Bad Biden? Map 1Proxy Battles In Asia Pacific Is China Afraid Of Big Bad Biden? Is China Afraid Of Big Bad Biden? Chart 9US Arms Sales To Taiwan US Arms Sales To Taiwan US Arms Sales To Taiwan China’s perennial geopolitical challenge is shown in Map 1. It is geographically encircled by nations that have grown increasingly wary of its regional ambitions and will reach out to the US and West. These countries wish to continue benefiting from China’s economic rise but seek security guarantees to offset China’s rising strategic clout. The result will be “proxy battles,” in some cases political, in others military (Chart 9). Taiwan, South Korea, the Philippines, and Vietnam each face substantial geopolitical risk. In the case of South Korea and the Philippines, this risk is partially priced by financial markets. But in the case of Taiwan and Vietnam, it is almost entirely underrated. Taiwan has only an ambiguous defense commitment from the US, while Vietnam is a Chinese rival that entirely lacks a security guarantee from the United States. Bottom Line: Geopolitical risk will remain elevated in Asia Pacific regardless of what occurs in the US election. The growth of Chinese power, and its state-led economic model, will ensure that trade tensions persist. These will culminate in strategic conflicts in certain neighboring countries. China Will Re-Consolidate Power When Trump was inaugurated in January 2017, we argued that the looming US-China trade war would not be determined solely by relative economic size and export exposure. Instead, political unity would be a critical factor. While the US ostensibly had the economic advantage, China had the political advantage. The nineteenth National Party Congress would see Xi Jinping consolidate power domestically, while President Trump would struggle with domestic opposition and divisions within the US and the West over his protectionism. Having secured an economic rebound this year, China is likely to consolidate domestic power even further in 2021-22. This period culminates in the critical twentieth National Party Congress. Originally Xi Jinping was expected to step down at this time and hand the reins to the leader of the opposing faction. Now the opposing faction has been laid low, and Xi is likely to promote his faction and entrench his rule. The period will likely be marked with at least one major crackdown on the regime’s political rivals. Ultimately, social and political control will be tightened, particularly beginning in late 2021. These events provide good reasons for anticipating that Chinese monetary, fiscal, and regulatory policy will not tighten drastically, but rather will merely normalize by mid-2021, assuming that the recovery stays on track (Chart 10). Yet this logic only goes so far – it is more bullish for the macro view today and in 2021, than it is in 2022. Obviously the regime wants to avoid a slump in 2021, the hundredth anniversary of the Communist Party, and investors should keep this in mind. But the 2017 party congress was attended by a deleveraging campaign that surprised the world in its intensity. The point is that stability, not rapid growth, is the imperative in 2022. If speculative bubbles have become a greater threat by that time, then the monetary and fiscal policy backdrop will lean hawkish rather than dovish. Tightening central control over the economy helps the Xi administration consolidate power. Chart 10China Still Consolidating Domestic Power, 2021-22 China Still Consolidating Domestic Power, 2021-22 China Still Consolidating Domestic Power, 2021-22 US Polarization A Risk For China If China continues to consolidate, the key question is what will happen in the United States. The answer will be known in short order, but what is critical to observe is that US political polarization is a geopolitical risk, and therefore if it continues to escalate it will be positive for the US dollar and negative for Chinese and other emerging market assets. The past several years have been marked by an increase in US social and political instability. Indeed, according to Worldwide Governance Indicators, the US’s governance has declined while China’s has improved, notably on the issue of political stability and the absence of violence (Chart 11). While these rankings are partial, nevertheless they point to the reality of US political division. The decade’s giant increase in political polarization has coincided with a bull market in US equities and the greenback, best exemplified by the outperformance of the US technology sector (Chart 12). Chart 11US Instability A Source Of Global Risk Is China Afraid Of Big Bad Biden? Is China Afraid Of Big Bad Biden? If President Trump prevails, this trend will continue. Trump cannot win the popular vote, but his regional support could grant him a victory in the Electoral College. Or he could prevail through a contested election adjudicated by the Supreme Court or the House of Representatives. If this should occur, polarization will intensify, as the government’s legitimacy will suffer due to lack of popularity in a democracy. Facing gridlock at home, Trump would pursue trade war – not only with China, but also conceivably with the European Union. The consequence is that a surprise Trump victory (45% odds) would be negative for the euro, the renminbi, and especially the Taiwanese dollar (Chart 13). Chart 12US Polarization Reinforces Safe-Haven Status US Polarization Reinforces Safe-Haven Status US Polarization Reinforces Safe-Haven Status Chart 13Trump Second Term Would Weigh On CNY, EUR, TWD Trump Second Term Would Weigh On CNY, EUR, TWD Trump Second Term Would Weigh On CNY, EUR, TWD However, if former Vice President Biden prevails, he could win in two possible ways: one with gridlock in Congress, the other with a Democratic sweep of the House and Senate. In the former case, US polarization will persist. Biden will be incapable of executing his domestic agenda, as he will be obstructed by a Republican Senate. This will drive him into foreign policy, where he will ultimately prove to be tough on China – and certainly tougher than the Obama administration. In the latter case, a Democratic sweep of legislative and executive branches, Biden will not face domestic constraints and will be primarily focused on an ambitious agenda for rebuilding and rebalancing the US economy, with elements of the New Deal and the Green New Deal. He will be less focused on international affairs, at least initially. Trade risks will decline, along with US fiscal risks, thus producing a higher-growth macro policy environment. In both cases, while we expect a President Biden to seek a diplomatic “reset” with China, he is unlikely to repeal President Trump’s tariffs. Instead he will seek to utilize the leverage that Trump has built up, while pursuing a new strategic and economic dialogue with China. Ultimately this dialogue will be undermined by China’s state-backed economic policies and foreign policy assertiveness (see previous section), as well as Biden’s simultaneous courting of Europe and other liberal democracies. But clearly there is more room for Chinese assets to outperform under a Biden victory, especially a Democratic sweep. Investment Takeaways If Biden wins, the stock market is likely to become overly exuberant about a Biden administration’s positive implications for China-exposed companies (Chart 14). The same can be said for Chinese tech companies that are highly export-oriented (Chart 15). In a Democratic sweep, this rally can be prolonged, as US equities will face greater political risk than international equities. But any rally in assets exposed to the US-China relationship will ultimately be a bull trap, as US grand strategy calls for containing China, while Chinese grand strategy calls for breaking through containment. The US and Chinese tech sectors and Taiwanese assets are by far the most vulnerable to this dynamic, given their lofty valuations. Chart 14Market Over-Optimistic On Biden Boost To China Plays Market Over-Optimistic On Biden Boost To China Plays Market Over-Optimistic On Biden Boost To China Plays Chart 15Chinese Tech Faces Trade Tensions Chinese Tech Faces Trade Tensions Chinese Tech Faces Trade Tensions If we are correct that geopolitical risk will persist for China regardless of US political party, then the primary beneficiaries of Chinese stimulus and US decoupling will be domestic-oriented Chinese equities as well as “China plays” – external markets that export machinery and resources to China, such as Australia, Brazil, and Sweden. China will still invest heavily in traditional infrastructure, property, and manufacturing to shore up demand whenever it sags amid the difficulties of the economic transition. Our China Play Index, designed by Mathieu Savary of our flagship The Bank Credit Analyst, neatly captures the potential for this index to outperform on the back of Chinese stimulus, which will be even more necessary if US policy continues to be punitive (Chart 16). The near term could involve substantial US fiscal risks as well as geopolitical risks with China, which can occur under a gridlocked Biden administration or a second term Trump administration. Over the next year, the looming Chinese and global recovery, combined with ultra-dovish US monetary policy, spells continued downside for the US dollar and upside for Chinese and emerging market currencies and risk assets (Chart 17). But while the dollar may face challenges to its reserve currency dominance, China’s geopolitical risks, at home and abroad, will prevent the renminbi from making more than incremental gains on the dollar. The euro is a much likelier alternative for the foreseeable future. Chart 16China Plays Will Benefit From Reflation China Plays Will Benefit From Reflation China Plays Will Benefit From Reflation Chart 17King Dollar Persists … But Cyclical Downside Looms King Dollar Persists ... But Cyclical Downside Looms King Dollar Persists ... But Cyclical Downside Looms   Appendix Table 1China’s 14th Five Year Plan Goals Is China Afraid Of Big Bad Biden? Is China Afraid Of Big Bad Biden?   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com

Your feedback is important to us. Please take our client survey today. Highlights Duration: The Fed’s adoption of an Average Inflation Target and the emerging correlation between bond yields and a “blue sweep” election outcome were the two main catalysts that caused us to reduce our recommended portfolio duration stance last week. Monetary Policy: The Fed is unlikely to increase its pace of Treasury purchases, unless a selloff in risky assets (equities and credit) threatens the economic recovery. As long as the Fed sticks with its ultra-dovish interest rate guidance, a moderate bear-steepening of the Treasury curve will not cause such a selloff. Economy: Weekly claims data are consistent with a continued decline in the unemployment rate, due mostly to fewer temporarily unemployed workers. All in all, the US economy is recovering, but it remains very far from full employment. Feature Chart 1Real Yields Have Troughed Real Yields Have Troughed Real Yields Have Troughed After having advocated “at benchmark” portfolio duration since March, we officially lowered our recommended duration stance to “below benchmark” in last week’s Special Report.1 Two main catalysts led us to this decision. First, there was the Fed’s late-August adoption of an Average Inflation Target. This was an important bond-bearish catalyst because it signaled that the Fed’s reaction function has reached its maximum dovishness. Treasury yields stayed low throughout the summer even as the economy recovered because the Fed was simultaneously guiding the market toward a more dovish reaction function. As evidence for this dynamic, notice that between March and August the uptrend in the cost of inflation compensation was completely offset by falling real yields (Chart 1). But now, the Fed has officially adopted its new Average Inflation Targeting framework. In addition, it has promised not to lift rates at all until inflation is above its 2% target and is expected to overshoot that target for some time. To get more dovish from here, the Fed would probably need to actually increase its long-run inflation target from 2% to 3%, a step it is not prepared to take. For this reason, we expect that the Fed has exhausted its ability to push real yields lower as the economy recovers. With the Fed’s interest rate reaction function at maximum dovishness, only a negative economic growth shock can push yields lower. With the Fed’s interest rate reaction function at maximum dovishness, only a negative economic growth shock can push yields lower. Such a shock would cause investors to anticipate a slower return of inflation and thus push bond yields down, even if the market’s assessment of the Fed’s willingness to respond to inflationary pressures (aka its reaction function) remains constant. The failure of Congress to deliver additional fiscal stimulus after the expiry of the CARES act’s main income-supporting provisions is the sort of thing that could cause such a shock. However, September’s market action made it clear that investors are willing to look past the failure to deliver a bill if they can look forward to a larger fiscal stimulus in January. As we wrote last week, the most likely election outcome of the Democrats winning the House, Senate and White House would certainly deliver on that promise. Bottom Line: The Fed’s adoption of an Average Inflation Target and the emerging correlation between bond yields and a “blue sweep” election outcome were the two main catalysts that caused us to reduce our recommended portfolio duration stance last week. Will  The Fed Use Its Balance Sheet To Keep Bond Yields Low? Chart 2Fed Treasury Holdings Over Time Fed Treasury Holdings Over Time Fed Treasury Holdings Over Time One possible counterargument to our bond-bearish view is that, even if the Fed’s interest rate guidance is as dovish as it will get, the central bank will simply ramp up asset purchases to prevent any significant rise in long-maturity bond yields. Certainly, the Fed has not shied away from transacting in the Treasury market this year (Chart 2). In fact, the Fed took down more than 100% of gross note and bond issuance in the second quarter (Chart 3) and its current stated policy is to purchase at least $80 billion of Treasury securities per month. At present, the Fed holds more than 35% of all outstanding Treasuries with more than 10 years to maturity and about one quarter of the outstanding supply for all other maturities (Chart 4). This is a significant presence in the Treasury market, but not so large that the Fed would think twice about increasing its pace of Treasury purchases if such a policy was deemed necessary. But what would actually make the Fed increase its pace of asset purchases? Would a modest bear-steepening of the Treasury curve (our base case outlook) be enough? We doubt it. Chart 3Fed Purchases Peaked In Q2 Fed Purchases Won’t Stop Bond Yields From Rising Fed Purchases Won’t Stop Bond Yields From Rising Chart 4Fed Owns A Good Chunk ##br##Of The Market Fed Purchases Won’t Stop Bond Yields From Rising Fed Purchases Won’t Stop Bond Yields From Rising Chart 5Financial Conditions Are Highly Accommodative Financial Conditions Are Highly Accommodative Financial Conditions Are Highly Accommodative The Fed would be concerned if broad measures of financial conditions started to tighten, as that would indicate a looming period of slower economic growth. But that’s very different from long-maturity Treasury yields moving somewhat higher in response to an improving economic outlook. In fact, to get a meaningful tightening in broad measures of financial conditions, we would need to see significant credit spread widening and weaker equity prices (Chart 5). A bear-steepening Treasury curve, even if long-dated yields move 40-50 bps higher, will not prompt a selloff in credit markets or equities as long as the market believes that the Fed is committed to maintaining an accommodative monetary policy stance. Bottom Line: The Fed is unlikely to increase its pace of Treasury purchases, unless a selloff in risky assets (equities and credit) threatens the economic recovery. As long as the Fed sticks with its ultra-dovish interest rate guidance, a moderate bear-steepening of the Treasury curve will not cause such a selloff. Can  The Fed Use It’s Balance Sheet To Keep Bond Yields Low? Chart 6Fed Purchases Work Mainly Through Signaling Interest Rate Intentions Fed Purchases Work Mainly Through Signaling Interest Rate Intentions Fed Purchases Work Mainly Through Signaling Interest Rate Intentions Of course, in the extreme, the Fed could decide to set a cap on the 10-year Treasury yield and promise to purchase as many securities as necessary to maintain that cap. This sort of Yield Curve Control would effectively prevent long-maturity Treasury yields from rising, even as the economy recovered. As discussed above, we think the economic situation would have to turn quite dire for the Fed to pursue such a policy. A more relevant question is whether, in the absence of a stated yield cap, the Fed’s current pace of $80 billion of Treasury purchases per month (or even $100 billion per month) will prevent Treasury yields from rising. Our sense is that, without a stated yield cap, Fed Treasury purchases won’t stop bond yields from rising. In fact, we see very little evidence to support the notion that changes in Fed Treasury purchases influence the trend in bond yields, beyond what the purchase announcements signal to markets about the Fed’s intentions with regards to interest rate policy. Consider Chart 6, which shows the 10-year Treasury yield alongside the Global Manufacturing PMI and two different measures of Fed Treasury purchases. At first blush, between 2010 and 2012, there is a fairly strong relationship between a falling 10-year Treasury yield and an increase in Fed Treasury holdings greater than five years. However, the correlation between the 10-year Treasury yield and the Global Manufacturing PMI during this period is even stronger. This suggests an alternative explanation where the decline in bond yields is driven by the market shifting its rate hike expectations out into the future in response to slowing economic growth. Greater Fed purchases only served to reinforce the Fed’s increasingly dovish interest rate guidance during this time. Without a stated yield cap, Fed Treasury purchases won’t stop bond yields from rising. The key point from Chart 6 is that it is difficult to identify periods when the Fed’s balance sheet policy and interest rate guidance suggest opposite outcomes for bond yields. Typically, when the Fed is ramping up asset purchases it is also signaling to the market that it will shift toward a more dovish interest rate policy. Similarly, when the Fed is reducing its asset purchases, it tends to also be preparing the market for eventual rate hikes. This makes it impossible to say conclusively whether a given move in bond yields is driven by interest rate guidance or balance sheet actions. In our minds, this casts a lot of doubt on the notion that the Fed could maintain its current interest rate guidance during the next 6-12 months while also preventing a rise in Treasury yields by increasing asset purchases. The policy of increasing asset purchases would appear incoherent if it wasn’t also paired with increasingly dovish forward rate guidance, guidance that the Fed is likely unwilling to deliver. Bottom Line: Even if the Fed modestly increases its monthly pace of Treasury purchases, or shifts some purchases further out the curve as some FOMC participants have suggested, the impact on long-dated Treasury yields will be negligible without a concurrent shift in interest rate guidance. The Hedging Effectiveness of Treasuries Is Diminished, But Not Gone Completely One topic that has come up a lot recently in our client interactions is the idea that Treasury securities are no longer an effective hedge for equity portfolios. There are two possible reasons why this could be true. The first is that with Treasury yields so close to the zero-lower-bound there is very little scope for capital appreciation in bonds. The second is that Treasury yields may not respond to falling equity prices by declining, as they have in the past. We don’t currently see much evidence for the second reason. The only way that bond yields wouldn’t decline alongside a major equity sell-off is if that sell-off was driven by high and rising inflation and expectations that the Fed would aggressively hike rates to combat higher prices. Inflation is nowhere near high enough for this to be a concern. The first reason, however, could hold some water. To test it, we first looked at this year’s COVID-driven 34% drop in the S&P 500 that occurred between February 19th and March 23rd (Table 1). If an investor purchased a 5-year Treasury note on February 19th and sold it on March 23rd, they would have earned 5.21% on that trade, offsetting some portion of the equity decline. The same trade in a 30-year T-bond would have earned 16.65%. Long-maturity Treasuries still perform their role as hedging instruments for equity portfolios. But with starting bond yields much lower today, Treasuries may not offer the same protection. Table 2 shows how much an investor would earn if they bought a Treasury security today, held it for six months, and during that timeframe the entire spot yield curve fell to zero. We also show what returns would be earned if the yield curve shifted in the same way it did during the Feb 19th – Mar 23rd equity selloff, except we don’t let any yields fall into negative territory.2 Table 1Total Returns From Stock Market Peak (Feb. 19th) To Stock Market Through (Mar. 23rd) Fed Purchases Won’t Stop Bond Yields From Rising Fed Purchases Won’t Stop Bond Yields From Rising Table 2Treasury Total Returns Over A Hypothetical 6-Month Period Fed Purchases Won’t Stop Bond Yields From Rising Fed Purchases Won’t Stop Bond Yields From Rising Notice that projected returns for shorter maturities in Table 2 are significantly lower than the returns earned during the Feb 19th – Mar 23rd episode. A 5-year Treasury note will earn only 1.90% during the next six months if the entire yield curve falls to zero, this is well below the 5.21% earned in February and March. However, for maturities beyond 10 years, returns are similar between Table 1 and Table 2. This makes sense because, unlike the short-end, those long-dated yields are still fairly far from the zero bound. Bottom Line: Treasuries still perform their role as hedging instruments for equity portfolios, but investors now have to move further out the curve, and thus take more interest rate risk, to get the same protection they received from less-risky shorter-maturity notes in the past. US Economy: Digging Into Claims Chart 7Labor Market Update Labor Market Update Labor Market Update Initial unemployment claims spooked some investors when the weekly number jumped to +898k two weeks ago, even as the consensus was calling for a small decline.3 But that spike was completely reversed last week, and a good chunk of it was actually revised out of the data. A delay in California’s reporting was one reason for the big swing. The state had failed to report claims data for two consecutive weeks at the beginning of the month. This meant that the national claims number was based on an assumed figure for the state. California resumed reporting last week and the result was a big drop in overall claims, back down to +787k. Stepping back from the large swings of the past two weeks, a good portion of which are statistical artifacts stemming from California’s reporting delay, we see that overall employment trends haven’t changed much. Initial claims have flattened-off since late-August, but continuing claims are still falling rapidly (Chart 7). This suggests that the unemployment rate will drop again next week when October’s employment report is released. The big question in next week’s employment report will be whether the decline in the unemployment rate is once again driven by falling temporary unemployment, or whether the number of permanently unemployed workers will reverse its uptrend (Chart 7, bottom panel). All in all, the labor market data continue to paint a picture of an economy that is recovering but that still has a very large output gap. In other words, the economy is a long way from generating meaningful inflationary pressure. Appendix A: Buy What The Fed Is Buying The Fed rolled out a number of aggressive lending facilities on March 23. These facilities focused on different specific sectors of the US bond market. The fact that the Fed has decided to support some parts of the market and not others has caused some traditional bond market correlations to break down. It has also led us to adopt of a strategy of “Buy What The Fed Is Buying”. That is, we favor those sectors that offer attractive spreads and that benefit from Fed support. The below Table tracks the performance of different bond sectors since the March 23 announcement. We will use this to monitor bond market correlations and evaluate our strategy’s success. Table 3Performance Since March 23 Announcement Of Emergency Fed Facilities Fed Purchases Won’t Stop Bond Yields From Rising Fed Purchases Won’t Stop Bond Yields From Rising   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy/Global Fixed Income Strategy Special Report, “Beware The Bond-Bearish Blue Sweep”, dated October 20, 2020, available at usbs.bcaresearch.com 2 Blank cells in Table 2 mean that returns are the same as in the “Spot Curve Falls To 0%” scenario. 3 Please see BCA Daily Insights, “Slowing US Labor Market Momentum: Investors Should Not Have Been Surprised”, dated October 15, 2020, available at din.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Global Duration: US Treasury yields have started to creep higher and the move is likely to continue in the coming months regardless of who wins the White House. Reduce overall global duration exposure to below-benchmark, focused on the US. Country Allocation: Based on our view that US Treasury yields have more upside, we are making the following changes to our recommended country allocations in the government bond portion of our model bond portfolio: downgrading the US to underweight, downgrading higher-beta Canada and Australia to neutral, and raising lower-beta Germany, France, Japan and the UK to overweight. Treasury-Bund Spread: We introduce a new trade in our Tactical Overlay to capitalize on our expectation of higher US bond yields and a wider Treasury-Bund spread: selling 10-year Treasury futures versus buying 10-year German bund futures. Feature In a Special Report jointly published last week with our colleagues at BCA Research US Bond Strategy, we laid out the case for why US Treasury yields have bottomed and should now begin to drift higher.1 We reached that conclusion for two reasons: 1) there will be a major US fiscal stimulus after the upcoming US election, especially so if Joe Biden becomes president and the Democrats take the Senate; and 2) the Fed’s shift to Average Inflation Targeting in late August represented the point of maximum Fed dovishness. The investment conclusions were to reduce duration exposure, while also downgrading our recommended allocation to US government bonds to underweight. We also advised cutting exposure to non-US government bond markets with relatively higher sensitivity to changes in US bond yields, while increasing allocations to countries with a lower “yield beta” to US Treasuries (Table 1). Table 1Updated GFIS Model Bond Portfolio Recommended Positioning The Global Bond Implications Of Rising Treasury Yields The Global Bond Implications Of Rising Treasury Yields In this follow-up report, we will further discuss the implications of our changed view on US yields for non-US developed market government bonds. This includes specific adjustments to the recommended country allocations in our model bond portfolio, as well as a new tactical trade to profit from a move higher in US yields that will not to be matched in Europe. Our Recommended Overall Duration Stance: Now Below-Benchmark The case for a future cyclical bottoming of global yields has been building for the past few months, even as yields have remained range-bound at very low levels across the developed economies. Our Global Duration Indicator, comprised of economic sentiment measures and leading economic indicators, bottomed back in March and has soared sharply since then (Chart of the Week). Given the usual lead time between peaks and troughs of the Indicator and global bond yields - around nine months, on average – that suggests yields should bottom out sometime before year-end. Chart of the WeekA Cyclical, US-Led Bottoming Of Global Bond Yields A Cyclical, US-Led Bottoming Of Global Bond Yields A Cyclical, US-Led Bottoming Of Global Bond Yields Chart 2UST Yields About To Break Out? UST Yields About To Break Out? UST Yields About To Break Out? In the US, we now think we are past that point, as we discussed last week. The 10-year US Treasury yield has been drifting higher during the month of October and is now bumping up against its 200-day moving average of 0.83% (Chart 2). This is only the first such attempt at a trend breakout in yields, and such a move is unlikely prior to US Election Day - or, more accurately, “US Election Is Decided Day” which may not be November 3! The case for a future cyclical bottoming of global yields has been building for the past few months, even as yields have remained range-bound. Outside the US, however, momentum of bond yields and potential trend breakouts paint a more mixed picture. German and French bond yields remain stable and generally trendless, with Italian and Spanish yields continuing to grind lower. At the same time, yields in the UK, Canada and Australia have started to perk up but remain just below their 200-day moving averages. Bond yields have not responded to the sharp cyclical rebound across the developed world, with large gaps between elevated manufacturing PMIs and stagnant bond yields (Chart 3). Low inflation, ample spare economic capacity and dovish monetary policies are all playing a role, with bond markets not expecting an imminent inflation surge that could drive up yields and fuel expectations of tighter monetary policy. By way of contrast, China - where domestic services sectors have improved at a rapid pace from the COVID-19 recession and where the central bank is not running an overly accommodative monetary policy – has seen a more typical positive correlation between government bond yields and the rising manufacturing PMI over the past several months (Chart 4). This suggests that developed market bond yields can begin to normalize if the domestic services side of those economies emerges more forcefully from the lockdown-induced downturn. Chart 3A Wide Gap Between Growth & Yields A Wide Gap Between Growth & Yields A Wide Gap Between Growth & Yields Chart 4Are Chinese Yields Sending A Message? Are Chinese Yields Sending A Message? Are Chinese Yields Sending A Message? The news on that front is more optimistic in the US compared in Europe. The Markit services PMIs for the euro area and UK have all weakened over the past few months, with headline inflation rates flirting with deflation (Chart 5). Similar data in the US has trended in the opposite direction, with stronger US services activity with rising inflation. Chart 5Deflation Risks In Europe, Not The US Deflation Risks In Europe, Not The US Deflation Risks In Europe, Not The US The pickup in new COVID-19 cases, and the degree of the response by governments to contain it, has been far stronger in Europe and the UK than in the US on a population-adjusted basis (Chart 6). Lockdowns have become more widespread across Europe to contain the second larger wave of the virus. The recent softer services PMI data in the euro area and UK are a reflection of those greater economic restrictions and weaker confidence. This gap between the US economy and non-US economies is only magnified by the fiscal stimulus measures proposed by both US presidential candidates.  In the US, governments have been far less willing to implement politically unpopular restrictions in an election year, while lockdown-weary consumers have been more willing to go about their lives rather than stay sheltered at home. The result is a healthier tone to the US data compared to other countries, even with the number of new US cases on the rise again. This gap between the US economy and non-US economies is only magnified by the fiscal stimulus measures proposed by both US presidential candidates. As we discussed in last week’s Special Report, both the Biden and Trump platforms are calling for major fiscal stimulus – between $5-6 trillion over the next decade, including tax changes – although the Biden plan has much more front-loaded direct government spending, only partially offset by tax increases, if fully implemented. This is the “Blue Sweep” scenario, with a Biden victory and Democratic Party control of the US Congress, that is most bearish for US Treasuries, as the outcome would eventually help reduce the expected 2021 US fiscal drag of -7.2% of GDP as estimated by the latest IMF Fiscal Monitor (Chart 7). Even a re-elected Trump, however, would also mean more US fiscal stimulus, although with a mix of tax cuts and spending increases. Chart 6The Latest COVID-19 Wave Is Hitting Europe Harder The Latest COVID-19 Wave Is Hitting Europe Harder The Latest COVID-19 Wave Is Hitting Europe Harder Combined with an improving services sector and rising inflation, this puts the US in a much different economic position than the major economies of Europe. Chart 7Post-Election US Stimulus Will Offset Fiscal Drag Post-Election US Stimulus Will Offset Fiscal Drag Post-Election US Stimulus Will Offset Fiscal Drag There, the IMF is also projecting some fiscal drag in 2021, but now with a much less healthy domestic economy due to the COVID-19 surge and where inflation is already near 0%. Our decision to reduce our recommended overall global duration stance to below-benchmark is largely driven by trends in the US that are more bond-bearish than in the rest of the developed world. There will likely be another round of fiscal measures to help combat virus-stricken economies in Europe and elsewhere, but the US election is bringing the issue to the forefront more quickly. In other words, the US will get a more bond-bearish fiscal stimulus before Europe does. Bottom Line: US Treasury yields have started to creep higher and the move is likely to continue in the coming months regardless of who wins the White House. Reduce overall global duration exposure to below-benchmark, focused on the US. Our Recommended Country Allocation: Downgrade US, Upgrade Lower-Beta Countries Net-net, our decision to reduce our recommended overall global duration stance to below-benchmark is largely driven by trends in the US that are more bond-bearish than in the rest of the developed world. This also has implications for our recommend country allocation in our model bond portfolio. First, are downgrading our recommended US Treasury allocation to underweight. We are also increasing our desired weighting in countries where government bond yields are less sensitive to changes in US Treasury yields – especially during periods when the latter are rising. We call this “upside yield beta”. The countries that have the highest such beta to US Treasuries are Canada, Australia and New Zealand, making them downgrade candidates (Chart 8). Similarly, lower upside beta countries like Germany, France, Japan and the UK are upgrade possibilities. Chart 8Favor Countries With Lower Yield Betas To USTs Favor Countries With Lower Yield Betas To USTs Favor Countries With Lower Yield Betas To USTs Already, we are seeing the widening of yield spreads between US Treasuries and non-US government markets – with more to come as US Treasuries grind higher over the next 6-12 months. We see the greatest upside for spreads between the US and the low upside yield beta countries – that means wider spreads for US-Germany, US-France, US-Japan and US-UK (Chart 9). Chart 9Expect More Underperformance From USTs Expect More Underperformance From USTs Expect More Underperformance From USTs Chart 10Fed QE Momentum Peaking, Unlike Other CBs Fed QE Momentum Peaking, Unlike Other CBs Fed QE Momentum Peaking, Unlike Other CBs Thus, this week are making significant changes to our strategic government bond country allocations (see page 15), as well as the country weightings in our model bond portfolio (see pages 13-14), based on our new view on US bond yields and non-US yield betas. Specifically, we are not only cutting our recommended US weighting to underweight, but we are also downgrading Canada and Australia from overweight to neutral. On the other side, we are upgrading UK Gilts to overweight from neutral, while also upgrading Germany, France and Japan to overweight. Importantly, we are maintaining our overweight stance on Italian and Spanish sovereign debt, as those markets are supported by greater European fiscal policy integration in the world of COVID-19 and, just as importantly, large-scale ECB asset purchases. More generally, the relative “aggressiveness” of central bank quantitative easing (QE) does play a role in our recommended country allocation. We expect the Fed to be more tolerant of higher Treasury yields if the move is driven by improving US growth and/or greater US fiscal stimulus – as long as the higher yields were not having a negative impact on equity or credit markets. We expect the Fed to be more tolerant of higher Treasury yields if the move is driven by improving US growth and/or greater US fiscal stimulus – as long as the higher yields were not having a negative impact on equity or credit markets. This means less expected QE buying of Treasuries by the Fed. Conversely, given how aggressive the Reserve Bank of Australia and Bank of Canada have been with expanding their balance sheet via QE (Chart 10), this makes us reluctant to shift to the underweight stance on those countries implied by their high beta to rising US Treasury yields. Therefore, we are only downgrading those two countries to neutral. Bottom Line: Based on our view that US Treasury yields have more upside, we are making the following changes to our recommended country allocations in the government bond portion of our model bond portfolio: downgrading the US to underweight, downgrading higher-beta Canada and Australia to neutral, and raising lower-beta Germany, France, Japan and the UK to overweight. A New Tactical Trade: A UST-Bund Spread Widener Using Futures This week, we are also introducing a new recommended trade in our Tactical Overlay portfolio on page 16 to take advantage of our view on US bond yields: a 10-year US-Germany spread widening trade using government bond futures. Chart 11A Tactical Opportunity For A Wider UST-Bund Spread A Tactical Opportunity For A Wider UST-Bund Spread A Tactical Opportunity For A Wider UST-Bund Spread This trade makes sense for several reasons: Germany has one of the lowest yield betas to US Treasuries during periods when the latter is rising, as shown earlier. Our US Treasury-German Bund fundamental fair value spread model – which uses relative policy interest rates, unemployment and inflation between the US and the euro area as inputs - suggests that the spread is now far too tight after the massive rally in US Treasuries in 2020 (Chart 11). The main reason why the spread looks so “expensive” is that the underlying fair value has risen with US inflation rising and euro area inflation falling (Chart 12, bottom panel). The UST-Bund yield differential is not stretched from a technical perspective, when looking at deviations of the spread from its 200-day moving average or the 26-week change in the spread; both measures suggest room for additional spread widening before reaching historical extremes (Chart 13). Also, duration positioning by US fixed income investors is only around neutral, according to the JP Morgan duration survey, suggesting scope to push yields higher if bond investors become more defensive. Chart 12Inflation Differentials Justify A Wider UST-Bund Spread Inflation Differentials Justify A Wider UST-Bund Spread Inflation Differentials Justify A Wider UST-Bund Spread Chart 13Technical Trends Favor A Wider UST-Bund Spread Technical Trends Favor A Wider UST-Bund Spread Technical Trends Favor A Wider UST-Bund Spread As a reference, we are initiating this trade with the cash bond 10-year US-Germany spread at +138bps, with a target range of +170-190bps over the 0-6 month horizon we maintain for our Tactical Overlay positions. Bottom Line: We introduce a new trade in our Tactical Overlay to capitalize on our expectation of higher US bond yields and a wider Treasury-Bund spread: selling 10-year Treasury futures versus buying 10-year German bund futures.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Please see BCA Research US Bond Strategy Special Report, "Beware The Bond-Bearish Blue Sweep", dated October 20, 2020, available at usbs.bcaresearch.com and gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index The Global Bond Implications Of Rising Treasury Yields The Global Bond Implications Of Rising Treasury Yields Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights We are upgrading Trump’s odds of winning to 45%. We have bet on a Democratic sweep all year. Incumbent parties rarely survive recessions, and President Trump has mishandled the pandemic. However, our updated quantitative election model – which relies heavily on short-term changes in the 50 states’ economies – points to a Trump victory with 279 Electoral College votes. The model puts Biden’s odds at 49%, i.e. “too close to call.”    Opinion polls still favor Biden – and polls are generally accurate with sitting presidents. Yet Biden’s lead in swing states is comparable to Hillary Clinton’s in 2016. And we all know how that ended.   Trump’s comeback, successful or not, will increase the chances of a contested election and will boost Republicans in Senate races. Our Senate model is also now flagging Republican control. The US fiscal policy outlook hinges on control of the Senate. Democrats would add 4%-7% of GDP to the fiscal thrust next year. We give 28% odds to a risk-off scenario, leaving a 72% chance that the policy setting will favor reflation.   Feature We are upgrading President Trump’s odds of winning the US election from 35% to 45%. Looking at opinion polls, Biden is still favored as we go to press. But according to our quantitative election model, which relies heavily on the economy, Trump will eke out an Electoral College victory. What matters is that the media and financial markets are once again underrating Trump. The race is getting closer in the final days. Not only is our model flagging a Trump win, but the V-shaped economic recovery is boosting Trump’s popular support in the battleground states critical to winning an Electoral College majority. At very least investors should hedge their bets on former Vice President Joe Biden, who is not, after all, an extraordinarily charismatic challenger. Biden is not polling much better than Hillary Clinton polled against Trump four years ago (Chart 1). Chart 1ABiden Not Polling Much Better Than Clinton … Biden Not Polling Much Better Than Clinton... Biden Not Polling Much Better Than Clinton... Chart 1B… Against Trump ... Against Trump ... Against Trump   The polling so far suggests that Trump suffered permanent damage from this year’s crisis and his support will hit a ceiling and relapse over the next week, confirming the month’s general tendency of a Biden win. But our confidence in the outcome is lower than before. The implication for investors is that the current volatility and risk-off sentiment could extend for one-to-three months, particularly given Congress’s failure to pass a new COVID relief package. However, beyond the near term, most scenarios are reflationary, positive for global equities and negative for low-yielding government bonds. There Are Still Undecided Voters Trump beat expectations in the final presidential debate on October 22, according to CNN polls. But debate performance does not accurately predict the winner of US elections. Moreover around 58 million voters have already voted based on prior information.1 Chart 2Still Enough Undecided Voters To Turn Election Upgrading Trump’s Odds Of Re-Election Upgrading Trump’s Odds Of Re-Election Still, Trump’s recovery in swing state polling is simultaneous with a lot of early voting in October, and there are enough undecided voters to change the outcome in critical swing states. About 6% of voters are undecided – virtually the same as in 2016. While the number of third-party supporters has fallen by 5.7 percentage points (ppt), this trend will not hurt Trump (Chart 2). In swing states in 2016, Libertarian Party voters outnumbered Green Party voters by a ratio of four to one, which does not suggest that these voters will all flock to Biden. They could even lean Trump. A large third party vote points to popular discontent, which hurts the incumbent party, as in 1980 and 1992. A lower third party vote is thus neutral for Trump. This is a major difference in 2020 from 1980 and 1992, which are the only two modern examples of a president losing after his first term. The best demographic projections have long shown that a rerun of the 2016 election, albeit with a normalization of the third-party vote share, would lead to an Electoral College tie. While it is virtually impossible for Trump to win the popular vote, he has a lifeline if state results are contested and/or the Electoral College is indecisive. Quant Model Gives Trump 279 Electoral College Votes Economic activity in the US continues to bounce back, according to flash PMIs in services and manufacturing as well as the latest data release from the Philadelphia Federal Reserve’s Coincident Economic Index. This index is the key input in our quantitative US election models for the White House and Senate, both of which now flag Republican victories. The latest reading pushes Trump’s odds of winning re-election up by 2ppt, to 51%, thus predicting that he will win with 279 Electoral College votes, an increase of 20 votes since our September update (Chart 3). Obviously this is not a high-confidence reading but rather an outcome that says the election is “too close to call.” Our model correctly predicts all election outcomes since 1984 during in-sample back testing, and all elections since 2000 on an out-of-sample basis.   Chart 3Quant Model Points To Trump Victory … A Risk To Our View Upgrading Trump’s Odds Of Re-Election Upgrading Trump’s Odds Of Re-Election A Trump victory would be a massive upset – as in 2016. According to PredictIt.org, there is a 40% chance that Republicans will keep the White House. Other prominent forecasting groups, like FiveThirtyEight and The Economist, give Trump much lower odds, at 12% and 4%, respectively. In our model, Michigan has moved comfortably toward a Republican win (74% odds), opposite the conventional wisdom. Michigan is the crux of our subjective difference with our quantitative model – we don’t see a path for Trump to win as the polls currently stand. New Hampshire is the model’s only toss-up state, with a 53% chance of switching to Republicans, another surprising find, albeit one punctuated by President Trump’s decision to campaign in the state over the weekend. Pennsylvania and Wisconsin, states won by the Republicans in 2016, are still expected to flip to the Democrats. State-level coincident economic indices have the largest impact in determining the outcome in the model. Our other explanatory variables are state-by-state margins of victory in 2016, a “time for change” variable that favors incumbent parties, and the range of Trump’s approval rating. These variables have not changed recently and will not change in the final days of the election. Improving economic activity across the US is the basis for our model’s finding. Chart 4Improvements In Swing State Economies Upgrading Trump’s Odds Of Re-Election Upgrading Trump’s Odds Of Re-Election The Philly Fed data show that 48 out of 50 states’ coincident economic indices increased over the past three months, an increase by 10 states since the previous month’s release. All swing states rose, while the previous toss-up state, Michigan, turned positive, according to our weighting method, which takes the three-month changes in the economic indicators and weights the final months of useable data more heavily than previous months in an election year (Chart 4). Michigan and New Hampshire account for 20 electoral votes, raising Trump from 259 to 279.  Clients have asked us why we use the range of President Trump’s approval rating rather than the level (Chart 5). We found this measure more statistically significant than other measures. If we manipulate the data we find that the model would still favor Trump if we looked at the two-year change of the approval rating or the October momentum of the approval rating. However, the model flags a Trump loss if we judge by the July or October level of his approval rating (which is historically low), or if we exclude the approval rating data altogether. The result of these alternate versions of our model is a Trump loss, with 246 Electoral College votes and Florida and Michigan remaining the critical toss-up states (Table 1). We are sticking with our original model, as the range of approval predicts electoral votes with a higher confidence level than other measures. Chart 5Trump’s Approval Range Is Narrow, Stable Upgrading Trump’s Odds Of Re-Election Upgrading Trump’s Odds Of Re-Election Table 1Variations In Quant Model Show Range Of Possibilities Upgrading Trump’s Odds Of Re-Election Upgrading Trump’s Odds Of Re-Election Bottom Line: Our quant model now favors Trump for re-election with 279 Electoral College votes. This economy-heavy model suggests that Trump is once again underrated, that the odds of a contested election are rising (in which Trump has some institutional advantages), and that Senate Republicans will benefit from the final sprint. Uncertainty and volatility will affect the market if the election result is indecisive, delayed, or if the GOP keeps the Senate (see below). Why We Do Not Favor Trump Outright Biden has been our pick since March based on the year’s huge external shock. The pandemic and recession have been harmful to the material wellbeing of the American public and therefore have sharply reduced the odds that the current president and ruling party will be re-elected. Looking at the level of Trump’s approval rating, he is comparable to George Bush Sr, who lost re-election in 1992 after a recession and race riots in Los Angeles. He is well beneath George Bush Jr and Barack Obama, who were re-elected handily in 2004 and 2012 (Chart 6). Chart 6Trump’s Approval Rating Level Is Relatively Low Upgrading Trump’s Odds Of Re-Election Upgrading Trump’s Odds Of Re-Election Joe Biden has a 7.9ppt lead in average national opinion polling. Looking at the breakdown across demographic groups reveals Trump’s serious liabilities. Biden has a 17ppt lead among women, compared to Clinton’s 15ppt lead in 2016 exit polls, and he is tied with Trump among men, compared to a 11ppt Trump lead in 2016 (Chart 7).2 Chart 7Trump Lagging In Key Demographic Groups Upgrading Trump’s Odds Of Re-Election Upgrading Trump’s Odds Of Re-Election Ethnic white voters still favor Trump by 5ppt but Trump has lost ground with this group since 2016, when he had a 15ppt advantage. Biden leads among voters who have some college education, while Trump’s lead among non-college graduates has fallen from 7ppt in 2016 to 4ppt this year. Chart 8Consumer Confidence Sounds Warning For President Consumer Confidence Sounds Warning For President Consumer Confidence Sounds Warning For President However, Black and Hispanic voters support Biden by a 74ppt and 31ppt margin, respectively, down from Clinton’s larger margins of 85ppt and 38ppt in 2016. While Trump is an exclusively commercial president, his approval rating never rose above 47% even when the economy was booming and consumer confidence soared. The collapse in consumer confidence has taken a toll on his approval, which struggles to break above 45% (Chart 8). Expectations have shot up, but voters are unhappy about current conditions. Consumer spending has not fully recovered and disposable income is in a freefall due to the failure of Congress to agree to a new fiscal relief deal since August, when benefits began to expire (Chart 9). Trump wanted a deal but so far Senate Republicans have proven unable to capitulate to House Democrats’ demands. Median family income has fallen over the course of Trump’s term. It spiked on the fiscal relief but then fell back when the latest phase of stimulus fell through (Chart 10). Chart 9Lack Of Fiscal Stimulus Weighs On Households Lack Of Fiscal Stimulus Weighs On Households Lack Of Fiscal Stimulus Weighs On Households Chart 10Median Income Down Over Four Year Term Median Income Down Over Four Year Term Median Income Down Over Four Year Term   Under Trump’s watch the unemployment rate has risen from 4.7% to 7.9%. Obviously the surge was due to the pandemic and unemployment has fallen from its peak. But rising joblessness weighs on a president’s approval rating in the final reckoning – this is a good rule of thumb for identifying one-term presidents (Chart 11). Permanent unemployment is also rising, creating a group of unhappy voters that could make a difference in elections with thin margins.   Chart 11AUnemployment Often Predicts … Unemployment Often Predicts ... Unemployment Often Predicts ... Chart 11B... The Election End-Game ...The Election End-Game ...The Election End-Game   The pandemic is not over. COVID-19 hospitalizations and deaths are climbing in Arizona, Michigan, Pennsylvania, and Wisconsin (Chart 12). Trump’s net approval rating is deeply negative with regard to his handling of the crisis, as opposed to the economy where his approval is still net positive (Chart 13). Chart 12Pandemic Re-Emerging, Hurts Trump Upgrading Trump’s Odds Of Re-Election Upgrading Trump’s Odds Of Re-Election Chart 13Trump Ailing On Pandemic Handling Upgrading Trump’s Odds Of Re-Election Upgrading Trump’s Odds Of Re-Election     Biden, a traditional Democrat, is an acceptable alternative to Trump. His lead over Trump is 7.9% in national polling and 4% in swing state polling. He polls considerably better than Hillary Clinton did. In Arizona his polling is rising; elsewhere it is flat (Chart 14A & B).  Chart 14ABiden Polling Stable … Biden Polling Stable... Biden Polling Stable... Chart 14B… And Better Than Hillary ...And Better Than Hillary ...And Better Than Hillary   Can the opinion polls be trusted? National polling is generally close to the mark – especially for incumbent presidents – and the winner of the national vote wins the Electoral College 91% of the time. Challengers who lose elections typically outperform their final polling by 1.4%. Those who win outperform by 3%. Whereas incumbent presidents who win outperform by 0.8% and those who lose outperform by 1% – i.e. they do better than expected but still lose (Chart 15A & B). Presidents are well known so they don’t tend to bring big surprises. However, there are major exceptions, namely Harry Truman.   Chart 15AOpinion Polls Fairly Accurate On Sitting Presidents Upgrading Trump’s Odds Of Re-Election Upgrading Trump’s Odds Of Re-Election Chart 15BOpinion Polls More Often Underrate Challengers Upgrading Trump’s Odds Of Re-Election Upgrading Trump’s Odds Of Re-Election Chart 16Trump Is Rising In Battleground State Polls Trump Is Rising In Battleground State Polls Trump Is Rising In Battleground State Polls What about state level polls? The big errors in 2016 occurred on the state level. However, swing state pollsters have improved their methods. This can be confirmed by the fact that Trump’s performance in battleground opinion polls closely aligns with his job approval rating (Chart 16). The approval rating is the most reliable of all US political polls. The fact that these two are in lockstep, as against Trump’s national support rate (which is weighed down by dyed-in-the-wool Democrats in populous states), suggests that swing state polling is not wildly off the mark. On the other hand, Biden’s 4ppt lead is not very large. Voter turnout will be very high this year. Both Professor Michael McDonald from the US Elections Project and Nate Silver of FiveThirtyEight expect turnout to be around 65%. High political polarization, get-out-the-vote campaigns by both parties, and expanded access to mail-in voting due to the pandemic have created a high-turnout environment. High turnout does not necessarily disfavor Trump, given that his political base consists of many low turnout groups. But it should hurt him in the context of higher unemployment, as was the case for the incumbent party in 1992 and 2008 (Chart 17). Bottom Line: History suggests the incumbent party will lose the White House. So do opinion polls, which tend to be accurate when it comes to sitting presidents. Trump’s momentum has picked up in swing state opinion polls this month, though it is pausing as we go to press. If he gains momentum in the final week then he could still win the election.  Chart 17AHigh Turnout Amid High Unemployment … Upgrading Trump’s Odds Of Re-Election Upgrading Trump’s Odds Of Re-Election Chart 17B…Hurts Incumbent Upgrading Trump’s Odds Of Re-Election Upgrading Trump’s Odds Of Re-Election   Trump’s Path To Victory Biden’s 4ppt lead in swing states is within the range of polling error. A last-minute Trump comeback is a risk. While presidents usually lose re-election if they suffer a recession, especially during the year of the election, there have been exceptions – namely in 1900, 1904, and 1924. The basis for Trump to make a comeback is the economic snapback and the fact that voters consistently rate the economy as the most important issue in the election. The crisis struck early enough in the year that the massive fiscal relief package has propped up demand in what could be the nick of time for the president (Chart 18).3 Chart 18Trump’s Biggest Help Is V-Shaped Recovery Trump's Biggest Help Is V-Shaped Recovery Trump's Biggest Help Is V-Shaped Recovery Trump is generally polling better than he did in 2016 and his polling is ticking up in the final weeks of the race despite a disastrous year (Chart 19). His polling is improving in Florida and Arizona, meaning that a single victory in the upper Midwest would keep him in the White House. Chart 19ATrump Rallying In Some Swing States … Trump Rallying In Some Swing States... Trump Rallying In Some Swing States... Chart 19B… Critical Trend If It Continues ...Critical Trend If It Continues ...Critical Trend If It Continues   Wage growth is also seeing a V-shaped recovery – particularly in the blue states, where services and knowledge-based sectors drive the economy, but also in “purple” swing states (Chart 20), though admittedly the purple states that voted for Trump are the laggards.  The manufacturing sector is also bouncing back, which is critical for the Midwestern Rust Belt that got pummeled by Trump’s trade war prior to the pandemic. The surge in credit fueled by the Federal Reserve’s liquidity provisions is a positive for this region (Chart 21). Chart 20Swing State Wage Growth Bounces Back Swing State Wage Growth Bounces Back Swing State Wage Growth Bounces Back Chart 21Midwestern Economy Snaps Back Midwestern Economy Snaps Back Midwestern Economy Snaps Back   The stock market rally is also positive for the incumbent. The S&P 500 predicts the election result 77% of the time going back to 1896. Specifically, its year-to-date performance as of October 31 of an election year is positively correlated with an incumbent party’s likelihood of winning the White House and is statistically significant at the 5% confidence level. Back in May, with the S&P down 13%, the stock market gave Trump a 16% chance of re-election. Today, up 6% YTD, it gives him a 66% chance (Chart 22). Chart 22Simple Stock Market Model Says Trump Favored For Re-Election Upgrading Trump’s Odds Of Re-Election Upgrading Trump’s Odds Of Re-Election We would not put too much emphasis on this measure, as the market also rallied prior to Carter’s and Bush’s losses in 1980 and 1992. But Trump is uniquely tied to the stock market and it is clearly good for him if the market does not collapse (though the failure to pass fiscal stimulus is a liability). Simply put, Trump is stronger than Mitt Romney 2012 and Biden is weaker than Barack Obama. The 3.9ppt margin of victory in the popular vote that year should be narrower this year. Run-of-the-mill Democrats have not received more than 49% of the popular vote in recent memory. And that was the popular Bill Clinton in 1996 (Table 2). If Trump clocks in at 46%, as in 2016, then he could squeak through the Electoral College once again.     Bottom Line: We are upgrading Trump’s odds to 45%.   Table 2US Presidential Election Popular Vote Upgrading Trump’s Odds Of Re-Election Upgrading Trump’s Odds Of Re-Election The Senate Is Too Close To Call Even if Trump’s comeback is “too little, too late,” it increases the chance of a contested election – in which he could get a lifeline through the Supreme Court or the House of Representatives – and also gives a boost to Republican Senators in tight races. Our Senate election model, like our presidential model, uses the Philly Fed coincident economic indicators. It has also flipped from favoring Democrats to narrowly predicting Republican control, with 51-49 seats. Specifically, Montana and North Carolina shifted into the Republican camp, though North Carolina remains a toss-up and would turn the overall balance of power (Chart 23).4   Chart 23Quant Model Says Senate Favors Republicans – A Risk To Reflation Trade Upgrading Trump’s Odds Of Re-Election Upgrading Trump’s Odds Of Re-Election Again the proper way of interpreting this reading is that the election is “too close to call,” with a 49% chance of Democratic control. Notably our Senate model relies more heavily on opinion polling than our presidential model – it incorporates the president’s approval rating level as well as the incumbent party’s net support rate in the generic congressional ballot (a poll that measures which party voters generally prefer for Congress). The economic recovery is the source of the boost for Republicans but marginal improvements in Republican polling do not hurt. The Senate race is critical to the overall policy significance of the US election. You cannot pass major legislation in the US without control of the Senate. And the Senate races are clearly tightening. This means uncertainty is rising, not falling, as the election approaches. Position For Reflation, The Likeliest Policy Outcome In particular the US fiscal outlook depends on the Senate. Chart 24 simulates the different courses of the deficit depending on election scenarios. If the Democrats win the White House, Senate, and House of Representatives, the budget deficit will rise from 16% of GDP in FY 2020 to 23% of GDP in FY 2021, as Biden will largely execute his policy agenda. Chart 24Democratic Sweep Offers Massive Fiscal Boost Upgrading Trump’s Odds Of Re-Election Upgrading Trump’s Odds Of Re-Election If Trump and the Republicans win the White House and retain the Senate, they will keep cutting deals with House Democrats as in recent years, and the deficit will at least remain flat. The only scenario in which the budget deficit contracts – i.e. a negative fiscal thrust threatens the US economic recovery – occurs if Biden wins the White House but Republicans obstruct his agenda. Realistically, this would result in something like the Republican status quo scenario in Chart 24 above, rather than the Congressional Budget Office’s baseline scenario. The baseline scenario would produce an intolerable 7.4% contraction in fiscal thrust under baseline scenario in 2021. GOP senators would not go so far. They are not the same as the House Freedom Caucus members who were so hawkish in 2010-16. Nevertheless investors cannot rule out the baseline scenario – which could cause a double-dip recession – until GOP senators allay their fears. The market will cheer if President Trump and the Republicans retain the White House and Senate, as the fiscal thrust will be neutral or slightly expansive. It will especially cheer if the Democrats win a clean sweep, adding anywhere from 4%-7% of GDP in fiscal thrust for FY 2021 – the most reflationary outcome. It will even cheer in the odd chance that Trump wins with a unified Democratic Congress, which would also be reflationary. But the market will not cheer if the election threatens premature fiscal tightening via Republican obstructionism under a Biden presidency. This is the only scenario that is deflationary. The market would have to riot to force Republican senators to cooperate with a Democratic president – and this would be the case in the lame duck session as well as for each new stimulus package and budget over 2021-22. Based on our updated quant models, this Biden+GOP scenario is about a 28% probability, a slight increase from our previous view. The flip side is that there is about a 72% probability of a reflationary outcome. Beyond the near term, a Biden presidency with a Republican senate is actually market positive. Republican senators would eventually have to agree to House-drawn budgets, but would prevent tax hikes and legislative overreach (the downside of a Democratic sweep). Meanwhile a President Biden would avoid sweeping unilateral tariffs against China and the EU (the downside of any Trump victory). Bottom Line: A Democratic sweep is the most fiscally proactive scenario but the odds have fallen from around 45% to 27% according to our quant models. The odds of Biden plus a GOP Senate have risen from 20% to 28%. The market would have to digest significant new fiscal risks in this case, so the dollar and US treasuries would initially rally.  The other scenarios combine to a 72% probability and are initially reflationary, albeit less so than a Democratic sweep, with the likelihood of massive trade war risk in 2021.  Trade Recommendations Courtesy Of The BCA Equity Analyzer As the US election approaches and the effects of the global pandemic linger, economic policy uncertainty remains elevated. Equity markets tend to behave very differently in times of acute uncertainty. In order to gauge the effects of uncertainty at the individual stock level, we turn to BCA’s stock-picking engine, the Equity Analyzer. We looked at factor performance when economic policy uncertainty (as defined by Baker, Bloom and Davis) exceeds the 150-line (Chart 25). This is quite high compared to history. Chart 25Policy Uncertainty: How High Will It Go? Upgrading Trump’s Odds Of Re-Election Upgrading Trump’s Odds Of Re-Election We look at the 30 factors included in the BCA Equity Analyzer and examine the Sharpe Ratio (Chart 26). The Sharpe ratio expresses the risk adjusted performance of long/short strategies based on each factor. Long/short strategies, in turn, are defined as going long the top 25% based on a factor and going short the bottom 25%. Chart 26Equity Analyzer Shows Key Traits For Navigating Uncertainty Upgrading Trump’s Odds Of Re-Election Upgrading Trump’s Odds Of Re-Election The results show that the best performing factors in times of high uncertainty are: Relative earnings yield  Low accruals5 BCA Style, which is an in-house combined measure for (1) value versus growth and (2) small caps versus large caps. One-month momentum With these results, we go back to the BCA Equity Analyzer to extract the top 25 stocks filtered by our top 4 factors during times of uncertainty. The results are shown in Table 3.6   The BCA score in this table ranges from 0 to 100% (from a strong sell to a strong buy). It is based on 30 factors distributed among seven broad categories: Macro, Value, Safety, Sentiment, Technical, Quality, Payout. These picks will improve performance during the upcoming spike in uncertainty, which is now even more likely than it was given the rising odds of a contested election and/or deflationary partisan gridlock. Table 3BCA Equity Analyzer Stock Picks For Election Uncertainty Upgrading Trump’s Odds Of Re-Election Upgrading Trump’s Odds Of Re-Election Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Guy Russell Research Analyst GuyR@bcaresearch.com David Boucher Chief Quantitative Strategist DavidB@bcaresearch.com Footnotes 1  See Lauren King and Lauren Lantry, “More than 58 million Americans have already voted,” ABC News, October 25, 2020, abcnews.go.com.  2  See “An examination of the 2016 electorate, based on validated voters,” Pew Research Center, August 9, 2018, pewresearch.org. 3  Back in April, former Obama economic adviser Jason Furman predicted that the likely timing of the economic snapback would be very favorable for President Trump: “We’re about to see the best economic data we’ve seen in the history of this country,” he said. See Ryan Lizza and Daniel Lippman, “The general election scenario that Democrats are dreading,” Politico, May 26, 2020, politico.com.    4  Given the Senate’s critical importance to US fiscal policy, we weren’t joking when we said that Democratic candidate Cal Cunningham’s sex scandal in North Carolina could end up making the difference for the election’s overall consequences as well as the global macro outlook! 5  Accounting accruals are the non-cash component of a firm’s earnings and can be used as a metric to gauge the overall quality of a firm. Firms with high accruals tend to underperform firms with low accruals because of the potential to mask poor performance through the practice of accrual accounting. 6  Screener is based on US exchanges, top 30% based on market cap, Relative Earning Yield Score above 50%, Accruals Score above 50%, 1-month Momentum above 50%, and BCA Style above 50%.

Your feedback is important to us. Please take our client survey today. Highlights For now, there is little evidence that the pandemic has adversely affected the global economy’s long-run growth potential. Even if one counts those who will be unable to work due to long-term health complications from the virus, the pandemic will probably reduce the global labor force by only 0.1%-to-0.15%. Labor markets have healed more quickly over the past few months than after the Great Recession. In the US, the ratio of unemployed workers-to-job openings has recovered most of its lost ground. Thanks in part to generous government support for businesses and the broader economy, commercial bankruptcy filings remain near historic lows. Meanwhile, new US business formation has surged to record highs. The combination of a vaccine and a decline in rents in city centres should persuade some people who were thinking of fleeing to the suburbs to stay put. This will ensure that most urban commercial and residential real estate remains productively engaged. Judging from corporate surveys, capital spending on equipment and intellectual property should continue to rebound. While the pandemic has caused numerous economic dislocations, it has also opened the door to a variety of productivity-enhancing innovations. An open question is whether all the debt that governments have taken on to alleviate the economic damage from the pandemic could in and of itself cause damage down the road. As long as interest rates stay low, this is not a major risk. However, today’s high government debt levels could become a problem if the pool of global savings dries up. Investors should continue to overweight stocks for the time being, while shifting their equity exposure from “pandemic plays” to “reopening plays.” A more cautious stance towards stocks may be appropriate later this decade.  The Pandemic’s Potentially Long Shadow In its latest World Economic Outlook, the IMF revised up its growth estimates for this year. Rather than contracting by 4.9%, as it expected in June, the Fund now sees the global economy shrinking by 4.4%. That said, the IMF’s estimates still leave global GDP in 2020 7.5% below where it projected it to be in January. Perhaps even more worrying, the IMF expects the global economy to suffer permanent damage from the pandemic (Chart 1 and Chart 2). It projects that real global GDP will be 5.3% lower in 2024 compared to what it expected last year. In the G7, real GDP is projected to be nearly 3% lower, with most of the shortfall resulting from a downward revision to the level of potential GDP (Chart 3). Chart 1Covid-19: The IMF Expects The Global Economy To Suffer Permanent Damage (Part I) How Much Permanent Economic Damage Will The Pandemic Cause? How Much Permanent Economic Damage Will The Pandemic Cause? Chart 2Covid-19: The IMF Expects The Global Economy To Suffer Permanent Damage (Part II) How Much Permanent Economic Damage Will The Pandemic Cause? How Much Permanent Economic Damage Will The Pandemic Cause?     The Congressional Budget Office is no less gloomy in its forecast. The CBO expects US real GDP to be 3.7% lower in 2024 than it projected last August. By 2029, it sees US GDP as being 1.8% below what it had expected prior to the pandemic, almost entirely due to slower potential GDP growth (Chart 4). Chart 3G7 Real GDP Growth Projections Have Been Revised Sharply Lower Due To The Pandemic How Much Permanent Economic Damage Will The Pandemic Cause? How Much Permanent Economic Damage Will The Pandemic Cause? Chart 4A Gloomy Forecast For The US Thanks To Covid-19 How Much Permanent Economic Damage Will The Pandemic Cause? How Much Permanent Economic Damage Will The Pandemic Cause? The worry that the pandemic will lead to a major permanent loss in output is understandable. That is precisely what happened after the Global Financial Crisis. Nevertheless, as we discuss below, there are good reasons to think that the damage will not be as pervasive as widely believed. The Drivers Of Potential GDP An economy’s potential output is a function of three variables: 1) the number of workers available; 2) the amount of capital those workers have at their disposal; and 3) the efficiency with which this labor and capital can be transformed into output, a concept economists call “total factor productivity.” Let us consider how the pandemic has affected all three variables. The Impact Of The Pandemic On The Labor Market At last count, the pandemic has killed over 1.1 million people worldwide, 222,000 in the US. While the human cost of the virus is immense, the economic cost has been mitigated by the fact that about four-fifths of fatalities have been among those over the age of 65 (Table 1). In the US, less than 7% of the labor force is older than 65. A reasonable estimate is that Covid deaths have reduced the US labor force by 55,000.1 Table 1Pandemic-Related Deaths Are Tilted Towards The Elderly, Who Are The Least Active Participants Of The Labor Force How Much Permanent Economic Damage Will The Pandemic Cause? How Much Permanent Economic Damage Will The Pandemic Cause? Chart 5The Number Of New Cases Continues To Increase Globally How Much Permanent Economic Damage Will The Pandemic Cause? How Much Permanent Economic Damage Will The Pandemic Cause? Granted, mortality is not the only way that the disease can impair one’s ability to work. As David Cutler and Larry Summers point out in a recent study, for every single person who dies from Covid-19, seven people will survive but not before manifesting severe or critical symptoms of the disease.2 Based on the experience from past coronavirus epidemics, Ahmed, Patel, Greenwood et al. estimate that about one-third of these survivors will suffer long-term health complications.3 If one assumes that half of these chronically ill survivors are unable to work, this would reduce the US labor force by an additional 65,000.4 Of course, the pandemic is not yet over. The number of new cases continues to rise in the US and globally (Chart 5). The only saving grace is that mortality and morbidity rates are lower than they were earlier this year. Nevertheless, many more people are likely to die or suffer debilitating long-term consequences before a vaccine becomes widely available. Using the US as an example, if the total number of people who end up dying or getting so sick that they are unable to work ends up being twice what it is so far, the pandemic will reduce the labor force by about 240,000. This is not a small number in absolute terms. However, it is less than 0.15% of the overall size of the US labor force, which stood at 164 million on the eve of the pandemic. The impact of the pandemic on the labor forces of other major economies such as Europe, China, and Japan will be even smaller. Labor Market Hysteresis People can drop out of the labor force even if they do not get sick. In fact, 4.4 million have left the US labor force since February, bringing the participation rate down from 63.4% to 61.4%. How great is the risk of “hysteresis,” a situation where the skills of laid-off workers atrophy so much that they become unwilling or unable to rejoin the labor force? At least so far, hysteresis has been limited. According to surveys conducted by the Bureau of Labor Statistics, most US workers who have dropped out of the labor force still want a job. The pandemic has made it more difficult for people to work even when they wanted to. During the spring, more than four times as many employees were absent from work due to childcare requirements than at the same time last year. Now that schools are reopening, it will be easier for parents to go back to work. Admittedly, not everyone will have a job to return to. While about a third of US unemployed workers are still on temporary layoff, the number of workers who have suffered permanent job losses has been steadily rising (Chart 6). The good news is that job openings have recovered most of their decline since the start of the year. Unlike in mid-2009, when there were 6.5 unemployed workers for every one job vacancy, today there are only two (Chart 7). Chart 6US: Permanent Job Losses Have Been Rising Steadily... US: Permanent Job Losses Have Been Rising Steadily... US: Permanent Job Losses Have Been Rising Steadily... Chart 7...But Job Openings Have Recovered Most Of Their Decline Since The Start Of The Year ...But Job Openings Have Recovered Most Of Their Decline Since The Start Of The Year ...But Job Openings Have Recovered Most Of Their Decline Since The Start Of The Year It is also worth noting that the vast majority of job losses during the pandemic has been among lower-income workers, especially in the retail and hospitality sectors. Most of these jobs do not require highly specialized sector-specific skills. Thus, as long as there is enough demand throughout the economy, unemployed workers will be able to find jobs in other industries. Wither The Capital Stock? The pandemic may end up reducing the value of the capital stock in two ways. First, it could render a portion of the existing capital stock unusable. Second, the pandemic could reduce the pace of new investment, leading to a smaller future capital stock than would otherwise have been the case. Let us explore both possibilities. On the first point, it is certainly true that the pandemic has left a lot of the capital stock idle, ranging from office buildings to shopping malls. However, this could turn out to be a temporary effect. Consider, for example, the case of China. After the pandemic began in Wuhan, China first shut down much of its domestic economy and then implemented an effective mass testing and contact tracing system. The strategy worked insofar as China is now nearly free of the virus. Today, few Chinese wear masks, the restaurants are full again, and domestic air travel is back to last year’s level. Even movie theatre revenue has rebounded. The rest of the world may not be able to replicate China’s success in combating the virus, but then again it won’t need to if an effective vaccine becomes available. Chart 8US Housing Is In A Good Place US Housing Is In A Good Place US Housing Is In A Good Place Even if the pandemic ends up leading to deep and lasting changes in the way people live, work, and shop, the market mechanism will ensure that all but the least desirable parts of the capital stock remain productively employed. As first year economics students learn, if the supply curve is vertical and the demand curve shifts inward, the result will be lower prices rather than diminished output. By the same token, if more companies and workers decide to relocate to the suburbs, urban rents will fall until enough people decide that they are better off staying put. An economy’s productive capacity does not change just because rents go down. What falling demand for urban real estate and increased interest in working from home will do is encourage people to buy larger homes in suburban areas. We have already seen this play out this year. Despite flagging commercial real estate construction in the US, residential construction has boomed. Single-family housing starts were up 24% year-over-year in September. Building permits and home sales have reached new cycle highs. Homebuilder confidence hit a new record in October (Chart 8). The Service Sector Is Not Particularly Capital Intensive Most recessions take a greater toll on the goods-producing sectors of the economy than the service sector. The pandemic, in contrast, has mainly afflicted services. The service sector is the least capital-intensive sector of the economy. This is especially the case when it comes to spending on capital equipment and investment in intellectual property (Chart 9). Chart 9Capex-Intensive Industries Have Let Go Of Less Workers During The Pandemic How Much Permanent Economic Damage Will The Pandemic Cause? How Much Permanent Economic Damage Will The Pandemic Cause? Chart 10Capex Intentions Have Bounced Back Capex Intentions Have Bounced Back Capex Intentions Have Bounced Back As such, it is not surprising that investment in equipment and IP fell less during this recession than one would have expected based on the historic relationship between investment and GDP growth. According to the Atlanta Fed’s GDPNow model, investment in equipment and IP is set to increase by 23% in the third quarter. The snapback in the Fed’s capex intention surveys suggests that investment spending should continue to rise in the fourth quarter and into next year (Chart 10). Productivity And The Pandemic Just as the impact of the pandemic on the labor supply and the capital stock is likely to be limited, the same is true for the efficiency with which capital and labor is transformed into output. For every person whose productivity is hampered by having to work from home, there is another person who feels liberated from the need to spend an hour commuting to work only to attend a series of pointless meetings. In fact, it is quite possible that the pandemic will nudge society from various “low productivity” equilibria to “high productivity” equilibria. For example, greater use of video conferencing could negate the need to take redeye flights to attend business meetings in person. Remote learning could enhance educational opportunities. More widespread use of telemedicine could eliminate the need to waste time waiting in a doctor’s office. Who knows, the pandemic could even fulfill my life-long mission to replace the unhygienic handshake with the much more elegant Thai wai. Granted, disruptive shifts could produce unintended consequences. There is a fine line between creative destruction and uncreative obliteration. If the pandemic forces otherwise viable businesses to close, this could adversely affect resource allocation. Chart 11New Business Applications Have Surged To Record Highs New Business Applications Have Surged To Record Highs New Business Applications Have Surged To Record Highs Chart 12Commercial Bankruptcy Filings Remain In Check How Much Permanent Economic Damage Will The Pandemic Cause? How Much Permanent Economic Damage Will The Pandemic Cause? Fortunately, at least so far, this does not seem to be happening on a large scale. After dropping by 25%, the number of active US small businesses has rebounded to last year’s levels. New business applications have surged to record highs (Chart 11). According to the American Bankruptcy Institute, commercial bankruptcy filings remain near historic lows. While Bloomberg’s count of large-company bankruptcies did spike earlier this year, it has been coming down more recently (Chart 12). Fiscal Stimulus To The Rescue Chart 13Personal Income Jumped Early On In The Pandemic Personal Income Jumped Early On In The Pandemic Personal Income Jumped Early On In The Pandemic How did so many households and businesses manage to avoid the financial suffering that usually goes along with deep recessions? The answer is that governments provided them with ample income support. In the US, real personal income rose by 11% in the first few months of the pandemic (Chart 13). Small businesses also benefited from the Paycheck Protection Program, which doled out low-cost loans to businesses which they will be able to convert into grants upon confirmation that the money was used to preserve jobs. Similar schemes, such as Germany’s Corona-Schutzschild, Canada’s Emergency Business Account program, and the UK’s Coronavirus Job Retention Scheme were launched elsewhere. The failure of the US Congress to pass a new stimulus bill could undermine the sanguine narrative presented above. Small businesses, in particular, are facing a one-two punch from the expiration of the Paycheck Protection Program and tighter bank lending standards. Ultimately, we think the US Congress will pass a new pandemic relief bill. However, the size of the bill could depend on the outcome of the election. In a blue sweep scenario, the Biden administration will push through a $2.5-to-$3.5 trillion stimulus package early next year, while laying the groundwork for a further 3% of GDP increase in government spending on infrastructure, health care, education, housing, and the environment. A fairly large stimulus bill could also emerge if President Trump manages to hang on to the White House, while the Democrats take control of the Senate. Unlike some Republican senators, Donald Trump is not averse to big increases in government spending. A continuation of the current political configuration in Washington would result in the smallest increase in spending. Nevertheless, some sort of deal is likely to emerge after the election. Even most Republican voters favor a large stimulus bill (Table 2). Table 2Strong Support For Stimulus How Much Permanent Economic Damage Will The Pandemic Cause? How Much Permanent Economic Damage Will The Pandemic Cause? A Double-Edged Sword? Bountiful fiscal support has undoubtedly lessened the economic scarring from the pandemic. However, could the resulting increase in government debt lead to supply-side problems down the road? The answer depends on what happens to interest rates. As long as interest rates stay below the growth rate of the economy, governments will not need to raise taxes to pay for pandemic relief. In fact, in such a setting, the public debt-to-GDP ratio will return to its original level with absolutely no change in the structural budget deficit (Chart 14). GDP growth in most developed economies has exceeded government borrowing rates for much of the post-war era (Chart 15). Thus, a free lunch scenario where governments never have to pay back the additional debt they incurred for pandemic relief cannot be ruled out. That said, it would not be prudent to bank on such an outcome. If the excess private-sector savings that have kept down borrowing costs run out, interest rates could rise. In a world awash in debt, this could lead to major problems. Thus, while the structural damage to the global economy from the pandemic appears to be limited for now, that could change in the future. Chart 14A Fiscal Free Lunch When r Is Less Than g How Much Permanent Economic Damage Will The Pandemic Cause? How Much Permanent Economic Damage Will The Pandemic Cause? Chart 15The Rate Of Economic Growth Has Usually Been Higher Than Interest Rates How Much Permanent Economic Damage Will The Pandemic Cause? How Much Permanent Economic Damage Will The Pandemic Cause?     Investors should continue to overweight equities for the time being. With a vaccine on the horizon, it makes sense to shift from favoring “pandemic plays” such as tech and health care stocks to favoring “reopening plays” such as deep cyclicals and banks. A more cautious stance towards stocks will be appropriate later this decade if, as flagged above, a stagflationary environment leads to higher interest rates and slower growth.   Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1 To estimate the direct impact of Covid-19 on the labor force, we calculate the decline in the labor force by age cohorts using Covid-19 death statistics and labor participation rates. 2 David M. Cutler, and Lawrence H. Summers, “The COVID-19 Pandemic and the $16 Trillion Virus,” JAMA Network, October 12, 2020. 3 Hassaan Ahmed, Kajal Patel, Darren Greenwood, Stephen Halpin, Penny Lewthwaite, Abayomi Salawu, Lorna Eyre, Andrew Breen, Rory O’Connor, Anthony Jones, and Manoj Sivan. “Long-Term Clinical Outcomes In Survivors Of Coronavirus Outbreaks After Hospitalisation Or ICU Admission: A Systematic Review And Meta-Analysis Of Follow-Up Studies,” medRxiv, April 22, 2020. 4 Calculated as 0.5 x (decline in labor force due to Covid-19 deaths) x 7 x (1/3).   Global Investment Strategy View Matrix How Much Permanent Economic Damage Will The Pandemic Cause? How Much Permanent Economic Damage Will The Pandemic Cause? Current MacroQuant Model Scores How Much Permanent Economic Damage Will The Pandemic Cause? How Much Permanent Economic Damage Will The Pandemic Cause?

Highlights US Election & Duration: We estimate that there is an 80% probability of a US election result that will give a lift to US Treasury yields via increased fiscal stimulus. Those are strong enough odds to justify a move to a below-benchmark cyclical US duration stance on a 6-12 month horizon. US Treasuries: We anticipate a moderate bear market in US Treasuries to unfold during the next 6-12 months. In addition to below-benchmark portfolio duration, investors should overweight TIPS versus nominal Treasuries, hold nominal and real yield curve steepeners, and hold inflation curve flatteners. Non-US Country Allocation: Within global government bond portfolios, downgrade the US to underweight. Favor countries that have lower sensitivity to rising US Treasury yields with central banks that are likely to be more dovish than the Fed in the next few years. That means increasing allocations to core Europe and Japan, while reducing exposure to Canada and Australia. Stay neutral on the UK given the near-term uncertainties over the final Brexit outcome. Feature With the US presidential election just two weeks away, public opinion polls continue to show that Joe Biden is the favorite to win the White House. However, the odds of a “Blue Sweep” - combining a Biden victory with the Democratic Party winning control of both the US Senate and House of Representatives - have increased since the end of September according to online prediction markets. US Treasury yields have also moved higher over that same period (Chart 1), which we interpret as the bond market becoming more sensitive to the likelihood of a major increase in US government spending under single-party Democratic control. Chart 1A Blue Sweep Is Bond Bearish A Blue Sweep Is Bond Bearish A Blue Sweep Is Bond Bearish According to a recent analysis done by the Committee for a Responsible Federal Budget, President Trump’s formal policy proposals would increase US federal debt by $4.95 trillion between 2021 and 2030, while Biden’s plan would increase the debt by $5.60 trillion (Table 1).1 While those are both massive fiscal stimulus plans, there is a stark difference in the policy mix of their proposals that matters for the future path of US bond yields. Table 1A Comparison Of The Candidates' Budget Proposals Beware The Bond-Bearish Blue Sweep Beware The Bond-Bearish Blue Sweep Under Biden, spending is projected to increase by a cumulative $11.1 trillion, partially offset by $5.8 trillion in revenue increases and savings with the former vice-president calling for tax hikes on corporations and high-income earners. On the other hand, Trump’s plan includes $5.45 trillion of spending increases and tax cuts over the next decade, offset by $0.75 trillion in savings. Conclusion: Biden would increase spending by over twice that of a re-elected Trump, with much of that spending expected to be front-loaded in the early part of his first term. Outright spending is more reflationary than tax cuts because it puts more money in the pockets of consumers (spenders) relative to producers (savers). The Biden plan would be more stimulating for overall activity even if the increase in debt is about the same. Another analysis of the Biden and Trump platforms was conducted by Moody’s in September, based on estimates of how much of each candidate’s promises could be successfully implemented under different combinations of White House and Congressional control.2 The stimulus figures were run through the Moody’s US economic model, which is similar to the budget scoring model of the US Congressional Budget Office, to produce a year-by-year path for the US economy over the next decade (Chart 2). Chart 2The Biden Platform Is Highly Stimulative The Biden Platform Is Highly Stimulative The Biden Platform Is Highly Stimulative Moody’s concluded that the US economy would return to full employment in the second half of 2022 under a President Biden – especially if the Democrats win the Senate - compared to the first half of 2024 under a re-elected President Trump. Such a rapid closing of the deep US output gap that opened up because of the COVID-19 recession would likely trigger a reassessment of the Fed’s current highly dovish policy stance. The US output gap would close more rapidly under a President Biden, likely triggering a reassessment of the Fed’s current highly dovish policy stance.  At the moment, the US overnight index swap (OIS) curve discounts one full 25bp Fed hike by late 2023/early 2024, and two full hikes by late 2024/early 2025 (Chart 3). This pricing of the future path of interest rates has occurred even with the Fed promising to keep the funds rate anchored near 0% until at least the end of 2023. The likelihood of some form of increased fiscal spending after the election will cause the bond market to challenge the Fed’s current forward guidance even more, putting upward pressure on Treasury yields. Chart 3US Fiscal Stimulus Will Pull Forward Fed Liftoff US Fiscal Stimulus Will Pull Forward Fed Liftoff US Fiscal Stimulus Will Pull Forward Fed Liftoff Our colleagues at BCA Geopolitical Strategy see a Blue Sweep as the most likely outcome of the US election, although their forecasting models suggest that the race for control of the Senate will be much closer than the Biden vs Trump battle (there is little chance that control of the House of Representatives would switch back to the Republicans).3 Their scenarios for each of the White House/Senate combinations, along with their own estimated probability for each, are the following: Biden wins in a Democratic sweep: BCA probability = 45%. The US economy will benefit from higher odds of unfettered fiscal stimulus in 2021, although financial markets will simultaneously have to adjust for the negative shock to US corporate earnings from higher taxes and regulation. Government bond yields should rise on the generally reflationary agenda. Trump wins with a Republican Senate: BCA probability = 30%. In this status quo scenario, a re-elected President Trump would still face opposition from House Democrats on most domestic economic issues, forcing him to tilt towards more protectionist foreign and trade policies in his second term. Fiscal stimulus would be easy to agree, though not as large as under a Democratic sweep. US Treasury yields would rise, but would later prove volatile due to the risk to the cyclical recovery from a global trade war, as Trump’s tariffs will not be limited to China and could even affect the European Union. Biden wins with the Senate staying Republican: BCA probability = 20%. This is ultimately the most positive outcome for financial markets - reduced odds of a full-blown trade war with China, combined with no new tax hikes. Bond yields would drift upward over time, but not during the occasional fiscal battles that would ensue between the Democratic president and Republican senators. The first such battle would start right after the election. Treasuries would remain well bid until financial market pressures forced a Senate compromise with the new president sometime in H1 2021. Trump wins with a Democratic Senate: BCA probability = 5%. This is the least likely scenario but one that could produce a big positive fiscal impulse. Trump is a big spender and will veto tax hikes, but will approve populist spending on areas where he agrees. The Democratic Senate would not resist Trump’s tough stance on China, however, thus keeping the risk of US-China trade skirmishes elevated. This is neutral-to-bearish for US Treasuries, depending on the size of any bipartisan stimulus measures and Trump’s trade actions. The key takeaway is that the combined probability of scenarios that will put upward pressure on US Treasury yields is 80%, versus a 20% probability of a more bond-neutral outcome. That is a bond-bearish skew worth positioning for by reducing US duration exposure now, ahead of the November 3 election. Of this 80%, 35 percentage points come from scenarios in which President Trump would remain in power. Hence his trade wars would eventually undercut his reflationary fiscal policy. This would become the key risk to the short duration view after the initial market response. Bottom Line: The most likely scenarios for the US election will give a cyclical lift to US Treasury yields via increased fiscal stimulus. This justifies a move to a below-benchmark US duration stance on a 6-12 month horizon. If Trump is re-elected, the timing of Trump’s likely return to using broad-based tariffs will have to be monitored closely. A Moderate Bear Market Chart 4Less Election-Day Upside Than In 2016 Less Election-Day Upside Than In 2016 Less Election-Day Upside Than In 2016 While our anticipated Blue Sweep election outcome will lead to a large amount of fiscal spending in 2021 and beyond, we anticipate only a modest increase in bond yields during the next 6-12 months. In terms of strategy, our recommended reduction in portfolio duration reflects the fact that fiscal largesse meaningfully reduces the risk of another significant downleg in bond yields and strengthens our conviction in a moderate bear market scenario for bonds. This does raise the question of how large an increase in US Treasury yields we expect during the next 6-12 months. We turn to this question now. Not Like 2016 First, we do not expect a massive election night bond rout like we saw in 2016 (Chart 4). For one thing, the Fed was much more eager to tighten policy in 2016 than it is today, and it did deliver a rate hike one month after the Republicans won the House, Senate and White House (Chart 4, bottom panel). This time around, the Fed has made it clear that it will wait until inflation is running above its 2% target before lifting rates off the zero bound and will not respond directly to expectations for greater fiscal stimulus. A complete re-convergence to long-run fed funds rate estimates would impart 80 – 100 bps of upward pressure to the 5-year/5-year forward Treasury yield. Second, 2016’s election result was mostly unanticipated. This led to a dramatic adjustment in market prices once the results came in. The PredictIt betting market odds of a “Red Sweep” by the Republicans in 2016 were only 16% the night before the election. As of today, the betting markets are priced for a 58% chance of a Blue Sweep in 2020. Unlike in 2016, bonds are presumably already partially priced for the most bond-bearish election outcome. A Slow Return To Equilibrium To more directly answer the question of how high bond yields can rise, survey estimates of the long-run (or equilibrium) federal funds rate provide a useful starting point. In a world where the economy is growing at an above-trend pace and inflation is expected to move towards the Fed’s target, it is logical for long-maturity Treasury yields to settle near estimates of the long-run fed funds rate. Indeed, this theory is borne out empirically. During the last two periods of robust global economic growth (2017/18 & 2013/14), the 5-year/5-year forward Treasury yield peaked around levels consistent with long-run fed funds rate estimates (Chart 5). As of today, the median estimates of the long-run fed funds rate from the New York Fed’s Survey of Market Participants and Survey of Primary Dealers are 2% and 2.25%, respectively. In other words, a complete re-convergence to these equilibrium levels would impart 80 – 100 bps of upward pressure to the 5-year/5-year forward Treasury yield. We expect this re-convergence to play out eventually, but probably not within the next 6-12 months. In both prior periods when the 5-year/5-year forward Treasury yield reached these equilibrium levels, the Fed’s reaction function was much more hawkish. The Fed was hiking rates throughout 2017 & 2018 (Chart 5, panel 4), and the market moved quickly to price in rate hikes in 2013 (Chart 5, bottom panel). The Fed’s new dovish messaging will ensure that the market reacts less quickly this time around. Also, continued curve steepening will mean that the 5-year/5-year forward yield’s 80 – 100 bps of upside will translate into significantly less upside for the benchmark 10-year yield. The 10-year yield and 5-year/5-year forward yield peaked at similar levels in 2017/18 when the Fed was lifting rates and the yield curve was flat (Chart 6). But, the 10-year peaked far below the 5-year/5-year yield in 2013/14 when the Fed stayed on hold and the curve steepened. Chart 5How High For Treasury Yields? How High For Treasury Yields? How High For Treasury Yields? Chart 6Less Upside In 10yr Than In 5y5y Less Upside In 10yr Than In 5y5y Less Upside In 10yr Than In 5y5y The next bear move in bonds will look much more like 2013/14. The Fed will keep a firm grip over the front-end of the curve, leading to curve steepening and less upside in the 10-year Treasury yield than in the 5-year/5-year forward. In addition to shifting to a below-benchmark duration stance, investors should maintain exposure to nominal yield curve steepeners. Specifically, we recommend buying the 5-year note versus a duration-matched barbell consisting of the 2-year and 10-year notes (Chart 6, bottom panel).4 TIPS Versus Nominals We have seen that a full re-convergence to “equilibrium” implies 80 – 100 bps of upside in the 5-year/5-year forward nominal Treasury yield. Bringing TIPS into the equation, we have also observed that long-maturity (5-year/5-year forward and 10-year) TIPS breakeven inflation rates tend to settle into a range of 2.3 – 2.5 percent when inflation is well-anchored and close to the Fed’s target (Chart 7). The additional fiscal stimulus that will follow a Blue Sweep election makes it much more likely that the economic recovery will stay on course, leading to an eventual return of inflation to target and of long-maturity TIPS breakeven inflation rates to a 2.3 – 2.5 percent range. However, as with nominal yields, this re-convergence will be a long process whose pace will be dictated by the actual inflation data. To underscore that point, consider that our Adaptive Expectations Model of the 10-year TIPS breakeven inflation rate – a model that is driven by trends in the actual inflation data – has the 10-year breakeven rate as close to fair value (Chart 8).5 This fair value will rise only slowly over time, alongside increases in actual inflation. Chart 7Overweight TIPS Versus Nominals Overweight TIPS Versus Nominals Overweight TIPS Versus Nominals Chart 8Real Yields Have Likely Bottomed Real Yields Have Likely Bottomed Real Yields Have Likely Bottomed All in all, we continue to recommend an overweight allocation to TIPS versus nominal Treasuries. TIPS breakeven inflation rates will move higher during the next 6-12 months, but are unlikely to reach our 2.3 – 2.5 percent target range within that timeframe. TIPS In Absolute Terms As stated above, we expect nominal yields to increase more than real yields during the next 6-12 months, but what about the absolute direction of real (aka TIPS) yields? Here, our sense is that real yields have also bottomed. If we consider the extreme scenario where the 5-year/5-year forward nominal yield returns to its equilibrium level and where long-maturity TIPS breakeven inflation rates return to our target range, it implies about 80 bps of upside in the nominal yield and 40 bps of upside in the breakeven. This means that the 5-year/5-year real yield has about 40 bps of upside in a complete “return to equilibrium” scenario. While we don’t expect this “return to equilibrium” to be completed within the next 6-12 months, the process is probably underway. The only way for real yields to keep falling in this reflationary world is for the Fed to become increasingly dovish, even as growth improves and inflation rises. After its recent shift to an average inflation target, our best guess is that Fed rate guidance won’t get any more dovish from here. Real yields fell sharply this year as the market priced in this change in the Fed’s reaction function, but the late-August announcement of the Fed’s new framework will probably mark the bottom in real yields (Chart 8, bottom panel).6 Two More Curve Trades Chart 9Own Inflation Curve Flatteners And Real Curve Steepeners Own Inflation Curve Flatteners And Real Curve Steepeners Own Inflation Curve Flatteners And Real Curve Steepeners In addition to moving to below-benchmark duration, maintaining nominal yield curve steepeners and staying overweight TIPS versus nominal Treasuries, there are two additional trades that investors should consider in order to profit from the reflationary economic environment. The first is inflation curve flatteners. The cost of short-maturity inflation protection is below the cost of long-maturity inflation protection, meaning that it has further to run as inflation returns to the Fed’s target (Chart 9). In addition, if the Fed eventually succeeds in achieving a temporary overshoot of its inflation target, then we should expect the inflation curve to invert. Real yield curve steepeners are in some ways the mirror image of inflation curve flatteners. Assuming no change in nominal yields, the real yield curve will steepen as the inflation curve flattens. But what makes real yield curve steepeners look even more attractive is that increases in nominal yields during the next 6-12 months will be concentrated in long-maturities. This will impart even more steepening pressure to the real yield curve. Investors should continue to hold inflation curve flatteners and real yield curve steepeners. Bottom Line: We anticipate a moderate bear market in US Treasuries to unfold during the next 6-12 months. In addition to below-benchmark portfolio duration, investors should overweight TIPS versus nominal Treasuries, hold nominal and real yield curve steepeners, and hold inflation curve flatteners. Non-US Government Bonds: Reduce Exposure To US Treasuries The mildly bearish case for US Treasuries that we have laid out above not only matters for our recommended duration stance, but also for our suggested country allocation within global government bond portfolios. Simply put, the risk of rising bond yields is much higher in the US than elsewhere, both for the immediate post-election period but also over the medium-term. Thus, the immediate obvious portfolio decision is to downgrade US Treasuries to underweight. The move higher in US Treasury yields that we expect is strictly related to spillovers from likely US fiscal stimulus. While other countries in the developed world are contemplating the need for additional fiscal measures, particularly in Europe where there is a renewed surge in coronavirus infections and growing economic restrictions, no country is facing as sharp a policy choice as the US with its upcoming election. The Fed has purchased 57% of all US Treasuries issued since late February of this year, in sharp contrast to the ECB and Bank of Japan that have purchased over 70% of euro area government bonds and JGBs issued. We can say with a fair degree of certainty that the US will have a relatively more stimulative fiscal policy stance than other developed economies over at least the next couple of years. This implies a higher relative growth trajectory for the US that hurts Treasuries more on the margin than non-US government debt. Chart 10The Fed Will Gladly Trade Less QE For More Fiscal Stimulus Beware The Bond-Bearish Blue Sweep Beware The Bond-Bearish Blue Sweep In addition, the likely path of relative monetary policy responses are more bearish for US Treasuries. As described above, the scope of the US stimulus will cause bond investors to further question the Fed’s commitment to keeping the funds rate unchanged for the next few years. That also applies to the Fed’s other policy tools, like asset purchases. The Fed is far less likely to continue buying US Treasuries at the same aggressive pace it has for the past eight months if there is less need for monetary stimulus because of more fiscal stimulus. According to the IMF, the Fed has purchased 57% of all US Treasuries issued since late February of this year, in sharp contrast to the ECB and Bank of Japan that have purchased over 70% of euro area government bonds and JGBs issued (Chart 10). If US Treasury yields are rising because of improving US growth expectations, fueled by fiscal stimulus, the Fed will likely tolerate such a move and buy an even lower share of Treasuries issued – particularly if the higher bond yields do not cause a selloff in US equity markets that can tighten financial conditions and threaten the growth outlook. The fact that US equities have ignored the rise in Treasury yields seen since the end of September may be a sign that both bond and stock investors are starting to focus on a faster trajectory for US growth. In terms of country allocation, beyond downgrading US Treasuries to underweight, we recommend upgrading exposure to countries that are less sensitive to changes in US Treasury yields (i.e. countries with a lower yield beta to changes in US yields). In Chart 11, we show the rolling beta of changes in 10-year government bond yields outside the US to changes in 10-year US Treasury yields. This is a variation of the “global yield beta” concept that we have discussed in the BCA Research bond publications in recent years. Here, we modify the idea to look at which countries are more or less correlated to US yields, specifically. A few points stand out from the chart: Chart 11Reduce Exposure To Bond Markets More Correlated To UST Yields Reduce Exposure To Bond Markets More Correlated To UST Yields Reduce Exposure To Bond Markets More Correlated To UST Yields All countries have a “US yield beta” of less than 1, suggesting that Treasuries are a consistent outperformer when US yields fall and vice versa. This suggests moving to underweight the US when US yields are rising is typically a winning strategy in a portfolio context. The list of higher beta countries includes Canada, Australia, New Zealand, the UK and Germany; although Canada stands out as having the highest yield beta in this group. The list of lower beta countries includes France, Italy, Spain, and Japan. In Chart 12, we show what we call the “upside yield beta” that is estimated only using data for periods when Treasury yields are rising. This gives a sense of which countries are more likely to outperform or underperform during a period of rising Treasury yields, as we expect to unfold after the election. From this perspective, the “safer” lower US upside yield beta group includes the UK, France, Germany and Japan. The riskier higher US upside yield beta group includes Canada, Australia, New Zealand, Italy and Spain. Chart 12Favor Bond Markets Less Correlated to RISING UST Yields Favor Bond Markets Less Correlated to RISING UST Yields Favor Bond Markets Less Correlated to RISING UST Yields Spain and Italy are less likely to behave like typical high-beta countries as US yields rise, however, because the ECB is likely to remain an aggressive buyer of their government bonds as part of their asset purchase programs over the next 6-12 months. We also do not recommend trading UK Gilts off their yield beta to US Treasuries in the immediate future, given the uncertainties over the negotiations over a final Brexit deal. Both sets of US yield betas suggest higher-beta Canada, Australia and New Zealand are more at risk of relative underperformance versus lower-beta France, Germany and Japan. In terms of government bond country allocation, we recommend reducing exposure to the former group and increasing allocations to the latter group. Bottom Line: Within global government bond portfolios, downgrade the US to underweight. Favor countries that have lower sensitivity to rising US Treasury yields, especially those with central banks that are likely to be more dovish than the Fed in the next few years. That means increasing allocations to core Europe and Japan, while reducing exposure to “higher-beta” Canada and Australia.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 http://www.crfb.org/papers/cost-trump-and-biden-campaign-plans 2 https://www.moodysanalytics.com/-/media/article/2020/the-macroeconomic-consequences-trump-vs-biden.pdf 3 Please see BCA Research Geopolitical Strategy Special Report, “Introducing Our Quantitative US Senate Election Model”, dated October 16, 2020, available at gps.bcaresearch.com 4 For more details on this recommended steepener trade please see US Bond Strategy Weekly Report, “Positioning For Reflation And Avoiding Deflation”, dated August 11, 2020, available at usbs.bcaresearch.com 5 For more details on our Adaptive Expectations Model please see US Bond Strategy Weekly Report, “How Are Inflation Expectations Adapting?”, dated February 11, 2020, available at usbs.bcaresearch.com 6 For a detailed look at the implications of the Fed’s policy shift please see US Bond Strategy / Global Fixed Income Strategy Special Report, “A New Dawn For US Monetary Policy”, dated September 1, 2020, available at usbs.bcaresearch.com

Highlights The US saves too much to achieve full employment but not enough to close the current account deficit. According to the “Swan diagram,” a weaker dollar would move the US economy closer to “external” and “internal” balance. Structural forces are unlikely to have much effect on the value of the dollar over the next few years: The neutral rate of interest is higher in the US than in most other developed economies; the US still earns more on its overseas assets than it pays on its liabilities; and there is no meaningful competition to the dollar’s reserve currency status. Cyclical forces, in contrast, will become more dollar-bearish over the coming months: A vaccine would buoy the global economy next year; interest rate differentials have moved sharply against the dollar; and further fiscal stimulus should lift US inflation expectations. Stocks tend to outperform bonds when the dollar is weakening. Investors should remain overweight global equities on a 12-month horizon, favoring non-US stocks and cyclical sectors. A Clash Of Views? Today marked the last day of BCA’s Annual Investment Conference, held virtually this year in light of the pandemic. As in past years, it was a star-studded cavalcade of the who’s who in financial and policymaking circles. I always find it interesting when two of our speakers seemingly disagree on a critical issue. Such was the case with Larry Summers and Stephen Roach. Larry kicked off the proceedings with an update of his secular stagnation thesis. He argued that his thesis had gone from “a hypothesis that needed to be considered” to a “presumptively accurate analysis of the status quo.” In Larry’s mind, the core problem facing the US and most other economies is a surplus of savings. Excess savings results in a chronic shortfall of spending relative to an economy’s productive capacity. Faced with the challenge of maintaining adequate employment, central banks have been forced to cut rates to extraordinarily low levels. Perpetually easy monetary policy has periodically spawned destabilizing asset bubbles. Larry recommends that governments ease fiscal policy in order to take the burden off central banks. Later that morning, we heard from Stephen Roach. Stephen expects the real US trade-weighted dollar to weaken by 35% by the end of next year. What’s behind this bearish forecast? The answer, according to Stephen, is that the US economy suffers from a shortage of savings. Unable to generate enough domestic savings to cover its investment needs, the US has ended up running persistent current account deficits. How can the US be saving too much, as Larry Summers claims, while also saving too little, as Stephen Roach insists? The two views seem utterly unreconcilable. In fact, I think there is a way to reconcile them with something called the Swan diagram. The Swan Diagram True to the reputation of economics as the dismal science, the Swan diagram – named after Australian economist Trevor Swan – depicts four “zones of economic unhappiness” (Chart 1). Each zone represents a different way in which an economy can deviate from “internal balance” (full employment and stable inflation) and “external balance” (a current account balance that is neither in deficit nor in surplus). Chart 1The Swan Diagram And The Four Zones Of Unhappiness Does The US Save Too Much Or Too Little? Does The US Save Too Much Or Too Little? The four zones are: 1) high unemployment and a current account deficit; 2) high unemployment and a current account surplus; 3) overheating and a current account deficit; and 4) overheating and a current account surplus. The horizontal axis of the Swan diagram depicts the budget deficit. A rightward movement along the horizontal axis corresponds to an easing of fiscal policy. The vertical axis depicts the real exchange rate. An upward movement along the vertical axis corresponds to a currency appreciation. The external balance schedule is downward sloping because an easing of fiscal policy raises aggregate demand (which boosts imports, resulting in a current account deficit). To restore the current account balance to its original level, the currency must weaken. A weaker currency will spur exports, while curbing imports. The internal balance schedule is upward sloping because an easing in fiscal policy must be offset by a stronger currency in order to keep the economy from overheating. The US presently finds itself in the top quadrant of the Swan diagram: It saves too much to achieve internal balance, but not enough to achieve external balance. From this perspective, both Larry Summers and Stephen Roach are correct. Unlike the US, the euro area, Japan, and China run current account surpluses. Rather than pursuing currency depreciation, the Swan diagram says that all three economies would be better off with more fiscal easing. What It Would Take To Eliminate The US Trade Deficit By how much would the real trade-weighted US dollar need to weaken to achieve external balance? According to the New York Fed, a 10% dollar depreciation raises export volumes by 3.5% after two years, while reducing import volumes by 1.6%.1 Given that exports and imports account for 12% and 15% of GDP, respectively, this implies that a 10% dollar depreciation would improve the trade balance by 0.12*0.035+0.15*0.016=0.7% of GDP. Considering that the trade deficit is around 3% of GDP, the dollar may need to weaken by 30%-to-50% to eliminate the trade deficit, a range which encompasses Stephen Roach’s projection for the dollar’s decline.  Don’t Hold Your Breath In practice, we doubt that the dollar will decline anywhere close to that much. Despite a net international investment position of negative 67% of GDP, the US still generates substantially more income from its overseas assets than it pays to service its liabilities (Chart 2). This reflects the fact that US foreign liabilities are skewed towards low-yielding government bonds, while its assets largely consist of higher-yielding equities and foreign direct investment (Chart 3). Chart 2The US Generates More Income From Its Overseas Assets Than It Pays On Its Liabilities The US Generates More Income From Its Overseas Assets Than It Pays On Its Liabilities The US Generates More Income From Its Overseas Assets Than It Pays On Its Liabilities Chart 3A Breakdown Of US Assets And Liabilities Does The US Save Too Much Or Too Little? Does The US Save Too Much Or Too Little? Given that the Fed will keep rates on hold at least until end-2023, it is unlikely that US government interest payments will rise substantially in the next few years. Faster Growth Helps Explain America’s Chronic Current Account Deficit The neutral rate of interest is higher in the US than in most other developed economies. Economic theory suggests that global capital will flow towards countries with higher interest rates, producing current account deficits (Chart 4).2 Chart 4Interest Rates And Current Account Balances Does The US Save Too Much Or Too Little? Does The US Save Too Much Or Too Little? The higher neutral rate in the US can be partly attributed to faster trend GDP growth. There are three reasons why faster growth will raise investment while lowering savings, thus leading to a current account deficit: Faster-growing economies require more investment spending to maintain an adequate capital stock. For example, if a country wants to maintain a capital stock-to-GDP ratio of 200% and is growing at 3% per year, it would need to invest (after depreciation) 6% of GDP. A country growing at 1% would need to invest only 2% of GDP. Governments may wish to run larger budget deficits in faster-growing economies in the belief that they will be able to outgrow their debt burdens. To the extent that faster growth may reflect productivity gains, households may choose to spend more and save less in anticipation of higher real incomes in the future. While trend growth is just one of several factors influencing the balance of payments, in general, the evidence does suggest that fast-growing developed economies such as the US and Australia have tended to run current account deficits, while slower-growing economies such as the euro area and Japan have generally run current account surpluses (Chart 5). Chart 5Fast-Growing Developed Economies Tend To Run Current Account Deficits, While Slower- Growing Economies Tend To Run Surpluses Does The US Save Too Much Or Too Little? Does The US Save Too Much Or Too Little? The Dollar’s Reserve Currency Status Is Not In Any Jeopardy Even if many commentators do tend to overstate the importance of having a reserve currency, the dollar’s special status in the global financial system will still provide it with support. The US dollar’s share of global central bank reserves stood at 61.3% in the second quarter of 2020, only modestly lower than where it was a decade ago (Chart 6). While the euro area is not at risk of collapse, it remains an artificial political entity. China’s role in the global economy continues to increase. However, the absence of an open capital account limits the yuan’s appeal. Chart 6The US Dollar’s Share Of Global Central Bank Reserves Has Barely Fallen Does The US Save Too Much Or Too Little? Does The US Save Too Much Or Too Little? Then there’s the dollar’s first mover advantage. During our conference, Marc Chandler likened the greenback to the QWERTY keyboard: It may not be perfect, but like it or not, it has become the default choice for typing.  I like to equate the dollar’s role with that of the English language. When a Swede has a business meeting with another Swede, they will speak in Swedish. However, when a Swede has a business meeting with an Indonesian, chances are they will speak in English. By the same token, when a Swede wants to purchase Indonesian rupiah, the bank is unlikely to convert krona directly to rupiah since the probability is low that many people will just happen to be looking to exchange rupiah for krona at precisely the same time. Rather, the bank will first convert the krona to US dollars and then convert the dollars to rupiah. The dollar is the hub of the global financial system. Just like the pound remained the global currency long after the sun had set on the British Empire, King Dollar will endure for many years to come. Cyclical Forces Will Drive The Dollar Lower Chart 7The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency The discussion above suggests that structural forces are unlikely to have much effect on the value of the dollar for the foreseeable future. Cyclical forces, in contrast, will become more dollar-bearish over the coming months. The US dollar is a countercyclical currency, meaning that it tends to move in the opposite direction of the global business cycle (Chart 7). According to the Good Judgment Project, there is a 43% chance that a Covid vaccine will be available by the first quarter of 2021, and a 91% chance it will be available by the end of the third quarter (Chart 8). A vaccine would supercharge global growth, causing the dollar to weaken.   Chart 8When Will A Vaccine Become Available? Does The US Save Too Much Or Too Little? Does The US Save Too Much Or Too Little? Interest rate differentials have moved considerably against the dollar – more so, in fact, than one would have expected based on the fairly modest depreciation that the greenback has experienced thus far (Chart 9). Chart 9A Relatively Muted Decline In The Dollar Given The Move In Real Yield Differentials A Relatively Muted Decline In The Dollar Given The Move In Real Yield Differentials A Relatively Muted Decline In The Dollar Given The Move In Real Yield Differentials Chart 10Stocks Tend To Outperform Bonds When The Dollar Is Weakening... As Do Non-US Stocks Versus US Stocks Tend To Outperform Bonds When The Dollar Is Weakening... As Do Non-US Stocks Versus US Stocks Tend To Outperform Bonds When The Dollar Is Weakening... As Do Non-US Stocks Versus US   An open question is how additional fiscal support will affect the dollar and other financial assets. Equity investors have brushed off the dwindling prospects for a pandemic relief bill before the election on the assumption that a “blue sweep” will allow the Biden administration to enact even more stimulus than was possible under President Trump and a Republican senate. The dollar rallied in the weeks following Donald Trump’s victory. The dollar also surged in the early 1980s after Ronald Reagan lowered taxes and raised military spending. A key difference between now and then is that real interest rates rose during both of those two prior episodes. Today, the Fed is firmly on hold. This implies that real rates are unlikely to rise much, and could even fall if inflation expectations move up in response to easier fiscal policy. Stocks tend to outperform bonds when the dollar is weakening (Chart 10). In particular, stock markets outside the US often do well in a soft-dollar environment. Investors should remain overweight equities on a 12-month horizon, favoring non-US stocks and cyclical sectors.   Peter Berezin Chief Global Strategist peterb@bcaresearch.com   Footnotes 1  Mary Amiti, and Tyler Bodine-Smith, “The Effect of the Strong Dollar on U.S. Growth,” Liberty Street Economics, (July 17, 2015). 2 There are many different ways to measure the neutral rate. As depicted in Chart 4, capital flows tend to equalize the neutral rate across countries. This is another way of saying that the neutral rate would be higher in the US were it not for the fact that the US runs a current account deficit.   Global Investment Strategy View Matrix Does The US Save Too Much Or Too Little? Does The US Save Too Much Or Too Little? Current MacroQuant Model Scores Does The US Save Too Much Or Too Little? Does The US Save Too Much Or Too Little? ​​​​​​​

Highlights The US Senate election is as important as the presidency for US politics and markets. Our quantitative Senate election model suggests Democrats will win control – as we have long argued – but there is a 49% chance that they do not, which is higher than consensus. A Republican Senate under a Biden presidency is positive for US stocks relative to global. Corporate taxes will stay put. However, fiscal reflation will have to be earned through tough budget battles, which will raise hurdles for markets. The Democratic sweep scenario is generating excessive enthusiasm in the media, as taxes will rise, but it is ultimately reflationary. It will benefit global stocks more than US stocks. Feature Chart 1Democratic Sweep Favors Global Stocks Versus US Democratic Sweep Favors Global Stocks Versus US Democratic Sweep Favors Global Stocks Versus US Throughout the year we have argued that, as a base case for the US election, investors should expect that the pandemic, recession, and widespread social unrest in the United States would culminate in an anti-incumbent movement among voters. President Trump and the Republicans would lose the White House and Senate in a Democratic sweep. The implication for markets was that, after election volatility, global equities would rally in expectation of less hawkish US foreign and trade policy, while US equities would underperform on the expectation of higher taxes and regulation at home. This view has now become the market consensus (Chart 1). However, our quantitative US election model – which does not rely on head-to-head opinion polling – has recently given President Trump a 49% chance of winning in the latest reading. It is flagging a Biden victory but is essentially “too close to call” (Chart 2). The rapid snapback in the economy provides a basis for Trump to make an eleventh-hour comeback, contrary to optics. Chart 2Quant Model Shows Trump Loss, But 49% Odds Of Winning Introducing Our Quantitative US Senate Election Model Introducing Our Quantitative US Senate Election Model In this report we present our quant model for the US Senate election, updated for the 2020 cycle. The Senate model is constructed with similar variables, though not exactly the same, and the result is that Democrats are favored to win control but only slightly. The implication is that Democrats are currently overrated by markets and that the election could still go either way. Uncertainty will go up for the remainder of the month. Ultimately we are sticking with our original forecast unless Trump and the Republicans regain momentum in opinion polling, but our models are flagging major risk. Investors should expect volatility to rise in the short term. We will maintain our tactical risk-off trades, since the risk of a contested election and/or a Trump re-election (and hence renewed global trade war) is rising. The Foundations Of Our Senate Model BCA Geopolitical Strategy developed a US Senate election model in September 2018 which quantified the margin of victory for the GOP among several Senate races during the 2018 mid-term election. The beta model focused on modeling individual Senate races, those deemed competitive by BCA’s Geopolitical Strategy at the time, by combining state and national level economic and political variables as well as the latest polling data applicable to each race.1 We are now re-introducing this model, but with a twist: this time we are adopting the same methodology as per our US presidential election model. The result is a state-by-state model that predicts the number of seats the incumbent party will win in the Senate election on November 3, 2020. Like our US election model, our Senate model is based off a probit model that produces a probability that each state will remain under the control of the incumbent party. The dependent variable (classified as “elected”) is stated as 1 = incumbent party wins the Senate election in each state; or 0 = incumbent party does not win the Senate election in each state. This method allows us to measure the probability that a state with certain characteristics will fall into one of these two categories. Therefore we can predict the probability of the incumbent party winning all the Senate seats in each of the 50 states (though, of course, this is only relevant to the one-third of the states that have a Senate seat up for election in 2020). Our model would have predicted the past five Senate election outcomes correctly on an in-sample basis and the past four Senate elections on an out-sample basis. Unlike our presidential election model, which sampled nine elections (1984 to 2016), our sample size for the Senate model is notably larger. That is, our sample consists of 18 Senate elections (1984 to 2018), across 50 states, amounting to 900 observations. While midterm Senate elections are different from those held during a presidential election year, we would not want to exclude the information they provide. The 2018 Senate race has a bearing on our 2020 prediction and this is appropriate. The Senate Model’s Variables Our Senate model includes six explanatory variables: 1. The Federal Reserve Bank of Philadelphia State Coincident Index. The coincident index for each state combines four of the state’s indicators to summarize current economic conditions in a single statistic. The four indicators are nonfarm payroll employment; average hours worked in manufacturing by production workers; the unemployment rate; and wage and salary disbursements plus proprietors' income deflated by the consumer price index (U.S. city average). Like in our US Presidential model, we applied several transformations to the data to obtain meaningful results in the modeling process. We found that using a three-month change of the state coincident index in our Senate model provided the most statistically significant result. Our Senate model suggests that Republican odds of winning are underrated by online betting markets, as with our presidential model. The three-month change of all the monthly state coincident indexes are given heavier weight as we approach the Senate election early in November. However, we only include the preceding year of a Senate election up until September of the election year (i.e. the last data release in October prior to the election itself). Senate elections occur every two years, and we excluded data that has been accounted for in previous elections. As we highlighted in the update of our US Election model we assume that prevailing economic conditions matter most to voters (as future expectations inevitably affect people’s assessment of their current situation), and this bolsters our rationale in using a 3-month change of the state coincident index. 2. The incumbent party’s margin of victory in previous Senate elections in each state Senate race. This is measured as the incumbent party’s share of the popular vote minus the non-incumbent party’s share. If the incumbent party failed to secure a solid win in each state in the previous Senate election, the probability of securing a solid win in the current election becomes smaller. Moreover, the larger the margin of victory in a previous Senate election race, the more likely that incumbent party will win re-election in said state. 3. Net average approval level of the incumbent president in a Senate election year. This is the difference between the incumbent president’s approval and disapproval levels in a Senate election year, from the start of the year up until the end of October of that year – taken as an average. 4. Generic congressional ballot (net support rate). The generic congressional ballot asks people which party they are likely to vote for in Congress. We take the average net support rate in a Senate election year (that being whichever party leads the other in congressional ballot polling). Democrats are usually favored in congressional generic ballot voting, so the net rate is more predictive than the gross rate 5. Dummy variable for congressional ballot. A dummy variable is assigned to variable number four. For example, dummy takes the value of 1 when Democrats have a positive net support rate in generic congressional ballot voting, and 0 when Republicans have a net positive support rate. We assign only one dummy variable to avoid a dummy variable trap.2 6. A “time for change” variable, a categorical variable indicating whether the incumbent party has controlled the Senate for three or more terms (six or more years). If the Senate has been controlled by the incumbent party for three or more terms, the model will “punish” the incumbent party, as we would expect to see a change in control of the Senate the longer one incumbent party controls it. Estimating The Model Since this is a probit model, the coefficients cannot be directly interpreted like in an ordinary regression.3 In Table 1, the sign of the coefficient corresponds to the direction of change in probability. An increase in the State Coincident Index, the incumbent’s margin of victory in previous Senate races, net approval of the incumbent president and generic congressional support ballot, all increase the probability of the incumbent winning a Senate election in a state. Table 1Senate Model Regression Coefficients Introducing Our Quantitative US Senate Election Model Introducing Our Quantitative US Senate Election Model Meanwhile occupying the Senate for more than three terms serves as a “punishment” and would decrease the probability of winning a Senate election in a state. The output of our model is the probability of an incumbent win in each state. As in our US Presidential election model, there are two ways of aggregating these probabilities to produce a national-level outcome: Proportional: Allocate the number of Senate seats won by the incumbent proportionally to their probability of victory in each state, and then sum them up across all states. Winner Takes All: As we do in our US Presidential election model, assume a probability threshold of 50%: any state with an incumbent win that is at least 50% likely is fully assigned to the incumbent. The latter, winner takes all, is the aggregation method we base our Senate prediction on. Senate Election Model Prediction Table 2 shows our 2020 prediction. Overall, the Republican Party is expected to win 49 Senate seats, a decrease of four seats from its current 53-seat majority. This means that the Democrats are expected to control the Senate with 51 seats (this includes Independents that caucus with Democrats). Moreover, the model suggests that Republicans have a 49% chance of retaining Senate control. Table 2Predicted 2020 Senate Balance Of Power Introducing Our Quantitative US Senate Election Model Introducing Our Quantitative US Senate Election Model This is substantially higher than consensus, which has put Republicans at 42% throughout the past month and currently has them at 37% (Chart 3). As with our presidential model, the rapid recovery in the state economic indicators is providing the Republicans with a last-minute boost that contradicts the gloomier picture painted by opinion polls. We do not think they will retain the Senate, but our conviction level is now lower. Chart 3Betting Market Overrates Democratic Odds Of Winning Senate Introducing Our Quantitative US Senate Election Model Introducing Our Quantitative US Senate Election Model In terms of Senate seats, our model expects Republicans to lose Arizona, Colorado, Maine, Montana, and North Carolina. This is enough for Democrats to obtain 51 seats, a majority, assuming that they lose Alabama. The full list of states that have Senate races in 2020 and the probabilities of a Republican win according to the model are shown in Chart 4. Chart 4Quant Model Shows Democrats Win Senate, But GOP Odds 49% Introducing Our Quantitative US Senate Election Model Introducing Our Quantitative US Senate Election Model Three Senate races are classified as toss-ups, which we define as having a probability between 45% and 55% according to the model. These states are Iowa (54%), Maine (48%) and North Carolina (49%). Montana is close to a toss-up, with a 44% chance of a Republican win. We expect Democrats to win control of the Senate with 51 votes. They need 50, plus the White House, to have a majority. Of these states, if Republicans retain any two, then they will retain their majority, so control of the Senate is on a knife’s edge. Chart 5 shows the odds for each of the 12 swing states in this election. Chart 5Our Senate Odds Compared With The Bookies Introducing Our Quantitative US Senate Election Model Introducing Our Quantitative US Senate Election Model Bear in mind that only 50 seats are needed for the party that wins the White House, since the Vice President is also the President of the Senate and casts the tiebreaking vote. Senate Races Of Interest Our results show that the consensus is underestimating the Republicans, except in Michigan and Montana. The latter could affect overall control of the Senate. The same can be said for Maine, where the Republican challenger may be underrated (Chart 6). The trend of opinion polling in Chart 6 generally shows closer races than the betting markets expect. Our model supports the betting markets on the unlikelihood that Democrats will prevail in several deep red states. Chart 6US Senate Polling And The Betting Odds Introducing Our Quantitative US Senate Election Model Introducing Our Quantitative US Senate Election Model The presidential race should be the decisive factor. If voters in swing states are sufficiently motivated to vote out the sitting president that they chose only four years ago, which is uncommon in modern US history, then they will likely repudiate the senators who carried that president’s water through a whirlwind of scandals and controversies. Yet with the races so precariously balanced, small or local factors could also decide the outcome. This is an important limitation on our macro method. For example, it is not at all clear that Democrats will win Maine. Our model gives Republicans a 48% chance, while online gamblers put it at 27%. Susan Collins is well-entrenched, having survived again and again since 1996. If Democrats do poach Maine, it is still not clear that they will carry Iowa and Montana, which are more conservative yet saw Democratic victories in 2018. Our model suggests Montana will go Democratic and Iowa will stay Republican. Democrats must win one of these two states (or North Carolina) or they will not take the Senate. A feather could tip the scales. A feather may already be doing that in North Carolina, the other key toss-up state. Democratic candidate Cal Cunningham’s sex scandal has roiled the race. It is not yet clear that voters will abandon Cunningham (see Chart 6, panel 1), but that is likely unless there is an unstoppable Democratic wave.4 If North Carolina stays Republican as a result, then, according to our model, the US Senate would tie at 50-50 and the winner of the White House would turn the balance. Some Democrats have argued that deeper red states may be in contention, such as Georgia, South Carolina, Alaska, Kansas, or Kentucky. Of these, Kansas is notable since no candidate has an incumbent advantage. However, our model rules these races out of play and we tend to agree. Bottom Line: Our model suggests that Democrats will narrowly win control of the Senate as things stand today. With several races extremely close, a trivial event in a single state could turn the balance of power in the US Senate and hence the policy consequences of the entire US election. However, the close contest implies that the party that wins the White House will also win the Senate. Back Testing Our Model Our Senate model performs at an acceptable level during in-sample and out-sample back testing. For in-sample testing, we test our model over our entire sample period (1984 – 2018) and find that 72% of Senate elections (control of the Senate) are correctly predicted, with the model predicting the outcome of the last five Senate elections correctly (Chart 7). Chart 7In-Sample Back Testing Results Introducing Our Quantitative US Senate Election Model Introducing Our Quantitative US Senate Election Model During out-sample back testing, we look at a sample period of 2000 – 2018, comprising of ten Senate elections, where our model correctly predicts 69% of actual outcomes. The previous four Senate elections are predicted correctly (Chart 8). There is still a roughly 50/50 chance of divided US government in 2021-22. Chart 8Out-Sample Back Testing Results Introducing Our Quantitative US Senate Election Model Introducing Our Quantitative US Senate Election Model Investment Takeaways Our US Senate model is based off a similar methodology as our US Presidential election model. There are however some minor differences. First, we use a weighted maximum likelihood estimate as opposed to a traditional maximum likelihood estimate. This is because of unbalanced binary outcomes in our dependent variable (see Appendix). Chart 9Fair Chance Of Divided Government Still Introducing Our Quantitative US Senate Election Model Introducing Our Quantitative US Senate Election Model Secondly, not all our explanatory variables are the same. While we maintain using the State Coincident Index as our one and only economic variable, our suite of political variables has changed to be more geared towards predicting the Senate outcome. Our Senate model predicts Republicans will retain only 49 seats and lose control of the Senate. The Democrats will take control with 51 seats. And yet Republicans have a 49% chance of retaining Senate control. This is equivalent to saying that the race is “too close to call” – which is similar to our presidential model results. The reason is the rapid snapback in the economy. Subjectively, the risk is to the downside for Republicans given the President’s poor polling, particularly on his handling of the pandemic, and the high unemployment rate. The Senate outcome should be determined by the White House race, but obviously there is a fair chance that the winner of the White House still loses control of the Senate (Chart 9). Chart 10Wall Street Expects Divided Government Wall Street Expects Divided Government Wall Street Expects Divided Government Chart 11Trump Protectionism Good For The Dollar Trump Protectionism Good For The Dollar Trump Protectionism Good For The Dollar The stock market is behaving like it expects gridlock, rather than a Democratic sweep – the latter offering greater downside and lesser upside, at least judging by history (Chart 10). So let’s boil this all down to what we know with reasonable certainty: If Trump wins with a Republican Senate, he will still face opposition from House Democrats, so he will be driven to foreign and trade policy in his second term. Protectionism will affect not only China but also Europe and other economies. This is broadly positive for the dollar and US equities relative to global stocks and commodities (Chart 11). Government bond yields would be volatile due to the risk to the cyclical recovery from global trade war. If Biden wins in a Democratic sweep, economies other than China will benefit from lower trade risk and the US will benefit from higher odds of unfettered fiscal stimulus in 2021. But financial markets will simultaneously have to adjust for the negative shock to US corporate earnings from higher taxes and regulation. This outcome is broadly negative for the dollar and US equities relative to global equities and commodities. Government bond yields would rise on the generally reflationary agenda. If Biden wins without the Senate, the market has the most positive outcome of all: less trade war yet no new tax hikes. Both US and global equities would benefit. Bond prices and the dollar would trend downward over time, but not during the occasional fiscal battles that would ensue between the Democratic president and Republican senators.   Guy Russell Research Analyst GuyR@bcaresearch.com Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Statistical Appendix A notable property in our dependent variable data requires a brief discussion. Our dependent variable classified as “elected” takes the form of a binary outcome. This data, however, is what’s called “unbalanced,” since incumbent Senators are re-elected approximately 80% of the time. This means that most outcomes in our dependent variable are coded as “1,” with fewer “0’s” because of the strong incumbency effect in Senate races. There are many data sets that exhibit this type of property, such as events like wars, vetoes, cases of political activism, or epidemiological infections, where non-events occur rarely. To alleviate this statistical property in the data, we estimate our model using a weighted maximum likelihood estimate as opposed to the ordinary maximum likelihood estimate usually used in a probit regression.5 This method assigns more weighting to the unbalanced data, or what is known theoretically as “rare event” data, to aid the probit regression in assigning higher probabilities to “0” outcomes. Through this process, we effectively deal with our unbalanced dependent variable data. That said, in developing our quantitative US Senate Election Model, we estimated a suite of probit regressions with several other variables that were theoretically assumed to be relevant and subsequently tested empirically. In Appendix Table 1 below, we only include variables 1, 2, 3 and 6 from our listed variables (we excluded the generic congressional ballot and its corresponding dummy variable). This model suggests that Republicans will hold control of the Senate with 51 seats. Back testing this model revealed that 71% of past Senate elections were correctly predicted, while 67% were correctly predicted in out-sample testing. This is only slightly worse of a track record than our final model. If this model proves more accurate in the event, the implication is that the generic congressional ballot is an unreliable poll. Americans could be shy about stating their support for the Republican Party in the era of Trump. For this outcome, Republicans would only lose Arizona and Colorado. Critical swing states here are Montana (53%) and Arizona (45%). Appendix Table 1Alternative Senate Model Predictions Introducing Our Quantitative US Senate Election Model Introducing Our Quantitative US Senate Election Model A re-work of the above model, but with a variable that punishes Republicans for holding the Senate for six years or more on average, suggests that Republicans will only win 47 seats in the Senate, giving up six seats (Appendix Table 2). Forecast accuracy is slightly worse off, giving just 68% and 67% predictive accuracy during in and out-sample forecasting of previous Senate elections, respectively. Compared to our primary model, Republicans would lose Arizona, Colorado, Iowa, Maine, Montana, North Carolina and Alabama. Alabama (45%) is the only critical swing state. Appendix Table 2Alternative Senate Model Predictions Introducing Our Quantitative US Senate Election Model Introducing Our Quantitative US Senate Election Model Note: This report has been corrected since publication due to errors in charting. Charts 7 and 8 showed the correct majority party in historical Senate elections but mistakenly attributed to that party the minority party’s number of seats. The changes do not affect the text or the substance of the report: our quantitative model’s accuracy levels remain unchanged, as does the model’s performance relative to historical election results. Footnotes 1 The model was able to predict 14 out of 18 (77%) Senate races flagged as competitive by BCA’s Geopolitical Strategy. Florida, North Dakota, Indiana and Missouri were flagged as Democratic by our model but were won by Republican candidates. 2 A dummy variable trap is a scenario in which the independent variables are multicollinear — a scenario in which two or more variables are highly correlated; or, in simple terms, in which one variable can be predicted from the others. To avoid such a trap, we must exclude one of the categorical variables. Since there are two categorical variables that can be represented here (Republican or Democrat), we use k-1 (where k = the number of categorical variables). 3 The coefficients in a probit regression model measure the change in the Z-score associated to each independent variable for a one-unit change in that variable. 4 See Evie Fordham, "NC Democrat Cal Cunningham faces FEC complaint over California trip amid affair," Fox News, October 13, 2020, foxnews.com. 5 Weighted maximum likelihood estimation is a reasonable approach in dealing with dependent variables that show significant imbalance in their data set. See: King, G. and Zeng, L., 2001. Logistic regression in rare events data. Political analysis, 9(2), pp.137-163.

Highlights Our model suggests that more rate hikes are ahead in 2021; we project a less than 50bps increase in the PBoC policy rate from the current level. Chinese stock prices positively correlate with interest rates and bond yields. The relationship has strengthened since 2015. In the next six to nine months, Chinese stock prices will likely trend up alongside a rising policy rate and an accelerating economic growth. Feature China’s policy rate and bond yields have been rising sharply since May and are breaching their pre-COVID 19 levels. Meanwhile, Chinese stock prices have moved sideways since mid-July, despite a steady recovery in the domestic economy. While some commentators view higher interest rates as a harbinger of an impending equity market weakness, our research shows that the relationship between China’s stock prices and short-term rates has been positive since 2015. A rally in Chinese stocks and outperformance of cyclical stocks relative to defensives positively correlate with rising interest rates and bond yields (Chart 1A and 1B). Chart 1ARising Bond Yields Coincide With Ascending Chinese Stock Prices... Rising Bond Yields Coincide With Ascending Chinese Stock Prices... Rising Bond Yields Coincide With Ascending Chinese Stock Prices... Chart 1B...And Offshore Cyclicals ...And Offshore Cyclicals ...And Offshore Cyclicals Chart 2Massive Stimulus In 2020 Will Accelerate Economic Growth Into 1H21 Massive Stimulus In 2020 Will Accelerate Economic Growth Into 1H21 Massive Stimulus In 2020 Will Accelerate Economic Growth Into 1H21 China’s massive stimulus this year generated some self-sustaining momentum that will likely push the nation’s output higher in 1H21(Chart 2). The PBoC may raise the policy rate by as much as 50bps in 2021 from its current level, but strong domestic fundamentals should be able to drive up Chinese stock prices, in both absolute term and relative to global equities in the next six to nine months. PBoC Policy Hikes:Still More Ahead While the PBoC’s policy rate has rebounded sharply, it remains at its lowest level since the Global Financial Crisis. Looking forward, will the central bank bring the policy rate (e.g. 3-month SHIBOR) back to its pre-COVID 19 range of 3 – 3.5% or the pre-trade war level near 5%? The acceleration in China’s economic recovery is expected to continue and would boost China’s annual output growth in 1H21 to two to three percentage points above its trend. Based on these estimates, our interest rate model implies more than 200bps in rate increases in 2021 from the current level1 (Chart 3). Chart 3Rising Odds Of PBoC Rate Hikes In 2021 Rising Odds Of PBoC Rate Hikes In 2021 Rising Odds Of PBoC Rate Hikes In 2021 Historically, our model has successfully captured the major turning points in China's policy rate cycles. This time around, however, the pandemic and the subsequent economic recovery may have complicated the model's predictive power. The model suggests that, in 1H21 the policy rate will return to its pre-trade war range of 4-5%, but we think the rate increases will be capped within 50bps.  The model follows a modified version of "Taylor's Rule," in which we assume that the PBoC will target its short-term interest rate based on the deviation between actual and desired inflation rates and the deviation between real GDP growth and China’s trend GDP growth rate. The latest data shows across-the-board strengthening in the economy; most indicators have surprised to the upside, confirming our optimistic  assessment.2 However, Taylor's Rule is not able to account for sudden shocks in the economy, such as a pandemic-induced global recession. Thus, the model exaggerates the magnitude of interest rate bumps, based on an economic growth acceleration following a one-off economic shock.  In a report earlier this year, we noted that the PBoC has been proactive in normalizing its monetary policy following short-term shocks.3 This is contrary to economic downturns when the PBoC has been a reactive central bank and its decisions often lagged a pickup in economic activity. As such, although interest rates have swiftly rebounded after the pandemic-induced growth contraction in Q1, we expect the pace of rate hikes to be slower in 2021. Chart 4Rapid RMB Appreciation Will Bring Headwinds To Chinese Industrial Profits Rapid RMB Appreciation Will Bring Headwinds To Chinese Industrial Profits Rapid RMB Appreciation Will Bring Headwinds To Chinese Industrial Profits External factors are accounted for in the model, though they may be underestimated. The US Federal Reserve Bank has decisively shifted its monetary policy to broadly accommodative and will stay behind the inflation curve in the next few years. The collapse in interest rate differentials between the US and China has made RMB-denominated assets attractive, boosting strong inflows of foreign capital and rapidly pushing up the value of the RMB (Chart 4, top panel).    While we think Chinese policymakers have pivoted to prefer a strong RMB, the recent countermeasures by the PBoC indicate that the central bank will not allow the RMB to climb too rapidly.4 China's drastic tightening in monetary conditions and the sharp rally in the trade-weighted RMB from 2011 to 2014 led to a prolonged economic downturn (Chart 4, bottom panel). Therefore, in the absence of synchronized policy tightening from other central banks, the magnitude of rate hikes by the PBoC will be measured.  Bottom Line: The PBoC will continue to push up the policy rate in 2021, but our baseline view is that the magnitude will be capped below 50bps. Interest Rates And Chinese Stocks Chart 5Chinese Stocks/Bond Yields Correlation Became Much More Positive After 2015 Chinese Stocks/Bond Yields Correlation Became Much More Positive After 2015 Chinese Stocks/Bond Yields Correlation Became Much More Positive After 2015 Many investors might think that stock prices tend to react negatively to monetary policy tightening because interest rate upturns and mounting bond yields lead to higher costs of funding for corporations and lower profit growth. However, Chinese stock prices started moving in the same direction with policy rates and bond yields following the burst of the 2014/15 stock market bubble (Chart 5 and Chart 1A and 1B on Page 4 and 2). In general, when China’s economic and profit growth accelerates, share prices can rise with higher interest rates. Share prices can still climb with cuts in interest rates even when economic growth slows but profit growth rate remains in positive territory. However, when profit growth is expected to drop below zero, share prices will drop even if rates are falling (Chart 6A and 6B).  In this vein, the most pertinent reason for Chinese stocks to move in tandem with bond yields is that Chinese stocks are increasingly driven by economic fundamentals, which are supported by the volume of total credit creation (measured by total social financing) rather than the price of money in China. Furthermore, the reverse relationship between the volume and price of money in China broke down after 2015; China’s credit creation has become less sensitive to changes in interest rates. Chart 6AWhen Interest Rates Rise... When Interest Rates Rise... When Interest Rates Rise... Chart 6B...Economic Growth Holds The Key For Stock Performance ...Economic Growth Holds The Key For Stock Performance ...Economic Growth Holds The Key For Stock Performance Since 2015, the PBOC shifted its policy to target interest rates instead of the quantity of money supply (Chart 7). In order to effectively manage the official interbank rates (the 7-day interbank repo rate), the central bank uses tools such as reserve requirement ratio cuts and liquidity injections in the interbank system (Chart 8).  In other words, the central bank has forgone its control of the volume of money. Moreover, since late 2016, rather than direct interest rate hikes, the PBoC has been taking monetary policy tightening measures through changes in its macro-prudential assessment (MPA). The changes in the MPA are evident in the 3-month / 1-week repo spread.5  As such, an increase in the 3-month interbank repo rate (and SHIBOR) is often intended to curb shadow-banking activities rather than depress aggregate credit creation and business activities (Chart 9). Chart 7Monetary Policy Regime Shifted In 2015 Monetary Policy Regime Shifted In 2015 Monetary Policy Regime Shifted In 2015 Chart 8More Open Market Operations Monetary Tightening ≠ Lower Stock Prices Monetary Tightening ≠ Lower Stock Prices Chart 9Most Monetary Tightening Has Been Carried Out Through MPA Since 2016 Most Monetary Tightening Has Been Carried Out Through MPA Since 2016 Most Monetary Tightening Has Been Carried Out Through MPA Since 2016 Another idiosyncrasy is China’s fiscal stimulus, which has become a more relevant driver of total social financing since the onset of the 2014/15 economic downcycle (Chart 10). The amount of government bond issuance is specified by the People’s Congress in March each year and is not affected by changes in interest rates or bond yields. Therefore, growth in total social financing can still accelerate despite a higher price of money (Chart 11). Chart 10Fiscal Lever Has Become More Prominent In Driving Business Cycles Since 2015 Fiscal Lever Has Become More Prominent In Driving Business Cycles Since 2015 Fiscal Lever Has Become More Prominent In Driving Business Cycles Since 2015 Chart 11Changes In Interest Rates Have Little Impact On Fiscal And Quasi-Fiscal Borrowing Changes In Interest Rates Have Little Impact On Fiscal And Quasi-Fiscal Borrowing Changes In Interest Rates Have Little Impact On Fiscal And Quasi-Fiscal Borrowing By the same token, a rising 3-month SHIBOR can also be the result of rapid fiscal and quasi-fiscal expansions, as seen in Q3 this year.  A flood of central and local government bond issuance drained liquidities from commercial banks, boosting the banks’ needs to borrow money from the interbank system. Nevertheless, the market’s appetite for risk assets increases because fiscal stimulus provides an imminent and powerful reflationary force in China’s business cycles. Chart 12Bank Lending Rates Can Still Trend Downwards Against A Rising Policy Rate Bank Lending Rates Can Still Trend Downwards Against A Rising Policy Rate Bank Lending Rates Can Still Trend Downwards Against A Rising Policy Rate Rising policy rates typically push up corporate bond yields. However, bond yields in China play a relatively small role in driving corporate financing costs on an aggregate level, since commercial banks are still dominant in China’s debt market. Commercial banks' average lending rates closely track the PBoC’s policy rate on a cyclical basis, but Chinese authorities periodically use window guidance to target the Loan Prime Rate (LPR), a reformed bank lending rate. Hence, the direction in both the LPR and the average lending rate can temporarily diverge from the policy rate. These measures can boost bank loan growth even in a rising interest rate environment (Chart 12). Bottom Line: The key driver of Chinese stock performance is the country’s domestic credit, business, and corporate profit growth cycles. Since the 2014/15 cycle, the policy rate has not been the determinant of China’s economic or credit growth. Investment Conclusions We expect that this year’s massive monetary and fiscal stimulus to accelerate the country’s economic recovery into 1H21. Therefore, even if interest rates and bond yields advance, Chinese stock prices can still trend upward. Chinese cyclical stocks should also continue to outperform defensives, in both the onshore and offshore markets (Chart 13A and 13B). Chart 13AStay Invested In Chinese Stocks Stay Invested In Chinese Stocks Stay Invested In Chinese Stocks Chart 13BCyclicals Still Have Upside Potentials Cyclicals Still Have Upside Potentials Cyclicals Still Have Upside Potentials Rates will begin to climb and fiscal policy will also become more restrictive if China’s output moves above trend growth through 1H21. Government bond quotas and fiscal budget will be determined at the National People’s Congress in March. If the economy is strong, odds are that fiscal stimulus will be scaled back. At that point, investors should start to look for a peak in China’s business cycle linked to monetary and fiscal policy tightening. As growth expectations start to downshift in the equity market, yields on long-dated government bonds will start to decline while yields on the short end will not drop. Additionally, the small-cap ChiNext market has been considered as a speculative segment of the domestic financial market with higher multiples and greater volatility than large-cap A shares. The bourse's trailing price-to-earnings ratio and price-to-book ratio are extremely elevated at 79 and 8.6, respectively, much higher than for broader onshore and offshore Chinese stocks. As such, this market will remain the most vulnerable to domestic liquidity tightening.   Jing Sima China Strategist jings@bcaresearch.com Footnotes 1 based on our estimates for 1h21: 7.5-8.0% GDP growth,  2.5-2.8% headline CPI, 6.5-6.7 USD/CNY, and the fed holding current fund rate unchanged. 2Please see China Investment Strategy Weekly Report "China Macro And Market Review," dated October 7, 2020, available at cis.bcaresearch.com 3Please see China Investment Strategy Weekly Report "Don’t Chase China’s Bond Yields Lower," dated February 19, 2020, available at cis.bcaresearch.com 4On October 12, the PBoC removed financial institutions’ Forex reserve ratio of 20%, making betting against the RMB cheaper.  5Please see China Investment Strategy Special Report "Seven Questions About Chinese Monetary Policy," dated February 22, 2018, available at cis.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations

Highlights Duration: Prospects for more pre-election fiscal stimulus are slim. But with the Democrats gaining ground in the polls, the bond market will stay focused on rising odds of a blue sweep election and greater fiscal stimulus in early 2021. Municipal Bonds: Municipal bonds offer exceptional value relative to both US Treasuries and corporate credit. Not only that, but rising odds of a blue sweep election make state & local government fiscal relief increasingly likely. Investors should overweight municipal bonds in US fixed income portfolios. Economy: The economic recovery continues to roll on, but it will be some time before the output gap is closed and inflation starts to rise. Slow consumer and corporate credit growth suggest that animal spirits have not yet taken hold. Meanwhile, the falling unemployment rate masks a persistent uptrend in the number of permanently unemployed. Feature Chart 1Breakout Breakout Breakout After having been lulled to sleep by several months of stagnant yields, bond investors experienced a minor shockwave in early October. The 10-year Treasury yield and 2/10 slope both broke out of well-established trading ranges and implied interest rate volatility bounced off all-time lows to reach its highest level since June (Chart 1). We suspect this might turn out to be just the first small tremor in a tumultuous month leading up to the US election. Specifically, there are two main political risks that will be resolved within the next month. Both have major implications for the bond market. Bond-Bullish Risk: No More Stimulus Before The Election  The first risk is the possibility that the current Congress will not deliver any more fiscal stimulus. This increasingly looks like less of a possibility and more of a likelihood, especially after the president tweeted that he is halting negotiations with House Democrats. While he partially walked those comments back the next day, the fact remains that there is very little time between now and November 3rd, and the two sides remain at loggerheads. We have argued that more household income support from Congress is necessary. Otherwise, consumer spending will massively disappoint during the next year.1 However, it could take a few more months before this becomes apparent in the consumer spending data. Real consumer spending still rose in August, though much less quickly than it did in June and July (Chart 2). Meanwhile, August disposable income remained above pre-COVID levels, as it continued to receive a boost from facilities related to the CARES act (Chart 2, bottom panel). This boost will fade as the CARES act’s money is doled out, pushing spending lower. That is, unless Congress enacts a follow-up bill. There are two main political risks that will be resolved within the next month and both have major implications for the bond market. It looks less and less likely that a bill will be passed this month but, depending on the election outcome, a follow-up stimulus bill could become more likely in January. If consumer spending can hang in for the next couple of months, then the bond market might look past Congress’ near-term failure. This appears to be what is happening so far. The stock market fell 1.4% last Tuesday after Trump tweeted about halting negotiations. The 10-year Treasury yield, however, dropped only 2 bps on the day. More generally, long-dated bond yields rose during the past month, even as stocks sold off and prospects for immediate fiscal relief dimmed (Chart 3). Chart 2September's Consumer Spending Report Is Critical September's Consumer Spending Report Is Critical September's Consumer Spending Report Is Critical Chart 3Bonds Ignore Stock ##br##Market... Bonds Ignore Stock Market... Bonds Ignore Stock Market... With all that in mind, we think September’s consumer spending data – the last month of data we will see before the election – are very important. If spending collapses, it might re-focus the market’s attention on Congress’ failure, sending bond yields down. However, we think the market would see through a modest drop in spending, especially if the election looks poised to bring us a larger bill in 2021. Bond-Bearish Risk: A Blue Sweep Election Chart 4...Take Cues From Election Odds ...Take Cues From Election Odds ...Take Cues From Election Odds This brings us to the second big political risk that could influence bond yields during the next month: The possibility of a “blue sweep” election where the Democrats win control of the House, Senate and White House. This would clearly be a bearish outcome for bonds, as an unimpeded Democratic party would enact a large stimulus package – likely worth $2.5 to $3.5 trillion – shortly after inauguration. It appears that the bond market is already tentatively pricing-in this outcome. While the recent increase in bond yields is hard to square with weak equity prices and souring expectations for immediate stimulus, it is consistent with rising betting market odds of a blue sweep election (Chart 4). To underscore the bond bearishness of this potential election outcome, consider that not only would a unified Congress be able to quickly deliver another fiscal relief bill, but Joe Biden’s platform calls for even more spending on infrastructure, healthcare, education and other Democratic priorities. In total, Biden is proposing new spending of around 3% of GDP, only about half of which will be offset by tax increases (Table 1). Table 1ABiden Would Raise $4 Trillion In Revenue Over Ten Years Political Risk Will Dominate In A Pivotal Month For The Bond Market Political Risk Will Dominate In A Pivotal Month For The Bond Market Table 1BBiden Would Spend $7 Trillion In Programs Over Ten Years Political Risk Will Dominate In A Pivotal Month For The Bond Market Political Risk Will Dominate In A Pivotal Month For The Bond Market How likely is a “blue sweep” election? It is our Geopolitical Strategy service’s base case.2 Also, fivethirtyeight.com’s poll-based forecasting model sees a 68% chance that Democrats win the Senate, a 94% chance that they win the House and an 85% chance that Joe Biden wins the presidency. Investment Strategy These two political risks appear to put bond investors in a bit of a conundrum. On the one hand, if no stimulus bill is passed this month and September’s consumer spending data are weak, then bond yields could fall in the near-term. However, we are inclined to think that if all that occurs against the back-drop of rising odds of a blue sweep election outcome, the bond market will look beyond the near-term and yields will move higher on expectations of larger stimulus coming in January. As such, we retain our relatively pro-reflation investment stance. We recommend owning nominal and real yield curve steepeners, inflation curve flatteners and maintaining an overweight position in TIPS versus nominal Treasuries. All these positions are designed to profit from a rising yield environment.3 Municipal bonds look extremely cheap compared to other US fixed income sectors. We retain an “at benchmark” portfolio duration stance for now, for two reasons. First, while a blue sweep election outcome looks like the most likely scenario, it is not a guarantee. Second, even against the backdrop of greater government stimulus and continued economic recovery, the US economy will still be dealing with a large output gap next year that will temper inflationary pressures. This will keep the Fed on hold, limiting the upside in bond yields. That being said, the odds of another significant downleg in bond yields look increasingly slim. We will likely shift to a more aggressive “below-benchmark” duration stance this month, if our conviction in a blue sweep election outcome continues to rise. A Rare Buying Opportunity In Municipal Bonds No matter how you slice it, municipal bonds look extremely cheap compared to other US fixed income sectors. First, we can look at the spread between Aaa-rated munis and maturity-matched US Treasury yields (Chart 5). When we do this, we find that 2-year and 5-year municipal bonds trade at about the same yields as their Treasury counterparts. This is despite municipal debt’s tax-exempt status. Munis look even more attractive further out the curve, with 10-year and 30-year bonds trading at a before-tax premium relative to Treasuries. Chart 5Aaa Munis Versus ##br##Treasuries Aaa Munis Versus Treasuries Aaa Munis Versus Treasuries Table 2Muni/Corporate Breakeven Effective Tax Rates (%) Political Risk Will Dominate In A Pivotal Month For The Bond Market Political Risk Will Dominate In A Pivotal Month For The Bond Market Next, we can look at how municipal bonds stack up compared to corporates. We do this in a couple different ways. In Table 2, we start with the Bloomberg Barclays Investment Grade Corporate Index split by credit tier. We then find the General Obligation (GO) municipal bond that matches each corporate index’s credit rating and maturity and calculate the breakeven effective tax rate between the two yields. The breakeven effective tax rate is the effective tax rate that would make an investor indifferent between owning the municipal bond and the corporate bond. For example, if an investor faces an effective tax rate of 7%, they will observe the same after-tax yield in a 12-year A-rated GO municipal bond as they do in a 12-year A-rated corporate bond. If their effective tax rate is more than 7%, the muni offers an after-tax yield advantage. Alternatively, we can look at the relative value between munis and credit using the Bloomberg Barclays Municipal Indexes. In Chart 6A, we start with the average yield on the Bloomberg Barclays General Obligation indexes by maturity. We then find the US Credit index that matches the credit rating and duration of the municipal index and calculate the yield differential.4 We find that in all cases, for GO bonds ranging from 6 years to maturity and higher, the muni offers a before-tax yield advantage compared to the Credit Index. This is also true when we perform the same exercise using municipal revenue bonds instead of GOs (Chart 6B). Chart 6AGO Munis Versus Credit GO Munis Versus Credit GO Munis Versus Credit Chart 6BRevenue Munis Versus Credit Revenue Munis Versus Credit Revenue Munis Versus Credit You may notice that municipal bonds trade at a before-tax premium to credit in Charts 6A and 6B, but at a discount in Table 2. This is because we compare bonds by maturity in Table 2 and by duration in Charts 6A and 6B. Unlike investment grade corporates, municipal bonds often carry call options making them negatively convex and giving them a duration that is much shorter than their maturity. Cheap For A Reason, Or Just Plain Cheap? Chart 7State & Local Balance Sheets Will Weather The Storm State & Local Balance Sheets Will Weather The Storm State & Local Balance Sheets Will Weather The Storm We have effectively demonstrated that municipal bonds offer value relative to both Treasuries and corporate credit. But attractive value is not enough to warrant an overweight allocation. Ideally, we would also like some degree of confidence that wide spreads won’t eventually be justified by a wave of downgrades and defaults. While state & local government balance sheets are certainly stressed, we see strong odds that the muni market will emerge from the COVID recession relatively unscathed. For starters, state & local governments were experiencing strong revenue growth prior to the pandemic (Chart 7, top panel). This allowed them to build rainy day funds up to all-time highs (Chart 7, panel 4). Second, income support for households from the CARES act helped prop up state & local income tax revenues in the second quarter (Chart 7, panel 2), though sales tax revenues took a significant hit (Chart 7, panel 3). Going forward, a blue sweep election scenario would not only provide more income support for households – helping income tax revenues – but a Democratic controlled Congress would also quickly deliver fiscal aid directly to state & local governments. In fact, it is this aid for state & local governments that is currently the key sticking point in fiscal negotiations. In the meantime, state & local governments will continue to clamp down on spending. This can already be seen in the massive drop in state & local government employment (Chart 7, bottom panel). This is obviously a drag on economic growth, but the combination of austerity measures and high rainy day fund balances will help municipal bonds avoid downgrades and defaults, at least until a fiscal relief bill is passed next year. While state & local government balance sheets are certainly stressed, we see strong odds that the muni market will emerge from the COVID recession relatively unscathed. Bottom Line: Municipal bonds offer exceptional value relative to both US Treasuries and corporate credit. Not only that, but rising odds of a blue sweep election make state & local government fiscal relief increasingly likely. Investors should overweight municipal bonds in US fixed income portfolios. Economy: Credit Growth & The Labor Market Credit Growth Slowing Chart 8No Animal Spirits No Animal Spirits No Animal Spirits Of notable economic data releases during the past two weeks, we find it particularly interesting that both consumer credit and Commercial & Industrial (C&I) bank lending continue to slow (Chart 8). On the consumer side, massive income support from the CARES act and few spending opportunities caused households to pay down debt this spring. Then, after two months of modest gains, consumer credit fell again in August (Chart 8, top panel). This strongly suggests that, even as lockdown restrictions have eased, consumers aren’t yet ready to open up the spending taps. On the corporate side, firms received much less of a direct cash injection from Congress and were forced to take on massive amounts of debt to get through the spring and early summer months. But as of the second quarter, we recently observed that nonfinancial corporate retained earnings now exceed capital expenditures.5 This strongly suggests that firms have taken out enough new debt and that C&I bank lending will remain slow in the coming months. Cracks Showing In The Labor Market Chart 9Far From Full Employment Far From Full Employment Far From Full Employment Finally, we should mention September’s employment report that was released two weeks ago (Chart 9). It is certainly positive that the unemployment rate continues to fall, but the main takeaway for bond investors should be that the US economy remains far from full employment, and therefore far away from generating meaningful inflationary pressure. While the unemployment rate fell for the fifth consecutive month, it is now dropping much less quickly than it did early in the summer (Chart 9, panel 2). Also, we continue to note that labor market gains are entirely concentrated in temporarily unemployed people returning to work. The number of permanently unemployed continues to rise (Chart 9, bottom panel). Bottom Line: The economic recovery continues to roll on, but it will be some time before the output gap is closed and inflation starts to rise. Slow consumer and corporate credit growth suggest that animal spirits have not yet taken hold. Meanwhile, the falling unemployment rate masks a persistent uptrend in the number of permanently unemployed. Appendix The Fed rolled out a number of aggressive lending facilities on March 23. These facilities focused on different specific sectors of the US bond market. The fact that the Fed has decided to support some parts of the market and not others has caused some traditional bond market correlations to break down. It has also led us to adopt of a strategy of “Buy What The Fed Is Buying”. That is, we favor those sectors that offer attractive spreads and that benefit from Fed support. The below Table tracks the performance of different bond sectors since the March 23 announcement. We will use this to monitor bond market correlations and evaluate our strategy’s success. Table 3Performance Since March 23 Announcement Of Emergency Fed Facilities Political Risk Will Dominate In A Pivotal Month For The Bond Market Political Risk Will Dominate In A Pivotal Month For The Bond Market Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “More Stimulus Needed”, dated September 15, 2020, available at usbs.bcaresearch.com 2 Please see Geopolitical Strategy Weekly Report, “It Ain’t Over Till It’s Over”, dated October 9, 2020, available at gps.bcaresearch.com 3 For more details on these recommended positions please see US Bond Strategy Weekly Report, “Positioning For Reflation And Avoiding Deflation”, dated August 11, 2020, available at usbs.bcaresearch.com 4 Note that we use the US Credit Index in Charts 6A and 6B. This index includes the entire US corporate bond index but also some non-corporate credit sectors like Sovereigns and Foreign Agency bonds. 5 Please see US Bond Strategy Weekly Report, “Out Of Bullets”, dated September 29, 2020, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification