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Highlights With a vaccine already rolling out in the UK and soon in the US, investors have reason to be optimistic about next year. Government bond yields are rising, cyclical equities are outperforming defensives, international stocks hinting at outperforming American, and value stocks are starting to beat growth stocks (Chart 1). Feature President Trump’s defeat in the US election also reduces the risk of a global trade war, or a real war with Iran. European, Chinese, and Emirati stocks have rallied since the election, at least partly due to the reduction in these risks (Chart 2). However, geopolitical risk and global policy uncertainty have been rising on a secular, not just cyclical, basis (Chart 3). Geopolitical tensions have escalated with each crisis since the financial meltdown of 2008. Chart 1A New Global Business Cycle Chart 2Biden: No Trade War Or War With Iran? Chart 3Geopolitical Risk And Global Policy Uncertainty Chart 4The Decline Of The Liberal Democracies? Trump was a symptom, not a cause, of what ails the world. The cause is the relative decline of the liberal democracies in political, economic, and military strength relative to that of other global players (Chart 4). This relative decline has emboldened Chinese and Russian challenges to the US-led global order, as well as aggressive and unpredictable moves by middle and small powers. Moreover the aftershocks of the pandemic and recession will create social and political instability in various parts of the world, particularly emerging markets (Chart 5). Chart 5EM Troubles Await Chart 6Global Arms Build-Up Continues We are bullish on risk assets next year, but our view is driven largely from the birth of a new economic cycle, not from geopolitics. Geopolitical risk is rapidly becoming underrated, judging by the steep drop-off in measured risk. There is no going back to a pre-Trump, pre-Xi Jinping, pre-2008, pre-Putin, pre-9/11, pre-historical golden age in which nations were enlightened, benign, and focused exclusively on peace and prosperity. Hard data, such as military spending, show the world moving in the opposite direction (Chart 6). So while stock markets will grind higher next year, investors should not expect that Biden and the vaccine truly portend a “return to normalcy.” Key View #1: China’s Communist Party Turns 100, With Rising Headwinds Investors should ignore the hype about the Chinese Communist Party’s one hundredth birthday in 2021. Since 1997, the Chinese leadership has laid great emphasis on this “first centenary” as an occasion by which China should become a moderately prosperous society. This has been achieved. China is deep into a structural economic transition that holds out a much more difficult economic, social, and political future. Chart 7China: Less Money, More Problems The big day, July 1, will be celebrated with a speech by General Secretary Xi Jinping in which he reiterates the development goals of the five-year plan. This plan – which doubles down on import substitution and the aggressive tech acquisition campaign – will be finalized in March, along with Xi’s yet-to-be released vision for 2035, which marks the halfway point to the “second centenary,” 2049, the hundredth birthday of the regime. Xi’s 2035 goals may contain some surprises but the Communist Party’s policy frameworks should be seen as “best laid plans” that are likely to be overturned by economic and geopolitical realities. It was easier for the country to meet its political development targets during the period of rapid industrialization from 1979-2008. Now China is deep into a structural economic transition that holds out a much more difficult economic, social, and political future. Potential growth is slowing with the graying of society and the country is making a frantic dash, primarily through technology acquisition, to boost productivity and keep from falling into the “middle income trap” (Chart 7). Total debt levels have surged as Beijing attempts to make this transition smoothly, without upsetting social stability. Households and the government are taking on a greater debt load to maintain aggregate demand while the government tries to force the corporate sector to deleverage in fits and starts (Chart 8). The deleveraging process is painful and coincides with a structural transition away from export-led manufacturing. Beijing likely believes it has already led de-industrialization proceed too quickly, given the huge long-term political risks of this process, as witnessed in the US and UK. The fourteenth five-year plan hints that the authorities will give manufacturing a reprieve from structural reform efforts (Chart 9). Chart 8China Struggles To Dismount Debt Bubble Chart 9China Will Slow De-Industrialization, Stoking Protectionism Chart 10China Already Reining In Stimulus A premature resumption of deleveraging heightens domestic economic risks. The trade war and then the pandemic forced the Xi administration to abandon its structural reform plans temporarily and drastically ease monetary, fiscal, and credit policy to prevent a recession. Almost immediately the danger of asset bubbles reared its head again. Because the regime is focused on containing systemic financial risk, it has already begun tightening monetary policy as the nation heads into 2021 – even though the rest of the world has not fully recovered from the pandemic (Chart 10). The risk of over-tightening is likely to be contained, since Beijing has no interest in undermining its own recovery. But the risk is understated in financial markets at the moment and, combined with American fiscal risks due to gridlock, this familiar Chinese policy tug-of-war poses a clear risk to the global recovery and emerging market assets next year. Far more important than the first centenary, or even General Secretary Xi’s 2035 vision, is the impending leadership rotation in 2022. Xi was originally supposed to step down at this time – instead he is likely to take on the title of party chairman, like Mao, and aims to stay in power till 2035 or thereabouts. He will consolidate power once again through a range of crackdowns – on political rivals and corruption, on high-flying tech and financial companies, on outdated high-polluting industries, and on ideological dissenters. Beijing must have a stable economy going into its five-year national party congresses, and 2022 is no different. But that goal has largely been achieved through this year’s massive stimulus and the discovery of a global vaccine. In a risk-on environment, the need for economic stability poses a downside risk for financial assets since it implies macro-prudential actions to curb bubbles. The 2017 party congress revealed that Xi sees policy tightening as a key part of his policy agenda and power consolidation. In short, the critical twentieth congress in 2022 offers no promise of plentiful monetary and credit stimulus (Chart 11). All investors can count on is the minimum required for stability. This is positive for emerging markets at the moment, but less so as the lagged effects of this year’s stimulus dissipate. Chart 11No Promise Of Major New Stimulus For Party Congress 2022 Not only will Chinese domestic policy uncertainty remain underestimated, but geopolitical risk will also do so. Superficially, Beijing had a banner year in 2020. It handled the coronavirus better than other countries, especially the US, thus advertising Xi Jinping’s centralized and statist governance model. President Trump lost the election. Regardless of why Trump lost, his trade war precipitated a manufacturing slowdown that hit the Rust Belt in 2019, before the virus, and his loss will warn future presidents against assaulting China’s economy head-on, at least in their first term. All of this is worth gold in Chinese domestic politics. Chart 12China’s Image Suffered In Spite Of Trump Internationally, however, China’s image has collapsed – and this is in spite of Trump’s erratic and belligerent behavior, which alienated most of the world and the US’s allies (Chart 12). Moreover, despite being the origin of COVID-19, China’s is one of the few economies that thrived this year. Its global manufacturing share rose. While delaying and denying transparency regarding the virus, China accused other countries of originating the virus, and unleashed a virulent “wolf warrior” diplomacy, a military standoff with India, and a trade war with Australia. The rest of Asia will be increasingly willing to take calculated risks to counterbalance China’s growing regional clout, and international protectionist headwinds will persist. The United States will play a leading part in this process. Sino-American strategic tensions have grown relentlessly for more than a decade, especially since Xi Jinping rose to power, as is evident from Chinese treasury holdings (Chart 13). The Biden administration will naturally seek a diplomatic “reset” and a new strategic and economic dialogue with China. But Biden has already indicated that he intends to insist on China’s commitments under Trump’s “phase one” trade deal. He says he will keep Trump’s sweeping Section 301 tariffs in place, presumably until China demonstrates improvement on the intellectual property and tech transfer practices that provided the rationale for the tariffs. Biden’s victory in the Rust Belt ensures that he cannot revert to the pre-Trump status quo. Indeed Biden amplifies the US strategic challenge to China’s rise because he is much more likely to assemble a “grand alliance” or “coalition of the willing” focused on constraining China’s illiberal and mercantilist policies. Even the combined economic might of a western coalition is not enough to force China to abandon its statist development model, but it would make negotiations more likely to be successful on the West’s more limited and transactional demands (Chart 14). Chart 13The US-China Divorce Pre-Dates And Post-Dates Trump Chart 14Biden's Grand Alliance A Danger To China The Taiwan Strait is ground zero for US-China geopolitical tensions. The US is reviving its right to arm Taiwan for the sake of its self-defense, but the US commitment is questionable at best – and it is this very uncertainty that makes a miscalculation more likely and hence conflict a major tail risk (Chart 15). True, Beijing has enormous economic leverage over Taiwan, and it is fresh off a triumph of imposing its will over Hong Kong, which vindicates playing the long game rather than taking any preemptive military actions that could prove disastrous. Nevertheless, Xi Jinping’s reassertion of Beijing and communism is driving Taiwanese popular opinion away from the mainland, resulting in a polarizing dynamic that will be extremely difficult to bridge (Chart 16). If China comes to believe that the Biden administration is pursuing a technological blockade just as rapidly and resolutely as the Trump administration, then it could conclude that Taiwan should be brought to heel sooner rather than later. Chart 15US Boosts Arms Sales To Taiwan Chart 16Taiwan Strait Risk Will Explode If Biden Seeks Tech Blockade Bottom Line: On a secular basis, China faces rising domestic economic risks and rising geopolitical risk. Given the rally in Chinese currency and equities in 2021, the downside risk is greater than the upside risk of any fleeting “diplomatic reset” with the United States. Emerging markets will benefit from China’s stimulus this year but will suffer from its policy tightening over time. Key View #2: The US “Pivot To Asia” Is Back On … And Runs Through Iran Most likely President-elect Biden will face gridlock at home. His domestic agenda largely frustrated, he will focus on foreign policy. Given his old age, he may also be a one-term president, which reinforces the need to focus on the achievable. He will aim to restore the Obama administration’s foreign policy, the chief features of which were the 2015 nuclear deal with Iran and the “Pivot to Asia.” The US is limited by the need to pivot to Asia, while Iran is limited by the risk of regime failure. A deal should be agreed. The purpose of the Iranian deal was to limit Iran’s nuclear and regional ambitions, stabilize Iraq, create a semblance of regional balance, and thus enable American military withdrawal. The US could have simply abandoned the region, but Iran’s ensuing supremacy would have destabilized the region and quickly sucked the US back in. The newly energy independent US needed a durable deal. Then it could turn its attention to Asia Pacific, where it needed to rebuild its strategic influence in the face of a challenger that made Iran look like a joke (Chart 17). Chart 17The "Pivot To Asia" In A Nutshell It is possible for Biden to revive the Iranian deal, given that the other five members of the agreement have kept it afloat during the Trump years. Moreover, since it was always an executive deal that lacked Senate approval, Biden can rejoin unilaterally. However, the deal largely expires in 2025 – and the Trump administration accurately criticized the deal’s failure to contain Iran’s missile development and regional ambitions. Therefore Biden is proposing a renegotiation. This could lead to an even greater US-Iran engagement, but it is not clear that a robust new deal is feasible. Iran can also recommit to the old deal, having taken only incremental steps to violate the deal after the US’s departure – manifestly as leverage for future negotiations. Of course, the Iranians are not likely to give up their nuclear program in the long run, as nuclear weapons are the golden ticket to regime survival. Libya gave up its nuclear program and was toppled by NATO; North Korea developed its program into deliverable nuclear weapons and saw an increase in stature. Iran will continue to maintain a nuclear program that someday could be weaponized. Nevertheless, Tehran will be inclined to deal with Biden. President Hassan Rouhani is a lame duck, his legacy in tatters due to Trump, but his final act in office could be to salvage his legacy (and his faction’s hopes) by overseeing a return to the agreement prior to Iran’s presidential election in June. From Supreme Leader Ali Khamenei’s point of view, this would be beneficial. He also needs to secure his legacy, but as he tries to lay the groundwork for his power succession, Iran faces economic collapse, widespread social unrest, and a potentially explosive division between the Iranian Revolutionary Guard Corps and the more pragmatic political faction hoping for economic opening and reform. Iran needs a reprieve from US maximum pressure, so Khamenei will ultimately rejoin a limited nuclear agreement if it enables the regime to live to fight another day. In short, the US is limited by the need to pivot to Asia, while Iran is limited by the risk of regime failure. A deal should be agreed. But this is precisely why conflict could erupt in 2021. First, either in Trump’s final days in office or in the early days of the Biden administration, Israel could take military action – as it has likely done several times this year already – to set back the Iranian nuclear program and try to reinforce its own long-term security. Second, the Biden administration could decide to utilize the immense leverage that President Trump has bequeathed, resulting in a surprisingly confrontational stance that would push Iran to the brink. This is unlikely but it may be necessary due to the following point. Third, China and Russia could refuse to cooperate with the US, eliminating the prospect of a robust renegotiation of the deal, and forcing Biden to choose between accepting the shabby old deal or adopting something similar to Trump’s maximum pressure. China will probably cooperate; Russia is far less certain. Beijing knows that the US intention in Iran is to free up strategic resources to revive the US position in Asia, but it has offered limited cooperation on Iran and North Korea because it does not have an interest in their acquiring nuclear weapons and it needs to mitigate US hostility. Biden has a much stronger political mandate to confront China than he does to confront Iran. Assuming that the Israelis and Saudis can no more prevent Biden’s détente with Iran than they could Obama’s, the next question will be whether Biden effectively shifts from a restored Iranian deal to shoring up these allies and partners. He can possibly build on the Abraham Accords negotiated by the Trump administration smooth Israeli ties with the Arab world. The Middle East could conceivably see a semblance of balance. But not in 2021. The coming year will be the rocky transition phase in which the US-Iran détente succeeds or fails. Chart 18Oil Market Share War Preceded The Last US-Iran Deal Chart 19Still, Base Case Is For Rising Oil Prices Chart 20Biden Needs A Credible Threat The lead-up to the 2015 Iranian deal saw a huge collapse in global oil prices due to a market share war with Saudi Arabia, Russia, and the US triggered by US shale production and Iranian sanctions relief (Chart 18). This was despite rising global demand and the emergence of the Islamic State in Iraq. In 2021, global demand will also be reviving and Iraq, though not in the midst of full-scale war, is still unstable. OPEC 2.0 could buckle once again, though Moscow and Riyadh already confirmed this year that they understand the devastating consequences of not cooperating on production discipline. Our Commodity and Energy Strategy projects that the cartel will continue to operate, thus drawing down inventories (Chart 19). The US and/or Israel will have to establish a credible military threat to ensure that Iran is in check, and that will create fireworks and geopolitical risks first before it produces any Middle Eastern balance (Chart 20). Bottom Line: The US and Iran are both driven to revive the 2015 nuclear deal by strategic needs. Whether a better deal can be negotiated is less likely. The return to US-Iran détente is a source of geopolitical risk in 2021 though it should ultimately succeed. The lower risk of full-scale war is negative for global oil prices but OPEC 2.0 cartel behavior will be the key determiner. The cartel flirted with disaster in 2020 and will most likely hang together in 2021 for the sake of its members’ domestic stability. Key View #3: Europe Wins The US Election Chart 21Europe Won The US Election The European Union has not seen as monumental of a challenge from anti-establishment politicians over the past decade as have Britain and America. The establishment has doubled down on integration and solidarity. Now Europe is the big winner of the US election. Brussels and Berlin no longer face a tariff onslaught from Trump, a US-instigated global trade war, or as high of a risk of a major war in the Middle East. Biden’s first order of business will be reviving the trans-Atlantic alliance. Financial markets recognize that Europe is the winner and the euro has finally taken off against the dollar over the past year. European industrials and small caps outperformed during the trade war as well as COVID-19, a bullish signal (Chart 21). Reinforcing this trend is the fact that China is looking to court Europe and reduce momentum for an anti-China coalition. The center of gravity in Europe is Germany and 2021 faces a major transition in German politics. Chancellor Angela Merkel will step down at long last. Her Christian Democratic Union is favored to retain power after receiving a much-needed boost for its handling of this year’s crisis (Chart 22), although the risk of an upset and change of ruling party is much greater than consensus holds. Chart 22German Election Poses Political Risk, Not Investment Risk However, from an investment point of view, an upset in the German election is not very concerning. A left-wing coalition would take power that would merely reinforce the shift toward more dovish fiscal policy and European solidarity. Either way Germany will affirm what France affirmed in 2017, and what France is on track to reaffirm in 2022: that the European project is intact, despite Brexit, and evolving to address various challenges. The European project is intact, despite Brexit, and evolving to address various challenges. This is not to say that European elections pose no risk. In fact, there will be upsets as a result of this year’s crisis and the troubled aftermath. The countries with upcoming elections – or likely snap elections in the not-too-distant future, like Spain and Italy – show various levels of vulnerability to opposition parties (Chart 23). Chart 23Post-COVID EU Elections Will Not Be A Cakewalk Chart 24Immigration Tailwind For Populism Subsided The chief risks to Europe stem from fiscal normalization and instability abroad. Regime failures in the Middle East and Africa could send new waves of immigration, and high levels of immigration have fueled anti-establishment politics over the past decade. Yet this is not a problem at the moment (Chart 24). And even more so than the US, the EU has tightened border enforcement and control over immigration (Chart 25). This has enabled the political establishment to save itself from populist discontent. The other danger for Europe is posed by Russian instability. In general, Moscow is focusing on maintaining domestic stability amid the pandemic and ongoing economic austerity, as well as eventual succession concerns. However, Vladimir Putin’s low approval rating has often served as a warning that Russia might take an external action to achieve some limited national objective and instigate opposition from the West, which increases government support at home (Chart 26). Chart 25Europe Tough On Immigration Like US Chart 26Warning Sign That Russia May Lash Out Chart 27Russian Geopolitical Risk Premium Rising The US Democratic Party is also losing faith in engagement with Russia, so while it will need to negotiate on Iran and arms reduction, it will also seek to use sanctions and democracy promotion to undermine Putin’s regime and his leverage over Europe. The Russian geopolitical risk premium will rise, upsetting an otherwise fairly attractive opportunity relative to other emerging markets (Chart 27). Bottom Line: The European democracies have passed a major “stress test” over the past decade. The dollar will fall relative to the euro, in keeping with macro fundamentals, though it will not be supplanted as the leading reserve currency. Europe and the euro will benefit from the change of power in Washington, and a rise in European political risks will still be minor from a global point of view. Russia and the ruble will suffer from a persistent risk premium. Investment Takeaways As the “Year of the Rat” draws to a close, geopolitical risk and global policy uncertainty have come off the boil and safe haven assets have sold off. Yet geopolitical risk will remain elevated in 2021. The secular drivers of the dramatic rise in this risk since 2008 have not been resolved. To play the above themes and views, we are initiating the following strategic investment recommendations: Long developed market equities ex-US – US outperformance over DM has reached extreme levels and the global economic cycle and post-pandemic revival will favor DM-ex-US. Long emerging market equities ex-China – Emerging markets will benefit from a falling dollar and commodity recovery. China has seen the good news but now faces the headwinds outlined above. Long European industrials relative to global – European equities stand to benefit from the change of power in Washington, US-China decoupling, and the global recovery. Long Mexican industrials versus emerging markets – Mexico witnessed the rise of an American protectionist and a landslide election in favor of a populist left-winger. Now it has a new trade deal with the US and the US is diversifying from China, while its ruling party faces a check on its power via midterm elections, and, regardless, has maintained orthodox economic policy. Long Indian equities versus Chinese – Prime Minister Narendra Modi has a single party majority, four years on his political clock, and has recommitted to pro-productivity structural reforms. The nation is taking more concerted action in pursuit of economic development since strategic objectives in South Asia cannot be met without greater dynamism. The US, Japan, Australia, and other countries are looking to develop relations as they diversify from China. Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com
Highlights Biden’s chances of winning the US election are rising, but it is still unsettled and could bring negative surprises to financial markets. The fiscal cliff will not subside immediately as the Senate Republicans have been vindicated for their fiscally hawkish approach. We doubt Democrats will win both Senate seats in Georgia to restore the lost “Democratic Sweep” scenario that offered maximum policy reflation. President Trump’s lame duck period, if he loses, lasts for three months and could bring negative surprises on China, the Taiwan Strait, Big Tech, Iran, or North Korea. The US remains at “peak polarization,” though we expect a growing national consensus over the long haul. Go long a basket of Trans-Pacific Partnership countries on a strategic time horizon to capitalize on what we believe will be Biden’s pro-trade-ex-China policy. Feature Chart 1Market Response To US Election The US presidential election remains undecided despite former Vice President Joe Biden’s increasing likelihood of victory. Votes will be recounted in several states while one potential tipping-point state, Pennsylvania, could easily swing on a Supreme Court decision. The Senate is likely to remain in Republican hands, though there is still a ~20% chance that it will flip if Democrats win both of the likely Georgia runoff elections on January 5. Thus our base case is the same as in our final forecast: Biden plus a Republican Senate. Financial markets first rallied and have now paused (Chart 1). The pause makes sense to us. Ultimately the best-case scenario of this election was always Biden plus a Republican Senate – neither tariffs nor taxes would increase. But this same scenario also always posed the highest risk of near-term fiscal tightening that would undermine the US recovery and global reflation trade. GOP Senators will insist on a smaller fiscal relief bill and may wait too long to enact it. Below we discuss these dynamics and why we maintain a tactically defensive position amid this contested election. We will not go full risk-on until the critical short-run risks subside: the contested election, the fiscal impasse, Trump’s “lame duck” executive orders, and the international response. Biden Not Yet President-Elect Biden is leading the vote tally in Arizona, Georgia, Michigan, Nevada, Pennsylvania, and Wisconsin as we go to press. To all appearances he has reclaimed the “Blue Wall” (MI, PA, WI) and made inroads in the Sun Belt (AZ, GA). We will not go full risk-on until the critical short-run risks subside. Map 1 shows tentative election results. Unsettled states are colored lightly while settled states are solid red or blue. This map points to a Biden victory even if Georgia and Pennsylvania slip back to Trump. The President would need to reclaim the latter two and one other state to reach 270 Electoral College votes. Map 1US 2020 Election Results (Tentative) Chart 2 shows the final prediction of our quantitative model. While our model predicted a Trump victory at 51% odds, we subjectively capped Trump’s odds at 45% because we disagreed that Trump would win Michigan.1 We did not do the same for our Senate model as the results matched with our subjective judgment that Republicans would keep control. Chart 2Our Presidential Quant Model Versus Actual Results Investors cannot yet conclude that the contested election risks have abated. If Biden wins only AZ, NV, MI, and WI, then he will end up with 270 Electoral College votes. This is the minimal vote needed for a victory. It is legitimate, but it means that a net of one faithless elector, or a disqualified elector, could throw the nation into a historic and nearly unprecedented crisis. If the Electoral College becomes indecisive for any reason, the House of Representatives will decide the election. Each state will get one vote. The results of the election suggest Republicans have four-to-ten seat majority of state delegations in the House (Table 1). Trump would win. Polarization and unrest would explode. Not for nothing did we brand this election cycle “Civil War Lite.” Table 1State Delegations In US House Of Representatives The greater the margin of victory in the Electoral College, the less vulnerable the nation is to indecision in the college, or to a result decided in the courts. The Republicans have a strong case in Pennsylvania that votes that arrived after November 3 should not be counted. It is not clear if the Supreme Court will revisit the case, having left it unresolved prior to the election. If Pennsylvania’s 20 electoral votes become the fulcrum of the election, and the Supreme Court rules to exclude votes received after November 3, and if Trump thereby wins the count, a national crisis will erupt. This is not high probability at the moment because Biden can afford to lose Pennsylvania if he wins Nevada or Georgia. But the history of contested elections teaches that investors should not rush to conclusions. Senate Gridlock Will Survive Georgia Runoffs The most likely balance of power is a Democratic president with a Republican Senate and Democratic House, i.e. gridlock. Chart 3 shows the likely balance of power in Congress. Democrats would need to win both runoff elections in Georgia to win 50 seats, which would give them a de facto majority if Biden wins, since Vice President Kamala Harris would become President of the Senate and break any tie votes there. They are unlikely to do so. Chart 3AGridlock In US Government Chart 3BGridlock In US Government Why do we doubt that Democrats will win both Georgia seats, given that Trump is now falling short in the statewide presidential vote? First, Republicans tend to do well in runoffs as Georgia is a conservative-leaning state (Chart 4). Second, the Republican vote was greater than the Democratic vote in both Senate elections, though falling short of 50%. Third, exit polls show that voters leaned Republican in the suburbs and were mostly concerned about the economy, not the coronavirus. Fourth, also clear from exit polls, Republican voters will be more motivated to retain control of the Senate with Trump out, while Democratic voters will be less motivated with Biden in (Chart 5). Voter turnout will drop in the special election as usual. Neither Trump nor the presidency will be on the ballot on January 5. Still, it is possible for Democrats to win both seats and hence de facto control of the Senate. We would say the odds are roughly 20% (0.5 x 0.4 = 0.2). Chart 4GOP Does Well In Georgia Runoffs Chart 5Georgia 2020 Election Results (So Far) If Democrats pulled off two victories in Georgia, the “Blue Sweep” scenario would be reaffirmed and several legislative proposals that had a 0% chance of passage in a Republican Senate would become at least possible. Certainly taxes would go up – the Democrats would be able to use the reconciliation process to push through reforms to the health care system paid for by partially repealing the Trump Tax Cut and Jobs Act. They would also be able to pass legislation that is popular with moderate Democrats who would then hold the balance in the Senate. The Green New Deal would become possible, if highly improbable. There would be a small chance of removing the filibuster in an exigency, but a vanishingly small chance of other radical structural changes, like creating new seats on the Supreme Court or granting statehood to Washington DC and Puerto Rico. A 50-50 count in the Senate, with Harris breaking the tie, would produce a larger increase in the budget deficit than otherwise. Stocks would have to discount the tax hike but they would recover quickly on the prospect of combined monetary and fiscal ultra-dovishness. Fiscal Impasse Prolonged Biden plus a Republican Senate is positive for the US corporate earnings outlook over the 24 months between now and the 2022 midterm election. It is also positive for the global earnings outlook over the four-year period due to the drastically reduced odds of a global trade war. But it is negative in the near term because it will result in a smaller and delayed fiscal relief package – and sooner than later the market will need a signal that the government will not pull the rug out from under the recovery. Biden plus a GOP Senate is negative in the near term due to fiscal risks but positive beyond that. True, the US economy continues to bounce back rapidly, which is why the Republicans performed so well in this election despite a recession, a pandemic, and a failure to pass another round of stimulus beforehand. In October the unemployment rate fell to 6.9%. Yet previous rounds of fiscal support are drying up. The job market is showing some signs of underlying weakness and these will worsen as long as benefits run out and COVID-19 cases discourage economic activity (Chart 6). Personal income has dropped off from its peak when the first round of stimulus was passed in March. Without the dole it will relapse (Chart 7). Chart 6US Job Market Weakening Sans Stimulus Chart 7US Personal Income Will Drop Sans Stimulus Will Senate Republicans agree to a fiscal deal in the “lame duck” session before the new Congress sits on January 3? We have no basis for a high-conviction view. They might agree to a deal in the range of $500 billion to $1 trillion, but only if the Democrats come down to these levels in the talks. Senate Majority Leader Mitch McConnell is one of the big winners of the election. He held his seat and likely maintained Republican control of the Senate without capitulating to House Speaker Nancy Pelosi’s demands of a $3 trillion-plus relief bill. He wagered that Republicans would do better with voters if they concentrated on reopening the economy (and confirming Amy Coney Barrett to the Supreme Court) while limiting any fiscal bill to targeted COVID response measures. He drew a hawkish line against broad-based social spending and bailouts for state and local governments. The gambit appears to have worked. House Democrats, far from gaining seats, lost five. We would not be surprised if Pelosi were replaced as speaker in 2021. Her plan backfired so badly that if Trump had stayed on message in his campaign, he might even have won. The implication is that unless Pelosi comes down to McConnell’s number, the fiscal impasse will extend into January and February. The American public approves of fiscal relief, but that did not force McConnell’s hand earlier, as the economy was recovering regardless (Table 2). Unless the economy slumps or financial markets selloff drastically, he will likely insist on a skinny deal that includes liability protections for businesses while minimizing bailouts for indebted blue states. Table 2Americans Support Fiscal Stimulus Package Hence investors are likely to get bad news before good news on the US fiscal front. And if other bad news arises, the absence of fiscal support will be sorely felt. This motivates our tactically defensive posture until the fiscal impasse is resolved. Peak Polarization Polarization is at peak levels in the US and the election result suggests it will remain elevated. Whichever party wins will win with a narrow margin. There is simply no commanding mandate for either party, as has been the case this century, so the struggle will continue (Chart 8). Chart 8Polarization Will Continue With Narrow Margins Of Victory Of course, polarization may subside temporarily, assuming Trump loses. At least under Biden the Electoral College vote will coincide with the popular vote, improving popular consent. Biden will have a lower disapproval rating, probably throughout his term. High disapproval tends to coincide with crises in modern US history, but in 2021, after the dust clears from this election, the country may catch its breath (Chart 9). Chart 9Presidential Disapproval Will Fall Much will depend on whether the presumed Biden administration is willing to sideline the left-wing of the Democratic Party to court the median voter. Exit polling in the swing states strongly suggests that the Biden administration won the election (if indeed it did) by improving Democratic support among the majority white population, non-college educated voters, and senior citizens, all groups that delivered Trump the victory in 2016. The Democrats had mixed results among ethnic minorities and suburban voters. Their biggest liability was their focus on issues other than the economy (Chart 10). Chart 10Exit Polls Say Focus On Bread And Butter Over the coming decade we think the combination of (1) cold war with China and (2) generational change on fiscal policy will produce a new national consensus. But we are not there yet. The contested election is not guaranteed to end amicably. If Trump wins on a technicality, the country will erupt into mass protests; if he loses and keeps crying stolen election, isolated domestic terrorist incidents are entirely possible. Moreover the battle over the 2020 census and redistricting process will be fierce. Democrats will be hungry to take the Senate in 2022, failing Georgia in January, to achieve major legislative objectives while Biden is in office. And the 2024 election will be vulnerable to the fact that Biden may have to bow out due to old age, depriving the Democrats of an incumbent advantage. The bottom line is that Republicans outperformed and will not be inclined to help the Biden administration start off on strong footing. The implication is the fiscal battle will extend into the New Year unless a stock market selloff forces Republicans to compromise. Fiscal cliffs will be a recurring theme until at least the 2022 election. A deflationary tail risk will persist. Obama’s Legacy Secured? The sole significance of a gridlocked Biden presidency will lie in regulatory affairs, foreign policy, and trade policy. These are the policy areas where presidents have unilateral authority and Biden can act without the Senate’s approval. In this context, Biden’s sole focus will be to consolidate the legacy of the Barack Obama administration, in which he served. 1. Obamacare (ACA): Republicans failed to repeal and replace this bill despite a red sweep in 2016. Biden’s election ensures that Obamacare will be implemented, if not expanded, as he will have the power to enforce the law at the executive level. The risk is that the conservative-leaning Supreme Court could strike it down. Based on past experience, the health care sector will benefit from the drop in uncertainty once the court’s decision is known (Chart 11). For investors the lesson of the past four election cycles is that Obamacare is here to stay, but Americans will not adopt a single-payer system until 2025 at the earliest conceivable date. We are long health equipment and see this outcome as beneficial to the health sector in general, particularly health insurance companies. Big Pharma, however, will suffer from bipartisan populist pressures to cap prices. 2. Iran Nuclear Deal (JCPA): Biden will seek to restore Obama’s signature foreign policy accomplishment, the Joint Comprehensive Plan of Action, i.e. the Iran nuclear deal of 2015. The purpose of the deal was to establish a modus vivendi in the Middle East so that the US could “pivot to Asia” and focus its energy on the existential strategic challenge posed by China. Biden will stick with this plan. The Iranians also want to restore the deal but will play hard to get at first. Israel and Saudi Arabia could act to thwart Iran and tie Biden’s hands in the final three months of Trump’s presidency while they have unmitigated American backing. Chart 11Obamacare Preserved The implication is that Iranian oil production will return to oil markets (Chart 12), but that conflict could cause production outages, and Saudi Arabia could increase production to seize market share. Hence price volatility is the outcome, which makes sense amid fiscal risks and COVID risks to demand as well. 3. The Trans-Pacific Partnership (CPTPP): Biden claims he will “renegotiate” the Trans-Pacific Partnership, which was the Obama administration’s key trade initiative. The idea was to group like-minded Pacific Rim countries into an advanced trade deal that addressed services, the digital economy, labor and environmental standards, and pointedly excluded China. Trump withdrew from the deal out of pique despite the fact that it served the purpose of diversifying the American supply chain away from China. The impact of rejoining is miniscule from an economic point of view (Chart 13), but it will be a boon for small emerging markets like Mexico, Chile, Vietnam, and Malaysia. Chart 12Restoring The Iran Nuclear Deal Chart 13Rejoining The Trans-Pacific Partnership The bigger takeaway is that Biden will continue the US grand strategic shift toward confronting China, which will be a headwind toward Chinese manufacturing and a tailwind for India, Latin America, Southeast Asia. The US will cultivate relations with the Association of Southeast Asian Nations (ASEAN) as a more coherent economic bloc and a manufacturing counterweight to China (Chart 14). A lame duck Trump will attempt to cement his legacy by targeting China/Taiwan, Iran, North Korea, or Big Tech. When it comes to on-shoring, Biden’s focus will be reducing dependency on China and improving the US’s supply security in sensitive areas like health and defense. Trade and strategic tensions with China will persist, but a global trade war is not in the cards. Manufacturing economies ex-China stand to benefit. 4. The Paris Climate Accord: Biden will not be able to pass his own version of the Green New Deal without the Senate, so investor excitement over a government-backed surge in green investment will subside for the time being (Chart 15). He will also moderate his stance on the energy sector after his pledge to phase out oil and gas nearly cost him the election. He was never likely to ban fracking comprehensively anyway. Chart 14ASEAN's Moment Biden will be able to rejoin the international Paris Agreement and reverse President Trump’s deregulation of the energy sector. He will re-regulate the economy to lift clean air, water, environment, and sustainability standards. This is a headwind for the energy sector, but stocks are already heavily discounted and congressional gridlock is a positive surprise. Chart 15Returning To The Paris Climate Accord There may be some room for compromise with Senate Republicans when it comes to renewables in a likely infrastructure package next year. Post-Trump Republicans may also be interested in Biden’s idea of a “carbon adjustment fee” on imports, which is another way of saying tariffs on Chinese-made goods. Like the health care sector, the election is tentatively positive for US energy stocks – especially once fiscal risks are surmounted. Investment Takeaways Chart 16Lame Duck Trump Risk: Taiwan Strait Three near-term risks prevent us from taking a tactically risk-on investment stance. First, the contested election, which could still throw up surprises. Second, the fiscal stimulus impasse, which could persist into January or February and will reduce the market’s margin of safety in the event of other negative surprises. Third, a lame duck Trump will attempt to cement his legacy via executive orders. He could target China/Taiwan, Iran, North Korea, or even Big Tech. On China, Trump is already tightening export controls on China and selling a large arms package to Taiwan (Chart 16). The lame duck period of any presidency is a useful time for the US to advance strategic objectives. Trump will also blame China and the coronavirus for his defeat. He could seek reparations for the virus, restrictions on Chinese manufacturing and immigration to the US, export controls or sanctions on tech companies, secondary sanctions over Iran or North Korea, delisting of Chinese companies listed in the US, sanctions over human rights violations in China’s autonomous regions, or travel bans on Communist Party members. During these three months, Big Tech will face crosswinds – risks from Trump, but opportunities from gridlock. Polarization has helped support US equity and tech outperformance over the past decade. Frequent hold-ups over the budget in Congress weigh on growth and inflation expectations, thus favoring growth stocks and tech. Internal divisions have prompted the US to lash out abroad, increasing risks to international stocks and driving safe-haven demand into the dollar and tech. More broadly the second wave of the pandemic is a boon for tech earnings and Biden will restore the Obama administration’s alliance with Silicon Valley. But tech is already priced for perfection and this favorable trend will be cut short when COVID restrictions ease and Biden works out a compromise with the Senate GOP over stimulus and the budget (Chart 17). Beyond these near-term risks, we have a constructive outlook for risk assets over the next 12 months. Chart 17Biden, Peak Polarization, And Big Tech Chart 18Global Stocks, Cyclicals Benefit When US Fiscal Impasse Resolved Insofar as Biden seeks to restore US commitment to global free trade, and more stable and cooperative relations with allies and partners ex-China, global policy uncertainty should fall relative to the United States. Once near-term fiscal hurdles are cleared, the dollar’s strength can subside and global stocks and global cyclicals can start to outperform (Chart 18). Chart 19Trump An Exclusively Commercial President We also favor stocks over bonds on a strategic horizon. Trump was an exclusively commercial president whose approval rating had a tight correlation with the stock-to-bond ratio (Chart 19). A surge in stocks would help power Trump’s approval. This relationship is not standard across presidents. But it does make sense during periods of policy change that affect earnings. Trump’s tax cuts are the best example. Equities outpaced bonds in anticipation of tax cuts in 2017. Trump’s approval rating recovered once the bill was passed. President Obama’s approval rating also correlated somewhat with the stock-to-bond ratio during the critical fiscal cliff negotiations under gridlock from 2010-12. Once Biden works out a compromise with GOP Senators, bond yields will rise and stocks will power upward. The takeaway from these points is that volatility can remain elevated over the next 0-3 months (Chart 20). We would not expect it to go as high as in 2000, when the dotcom bubble burst, but Trump’s lame duck maneuvers against China could generate a massive selloff. But this cannot be ruled out. Indeed, Trump’s constraints have almost entirely fallen away regardless of whether he loses or wins. Investors should take a phased and conservative approach to adding risk in the near term. The outlook will brighten up when the president is known, a fiscal deal is reached, and President Trump’s legacy as the Man Who Confronted China is complete. Chart 20Volatility Will Stay Elevated In Short Run Chart 21Go Long Trans-Pacific Partnership Given our view that Biden will be hawkish on China, especially amid gridlock at home, we are maintaining our short CNY-USD trade. We also recommend buying a basket of Trans-Pacific Partnership bourses, weighted by global stock market capitalization, on a strategic time-frame to capture what we expect will be Biden’s pro-trade-ex-China policy (Chart 21). Finally, to capture the views expressed above regarding Biden’s likely market impacts, over the short and long run, we will go long US health care relative to the broad market on a tactical basis and long US energy on a strategic basis. Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Footnotes 1 As things stand, the model overrated the Republicans in Arizona and Georgia as well, though really Georgia looks to be the only state Democrats won that the model gave high odds of staying Republican. If we had used the level rather than the range of Trump’s approval rating – or if we had neglected opinion polling altogether – the model would have called a Biden win.
Chart Of The WeekInvestor Consensus Is Bearish On Dollar Today we are releasing another issue from our series Charts That Matter. Going forward, this publication will become a regular monthly deliverable to our clients. This is a charts-only report with minimal wording. It presents the key charts, indicators, and relationships that we monitor at the time of publication. Needless to say, the importance of different indicators and factors varies over time. Thus, each issue of Charts That Matter will present different charts, indicators and relationships. Presently, global assets are experiencing a tug-of-war. On the one hand, equity and credit markets are overbought and have elevated valuations. On the other hand, expectations of a large US fiscal stimulus package are sustaining prospects of continued US and global economic recoveries. We have been expecting a pullback in risk assets before year-end due to a delay in significant US fiscal stimulus, potential volatility around the US elections as well as overbought conditions in risk assets. In addition, since April commodities prices have benefited from China’s growth recovery as well as inventory restocking (see Charts on page 11). Given that the latter is likely to be followed by a destocking phase, we believe resource prices are at a risk of experiencing a setback. This will weigh on commodity-producing emerging markets. The correction in September has been short circuited. It seems the prospects of an eventual large US fiscal stimulus package, even if it is next year, and the ongoing recovery in China (Charts on pages 8-9) are sustaining a bid under risk assets. Besides, cash on the sidelines has not been fully exhausted (Charts on page 6). Consistently, we illustrate on pages 3 that various US equity indexes are presently trying to break out and that the US equity market breadth has recently been strong. In contrast, EM equity breadth has been very weak (Chart on page 4). The latest rebound in the EM equity index has been again narrow, led by mega-cap new economy stocks in China, Korea and Taiwan. Provided such poor EM equity breadth in both absolute terms and relative to the US, we are reluctant to upgrade EM equities from neutral to overweight in a global equity portfolio. As to absolute performance, the Charts on pages 12-18 illustrate that many market-based indicators are flagging yellow or red lights for EM risk assets. Even though we turned structurally bearish on the US dollar in early July, we currently expect a tactical rebound in the greenback. Investor sentiment on the greenback is very depressed, which is positive for the US dollar from a contrarian perspective (Chart of the Week on page 1). In short, global financial markets are due to reset, which will not be long-lasting but will be meaningful and produce a better entry point. For now, we maintain a neutral allocation to EM stocks and credit markets within global equity and credit portfolios, respectively. In the currency space, we are short several EM currencies – BRL, CLP, ZAR, TRY, KRW and IDR – versus a basket of the euro, CHF and JPY. As to local rates, we are long duration – receiving 10-year swap rates in several countries – but are reluctant to take on currency risk at the moment. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com US Equities Have Been Trading Well Various US equity indexes have broken out to new cyclical highs. This is a sign of a broad-based rally. Chart I-1US Equities Have Been Trading Well Chart I-2US Equities Have Been Trading Well Equity Market Breadth Is Strong In The US But Poor In EM The advance-decline line for the US equity market has rebounded from the neutral level of 0.5. On the contrary, the same measure for EM stocks remains below the 0.5 line, signaling poor breadth despite the rebound in the EM equity index. Chart I-3Equity Market Breadth Is Strong In The US But Poor In EM The World Economy And Global Trade Are Reviving Economic data for September continue to register a sequential revival in business activity in most parts of the world. Chart I-4The World Economy And Global Trade Are Reviving Chart I-5The World Economy And Global Trade Are Reviving The US: Cash On The Sidelines Has Declined But Is Not Exhausted US institutional and money market funds presently amount to 8.5% of the value of the US equity market cap plus all US-dollar denominated bonds available to investors. The Fed and commercial banks hold $11 trillion of debt securities. This amount of securities has been withdrawn from the market and is not available to non-bank investors. Chart I-6The US: Cash On The Sidelines Has Declined But Is Not Exhausted Chart I-7The US: Cash On The Sidelines Has Declined But Is Not Exhausted A Delay In The US Fiscal Stimulus Package Is A Risk to The US Economy US fiscal transfers have produced a surge in household disposable income, which through consumer spending have contributed to the global recovery via a widening trade deficit. In the absence of large fiscal transfers to consumers, the opposite dynamics will prevail. Chart I-8A Delay In The US Fiscal Stimulus Package Is A Risk to The US Economy Chart I-9A Delay In The US Fiscal Stimulus Package Is A Risk to The US Economy The Business Cycle In China Is Recovering China’s domestic demand and production are recovering but labor market improvements are still timid. Chart I-10The Business Cycle In China Is Recovering Chart I-11The Business Cycle In China Is Recovering China: The Stimulus Is Working Its Way Into The Economy In China, the credit and fiscal stimulus leads the business cycle by about nine months. Thereby, China’s recovery will continue until the end of Q2 2021. Chart I-12China: The Stimulus Is Working Its Way Into The Economy Chart I-13China: The Stimulus Is Working Its Way Into The Economy China: Liquidity Tightening Has Not Yet Affected Money And Credit Growth The PBoC has withdrawn liquidity, pushing up the policy rate and bond yields. With a time lag, money and credit growth will eventually roll over. But for now, China is enjoying another period of credit splurge and the credit excesses are getting larger. Chart I-14China: Liquidity Tightening Has Not Yet Affected Money And Credit Growth Chart I-15China: Liquidity Tightening Has Not Yet Affected Money And Credit Growth China: From Commodities Restocking To Destocking? Chinese imports of many commodities have been super strong since April. However, they have substantially outpaced their final demand. This suggests there has been an inventory restocking phase. This will likely soon be followed by a period of destocking when Chinese imports of resources dwindle for several months. Chart I-16China: From Commodities Restocking To Destocking? Chart I-17China: From Commodities Restocking To Destocking? Red Flags For EM Currencies The rollover in platinum prices and pick-up in EM currency volatility (shown inverted on the bottom panel) point to a rebound in the US dollar and a relapse in EM exchange rates. Chart I-18Red Flags For EM Currencies Yellow Flags For EM Equities The new cyclical high in EM share prices has not been confirmed by a new low in EM equity volatility (the latter shown inverted in the top panel). Moreover, our Risk-On/Safe-Haven Currency ratio has been trending lower since June, flagging risks to EM assets. Finally, global ex-TMT stocks are struggling to break above their June highs. Chart I-19Yellow Flags For EM Equities EM Sovereign And Corporate Spreads, Currencies, Equities And Commodities Commodities prices and EM currencies drive EM sovereign and corporate spreads while EM corporate bond yields (shown inverted in the bottom panel) correlate with EM share prices. Chart I-20EM Sovereign And Corporate Spreads, Currencies, Equities And Commodities Many Currencies Against The US Dollar Are At Critical Resistances If these currencies break out of these technical resistance levels, they will experience a lasting appreciation versus the US dollar. However, in our view, they will initially weaken before breaking out next year. Chart I-21Many Currencies Against The US Dollar Are At Critical Resistances Chart I-22Many Currencies Against The US Dollar Are At Critical Resistances Are Global Defensive Equity Sectors On A Cusp Of Outperformance? Many defensive equity sectors have reached or are close to their technical support lines. Their outperformance will likely occur during a risk-off period. Chart I-23Are Global Defensive Equity Sectors On A Cusp Of Outperformance? Chart I-24Are Global Defensive Equity Sectors On A Cusp Of Outperformance? These Markets Have Not Yet Entered A Bull Market These markets have rebounded to their technical resistance lines but have so far failed to break out. This gives us comfort to remain neutral on EM by expecting a pullback. Chart I-25These Markets Have Not Yet Entered A Bull Market Chart I-26These Markets Have Not Yet Entered A Bull Market Risk Measures Signal Modest Investor Complacency The SKEW index for the S&P 500 is low, entailing that investors are not hedging tail risks. The put-call ratio is not elevated despite many investors hedging against the US election uncertainty. Critically, the Nasdaq’s volatility is in a bull market. Chart I-27Risk Measures Signal Modest Investor Complacency Chart I-28Risk Measures Signal Modest Investor Complacency EM (ex-China, Korea And Taiwan): The Recovery Is Sluggish And Subdued Outside China, Korea and Taiwan, EM domestic demand recovery is very slow and tame. In these economies, the fiscal stimulus has been small, the banking system is unhealthy and the monetary transmission mechanism is broken, i.e. banks are failing to properly transmit monetary easing into the real economy. Chart I-29EM (ex-China, Korea And Taiwan): The Recovery Is Sluggish And Subdued Chart I-30EM (ex-China, Korea And Taiwan): The Recovery Is Sluggish And Subdued Footnotes Equities Recommendations Currencies, Credit And Fixed-Income Recommendations
Highlights Both public opinion polls and betting markets suggest that Joe Biden will become President, with the Democrats gaining control of the Senate and retaining the House of Representatives. Such a “blue wave” would have mixed effects on the value of the S&P 500. On the one hand, corporate taxes would rise under a Biden administration. On the other hand, trade relations with China would improve. The Democrats would also push for more fiscal stimulus, which the stock market would welcome. The odds of Republicans and Democrats agreeing on a major new stimulus deal before the November elections look increasingly slim. In a blue wave scenario, the Democrats will enact $2.5-to-$3.5 trillion in pandemic relief shortly after Inauguration Day. Joe Biden‘s platform also calls for around 3% of GDP in additional spending on infrastructure, health care, education, climate, housing, and other Democratic priorities. Unlike in late 2016, the Fed is in no mood to raise interest rates. Large-scale fiscal easing will push down the value of the US dollar, while giving bond yields a modest boost. Non-US stocks will outperform their US peers. Value stocks will outperform growth stocks. Looking further out, Republicans will move to the left on economic issues, leaving corporate America with no clear backer among the two major parties. As such, while we are constructive on equities over the next 12 months, we see grave dangers ahead later this decade. Look, Here's The Deal: Joe Biden Is In The Lead With four weeks remaining until the US presidential election, Joe Biden remains on course to become the 46th president of the United States. According to recent public opinion polls, the former vice president leads Donald Trump by 10 percentage points nationwide, and by 4 points in battleground states (Chart 1). Far fewer voters are undecided today compared to 2016. This suggests that there is less scope for President Trump to narrow his deficit in the polls. Betting markets give Biden a 68% chance of prevailing in the race for the White House (Chart 2). They also assign a 67% probability that the Democrats will take control of the Senate and 89% odds that they will retain their majority in the House of Representatives. Chart 1Opinion Polls Favor Biden ... Chart 2.... As Do Betting Markets Mixed Impact On The S&P 500 What would the market implications of a “blue wave” be? Our sense is that the overall impact on the value of the S&P 500 would be small, largely because some negative repercussions from a Democratic sweep would be offset by positive repercussions. On the negative side, Biden has pledged to raise the corporate income tax rate from 21% to 28%, bringing it halfway back to the 35% rate that prevailed in 2017. He has also promised to introduce a minimum of 15% tax on the income that companies report in their financial statements to shareholders, raise taxes on overseas profits, and lift payroll taxes on households with annual earnings in excess of $400,000. Together, these measures would reduce S&P 500 earnings-per-share by 9%-to-10%. On the positive side, while geopolitical tensions will persist, US trade relations with China would likely improve if Joe Biden were to become the president. Biden has roundly criticized Trump’s tariffs, saying that they are “crushing farmers” and “hitting a lot of American manufacturing… choking it to within an inch of its life.”1 He has pledged to honor multilateral agreements. The World Trade Organization concluded on September 15 that Trump’s tariffs violated international trade rules. This judgement and the desire to turn the page on the Trump era could give Biden the impetus to eventually roll back some of the tariffs. In contrast, having been stricken by what he has called the “China virus,” Trump could take things personally and retaliate with a flurry of new punitive measures. Fiscal policy would be further loosened in a blue wave scenario, an outcome that the stock market would welcome. Voters would also applaud more pandemic relief. Table 1 shows that 72% of Americans, including the majority of Republicans, support the broader contours of the $2 trillion stimulus package that President Trump has rejected. Table 1Voters Support A New $2 Trillion Coronavirus Stimulus Package By A Fairly Wide Margin At this point, the odds of Republicans and Democrats agreeing on a major new stimulus deal before the November elections look increasingly slim. If Biden wins and the Republicans lose control of the senate, the Democrats would likely enact a stimulus package worth $2.5-to-$3.5 trillion shortly after Inauguration Day on January 20. In addition to pandemic-related stimulus, Joe Biden has called for around 3% of GDP in spending on infrastructure, health care, education, climate, housing, and other Democratic priorities. Only about half of those expenditures would be matched by higher taxes, implying substantial net stimulus for the economy. A Weaker Dollar And Modestly Higher Bond Yields The greenback jumped on Tuesday after President Trump said he is breaking off negotiations with the Democrats over a new stimulus bill. This suggests that the dollar will weaken if fiscal policy is loosened. If that were to happen, it would be different from what transpired following Trump’s victory in 2016 when the dollar strengthened. Why the disconnect between now and then? The answer has to do with the outlook for monetary policy. Back then, the Fed was primed to start raising rates again – it hiked rates eight times beginning in December 2016, ultimately bringing the fed funds rate to 2.5% by end-2018 (Chart 3). This time around, the Fed is firmly on hold, with the vast majority of FOMC members expecting policy rates to stay at rock-bottom levels until at least 2023. This suggests that nominal bond yields will rise less than they did in late 2016. Since inflation expectations will likely move up in response to more stimulative fiscal policy, real yields will rise even less than nominal yields. Over the past 18 months, US real rates have fallen a lot more in relation to rates abroad than what one would have expected based on the fairly modest depreciation in the US dollar (Chart 4). If US real rates remain entrenched deep in negative territory, while the US current account deficit widens further on the back of strong domestic demand, the dollar will continue to weaken. Chart 3Trump Victory Was Followed By Rising Interest Rates Chart 4A Relatively Muted Decline In The Dollar Given The Move In Real Yield Differentials Favor Non-US And Value Stocks Non-US stocks typically outperform their US peers when the dollar is weakening (Chart 5). This partly stems from the fact that cyclical stocks are overrepresented in stock markets outside of the United States. It also reflects the fact that cash flows denominated in say, euros or yen, are worth more in dollars if the value of the dollar declines. Chart 5A Weaker Dollar Tends To Benefit Cyclical And Non-US Stocks Financial stocks are overrepresented outside the US (Table 2). They are also overrepresented in value indices (Table 3). While a Biden administration would subject the largest US banks to additional regulatory scrutiny, the impact on their bottom lines would likely be small. US banks have been living under the shadows of the Dodd-Frank Act for over a decade. Today, banks operate more as stable utilities than as cavalier casinos. Table 2Financials Are Overrepresented In Ex-US Indexes, While Tech Dominates The US Market Table 3Financials Are Overrepresented In Value, While Tech Dominates Growth Indexes Stronger stimulus-induced growth next year will allow many banks to release some of the hefty provisions against bad loans that they built up this year, while modestly steeper yields curves will boost net interest margins. Tech stocks are overrepresented in growth indices. Better trade relations would help US tech companies, as would a weaker dollar. That said, Joe Biden’s plan to increase taxes on overseas profits would hit tech companies disproportionately hard since the tech sector derives over half its revenue from outside the United States. Stepped up antitrust enforcement and more stringent privacy rules could also weigh on tech profits. On balance, while there are many moving parts, a Democratic sweep would favor non-US equities over US equities, and value stocks over growth stocks. Trumpism Transcends Trump Chart 6Trump Targeted Socially Conservative Voters In 2016, we bucked the consensus view that Hillary Clinton would win the election. On September 30, 2016, we predicted that “Trump will win and the dollar will rally,” noting that “Trump has seen a huge (yuge?) increase in support among working-class whites. If the so-called “likely voters” backing Clinton are, in fact, less likely to turn out at the polls than those backing Trump, this could skew the final outcome in Trump's favor.”2 Right-wing populism was the $1 trillion bill lying on the sidewalk that no mainstream Republican politician seemed eager to pick up. According to the Voter Study Group, only 4% of the US electorate identified as socially liberal and fiscally conservative in 2016, compared to 29% who saw themselves as fiscally liberal and socially conservative (Chart 6). The latter group had no political home, at least until Donald Trump came along. Rather than waxing poetically about small government conservatism – as most establishment Republicans were wont to do – Trump railed against mass immigration, unfair trade deals, rising crime, never-ending wars, and what he described as out-of-control political correctness. While Trump was able to carry out parts of his protectionist agenda, most of his other actions fell well short of what he had promised. His only major legislative achievement was a massive tax cut for corporations and wealthy individuals – something that the vast majority of his base never asked for. The Rich Are Flocking To The Democratic Party How did corporations and wealthy Americans reward Trump for lowering their taxes? By shifting their allegiances towards the Democrats, that’s how. According to the Pew Research Center, households earning more than $150,000 favored Democrats by 20 percentage points during the 2018 Congressional elections, a 13-point jump from 2016. Households earning between $30,000 and $149,999 favored Democrats by only 6 points in 2018. The only other income group that strongly favored Democrats were those earning less than $30,000 per year (Table 4). Table 4Democratic Candidates Had Wide Advantages Among The Highest-And-Lowest Income Voters Chart 7Democratic Districts Have Fared Better Over The Past Decade Other data tell a similar story. Median household income in Democratic congressional districts rose by 13% between 2008 and 2017. It fell by 4% in Republican districts. Today, on average, Republican districts have a median income that is 13% below Democratic districts (Chart 7). Campaign donations have shifted towards the Democrats. The latest monthly fundraising data shows that the Biden campaign received three times more large-dollar contributions in total than the Trump campaign. The nation’s CEOs have not been immune from this transformation. Seventy-seven percent of the business leaders surveyed by the Yale School of Management on September 23 said they would be voting for Joe Biden.3 As elites desert the Republican Party, will the Democratic Party start championing lower taxes and less regulation? That seems unlikely. According to the Voter Study Group, higher-income Democrats are actually more likely to support raising taxes on families earning more than $200,000 per year than lower-income Democrats (83% versus 79%). Among Republicans, the opposite is true: 45% of lower-income Republicans are in favor of raising taxes, compared to only 23% of higher-income Republicans.4 There used to be a time when companies tried to steer clear of the political limelight. This is starting to change. As the relative purchasing power of Democratic voters has risen, many companies have become emboldened to adopt overtly political stances on a variety of hot-button social and cultural issues, even if those stances alienate many conservative customers. What does this imply for investors? If big business abandons conservative voters, conservative voters will abandon big business. Corporate America will be left with no clear backer among the two major parties. Over the long haul, this is likely to be bad news for equity investors. As such, while we are constructive on equities over the next 12 months, we see grave dangers ahead later this decade. Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1 “Biden Takes On ‘Trump’s Tariffs’,” The Wall Street Journal, June 12, 2019. 2 Please see Global Investment Strategy Special Report, “Three (New) Controversial Calls,” dated September 30, 2016. 3 “CEO Caucus Survey: Business Leaders Fault Trump Administration on COVID and China,” Yale School of Management, September 24, 2020. 4 Lee Drutman, Vanessa Williamson, Felicia Wong, “On the Money: How Americans’ Economic Views Define — and Defy — Party Lines,” votersstudygroup.org, June 2019. Global Investment Strategy View Matrix Current MacroQuant Model Scores
Highlights The rising policy rate in the past couple months has been driven by a liquidity crunch, which is expected to ease in Q4. Government bond yields, which have been trending upwards since May, will also take a breather. The extremely accommodative phase of monetary conditions has ended. Monetary policy will be tightened, possibly by the middle of next year. We expect the yield curve to move broadly sideways in Q4 and into early 2021. As early as Q2 next year, a rebound in rate hike expectations will cause the curve to flatten. We remain overweight on Chinese stocks over the next six to nine months. Beyond that, a more restrictive monetary policy and less buoyant economic outlook may warrant a trimming of positions in Chinese stocks. Feature Chinese government bond yields have rebounded sharply since bottoming in late April; 10-year yields have climbed by 62 basis points to 3.1% as we go to press. Given that the 3-month SHIBOR (the PBoC’s de facto policy rate) has gone up by 128 basis points from its nadir in April, the higher bond yields reflect policy-driven liquidity tightening. The economy’s quick turnaround following the reopening of business activities has prompted the authorities to normalize the monetary stance (Chart 1). China recently made more interbank liquidity injections to slow the speed of policy rate normalization. We think it is the right move. China’s economic recovery is still at an early stage and may not withstand a rapid tightening in monetary policy. Furthermore, the chances are low that the 3-month SHIBOR will rise above its pre-COVID-19 level of 3% in this calendar year. Yields on short-duration government bonds will have little room to move higher in 2020. China’s 10-year government bond yield may even drop slightly when geopolitical tensions between the US and China heat up as the US election nears. Chart 1Policy Rate Normalization Started In May Chart 2Rate Normalization Will Resume In 2021 As China’s economic recovery is expected to continue accelerating into the first half of 2021, interest rates will also resume their climb (Chart 2). Our base case view is that the first rate hike, which will lift the policy rate above its pre-COVID-19 level, will happen as early as Q2 next year but no later than mid-2021. This means that the cyclical bear market in the bond market will continue. A Temporary Easing In Q4… In our report published on February 19, we argued that the rally in Chinese government bonds in early 2020 would be short lived rather than a cyclical (6-12 month) play.1 Furthermore, a journey back to the pre-outbreak monetary stance would start as early as Q2 this year. Notably, Chinese policymakers have pivoted to normalize monetary policy from an ultra-loose stance linked to COVID-19. In our view, the speed of the rebound in the policy rate has run ahead of the economic recovery. In other words, the policy stance tightened before inflation expectations turned more optimistic (Chart 3). Retail sales growth barely turned positive in August from a year ago, core inflation has dropped to its lowest level since the Global Financial Crisis and producer prices are still contracting on an annual basis (Chart 4). Chart 3Policy Stance Tightened Before Inflation Moved Higher In the past two weeks, the PBoC has injected liquidity more frequently through open market operations, an indication that policymakers may be trying to slow the pace of tightening (Chart 5). Maintaining nominal GDP growth above 4% this year is politically imperative for the Communist Party to achieve its employment growth objective.2 This overarching goal will likely hold back the PBoC from easing off the gas too abruptly. Chart 4The Economy Is Still Growing Below The Trend Growth Liquidity conditions will continue to improve into Q4, moderating the rise in the 3-month SHIBOR. The liquidity crunch in the banking system since May was created by a massive government bond issuance and curbing of high-yield structured deposits. Government bond issuance has reached its peak this year and bond quotas will plummet in Q4, which will help ease liquidity shortages in the banking sector (Chart 6). In turn, demand for interbank liquidity should moderate as banks have fewer bond purchasing obligations, giving the 3-month SHIBOR some breathing room with or without the PBoC’s intervention. Chart 5The PBoC May Be Trying To Slow The Pace Of Its Rate Normalization A pause in the policy rate hike will limit any upside risks for yields on short-duration government bonds. Yields on 10-year bonds may even drop if tensions between the US and China escalate leading up to the November US election, and/or additional significant pandemic waves affect the global economy. Chart 6Liquidity Conditions Should Ease In Q4 Bottom Line: It is unlikely that China’s policy rate and the long-duration government bond yield will end the year above their pre-COVID-19 levels. …Followed By Decisive Rate Hikes In 2H21 There are good and rising odds that Chinese authorities will fully switch to a tightening mode in 2021. Barring any domestic resurgence in COVID-19 that could trigger lockdowns, the PBoC may resume policy rate hikes as early as Q2, and no later than mid-2021. Our reasoning is as follows: Chart 7The PBoC Has Been Consistent With Policy Reaction In Previous Recoveries Consistent policy reaction in previous recoveries. Our April 23 report showed how the PBoC has been consistent in normalizing its monetary policy following each of the past three economic and credit cycles.3 The central bank raised interest rates on average nine months following a bottom in the business cycle. The tightening of interest rates occurred even after the prolonged economic downturn and deep deflationary cycle in 2015/16. The structurally slowing rate of China’s economic growth since 2011 has not prevented the PBoC from cyclically raising its policy rate (Chart 7). When the output gap is closed in 1H21, the PBoC will gain enough confidence to push for higher interest rates. Property market is strong. The property market has been heating up on the back of falling bank lending rates, despite policymakers’ efforts to curb both property lending and purchases. New home sales surged by 40% in August, the highest year-over-year growth since the last housing boom in 2016. In particular, demand for the first- and second-tier cities have rebounded sharply (Chart 8). This trend will likely prompt policymakers to enact stronger and earlier policy responses by tightening the medium lending facility (MLF) rate, an anchor for the mortgage lending rate. The labor market is recovering. The employment sub-indexes in the official PMIs of late point to an improvement in both the manufacturing and non-manufacturing sectors (Chart 9). Additionally, by the end of June, the number of returned migrant workers reached 96% of last year’s level. At this rate, the labor market should return to its pre-COVID-19 level by early next year. Chart 8Property Market Is Heating Up Chart 9The Labor Market Is Recovering Inflation will probably accelerate next year. We expect the recovery in the labor market to drive up both wage income and core CPI next year. Higher oil and industrial metals prices should also lift producer prices (Chart 10). Higher interest rates may not be counterproductive to policymakers’ support for SMEs. This is due to the authorities’ “window guidance”, mandating banks to reduce the spread between the loan prime rate (LPR) and bank lending rates. As seen in the past five months, although the policy rate has been rising, average bank lending rates have fallen (Chart 11). Policymakers will likely continue hiking policy rate to curb financial and property market speculations, but at the same time still able to guide bank lending rates lower and target their support for SMEs. Chart 10Inflation Will Likely Accelerate Along With Economic Growth In 1H21 Chart 11Bank Lending Rates Have Been Trending Down Despite Rising Policy Rate Bottom Line: Odds are rising that the PBoC will continue to hike interest rates (short and medium-term) by the middle of next year. In turn, the rebound in Chinese government bond yields will resume early next year in the expectation of better economic conditions and policy tightening. Investment Conclusions The upward momentum in both the short and long-end of the yield curve will likely abate from now till year-end (Chart 12, top panel). As early as Q2 next year, however, a rebound in rate hike expectations will cause the curve to flatten. Historically, the yield curve has always moved in lockstep with the 3-month SHIBOR with a perfect reverse correlation (Chart 12, bottom panel). Given the extremely dovish stance among central banks (the Fed in particular), the upside in rate hikes by PBoC will be capped. We expect a less than 30bps rise in long-term bond yields. Tighter monetary policy is bullish for the RMB. Nonetheless, the risk-return profile of taking a direct bet on the RMB is not attractive in either direction. The CNY has appreciated against the USD by 5% since bottoming in May, and we doubt that there will be a meaningful upside in the RMB against the dollar leading up to the US election. Meanwhile, widening interest-rate differentials have further reduced the odds of any significant CNY/USD depreciation (Chart 13). Chart 12A Rebound In Rate Hike Expectations In 1H21 Will Flatten The Yield Curve Chart 13Limited Upside For The RMB Against USD And On Trade-Weighted Basis In this vein, the CNY/USD exchange rate will be dominated by broader dollar performance. Furthermore, it is highly unlikely that the PBoC will tolerate sharp, trade-weighted currency appreciations. A declining USD will also limit the upside in the trade-weighted RMB. The RMB may be less reflationary to businesses in China, but it will not become outright deflationary for the time being (Chart 13, middle and bottom panels). In terms of equities, we maintain our positive cyclical view on China's growth outlook. The PBoC will maintain its tightening bias, but this should not lead to major growth disappointments. We continue to expect Chinese domestic and investable equities to outperform in both absolute and relative terms, at least for the next six to nine months. Beyond the next six months, however, a more restrictive monetary policy should bring China’s economy closer to its trend growth in 2H21. Sectors such as technology and real estate, which benefit the most from easy liquidity conditions and strong economic growth, will be negatively and disproportionally impacted. Given their heavy weight in China’s investable equity market, we will probably trim our positions in investable stocks by the middle of next year. Jing Sima China Strategist jings@bcaresearch.com Footnotes 1 Please see BCA Research China Investment Strategy Weekly Report, "Don’t Chase China’s Bond Yields Lower", dated February 19, 2020, available at cis.bcareseach.com. 2 Please see BCA Research China Investment Strategy Weekly Report, "Taking The Pulse Of The People’s Congress", dated May 28, 2020, available at cis.bcareseach.com. 3 Please see BCA Research China Investment Strategy Weekly Report, "Three Questions Following The Coronacrisis", dated April 23, 2020, available at cis.bcareseach.com. Cyclical Investment Stance Equity Sector Recommendations
Highlights Consumers are the beating heart of the US economy, … : By showering cash on the newly unemployed, and issuing checks to more than half of all taxpayers, the CARES Act arrested April’s free fall in consumption and helped households meet their financial obligations. … and if they’re waylaid by the pandemic, only a forceful fiscal response stands in the way of reduced future growth: Bankruptcies and widespread displacement of workers would turn a nasty cyclical shock into lower trend growth. How big does the next round need to be?: Applying a framework developed by our US Bond Strategy colleagues, we estimate that consumption growth will get back to trend if Congress provides $800 billion of aid to households through the first half of next year. Is it likely something that size can get through Capitol Hill?: Assistance for reeling states is a potential sticking point, but we continue to believe that a major aid package will pass. If it doesn’t, the election outcome will loom large over the 2021 outlook. Feature Over BCA’s 70-plus years, our research teams have developed hundreds if not thousands of proprietary indicators to project where financial markets and the major economies are headed. They are central to our process and we are continuously engaged in trying to improve them. Sometimes, though, it helps to take a step back and look at the landscape from the broadest and simplest perspective. When we do, we remind ourselves of what we have come to think of as macroeconomics’ fundamental lesson: My spending is your income and your spending is my income. Consumption isn't just four times as large as each of the other two main components of US GDP, it also exerts a gravitational pull on them. The truth of this simple formulation is especially easy to see in the United States, where consumption accounts for two-thirds of GDP (investment and government spending each contribute one-sixth, ignoring net exports’ modest drag). The US economy would shrivel if household spending were to fall sharply, and the second-order effects on investment and government receipts would prolong the agony. The former is a function of consumption; businesses only invest once it’s clear that demand has overtaken existing capacity or will soon do so. Reduced consumption would pressure employment and profits, squeezing federal revenues that are almost entirely composed of individual income taxes, payroll taxes and corporate income taxes (Chart 1). Transfers from the federal government account for one-third of the states’ total revenues (Chart 2); since most of them are forbidden to run budget deficits, they would face immediate cutbacks if the flows from Washington were to slow. Chart 1Consumption Exerts An Outsized Impact On Federal ... Chart 2... And State Government Revenues Plugging The Gap Recognizing that a wobbling consumer has the potential to topple several economic dominos, Congress undertook extraordinary measures to keep a vicious short-term shock from impairing growth into the intermediate and long term.1 The CARES Act included provisions to support ailing industries and small businesses, but its efforts at shoring up vulnerable households have been the most effective by far. Direct payments of $1,200 to every adult and $500 to every child in households earning less than $99,000 ($198,000 for married filing jointly taxpayers) and weekly $600 supplemental unemployment benefits helped push personal income well above February’s pre-pandemic level (Chart 3). Chart 3The CARES Act Gave Lower-Income Households An Enormous Boost With income rising, especially for those at the lower end of the income distribution, households were able to stay current on their rent (Table 1), their mortgage and all their other obligations (Table 2). They were even able to pay down their credit card balances, an unusual occurrence at the start of a recession (Chart 4). Residential landlords and personal lenders breathed a sigh of relief, along with the entities that have lent to them, though they must be wondering how their obligors will fare now that the CARES Act’s supplemental unemployment benefit has expired. Households built up $325 billion of savings from March through July, which helped tide them over in August and is presumably doing so in September, but we expect that cracks may be beginning to show and that they will emerge in force in October if another round of aid is not forthcoming. Emergency CARES Act fiscal transfers were so large that they more than offset the drag from declining compensation as employees were laid off or worked less than full time during the lockdowns. Table 1September Slowdown? Table 2Credit Performance Across Personal Loan Categories Was Solid Through July Chart 4Strapped Households Usually Run Up Their Credit Card Balances When Recessions Hit How Much Will It Take? Deficit spending is a charged issue, especially among those at the upper end of the income distribution who will ultimately be taxed to repay the debt to fund today’s deficits. However, we agree with the mainstream economic consensus that issuing another two or three trillion dollars of debt at negative real yields is preferable to suffering the hysteresis effects of an uncontained surge of bankruptcies. From a short-term perspective, vigorous fiscal support is the only thing that can preserve the seeming dichotomy between the real economy’s struggles and the equity and credit markets’ bliss.2 The key practical question is how big the next round needs to be to allow policymakers to extend the bridge over the gap opened by the pandemic. Our US Bond Strategy colleagues addressed that question head on last week.3 They proceeded from the assumption that a certain minimum level of consumer spending growth is necessary to meet market participants’ generally sanguine recovery expectations. They then focused on how household income (what comes in) and the savings rate (how much is held back) might evolve under pessimistic and optimistic scenarios and a base-case scenario that splits the difference between the two. Their estimates of required support from a new round of fiscal transfers are simply the difference between the spending that would occur without the transfers and the minimum required spending. Looking at the 12-month moving average of consumer spending to smooth out single-month swings, and comparing it to its year-ago level (a 12-month-over-12-month basis), we map out three nominal growth targets for the August 2020 to July 2021 period: 3%, 4% and 5%, consistent with the range that prevailed once the economy found its footing after the global financial crisis (Chart 5). Instead of performing the analysis under all three of our colleagues’ scenarios, we simply use the split-the-difference base case that has household income ex-CARES Act transfers (Chart 6, top panel) and the savings rate (Chart 6, bottom panel) returning to their pre-pandemic level by September 2021. Chart 5Outside Of Recessions, Consumer Spending Growth Typically Occupies A Tight Range Chart 6Recovery Scenarios For Consumption's Drivers The results are shown in Table 3. The 4% nominal rate of consumption matches the economy’s trend growth since the GFC (2-to-2.25% real plus 1.75-to-2% inflation), 3% allows for a sluggish recovery in which the virus only slowly loosens its grip and 5% covers the possibility of a burst of above-trend growth that might follow a better-than-expected virus outcome. We project that households will require an average of $70-to-94 billion of monthly income support to grow 12-month-on-12-month consumption by 3-to-5%. A repeat round of stimulus checks would chip in $23 billion, leaving supplemental unemployment insurance benefits and the extension of benefits to workers that would not otherwise be covered by their state unemployment insurance program to pick up much of the rest of the $50-to-70 billion tab. Once those programs were fully up and running in May, June and July, they distributed an average of $92 billion per month ($77 billion supplemental benefits and $15 billion expanded eligibility). Those numbers suggest that unemployment-related transfers amounting to 55-to-75% of the CARES Act transfers would suffice, which is encouraging because the Senate and the White House now view its $600 weekly supplement as too generous. The unemployment rate has fallen since the spring, however, with fewer households in line to receive payments, so lawmakers will have to devise other ways to get money into the hands of consumers. Given that states and municipalities face an acute cash crunch and Democrats have insisted on addressing it, there is a good chance that states will receive a healthy allocation and some of the state funds will eventually find their way to households. Table 3Another Round, Please The bottom line for investors assessing the adequacy of a stimulus bill is that we think it should allocate at least $800 billion to support household income. A bill in the mid-to-high $1 trillion range that would split the difference between Republican and Democratic proposals should suffice and it would leave ample room for desperately needed support for state and local governments. Public transit systems like the gasping New York city subway, which suffered ridership declines of as much as 80-90% at the height of the lockdown while incurring significant new cleaning costs, may otherwise have to impose draconian service cutbacks that undermine their local economies’ efforts to reopen. The Fundamental Theorem Of Microeconomics At the University of Chicago’s Booth School of Business, Introductory Microeconomics is called Price Theory to keep the central lesson of the course in every student’s mind: people respond to incentives. We have come to think of this as the fundamental rule of microeconomics. It is the foundation of public policy’s attempts to shape behavior: If you want more of something, subsidize it; if you want less of something, tax it. When mulling the prospects for the passage of a significant new aid bill, we begin and end with a consideration of the key players’ incentives. The Democrats want a bill to demonstrate that government can be the solution and to push back against the anti-government narrative that has taken root over the last 40 years. The administration should be doing its utmost to obtain a robust spending package since recessions have reliably sunk incumbent presidents’ re-election prospects. Republican senators, even those who are not up for election this year, should want a bill because control of the Senate is likely to go to the party that wins the White House and individual senators’ power and influence are magnified when they are in the majority. Despite months of posturing and foot-dragging, we second our geopolitical strategists’ view that an aid package aligning with all the major players’ interests will pass soon. Investment Implications Much of our constructive take on markets and the economy proceeds from our view that another significant round of fiscal aid is forthcoming. If it is not, we would revisit our bullish 12-month asset allocation recommendations and we would close out our overweight on the SIFI banks’ stocks. An assumption that humankind will find a way to tame COVID-19 on a timetable in line with market expectations is also embedded in our 12-month equity overweight. If a second wave of infections takes hold, the mortality rate moves significantly higher and treatment and/or vaccine progress unexpectedly reverses, our recommendations will get more cautious. If it is in the interests of all of Washington's key players to pass a bill, there's an awfully good chance that bill will get passed. Although those in the know have lately become more optimistic that the first installment(s) of an effective vaccine(s) will become available in the next two quarters (Chart 7), such an outcome is not assured. A client asked us last week what would ensue if a vaccine is not available until the third or fourth quarter of 2021. As we talked through it with her, we could not escape the idea that the election could be hugely consequential for markets if the lack of a vaccine coincides with a failure to pass a stimulus package before the election, or with a stimulus package that does not extend beyond the end of March. Chart 7Rising Odds Of A Vaccine Within The Next Six Months If the next round of stimulus is not passed before the election, or if it is set to expire two or three quarters before an effective vaccine will be available in sufficient quantities to turn the public health tide, fiscal policy would become the single most important driver of the near-term market and economic outlook, given our view that the Fed has already done nearly all it can do. Congress would then take center stage, with the White House playing a secondary role based on its veto power and the influence of the bully pulpit. In that case, we would expect equity and credit markets to fare much better under a Blue Wave outcome in which the Democrats sweep the election than they would in any outcome that leaves Republicans in control of the Senate. Think of it like this: if the economy needed fiscal aid to counter six-to-twelve more months of pandemic disruptions two years before Congress again had to face voters, would you rather appeal to Pelosi, Schumer and Biden, champing at the bit to demonstrate how government can alleviate suffering, or Mitch McConnell, itching to teach profligate cities and states a lesson? Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 The Fed leaped into the breach as well, but we have already discussed its efforts in detail. This report focuses on fiscal policy. 2 Please see the September 18, 2020 BCA Research Special Report, "The US Economy vs. The Stock Market: Is There A Disconnect?" available at www.bcaresearch.com. 3 Please see the September 15, 2020 US Bond Strategy Weekly Report, "More Stimulus Needed," available at usb.bcaresearch.com.
This report contains an error in the section related to consumer spending and fiscal policy. That error somewhat changes the conclusions from the report, and it particularly impacts Chart 3, Table 2 and Table 3. The attached note explains the mistake and includes corrected versions of Chart 3, Table 2 and Table 3. Highlights Duration: A re-rating of Tech stock valuations is likely not a near-term catalyst for significantly lower bond yields. Congress’ continued failure to pass a follow-up to the CARES act is a greater near-term risk for bond bears. We continue to recommend an “at benchmark” portfolio duration stance alongside duration-neutral yield curve steepeners. Fiscal Policy: Without additional household income support from Congress, at least on the order of $500 - $800 billion, consumer spending will massively disappoint expectations during the next 6-12 months. Inflation: Inflation will continue its rapid ascent between now and the end of the year, but it is likely to level-off in 2021. We recommend staying long TIPS versus nominal Treasuries for the time being, but we will be looking to take profits on that position later this year. Feature Bond Implications Of A Tech Stock Sell-Off Risk-off sentiment reigned in equity and credit markets during the past two weeks. The S&P 500 fell 7% between September 2nd and 8th and the average junk spread widened from 471 bps to 499 bps. This represents the largest sell-off since June when the equity market saw a similar 7% decline and the junk spread widened from 536 bps to 620 bps (Chart 1). Chart 1Two Equity Sell-Offs, Two Different Bond Market Reactions A comparison between the September and June episodes is particularly interesting for bond investors because Treasuries behaved very differently in each case. In June, bonds benefited from a flight to quality out of equities and the 10-year Treasury yield fell 22 bps. But this month, Treasuries actually delivered negative returns and the 10-year Treasury yield rose 3 bps (Chart 1, bottom panel). Table 1Selected Asset Class Performance During Last Two Equity Sell-Offs Why would Treasuries perform so well in June but fail in their role as a diversifier of equity risk in September? The answer lies in the underlying drivers of the stock market’s decline, which are easily identified when we look at the performance of different equity sectors. Table 1 shows the performance of different equity sectors in both the June and September sell-offs. In June, it was the cyclical equity sectors – Industrials, Energy and Materials – that led the decline. These sectors tend to be the most sensitive to global economic growth. This month’s equity drawdown was led by Tech stocks, while cyclical and defensive sectors saw much smaller drops. Table 1 also shows that a broad measure of commodity prices – the CRB Raw Industrials index – rose by 0.79% during the September equity sell-off, significantly outpacing gains in the gold price. In June, the CRB index still rose but it lagged gold by a wide margin. The underlying drivers of the stock market’s decline explain why Treasuries performed well in June and underperformed in September. We bring up the performance of different equity sectors, commodity prices and gold because bond yields correlate most strongly with: The performance of cyclical equities over defensive equities (Chart 2, top panel). The ratio of CRB Raw Industrials over gold (Chart 2, bottom panel). Chart 2High-Frequency Bond Indicators These correlations explain why bond yields fell a lot in June but not in September. June’s equity sell-off was more like a traditional risk-off event that saw investors questioning the sustainability of the global economic recovery. The cyclical equity sectors that are most exposed to the global economic cycle experienced the worst losses and demand for safe-haven gold far outpaced the demand for growth-sensitive industrial commodities. In contrast, this month’s sell-off was driven by a re-rating of Tech stock valuations, not so much expectations for a negative economic shock. Technology now makes up such a large portion of the equity index’s market cap that this sort of move can cause the entire stock market to fall, but the pass-through to bonds will be much smaller for any equity sell-off that isn’t prompted by a negative economic shock and led by cyclical equity sectors. Implications For Bond Investors Even after this month’s drop, there remains a legitimate concern about extreme Tech stock valuations. The fact that many of the larger Tech names, like Microsoft and Apple, have benefited from the pandemic only makes it more likely that their stock prices will suffer as the world slowly returns to normal. From a bond investor’s perspective, we doubt that even a large drop in Tech stock prices would lead to significantly lower bond yields, especially if that drop occurs in the context of an economy that continues to recover. Bond yields will only turn down if the market starts to question the sustainability of the economic recovery, an event that would be negative for cyclical equity sectors but much less so for the big Tech names. With that in mind, our base case outlook calls for continued economic recovery during the next 6-12 months, but we do see a significant risk that the failure to pass a follow-up to the CARES act will lead to just such a deflationary shock during the next couple of months. We therefore recommend keeping portfolio duration close to benchmark, while positioning for continued economic recovery via less risky duration-neutral yield curve steepeners. The Outlook For Consumer Spending And The Necessity Of Fiscal Stimulus After plunging during the lock-down months of March and April, consumer spending has rebounded strongly during the past few months. But can this strong rebound continue? Our view is that it cannot. That is, unless Congress delivers more income support to households. Even a large drop in Tech stock prices is unlikely to lead to significantly lower bond yields, especially if that drop occurs in the context of an economy that continues to recover. In this section we consider several different economic scenarios and estimate the amount of further income support that is necessary to sustain an adequate level of consumer spending. First off, to make forecasts for consumer spending we need to consider two main parameters: household income and the personal savings rate (Chart 3). More income leads to more spending in most cases. The only exception would be if cautious households decide to increase the amount they save relative to the amount they spend. Chart 3Consumer Spending Driven By Income & The Savings Rate We’ve actually seen that exception play out somewhat during the past five months. The CARES act provided households with an income windfall, but the savings rate also shot higher. This suggests that households had enough income to spend even more during the past few months but have been much more cautious than usual. We cannot overstate the role the CARES act has played in supporting household incomes since March. Disposable income has grown 7.4% during the past five months compared to the five months prior to COVID, and the CARES act’s provisions pressured income 10.3% higher during that period (Chart 4). The CARES act’s one-time $1200 stimulus checks and expanded $600 weekly unemployment benefits were the two most important provisions in this regard. Together, they pushed disposable income higher by 7.5%. Chart 4Disposable Personal Income Growth And Its Drivers This presents an obvious problem. The income support from the CARES act is now expired and Congress has yet to pass a follow-up stimulus bill. How vital is it that we get a new bill? And how large does it need to be? To answer these questions, we first need to set a target for adequate consumer spending growth. The second panel of Chart 3 shows 12-month over 12-month consumer spending growth. That is, it looks at total consumer spending during the last 12 months and shows how much it has increased (or decreased) compared to the previous 12 months. Notice that the worst 12-month period during the 2008 Great Financial Crisis (GFC) saw 12-month over 12-month consumer spending growth of -3%. During the economic recovery that followed, consumer spending growth fluctuated between +2% and +6%. Exercise 1: The March 2020 To February 2021 Period Chart 5Three Scenarios For Income And Savings In our first exercise, we consider the 12-month period starting at the very beginning of the COVID recession in March 2020 and ending in February 2021. As a bare minimum, we target consumer spending growth of -3% for this 12-month period on the presumption that 12-month spending growth equal to the worst 12 months seen during the GFC is the bare minimum that markets might tolerate. We also consider somewhat rosier scenarios of 0% and 2% spending growth. In addition to consumer spending targets, we also make assumptions for household income and the savings rate. We consider income coming from all sources including automatic government stabilizers, but without assuming any additional fiscal support from the government. We consider three scenarios (Chart 5): A pessimistic scenario where both income and the savings rate hold steady at current levels. An optimistic scenario where both income and the savings rate return to pre-COVID levels by February 2021. A “split the difference” scenario where both income and the savings rate get halfway back to pre-COVID levels by next February. Table 2 shows how much additional income support from the government is needed between now and February to achieve each of our consumer spending growth targets in each of our three scenarios. For example, in the optimistic scenario the government will need to provide $434 billion of additional income support between now and February for consumer spending to hit our minimum -3% threshold. In the more realistic “split the difference” scenario, households will require another $777 billion of stimulus. Table 2 also shows that stimulus on a monthly basis and compares the monthly rate of stimulus to the rate provided by the CARES act. For example, an additional $777 billion of income doled out between August and February works out to $111 billion per month, 61% of the amount of monthly stimulus provided by the CARES act between April and July. Table 2Without More Stimulus COVID's Impact On Consumer Spending Will Be Worse Than The GFC Two main conclusions jump out from this analysis. The first is that more income support from Congress is absolutely required. Otherwise, consumer spending will come in worse during the March 2020 to February 2021 period than it did during the worst 12 months of the GFC. Second, unless we assume a truly dire economic scenario, the follow-up stimulus does not need to be as large as the CARES act. In our most realistic “split the difference” scenario, that $777 billion of required stimulus is only 61% of what the CARES act doled out on a monthly basis. In that same scenario, a follow-up bill that delivered the same monthly stimulus as the CARES act would lead to positive 12-month consumer spending growth. Exercise 2: The August 2020 To July 2021 Period Chart 6One More Scenario One potential problem with our last exercise is that our target was for total consumer spending between March 2020 and February 2021. This period includes five months for which we already have data and the exercise is therefore partially backward-looking. A more relevant analysis might target consumer spending on a purely forward-looking basis from August 2020 to July 2021. We therefore perform our calculations again for the August 2020 to July 2021 period. This time, we consider only one economic scenario where income and the savings rate both return to pre-COVID levels by July 2021 (Chart 6). This scenario works out to be slightly more optimistic than the “split the difference” scenario we considered earlier. Also, since our target 12-month spending growth period no longer contains the downtrodden months of March and April, we require a more ambitious target than -3% growth. A return to the post-GFC range of 2% to 6% represents a target that is likely more representative of market expectations. Table 3 shows the results of this second analysis. Once again, we see that some additional government stimulus is necessary to meet our spending targets. Even to achieve 0% spending growth over the next 12 months will require another $249 billion from the government, and that outcome would almost certainly disappoint markets. We calculate that an additional $534 billion is required to achieve 2% spending growth during the August 2020 to July 2021 timeframe. This result is consistent with the $777 billion we calculated in Table 2, though it has come down a bit because we have made slightly more optimistic economic assumptions. Table 3At Least Half A Trillion More Government Income Support Is Needed Bottom Line: Our analysis suggests that further stimulus is needed to sustain the recovery in consumer spending. A new stimulus package doesn’t need to be as large as the CARES act on a monthly basis, but it should provide at least $500 - $800 billion of additional income support to households. With Congress still dithering on this issue, financial markets appear overly complacent in the near-term. While the economic constraints suggest that a deal should be reached soon, policymakers may need to see a spate of negative economic data and/or poor market performance before being spurred into action. In acknowledgement of this significant near-term risk to the economic outlook, bond investors should refrain from getting too bearish, and keep portfolio duration close to benchmark for the time being. Inflation’s Snapback Phase Chart 7Inflation Coming In Hot The core Consumer Price Index rose 0.4% in August, the third large monthly increase in a row (Chart 7). We see inflation continuing to come in hot between now and the end of the year, before tapering off in 2021. As of now, we would describe inflation as being in a snapback phase. That is, back in March and April, when lock-down measures were widespread across the country, the sectors that were most affected by the shutdowns experienced massive price declines. However, notice that core inflation fell by much more than median or trimmed mean inflation during this period (Chart 7, panels 2 & 3). The median sector’s price didn’t fall that much, but the overall inflation number moved down because of deeply negative prints in a few sectors. Now that the economy is re-opening, many of the sectors that were most beaten down in March and April are coming back to life. As a result, those massive price declines are turning into massive price increases. Once again, the median and trimmed mean inflation figures have been much more stable. This “snapback” dynamic is illustrated very clearly in Chart 8 which shows the distribution of monthly price changes for 41 different sectors in April and in August. Notice that while the middle of the distribution hasn’t changed that much, April’s massive left tail has morphed into August’s massive right tail. Chart 8Distribution Of CPI Expenditure Categories The continued wide divergence between core inflation and the median and trimmed mean measures suggests that this snapback phase has further to run. In other words, we will likely continue to see strong inflation prints for a few more months as the sectors that were most downbeat in March and April continue their rebounds. However, once core catches back up to the median and trimmed mean inflation measures, this snapback phase will come to an end and inflation’s uptrend will probably level-off. The continued wide divergence between core inflation and the median and trimmed mean measures suggests that this inflation’s snapback phase has further to run. We recommend that bond investors continue to favor TIPS over nominal Treasuries during this snapback phase, but we will be looking for an opportunity to go underweight TIPS versus nominal Treasuries later this year, once core inflation moves closer to the median and trimmed mean measures and the snapback phase ends. 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 4Performance Since March 23 Announcement Of Emergency Fed Facilities Ryan Swift US Bond Strategist rswift@bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification
Highlights The dollar has entered a structural bear market but is at risk of a countertrend bounce. The catalyst for such a bounce will be the underperformance of G10 economies, specifically the euro area relative to the US. The immediate trigger is a renewed surge in infections in the euro area. Eventually, in a post-COVID-19 world, the structural growth rate of the euro area should improve relative to the US. The Federal Reserve’s resolve to allow for an inflation overshoot will amplify the global supply of dollars. This will lead to a self-reinforcing spiral of better global growth, and a weaker dollar. Emerging market currencies have underperformed the drop in the dollar but will play catch up. We continue to recommend a three-pronged strategy for playing dollar shorts: Hold Scandinavian currencies, precious metals (especially silver and platinum), and the Japanese yen as insurance. We were stopped out of our tactical short GBP position. Stand aside for now. Our FX model remains dollar bearish and is recommending shorting the DXY for the month of September. Feature August is seasonally a strong month for the dollar (and other safe-haven currencies, for that matter), but this year bucked that trend. Despite the DXY index punching below key support levels since the March highs and becoming very oversold, the downtrend continued in August unabated. Technically, it suggests that the forces against the US dollar are quite powerful. Our trade basket has benefitted tremendously from the drop in the dollar this year, and we continue to advocate short dollar positions over a 12-month horizon. That said, we had tried playing a tactical bounce in the DXY via a short GBP position last month and got stopped out. September remains a seasonally weak month for the pound, but the dollar also tends to be weak against most other procyclical currencies (Chart I-1). As such, our bias is that while the dollar is due for a countertrend bounce, it might not be a playable one. Technical indicators also suggest that the dollar is likely to consolidate losses in the weeks ahead. Technical indicators also suggest that the dollar is likely to consolidate losses in the weeks ahead. Our intermediate-term indicator is oversold, and speculators are quite short the cross (Chart I-2). However, any bounce should be used as an opportunity to establish fresh short positions, as the DXY is likely to punch below 90 by year end. Chart I-1September Is A Good Month For Dollar Shorts Chart I-2Rising Number Of ##br##Dollar Bears What Are The Catalysts For A Countertrend Bounce? While the dollar has entered a structural bear market, two catalysts are lining up which could trigger a countertrend bounce: The Eurozone, which was well into its reopening phase, has been hit hard by a second wave of COVID-19. Meanwhile, new infections in the US have started to flatten out (Chart I-3). As a result, economic momentum, which was higher outside the US, has rolled over. Improving relative economic performance between the US and other G10 countries could be a key catalyst behind dollar strength (Chart I-4). It is true that the number of new deaths in both France and Spain remain low compared to the surge in the number of new cases. But, while it might ease draconian government lockdowns, citizens are likely to have concerns and may pay heed to the potential of being infected (and dying). This could slow economic activity. Chart I-3US Cases Are ##br##Flattening Chart I-4Economic Momentum Rolling Over Outside The US The US stock market is overstretched and is at risk of a more significant correction in the near term, which could introduce some volatility in global bourses and buffet the dollar. The fall in the DXY has been a mirror image of the rise in the S&P 500 (Chart I-5). Renewed geopolitical tensions between China and the US as well as the upcoming US presidential election are sources of risk, and a catalyst to hedge short positions. Historically, the dollar has tended to rise with both increasing equity and geopolitical risk premia. This is the benefit of being a reserve currency. Chart I-5The Dollar & S&P 500 In a nutshell, the US economy had been relatively weak compared to the rest of the world. Tentative August data is showing that this trend may now be reversing. While one cannot use one data point to extrapolate a trend, it is worth monitoring. What Does The Federal Reserve Shift Mean For The Dollar? Beyond a countertrend rally, the balance of forces are still stacked against the US dollar. The Fed’s pivot to target average inflation will only accentuate these forces. In a special report this week, our fixed income strategists outlined the major takeaways from the Fed’s policy shift.1 In a nutshell, the Fed will now allow for an inflation overshoot on a going-forward basis. Part of the reason the US dollar outperformed from 2011 on was because economic growth was relatively better, which allowed interest rates to be higher. With economic growth in the US held hostage by the pandemic, the Fed has been forced to drop rates to zero, effectively wiping out the nominal US interest rate advantage (Chart I-6). The fall in the DXY has been a mirror image of the rise in the S&P 500. Going forward, we know two things. First, the Fed (or any other central bank for that matter) will not raise rates anytime soon. But more importantly, the Fed has telegraphed that they will allow for an inflation overshoot. This means that real rates in the US are bound to become even more negative. It is impressive that countries like Switzerland and Japan, with negative policy rates, have much higher real rates than the US today (Chart I-7). This does not bode well for the dollar. Chart I-6Interest Rates In The US Have Collapsed Chart I-7Real Yields Could Be Lowest In The US Has The Euro Rallied Too Fast? The rise in the euro has certainly stirred discussion among policymakers and investors, with some commentators pointing to some measures of the trade-weighted currency being near record highs. While the euro certainly has scope to correct towards the 1.15-1.16 level, this should be used to accumulate long positions. In our view, there is little indication that currency strength is becoming a headwind for the economy. Indeed: The euro area continues to sport a very healthy trade and current account surplus, a sign that the euro remains very competitive among its trading partners (Chart I-8). This is remarkable in a world of slowing global trade. Correspondingly, the euro still remains 12% undervalued against our fair value purchasing power parity (PPP) models (Chart I-9) Chart I-8Is This An Expensive Currency? Chart I-9The Euro Is Cheap Much ink is being spilled over the fact that headline inflation in the euro area fell below zero for the first time since 2016. Quickly forgotten is that a fall in inflation actually increases the fair value of the currency in a PPP framework. It also makes European goods more competitive. In the long term, that could be the difference between whether foreigners buy Cadillacs or BMWs. The structural appreciation in the trade-weighted Swiss franc is a case in point. As intra-European trade represents a large share of cross-border transactions, currency considerations become more of a moot point. In 2019, most member states had a share of intra-EU exports of between 50% and 75% (Chart I-10). Chart I-10Europe Exports A Lot To Europe Going forward, an agreement on the mutualization of European debt means we can begin to expect more synchronized business cycles as fiscal stabilizers kick in.2 The reality is much more complicated, of course, but the biggest roadblock to mutualized debt (which is that it could never happen) has been toppled. This will allow the neutral rate of interest in the euro area to head higher (Chart I-11). The reason is that both fiscal and monetary policy can now be synchronized across member states: Chart I-11Can Euro Area Growth Accelerate? The European Central Bank and European Commission have successfully lowered the cost of capital in the euro area, probably well below the return on capital. With Italian and Spanish bond yields now collapsing towards those in the core, liquidity is flowing to where it is most needed, significantly curtailing euro break-up risk. Social distancing might remain in place for a while, meaning services will suffer more than manufacturing. More importantly, a huge proportion of the service sectors in the euro area is tied to tourism (Chart I-12), while it remains domestic in places like the US. So, as the tourism season wanes and we get into the winter months where social distancing is all the more important, the underlying trend growth in manufacturing could be higher. A more drawn-out services recovery raises the prospect that countries geared more towards manufacturing such as Europe, Japan and China, could experience better growth (Chart I-13). Chart I-12Tourism Is Important For Europe Chart I-13Higher Service Share In The US This will occur at a time when European equities, especially those in the periphery, are very cheap. Part of the reason is that most Eurozone bourses are heavy in cyclical stocks that are well into a 10-year relative bear market.3 A re-rating of cyclical stocks, especially banks and energy, relative to defensives could be the catalyst that carries the next leg of the euro rally. This could push the EUR/USD towards 1.25. Does Abe’s Resignation Change The Yen’s Outlook? Chart I-14More Jobs, More Savings Japanese Prime Minister Shinzo Abe’s health has pushed him to resign from office. The front runner from the Liberal Democratic Party (LDP), Yoshihide Suga, is likely to be his successor. Suga-san has publicly said he would like to continue with “Abenomics” and even enhance it. As such, the status-quo is more likely than a draconian policy change, as argued by our geopolitical colleagues.4 That said, there is a narrative floating around that he could be more of a fiscal hawk. Our belief is that economic forces are usually more powerful than political ones over the long term. And the economic force holding Japan hostage right now is the real threat of a deflationary spiral, which will send the yen higher and lead into a negative self-reinforcing feedback loop. Japanese companies certainly do not appreciate an excessively stronger yen, due to negative translation effects on profits. And neither does the Japanese government, since it is deflationary, and high government debt levels cannot be inflated away. With Japan having one of the highest real rates in the G10 right now, Suga-san’s more moderate fiscal stance might be overcome by a powerful deflationary wave in Japan. It is remarkable that while Japan had been able to keep a lid on the pandemic, it did see a short resurgence of new cases. That has since subsided, but it remains a clear reminder to the public that going out to spend money is risky business. As a result, the worker’s saving ratio continues to surge as unemployment rises and consumer confidence drops (Chart I-14). This is a trend any politician will find very difficult to ignore. As Suga-san stumbles to establish his stance, the yen could rise. Emerging market (EM) currencies such as the BRL, ZAR, INR, or even until recently the CNY, have lagged behind the drop in the DXY index. As we outlined in our weekly report in June, we remain yen bulls.5 This view rests on three pillars. First, Japan has one of the highest real rates in the G10, meaning outflows from Japanese fixed income investors will fall. Second, the yen is very cheap relative to the US dollar. And finally, during dollar bear markets, the yen more often than not outperforms the USD. This suggests holding a long yen position is a “heads I win, tails I do not lose much” proposition. EM Currencies Have Underperformed, Why? A lot of skepticism on the dollar rally has centered on the fact that emerging market (EM) currencies such as the BRL, ZAR, INR, or even until recently the CNY, have lagged behind the drop in the DXY index (Chart I-15). While this has been a historically rare event, so has the pandemic. As a result, we have witnessed a few economic shifts: Chart I-15EM Currencies Are Lagging Since 2014-2015, central banks have been aggressively trying to diversify out of dollar reserves. Unfortunately for most currencies, their alternative has been other safe-haven assets such as gold and the yen. IMF reserve data show that both the yen and gold have borne the brunt of dollar diversification. This trend has been supercharged in 2020, with the addition of the euro (Chart I-16). To put this in perspective, Russia now over 24% of its FX reserves in gold versus under 3% in 2008. Russia has very little dollar reserves. China has risen from less than half a percentage point of gold reserves in 2008 to over 3%. Imagine if China were to shift half of its gargantuan Treasury holdings into alternative assets? The perfect “robust” portfolio in simple terms has been a 60/40 one: 60% in equities, 40% in bonds. This has delivered low volatility and exceptional returns. But with government fixed income rates near zero, managers are now looking for alternatives. Gold and precious metals look like a perfect candidate in a world where central banks want to asymmetrically generate inflation (Chart I-17). Chart I-16Diversification Out Of Dollars Into Gold Chart I-17Would You Bet On US Bonds Or Gold At Zero Rates? The pandemic raged in a lot of EM countries while it was falling in DM. This has weakened EM fundamentals relative to their developed-market peers. The EM Markit PMI index has been falling sharply relative to that in the US, a sea-change from what we saw earlier this year (Chart I-18). As a result, many EM central banks have aggressively cut rates, narrowing interest rate differentials with the US. In their latest report, our emerging market colleagues contend that EM fundamentals remain poor, but could improve Chart I-18EM Relative Growth Relapsing EM currencies have a lot going for them. First, some are extremely cheap by historical standards. This should greatly help ease financial conditions. Second, our technical indicator shows that the dollar decline is becoming a lot more broad-based at the margin (Chart I-19). The percentage of countries with rising exchange rates versus the dollar has surged. Within EM, we continue to favor precious metal producers (in line with our BCA Research bullish precious metals view) and oil producers, versus a basket of oil consumers. Chart I-19Dollar Drawdown More Widespread The Message From Our Trading Model Our FX trading model remains bearish on the US dollar for the month of September. It has upgraded Australia and Norway, while downgrading New Zealand (Chart I-20). The white paper for the model can be found here. Chart I-20AModel Recommendations For September Chart I-20BModel Recommendations For September Our bias, however, is that the dollar is due for a tactical bounce. We tried to implement this via a short GBP position but were thrown offside. So far, the UK PMI continues to outperform both that of the US and the euro area, suggesting the UK economy has been relatively more resilient to the pandemic. As such, we prefer to tighten stops on our profitable trades as a way to manage risk. Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Please see US Bond Strategy and Global Fixed Income Strategy Special Report, "A New Dawn For US Monetary Policy", dated September 1, 2020. 2 Please see Foreign Exchange Strategy Weekly Report, "EUR/USD And The Neutral Rate Of Interest", dated June 14, 2019. 3 Please see Foreign Exchange Strategy Special Report, "Currencies And The Value-Vs Growth Debate", dated July 10, 2020. 4 Please see Geopolitical Strategy Weekly Report, "Abenomics Will Smell As Sweet By Any Other Name", dated September 4, 2020. 5 Please see Foreign Exchange Strategy Weekly Report, "An Update On The Yen", dated June 12, 2020. Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the US has been solid: The Markit manufacturing PMI rose from 50.9 to 53.1 in August. The ISM manufacturing PMI also climbed from 54.2 to 56, expanding for a fourth straight month. Notably, the ISM new orders index soared from 61.5 to 67.6. The goods trade deficit widened to $79.32 billion from $70.99 billion in July. Initial jobless claims decreased to 881K for the week ending August 28th. The DXY index recovered by 1% this week, supported by promising PMI releases. In the long run however, our bias is that the USD might be on the verge of a long bear market. Diminished advantage of interest rate differentials, higher twin deficits and negative sentiment all point to a lower dollar going forward. Report Links: A Simple Framework For Currencies - July 17, 2020 DXY: False Breakdown Or Cyclical Bear Market? - June 5, 2020 Cycles And The US Dollar - May 15, 2020 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area have been negative: The Markit manufacturing PMI remained flat at 51.7 in August while the services PMI fell from 54 to 50.5. Headline consumer price inflation fell from 0.4% to -0.2% year-on-year in August. Headline inflation sank from 1.2% to 0.4%. Moreover, producer prices decreased by 3.3% year-on-year in July. The unemployment rate ticked up from 7.7% to 7.9% in July. The euro fell by 1.2% against the US dollar this week. The negative inflation rate raises questions about ECB’s baseline inflation scenario and inflation forecasts, putting more pressure on the ECB to adopt a more dovish stance ahead of the monetary policy meeting next week. Report Links: On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 On Money Velocity, EUR/USD And Silver - October 11, 2019 Japanese Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan have been mostly negative: The manufacturing PMI increased from 45.2 to 47.2 in August, while the services PMI slipped to 45 from 45.4. Retail trade fell by 2.8% year-on-year in July, following a 1.3% decline the previous month. Moreover, industrial production plunged by 16.1% year-on-year in July after an 18.2% decrease in June. Construction orders fell by 22.9% year-on-year in July. Housing starts also plunged by 11.4%. The jobs-to-applicants ratio fell from 1.11 to 1.08 in July. The unemployment rate increased from 2.8% to 2.9%. The Japanese yen remained flat against the US dollar this week. We continue to favor the Japanese yen as fears grow for a second wave of COVID-19. Moreover, Japan now sports the second highest real interest rates in the G10 universe. Report Links: The Near-Term Bull Case For The Dollar - February 28, 2020 Building A Protector Currency Portfolio - February 7, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the UK have been positive: The manufacturing PMI rose to a 30-month high of 55.2 in August from 53.3 in July. The services PMI also increased to 58.8 from 56.5 the previous month. Mortgage approvals increased by 66.3K in July, up from 39.9K in June. Housing prices grew by 3.7% year-on-year in August. The British pound appreciated by 0.9% against the US dollar this week. While the latest PMI release showed fast expansion in the manufacturing sector for the month of August, the employment outlook remained unfavorable. Moreover, COVID-19 and Brexit uncertainties remain headwinds for the British pound. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 A Few Trade Ideas - Sept. 27, 2019 United Kingdom: Cyclical Slowdown Or Structural Malaise? - Sept. 20, 2019 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia have been mostly negative: GDP slumped by 7% quarter-on-quarter in Q2, the worst figure on record, confirming the nation’s first recession in almost 30 years. The commonwealth manufacturing PMI increased from 48.8 to 49.4 in August. Exports tumbled by 4% month-on-month while imports surged by 7% monthly in July. The trade surplus shrank by A$3.6 billion to A$4.6 billion. Building permits increased by 6.3% year-on-year in July, following a 15.8% contraction the previous month. AUD/USD fell by 1.6% this week. The RBA left its interest rate unchanged at 0.25% on Tuesday. However, it has increased the size of the term funding facility and extended the banks’ access to low-cost funding through the end of June 2021. Report Links: On AUD And CNY - January 17, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 A Contrarian View On The Australian Dollar - May 24, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand has been mixed: The ANZ business confidence index increased marginally from -42.4 to -41.8 in August, while the activity outlook index slipped from -17 to -17.5. Building permits fell by 4.5% month-on-month in July. The goods terms of trade index rose by 2.5% quarter-on-quarter in Q2. The New Zealand dollar depreciated by 0.7% against the US dollar this week. In the Wellington speech this Wednesday, RBNZ Governor Adrian Orr said that “We strongly believe that the best contribution we can make to our monetary and financial stability mandates is ensuring we head off unnecessarily low inflation or deflation, and high and persistent unemployment”, suggesting a more dovish stance in the coming monetary policy reviews. Report Links: Currencies And The Value-Versus-Growth Debate - July 10, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Place A Limit Sell On DXY At 100 - November 15, 2019 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada has been mostly negative: Annualized GDP slumped by 38.7% quarter-on-quarter in Q2. The manufacturing PMI rose to 55.1 in August from 52.9 the previous month. Building permits fell by 3% month-on-month in July. Exports rose to C$45.4 billion from C$40.9 billion in July. Imports also increased to C$47.9 billion from C$42.5 billion. The trade deficit widened by C$0.9 billion to C$2.5 billion. The Canadian dollar depreciated by 0.6% against the US dollar this week. The contraction in Q2 GDP is more than twice as bad as the lowest point reached during the GFC. On the positive side, the June monthly GDP increase of 6.5%, compared with the previous month, is showing signs of recovery with the easing of COVID-19 restrictions at the end of Q2. Report Links: Currencies And The Value-Versus-Growth Debate - July 10, 2020 More On Competitive Devaluations, The CAD And The SEK - May 1, 2020 A New Paradigm For Petrocurrencies - April 10, 2020 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland have been mixed: The KOF leading indicator surged from 86 to 110.2 in August. Real retail sales increased by 4.1% year-on-year in July. The manufacturing PMI increased from 49.2 to 51.8 in August. Headline consumer prices remained in deflation territory at -0.9% year-on-year in August. The Swiss franc remained flat against the US dollar this week. The SNB Governing Board Member Andrea Maechler said on Tuesday that negative interest rates are “extremely important” for Switzerland. Being deeply in deflation for seven consecutive months, Switzerland now sports the highest real rate in G10. Report Links: On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 Portfolio Tweaks Before The Chinese New Year - January 24, 2020 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway have been negative: The current account surplus narrowed to NOK 20.5 billion in Q2 from NOK 27 billion in the same quarter last year, the smallest surplus since the fourth quarter of 2017. The Norwegian krone depreciated by 2.2% against the US dollar this week, making it the worst-performing G10 currency. That said, we remain positive on the Norwegian krone. Our FX model indicator for the NOK increased from 1 to 2 for the month of September, signaling a strong buy for the currency and pushing the sentiment component up from neutral to long. Report Links: A New Paradigm For Petrocurrencies - April 10, 2020 Building A Protector Currency Portfolio - February 7, 2020 On Oil, Growth And The Dollar - January 10, 2020 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden have been mixed: GDP fell by 7.7% year-on-year in Q2, or 8.3% quarter-on-quarter, the steepest contraction on record. The manufacturing PMI increased from 51.4 to 53.4 in August, the fourth consecutive month of manufacturing expansion. The new orders index surged from 52.2 to 56. The Swedish krona fell by 1.1% against the US dollar this week. As one of the most pro-cyclical currencies, the Swedish krona will benefit the most from the global business cycle recovery. Moreover, the SEK is still trading at a tremendous discount against its fair value, as compared to the US dollar. We continue to overweight the Nordic basket to both USD and EUR but are tightening the stop loss this week amidst potential market volatilities. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019 Balance Of Payments Across The G10 - February 15, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades