Developed Countries

Highlights A blue wave will likely supercharge the dollar’s downtrend in 2021. The key beneficiaries of this decline will be the much undervalued Scandinavian currencies, as well as those of commodity-producing countries. The initial knee-jerk reaction from the dollar could be positive as inflation lags the improvement in aggregate demand. Our trading model continues to recommend shorting the dollar. This simple three-factor model has outperformed the DXY index by over 300% since 1980. We were stopped out of our short NZD/CAD trade. This is a portfolio hedge. Look to reinstate. Feature The US political landscape is becoming more dollar bearish. This is because a blue wave will likely supercharge fiscal spending and allow for a partial repeal of the Trump tax cuts. Both will boost aggregate demand, without an equivalent offset from higher US interest rates. As we explain below, this is negative for the greenback. As a key reflator for the global economy, a lower US dollar will lead to an outperformance of non-US bourses, lifting animal spirits abroad and in a virtuous cycle, pressuring the dollar even lower. From a technical perspective, the dollar remains very oversold, having declined in almost a straight line since last March. While we continue to expect a dollar bounce, we had initially highlighted in previous reports it will be technical in nature, capped at around 2%-4%. Given this week’s news, chances of a technical bounce remain high, but the amplitude will be much more muted than we initially expected. This dovetails nicely with our trading model, which is politically agnostic, and continues to recommend shorting the dollar for the month of January. Implications Of A Blue Sweep It has been clear since the US election campaign began that Democratic leaders have been more aggressive in their demands for a greater government role in the economy. As such, a blue wave should widen the US budget deficit by much more than was expected under a Republican Senate. All things equal, a wider budget deficit is negative for the greenback. All things equal, a wider budget deficit is negative for the greenback (Chart I-1).1 Higher aggregate demand (via higher government spending) should allow the US output gap to close faster than would have otherwise been the case. This should begin to put upward pressure under domestic inflation. If the Federal Reserve chooses to allow an inflation overshoot, this will depress US real rates further and hurt the dollar in the process. There is a well-established relationship between real interest rate differentials and the greenback (Chart I-2). Chart I-1The Dollar And Budget Deficits Chart I-2The Dollar And Real Interest Rates The US continues to run a large current account deficit, meaning domestic savings have been insufficient to finance investment. A higher budget deficit is likely to widen the current account deficit, assuming private-sector savings do not rise significantly. To finance the shortfall in spending, foreign investors might require a higher risk premium on US assets via higher yields and/or a lower exchange rate. With the Federal Reserve effectively capping nominal yields, a lower exchange rate will be needed to entice foreign investors. A reason behind the dollar’s decline last year has been a stampede out of the Treasury market by foreign investors (Chart I-3). Chart I-3A Dearth Of Foreign Investors Part of the Biden campaign pledge has also been to raise both corporate and personal income taxes. The US currently enjoys favorable corporate taxes relative to its G10 and BRICS peers (Chart I-4). Higher taxes would lower the return on capital for US investments. Our US Equity Strategists reckon the hit to the technology and health care sectors from a change in the tax rate will be particularly acute, in an order of magnitude of about 13.5% and 13.1% of earnings-per-share, respectively. Inflows into US equities exploded higher last year on the back of low rates and the higher weighting of technology and health care sectors in US bourses (Chart I-5). A reversal of these flows will hurt the dollar. This will occur at a time when expected returns on US equities are particularly low, compared to those in Europe and Japan (Chart I-6). Chart I-4Biden's Tax Plan In Perspective Chart I-5US Equity Inflows Have Been Strong Chart I-6ALow Expected Return On US Equities Chart I-6BBetter Expected Returns On Eurozone Equities Chart I-6CBetter Expected Returns On Japanese Equities Is COVID-19 A Red Herring? Chart I-7A Covid-19 Growth Scare? The analysis above suggests the outlook for the dollar should be bearish. Then why has the greenback been rebounding since the unveiling of a blue sweep? There are two reasons. First, the dollar was already very oversold, suggesting the short-term reward/risk from shorting the currency was not very favorable. Second, inflation is a lagging economic variable, so any impact from fiscal stimulus will first be on real growth, with inflation rising much later. Therefore, fiscal stimulus in the US will likely boost US economic performance relative to its peers in the short term. Meanwhile, as we navigate the winter season in the northern hemisphere, a new wave of infections has taken root. This will likely lead to a widespread deterioration in economic conditions, as economies enter more stringent lockdowns. Around the G10, various measures of lockdowns are being implemented, with particularly restrictive measures in the UK and Canada where new cases are close to record highs. Infection trends remain favorable in Australia and New Zealand, probably due to previous localized lockdowns (Chart I-7). However, with new, more infectious strains being first spotted in the UK and then South Africa, the bar is very low for a worldwide-renewed infection wave. The impact on currency markets is two-fold. First, the dollar is a counter-cyclical currency and so will benefit from safe-haven flows that will erupt with any renewed relapse in growth. With the dollar having traded inversely neck-in-neck with the S&P 500, any equity correction will provide a much healthy catalyst for a dollar bounce (Chart I-8). Any bounce in the USD should be faded as robust global growth in 2021 is expected. More directly, the impact for currency markets will be through relative economic growth. The improvement in the December Purchasing Managers’ Index was more favorable outside the US, particularly in Sweden, Canada, and the UK. That said, the greenback has undershot the trend dictated by the relative economic performance between the US and the rest of the G10 (Chart I-9). Should the US quickly bridge the gap between herd immunity (through vaccinations) and the spread of the virus, US economic growth could gain the upper hand. Chart I-8The Dollar And Markets Chart I-9The Dollar And Relative Growth Ultimately, the near-term potential impact from COVID-19 will be much less than economies endured in the first half of 2020. The main reason is that the vaccine rollout is accelerating, with many other candidates in the pipeline. This will allow for robust global growth in 2021, which will ease safe-haven flows into the US dollar. Thus, any bounce in the USD should be faded rather than leaned into, as we have been arguing since October of last year.2 FX Trading Model Chart I-10BCA FX Trading Model How does our trading model feel about a blue sweep? It is agnostic, given that none of the inputs are directly driven by US politics. The one area where US politics could affect the model is through real rates, but as we have argued, this is a slow-moving process. More importantly, the model serves as a rules-based approach in trading foreign exchange. In short, three criteria drive the model:3 A macroeconomic variable that captures the most important relative price between any two currencies: the real interest rate. A valuation measure that captures dislocation in a currency pair relative to its own history. A key assumption is stationarity, meaning the currency cross will mean-revert back to fair value over time. A sentiment indicator. The key assumption here is that the dollar is a momentum currency. This very simplistic approach has outperformed a buy-and-hold DXY portfolio by 325% since 1980 (Chart I-10). Given the encouragement from this initial result, we will be releasing part two of the model in the coming weeks.  The FX market is likely to become more volatile and provide more opportunities. For now, the model recommends shorting the DXY for the month of January, driven by long positions in the Swedish krona, Swiss franc, and Japanese yen. Less favorable currencies are the Australian and New Zealand dollars (Chart I-11). Such a barbell strategy of some high-beta currencies, together with some safe havens, might be just what the doctor ordered. In our FX portfolio, we prefer to stick with trades at the crosses. So far, our trading recommendations have benchmarked favorably against the model recommendations (Chart I-12). We will build on this success in future iterations. Chart I-11Long = Greater Than 0; Short = Less Than 0 Chart I-12Man Versus BCA Machine Housekeeping Our portfolio has benefited tremendously from the overall short dollar position we have been recommending since 2019. However, in light of possible volatility in the coming weeks, we are tightening stop-losses on a few of our profitable trades. We hold a basket of Scandinavian currencies against both the dollar and the euro. Tighten the stop loss to a 2% loss from initiation, given recent gains. Stay long silver versus gold but tighten the stop loss to 75 to lock in some profits. Our long yen portfolio hedge has performed quite well. Tighten the stop loss from 110 to 105. We were stopped out of our short NZD/CAD trade for a loss of 1.8%. Stand aside for now, with a view to re-establish later. We are still short NZD versus AUD. Tighten the stop loss to 1.02. In our view, the FX market is likely to uncover many macro opportunities as the year unfolds. Stay tuned.    Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes   1 Please see Foreign Exchange Strategy Weekly Report, “The Dollar And The Budget Deficit: From Theory To Practice,” dated August 14, 2020. 2 Please see Foreign Exchange Strategy Weekly Report, “Tail Risks In FX Markets,” dated October 2, 2020. 3 Please see Foreign Exchange Strategy Weekly Report, “Building A Protector Currency Portfolio,” dated February 7, 2020. Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the US have been robust: The final read of the Markit Manufacturing PMI was 57.1 in December, compared to a prior reading of 56.5. The ISM manufacturing index came in at a very robust 60.7 for the month of December, well above expectations. The trade balance in the US remained near cycle lows at -$68.1bn for November. The DXY index fell slightly this week. It is becoming quite clear that December was a robust month for economic data, both in the US and abroad. As a result, the US dollar, which is a counter-cyclical currency, depreciated modestly. With the prospect of higher fiscal stimulus in the US, but an accommodative Federal Reserve, lower real rates should keep a cap on the dollar.   Report Links: The Dollar Conundrum And Protection - November 6, 2020 The Dollar In A Market Reset - October 30, 2020 A Few Market Observations - October 23, 2020 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data from the euro area have held up: The Markit Manufacturing Index remained at the 55 level for the month of December (from 55.5 to 55.2). Producer prices continue to deflate at 2% per year, but the November decline compares favorably to the 5% year-on-year drop in May last year. Core CPI remained flat at 0.2% in December. The euro appreciated by 0.2% against the US dollar this week. The dominant theme in markets remains a broad-based dollar decline, with the euro being the key liquid beneficiary of this move. Most of Europe has managed to flatten the infection curve for Covid-19, which should allow economic momentum to improve further. Report Links: The Dollar Conundrum And Protection - November 6, 2020 Addressing Client Questions - September 4, 2020 On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 The Japanese Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data from Japan has been quite disappointing: Cash earnings fell by 2.2% for the month of November. The key driver was a 10.3% decline in overtime pay and 22.9% decline in bonus payments. The Jibun manufacturing PMI was relatively flat at the 50 boom/bust level in December. On a positive note, vehicle sales improved by 7.4% year-on-year in December. It is becoming more evident that a replacement cycle in Japanese autos in underway. The Japanese yen depreciated by 0.7% against the US dollar this week. The key theme this week was a rise in US bond yields, which made the allure of Japanese fixed income less attractive. With Japanese yields anchored at 0%, rising global yields make Japan fixed income returns attractive, but the currency a short in a global portfolio. We are long the Japanese yen and are tightening stops to protect profits.  Report Links: The Dollar Conundrum And Protection - November 6, 2020 The Near-Term Bull Case For The Dollar - February 28, 2020 Building A Protector Currency Portfolio - February 7, 2020 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the UK have been mixed: The Markit Manufacturing PMI printed a final 57.5 for December. Mortgage approvals continue to inflect higher, with 105K submissions absorbed in November. UK services remain in recession. The Markit services PMI came in at 49.4 in December, from 49.9 last month. The British pound was flat this week. The Brexit imbroglio is now behind us, and the UK must now contend with the uncomfortable combination of rising Covid-19 cases and a new relationship with the EU. This has prevented the pound from fully celebrating an end to uncertainty. Our roadmap remains valuation, as we see the pound as cheap versus both the dollar and euro, hence our short EUR/GBP position. Report Links: The Dollar Conundrum And Protection - November 6, 2020 Revisiting Our High-Conviction Trades - September 11, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia have been solid: Building approvals improved 2.6% month-on-month in November. The trade balance remains at a healthy surplus of A$5bn in November. While imports expanded 10% month-on-month, exports remained a healthy 3% over the October print. The Australian dollar appreciated by 1.2% against the US dollar this week. The AUD continues to benefit from favorable terms-of-trade, not only from high iron ore prices, but from the looming shortage of readily available liquefied natural gas (LNG) as Japan and Korea enter unusually cold weather. This is bullish the AUD. Report Links: An Update On The Australian Dollar - September 18, 2020 On AUD And CNY - January 17, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 There was scant data out of New Zealand this week: CoreLogic house prices expanded by 11.1% year-on-year in December. The New Zealand dollar appreciated by 1.1% against the US dollar this week. The kiwi has been on fire in recent weeks, driven not only by the unwinding of expectations of negative rates by the RBNZ, but also by rising terms of trade as agricultural prices recover. We have been fading the kiwi rally, and were offside on our short NZD/CAD trade for a cumulative loss 1.8% loss this week. We are standing aside for now. 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 from Canada have held up: The Markit manufacturing PMI came in at 57.9 in December, an increase from the prior read of 55.8. The trade balance remains in a deficit of $C3.34bn for November, in line with the previous month. The Canadian dollar appreciated by 0.8% against the US dollar this week. There was good news on the oil front that boosted the loonie. Saudi Arabia agreed to absorb cuts of 1 million barrels a day, allowing a more fervent rebalancing of the oil market. This boosted petrocurrencies, including the loonie. 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 from Switzerland have been mixed: The manufacturing PMI came in at 58 in December, well above expectations of 54.3 and a prior reading of 55.2. Switzerland remains in deflation. Core CPI came in at -0.4% in December versus expectations of -0.2%. Headline CPI was even more negative at -0.8%. The Swiss franc depreciated by 0.4% against the US dollar this week. There is no doubt that the strong franc is exerting deflationary pressures into the Swiss economy. This is evident not only from tradeable prices, but also from domestic inflation. Encouragingly, the manufacturing sector is picking up, which is providing a valve for less intervention by the SNB. We are long EUR/CHF on grounds that the franc is too strong versus the euro. Report Links: The Dollar Conundrum And Protection - November 6, 2020 On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 There was scant data out of Norway this week: The DNB/NIMA manufacturing PMI was flat at 51.9 in December. The Norwegian krone surged by 1.44% against the US dollar this week as the best performing G10 currency. Given the lack of economic data, the key narrative was the oil deal where the Saudis curtailed production. As our top pick for currency outperformance this year, this is much welcomed news. Stay long NOK versus both the USD and EUR. Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 A New Paradigm For Petrocurrencies - April 10, 2020 Building A Protector Currency Portfolio - February 7, 2020 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data from Sweden have been robust: The Swedbank/Silf manufacturing PMI surged from 59.1 to 64.9. The Swedish krona rose by 0.7% against the US dollar this week. Sweden is in a sweet spot, where low interest rates are emboldening risk taking and a robust global manufacturing cycle is keeping Swedish supply chains busy. With this virtuous cycle slated to continue, this would continue to be a boost for the krona. Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights Markets largely ignored the uproar at the US Capitol on January 6 because the transfer of power was not in question. Democratic control over the Senate, after two upsets in the Georgia runoff, is the bigger signal. US fiscal policy will become more expansive yet the Federal Reserve will not start hiking rates anytime soon. This is a powerful tailwind for risk assets over the short and medium run. Politics and geopolitics affect markets through the policy setting, rather than through discrete events, which tend to have fleeting market impacts. The current setting, in the US and abroad, is negative for the US dollar. The implication is positive for emerging market stocks and value plays. Go long global stocks ex-US, long emerging markets over developed markets, and long value over growth. Cut losses on short CNY-USD. Feature Chart 1Market's Muted Response To US Turmoil Scenes of mayhem unfolded in the US Capitol on January 6 as protesters and rioters flooded the building and temporarily interrupted the joint session of Congress convened to count the Electoral College votes. Congress reconvened later and finished the tally. President-elect Joe Biden will take office at noon on January 20. Financial markets were unperturbed, with stocks up and volatility down, though safe havens did perk up a bit (Chart 1). The incident supports our thesis that the US election cycle of 2020 was a sort of “Civil War Lite” and that the country is witnessing “Peak Polarization,” with polarization likely to fall over the coming five years. The incident was the culmination of the past year of pandemic-fueled unrest and President Trump’s refusal to concede to the Electoral College verdict. Trump made a show of force by rallying his supporters, and apparently refrained from cracking down on those that overran Congress, but then he backed down and promised an orderly transfer of power. The immediate political result was to isolate him. Fewer Republicans than expected contested the electoral votes in the ensuing joint session; one Republican is openly calling for Trump to be forced into resignation via the 25th amendment procedure for those unfit to serve. The electoral votes were promptly certified. Vice President Mike Pence and other actors performed their constitutional duties. Pence reportedly gave the order to bring out the National Guard to restore order – hence it is possible that Pence and Trump’s cabinet could activate the 25th amendment, but that is unlikely unless Trump foments rebellion going forward. Vandals and criminals will be prosecuted and there could also be legal ramifications for Trump and some government officials. Do Politics And Geopolitics Affect Markets? The market’s lack of concern raises the question of whether investors need trouble themselves with politics at all. Philosopher and market guru Nassim Nicholas Taleb tweeted the following: If someone, a year ago, described January 6, 2021 (and events attending it) & asked you to guess the stock market behavior, admit you would have gotten it wrong. Just so you understand that news do not help you understand markets.1 This is a valid point. Investors should not (and do not) invest based on the daily news. Of course, many observers foresaw social unrest surrounding the 2020 election, including Professor Peter Turchin.2 Social instability was rising in the data, as we have long shown. When you combined this likelihood with the Fed’s pause on rate hikes, and a measurable rise in geopolitical tensions between the US and other countries, the implication was that gold would appreciate. So if someone had told you a year ago that the US would have a pandemic, that governments would unleash a 10.2% of global GDP fiscal stimulus, that the Fed would start average inflation targeting, that a vaccine would be produced, and that the US would have a contested election on top of it all, would you have expected gold to rise? Absolutely – and it has done so, both in keeping with the fall in real interest rates plus some safe-haven bonus, which is observable (Chart 2). Chart 2Gold Price In Excess Of Fall In Real Rates Implies Geopolitical Risk The takeaway is that policy matters for markets while politics may only matter briefly at best. Which brings us back to the implications of the Trump rebellion. What Will Be The Impact Of The Trump Rebellion? We have highlighted that this election was a controversial rather than contested election – meaning that the outcome was not in question after late November when the court cases, vote counts, and recounts were certified. This was doubly true after the Electoral College voted on December 14. The protests and riots yesterday never seriously called this result into question. Whatever Trump’s intentions, there was no military coup or imposition of martial law, as some observers feared. In fact the scandal arose from the President’s hesitation to call out the National Guard rather than his use of security forces to prevent the transfer of power, as occurs during a coup. This partially explains why the market traded on the contested election in December 2000 but not in 2020 – the result was largely settled. The Biden administration now has more political capital than otherwise, which is market-positive because it implies more proactive fiscal policy to support the economic recovery. Trump’s refusal to concede gave Democrats both seats in the Georgia Senate runoffs, yielding control of Congress. Household and business sentiment will revive with the vaccine distribution and economic recovery, while the passage of larger fiscal stimulus is highly probable. US fiscal policy will almost certainly avoid the mistake of tightening fiscal policy too soon. Taken with the Fed’s aversion to raising rates, greater fiscal stimulus will create a powerful tailwind for risk assets over the next 12 months. The primary consequence of combined fiscal and monetary dovishness is a falling dollar. The greenback is a counter-cyclical and momentum-driven currency that broadly responds inversely to global growth trends. But policy decisions are clearly legible in the global growth path and the dollar’s path over the past two decades. Japanese and European QE, Chinese devaluation, the global oil crash, Trump’s tax cuts, the US-China trade war, and COVID-19 lockdowns all drove the dollar to fresh highs – all policy decisions (Chart 3). Policy decisions also ensured the euro’s survival, marking the dollar’s bottom against the euro in 2011, and ensuring that the euro could take over from the dollar once the dollar became overbought. Today, the US’s stimulus response to COVID-19 – combined with the Fed’s strategic review and the Democratic sweep of government – marked the peak and continued drop-off in the dollar. Chart 3Euro Survival, US Peak Polarization, Set Stage For Rotation From USD To EUR Chart 4China's Yuan Says Geopolitics Matters The Chinese renminbi is heavily manipulated by the People’s Bank and is not freely exchangeable. The massive stimulus cycle that began in 2015, in reaction to financial turmoil, combined with the central bank’s decision to defend the currency marked a bottom in the yuan’s path. China’s draconian response to the pandemic this year, and massive stimulus, made China the only major country to contribute positively to global growth in 2020 and ensured a surge in the currency. The combination of US and Chinese policy decisions has clearly favored the renminbi more than would be the case from the general economic backdrop (Chart 4). Getting the policy setting right is necessary for investors. This is true even though discrete political events – including major political and geopolitical crises – have fleeting impacts on markets. What About Biden’s Trade Policy? Trump was never going to control monetary or fiscal policy – that was up to the Fed and Congress. His impact lay mostly in trade and foreign policy. Specifically his defeat reduces the risk of sweeping unilateral tariffs. It makes sense that global economic policy uncertainty has plummeted, especially relative to the United States (Chart 5). If US policy facilitates a global economic and trade recovery, then it also makes sense that global equities would rise faster than American equities, which benefited from the previous period of a strong dollar and erratic or aggressive US fiscal and trade policy. Trump’s last 14 days could see a few executive orders that rattle stocks. There is a very near-term downside risk to European and especially Chinese stocks from punitive measures, or to Emirati stocks in the event of another military exchange with Iran (Chart 6). But Trump will be disobeyed if he orders any highly disruptive actions, especially if they contravene national interests. Beyond Trump’s term we are constructive on all these bourses, though we expect politics and geopolitics to remain a headwind for Chinese equities. Chart 5Big Drop In Global Policy Uncertainty US tensions with China will escalate again soon – and in a way that negatively impacts US and Chinese companies exposed to each other. Chart 6Geopolitical Implications Of Biden's Election The cold war between these two is an unavoidable geopolitical trend as China threatens to surpass the US in economic size and improves its technological prowess. Presidents Xi and Trump were merely catalysts. But there are two policy trends that will override this rivalry for at least the first half of the year. First, global trade is recovering– as shown here by the Shanghai freight index and South Korean exports and equity prices (Chart 7). The global recovery will boost Korean stocks but geopolitical tensions will continue to brood over more expensive Taiwanese stocks due to the US-China conflict. This has motivated our longstanding long Korea / short Taiwan recommendation. Chart 7Global Economy Speaks Louder Than North Korea Chart 8China Wary Of Over-Tightening Policy Chart 9Global Stock-Bond Ratio Registers Good News Second, China’s 2020 stimulus will have lingering effects and it is wary of over-tightening monetary and fiscal policy, lest it undo its domestic economic recovery. The tenor of China’s Central Economic Work Conference in December has reinforced this view. Chart 8 illustrates the expectations of our China Investment Strategy regarding China’s credit growth and local government bond issuance. They suggest that there will not be a sharp withdrawal of fiscal or quasi-fiscal support in 2021. Stability is especially important in the lead up to the critical leadership rotation in 2022.3 This policy backdrop will be positive for global/EM equities despite the political crackdown on General Secretary Xi Jinping’s opponents will occur despite this supportive policy backdrop. The global stock-to-bond ratio has surged in clear recognition of these positive policy trends (Chart 9). Government bonds were deeply overbought and it will take several years before central banks begin tightening policy. What About Biden’s Foreign Policy? Chart 10OPEC 2.0 Cartel Continues (For Now) Iran poses a genuine geopolitical risk this year – first in the form of an oil supply risk, should conflict emerge in the Persian Gulf, Iraq, or elsewhere in the region. This would inject a risk premium into the oil price. Later the risk is the opposite as a deal with the Biden administration would create the prospect for Iran to attract foreign investment and begin pumping oil, while putting pressure on the OPEC 2.0 coalition to abandon its current, tentative, production discipline in pursuit of market share (Chart 10). Biden has the executive authority to restore the 2015 nuclear deal (Joint Comprehensive Plan of Action). He is in favor of doing so in order to (1) prevent the Middle East from generating a crisis that consumes his foreign policy; (2) execute an American grand strategy of reviving its Asia Pacific influence; (3) cement the Obama administration’s legacy. The Iranian President Hassan Rouhani also has a clear interest in returning to the deal before the country’s presidential election in June. This would salvage his legacy and support his “reformist” faction. The Supreme Leader also has a chance to pin the negative aspects of the deal on a lame duck president while benefiting from it economically as he prepares for his all-important succession. The problem is that extreme levels of distrust will require some brinkmanship early in Biden’s term. Iran is building up leverage ahead of negotiations, which will mean higher levels of uranium enrichment and demonstrating the range of its regional capabilities, including the Strait of Hormuz, and its ability to impose economic pain via oil prices. Biden will need to establish a credible threat if Iran misbehaves. Hence the geopolitical setting is positive for oil prices at the moment. Beyond Iran, there is a clear basis for policy uncertainty to decline for Europe and the UK while it remains elevated for China and Russia (Chart 11). Chart 11Relative Policy Uncertainty Favors Europe and UK Over Russia And China The US international image has suffered from the Trump era and the Biden administration’s main priorities will lie in solidifying alliances and partnerships and stabilizing the US role in the world, rather than pursuing showdown and confrontation. However, it will not be long before scrutiny returns to the authoritarian states, which have been able to focus on domestic recovery and expanding their spheres of influence amid the US’s tumultuous election year. Chart 12GeoRisk Indicators Say Risks Underrated For These Bourses The US will not seek a “diplomatic reset” with Russia, aside from renegotiating the New START treaty. The Democrats will seek to retaliate for Russia’s extensive cyberattack in 2021 as well as for election interference and psychological warfare in the United States. And while there probably will be a reset with China, it will be short-lived, as outlined above. This situation contrasts with that of the Atlantic sphere. The Biden administration is a crystal clear positive, relative to a second Trump term, for the European Union. The EU and the UK have just agreed to a trade deal, as expected, to conclude the Brexit process, which means that the US-UK “special relationship” will not be marred by disagreements over Ireland. European solidarity has also strengthened as a result of the pandemic, which highlighted the need for collective policy responses, including fiscal. Thus the geopolitical risks of the new administration are most relevant for China/Taiwan and Russia. Comparing our GeoRisk Indicators, which are market-based, with the relative equity performance of these bourses, Taiwanese stocks are the most vulnerable because markets are increasingly pricing the geopolitical risk yet the relative stock performance is toppy (Chart 12). The limited recovery in Russian equities is also at risk for the same reason. Only in China’s case has the market priced lower geopolitical risk, not least because of the positive change in US administration. We expect Biden and Xi Jinping to be friendly at first but for strategic distrust to reemerge by the second half of the year. This will be a rude awakening for Chinese stocks – or China-exposed US stocks, especially in the tech sector. Investment Takeaways Chart 13Global Policy Shifts Drive Big Investment Reversals The US is politically divided. Civil unrest and aftershocks of the controversial election will persist but markets will ignore it unless it has a systemic impact. The policy consequence is a more proactive fiscal policy, resulting in virtual fiscal-monetary coordination that is positive both for global demand and risk assets, while negative for the US dollar. The Biden administration will succeed in partially repealing the Trump tax cuts, but the impact on corporate profit margins will be discounted fairly mechanically and quickly by market participants, while the impact on economic growth will be more than offset by huge new spending. Sentiment will improve after the pandemic – and Biden has not yet shown an inclination to take an anti-business tone. The past decade has been marked by a dollar bull market and the outperformance of developed markets over emerging markets and growth stocks like technology over value stocks like financials. Cyclical sectors have traded in a range. Going forward, a secular rise in geopolitical Great Power competition is likely to persist but the macro backdrop has shifted with the decline of the dollar. Cyclical sectors are now poised to outperform while a bottom is forming in value stocks and emerging markets (Chart 13). We recommend investors go strategically long emerging markets relative to developed. We are also going long global value over growth stocks. We are not yet ready to close our gold trade given that the two supports, populist fiscal turn and great power struggle, will continue to be priced by markets in the near term. We are throwing in the towel on our short CNY-USD trade after the latest upleg in the renminbi, though our view continues to be that geopolitical fundamentals will catch yuan investors by surprise when they reassert themselves. We also recommend preferring global equities to US equities, given the above-mentioned global trends plus looming tax hikes.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1 January 6, 2020, twitter.com. 2 See Turchin and Andrey Korotayev, "The 2010 Structural-Demographic Forecast for the 2010-2020 Decade: A Retrospective Assessment," PLoS ONE 15:8 (2020), journals.plos.org. 3 Not to mention that 2021 is the Communist Party’s 100th anniversary – not a time to make an unforced policy error with an already wobbly economy.

Highlights The (earnings) yield premium on tech stocks versus the 10-year bond yield is at its 2.5 percent lower threshold that has signalled four previous market fragilities. Additionally, the 65-day fractal structure of stocks versus bonds has collapsed, signalling a high probability of an exhaustion or correction over the next 65 days. Likewise, the 130-day fractal structure of bitcoin has also collapsed, signalling a high probability of an exhaustion or correction over the next 130 days. Bond yields are unlikely to go much higher; they are likely to go lower. Prefer utilities within the value segment, and prefer healthcare within the growth segment. Offices and bricks-and-mortar retail will never fully reopen. This will devastate the jobs market once the protection from government-funded furlough schemes winds down in 2021. Feature The pandemic will ease in 2021, and with it many of the restrictions on our lives. Yet when it comes to the economy and investment, the great reopening narrative for 2021 is misleading because the world economy has already largely reopened. We quickly learned that, with some adaptations, like working from home, and doing our shopping online, almost all economic activity can resume during a raging global pandemic. As a result, global profits have already rebounded very strongly (Chart of the Week). Chart of the WeekGlobal Profits Have Already Rebounded Very Strongly Manufacturing is fully open. Construction is fully open. Industrial production is fully open. Finance and most services are fully open. Looking at the world’s two largest economies, China is already beyond its pre-pandemic levels of output (Chart I-2), while the US is a mere 0.9 percent below (based on the Atlanta Fed Nowcast of 2.6 percent growth in the fourth quarter)1 (Chart I-3). Chart I-2The Chinese Economy Has Already Rebounded Chart I-3The US Economy Has Already ##br##Rebounded   Offices And Bricks-And-Mortar Retail Will Never Fully Reopen In the great reopening narrative, the end of the pandemic will allow the full reopening of offices, shops, restaurants, bars, travel and leisure. But will former office workers flock back to their offices full-time, or even majority-time? Will consumers flock back to bricks-and-mortar retailers? Will firms flock back to the same extent of business travel? Our high conviction answers are no, no, and no. The reason we will not go back to the pre-pandemic way of doing things is because we have found a better way of doing things. Obviously, we will relish our re-found ability to go on holiday and to meet our fellow humans in the flesh. But do we really need to meet our co-workers every day, or even most days? Do we really need to do our shopping in person every time, or even most times? Do we really need to visit the overseas office every quarter? In 2021 and beyond, we will continue to work, shop, and interact more remotely, not because a pandemic forces us to, but because it improves the quality of our personal and working lives. It improves our standard of living. In 2021 and beyond, we will continue to work, shop, and interact more remotely. Unfortunately, there will be collateral damage. As working from home becomes mainstream, the ecosystem of city centre bars, restaurants, and shops that rely on office workers will wither. This ecosystem’s large footprint can be illustrated by a remarkable fact: the pre-pandemic populations of both Manhattan and central London were 2 million people greater during the weekday daytime than during the night-time. Likewise, as online shopping becomes the default, bricks-and-mortar retailing will go into terminal decline. This is significant because retail employs 10 percent of all workers in the US and the UK, the majority in bricks-and-mortar retail outlets. In the same way, more online meetings and fewer business trips means less employment in the travel and accommodation sectors.  The common thread connecting retail and accommodation and food services is that they produce relatively little output, but account for a lot of jobs – in fact, just 8 percent of output but 20 percent of all jobs (Table I-1). Table I-1Retail Plus Accommodation And Food Services Account For 8 Percent Of Output But 20 Percent Of Jobs Hence, as these sectors wither, the good news is that the impact on economic output will be modest. The bad news is that the ultimate impact on the jobs market will be devastating. Crucially, this ultimate impact on the jobs market will only be felt once the protection from government-funded furlough schemes winds down in 2021. In time, a dynamic economy will redeploy the army of shop assistants, city centre bar and restaurant staff, and cabin crew into fast growing sectors such as healthcare and education. But a process that requires retraining and reskilling will take years not months. During this long adjustment, there is likely to be huge slack in developed economy labour markets. Given that central banks are now explicitly targeting labour market slack, these central banks will be forced to keep nominal bond yields at ultra-low levels for a very long time. The Near-Term Constraint On Bond Yields In the near term, there is an even greater force holding bond yields in check, and that force is something that central banks also explicitly target – financial stability. Higher bond yields would imperil financial stability. The global stock market is at an all-time high because valuations stand 25 percent higher than a year ago (Chart I-4). Valuations have surged because bond yields have collapsed (Chart I-5), but even relative to these ultra-low bond yields, technology sector valuations are now stretched. Chart I-4The Global Stock Market Is At An All-Time High Because Valuations Are 25 Percent Higher Chart I-5Valuations Are 25 Percent Higher Because Bond Yields Have Collapsed The (earnings) yield premium on tech stocks versus the 10-year bond yield is at its 2.5 percent lower threshold that has signalled four previous market fragilities. These previous market fragilities resulted in an exhaustion, or worse, a correction in the stock market in February 2018, October 2018, April 2019, and January 2020. Just as important, these points of fragility signalled that bond yields were approaching a major or minor peak (Chart I-6). Chart I-6Tech Stock Valuations Are Fragile Hence, in the early part of 2021 at least, steer towards investments that will benefit from a backing down of bond yields. This means avoiding value stocks as an aggregate, because value cannot outperform growth unless bond yields are rising (Chart I-7). However, it also means avoiding growth stocks in aggregate as the fragility lies in tech stock valuations. Chart I-7Value Cannot Outperform Growth Unless Bond Yields Are Rising A good strategy is to prefer utilities within the value segment, given that utilities benefit from lower bond yields (Chart I-8). And prefer healthcare within the growth segment, given the sector’s more reasonable valuation. Chart I-8Banks Cannot Outperform Utilities Unless Bond Yields Are Rising Stocks Are Vulnerable… And So Is Bitcoin Manias occur in markets when marginal buyers keep flooding in at a higher and higher price. (Likewise, panics occur when marginal sellers keep flooding in at a lower and lower price.) The supply of marginal buyers fuelling the strong uptrend tends to come from longer-term investors who are uncharacteristically behaving like short-term momentum traders for fear of missing out on the rally. For example, an investor with a 130-day investment horizon shouldn’t buy because of a one-day price increase. If he does, then his investment horizon has shrunk to 1-day. In this example, the strong uptrend will run out of fuel when the 130-day investors who are fuelling it are all in. This is defined by the 130-day fractal structure of the investment collapsing, meaning that its 130-day fractal dimension has reached its lower bound. If someone now puts on a sell order, there are no more 130-day horizon investors available to be the marginal buyer at the current price. Having sucked in all the 130-day investors, an investor with an even longer horizon, say 260 days, must step in as the marginal buyer. The likely outcome is a price correction because the longer-term investor is likely to buy only when a lower price satisfies his value compass. The other possibility is that the 260-day investor joins the uptrend, becoming a marginal buyer at the current price, adding more fuel to the mania. This is the less likely outcome because the longer that an investor’s horizon is, the more faithful he is likely to be to his valuation compass. Nevertheless, sometimes the valuation compass goes awry because of structural shifts or massive intervention by policymakers, allowing the trend to continue. The above describes the basis of our proprietary fractal trading system. In a nutshell, when the fractal structure of an investment collapses, the probability of a trend reversal increases sharply, and the probability of a trend continuation decreases sharply. Right now, the 65-day fractal structure of stocks versus bonds has collapsed, signalling a high probability of an exhaustion or correction over the next 65 days (see final section). Likewise, the 130-day fractal structure of bitcoin has also collapsed, signalling a high probability of an exhaustion or correction over the next 130 days (Chart I-9). Chart I-9The 130-Day Fractal Structure Of Bitcoin Has Collapsed To be clear, these rallies can continue uninterrupted if longer-term investors join the bandwagon. But this would require them to discard their valuation compasses. Hence, on balance, we think that this is the lower probability outcome. Also, to be clear, the long-term direction of both stocks versus bonds and bitcoin is up. The vulnerability we refer to is of a tactical pullback within a structural uptrend. An Excellent Year For The Fractal Trading System Among our most recent trades, overweight Portugal versus Italy achieved its 7 percent profit target, and underweight Australian construction materials (James Hardie, Lendlease, and Boral) achieved its 6 percent profit target. This takes the 2020 win ratio to a very pleasing 63 percent, comprising 18.4 winning trades versus 11 losing trades. Using a position size that delivers 2 percent for a win (and -2 percent for a loss), this equates to a 2020 return of 15 percent with a worst drawdown of -6 percent. By comparison, the MSCI All Country World index delivered a similar return of 17 percent but with a much more severe worst drawdown of -34 percent. 63 percent is a great win ratio. 63 percent is a great win ratio, but our aim is to reach 70 percent. To this end we are preparing several enhancements to the system which we will unveil in the coming weeks. Stay tuned. Fractal Trading System* As already discussed, we are targeting a tactical pullback in the MSCI All Country World Index versus the 30-year T-bond. The profit-target and symmetrical stop-loss are set at 5.8 percent. Chart I-10 The rolling 12-month win ratio now stands at 63 percent. When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated   December 11, 2014, available at eis.bcaresearch.com.   Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1 The GDP rebound creates a dissonance. If GDP is indicating a largely recovered economy, but our lives feel far from normal, is GDP really a good measure or objective for our wellbeing? We will leave a deeper discussion of this to a later date. Fractal Trading System   Cyclical Recommendations Structural Recommendations Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields   Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations