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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
Dear Client, We are sending you our Strategy Outlook today, where we outline our thoughts on the macro landscape and the direction of financial markets for 2021 and beyond. Next week, please join me for a webcast on Thursday, December 17 at 10:00 AM EST (3:00 PM GMT, 4:00 PM CET, 11:00 PM HKT) where I will discuss the outlook. Our publishing schedule will resume early next year. On behalf of the entire Global Investment Strategy team, I would like to wish you a Merry Christmas, Happy Holidays, and a Healthy New Year! Best regards, Peter Berezin, Chief Global Strategist Highlights Macroeconomic outlook: The global economy will strengthen in 2021 as the pandemic winds down. Inflation will remain well contained for the next 2-to-3 years before moving sharply higher by the middle of the decade. Global asset allocation: Stocks are technically overbought and vulnerable to a short-term correction. Nevertheless, investors should favor equities over bonds in 2021 given the likelihood that earnings will accelerate while monetary policy stays accommodative. Equities: This year’s losers will be next year’s winners. In 2021, international stocks will outperform US stocks, small caps will outperform large caps, banks will outperform tech, and value stocks will outperform growth stocks. Fixed income: Bond yields will rise modestly next year, implying that investors should maintain below average duration exposure. Spread product will outperform safe government bonds. Favor inflation-protected securities over nominal bonds. Currencies: The US dollar will continue to weaken in 2021. The collapse in US interest rate differentials versus its trading partners, stronger global growth, and a widening US trade deficit are all bearish for the greenback. Commodities: Tight supply conditions and a cyclical recovery in oil demand will support crude prices. Investors should favor gold over bitcoin as a hedge against long-term inflation risk. I. Macroeconomic Outlook V Is For Vaccine Chart 1Efficacy Rates Of Seasonal Flu Vaccines Are Well Below Those Of The Covid-19 Vaccines Ten months after the start of the pandemic, there is a light at the end of the tunnel. Both of the vaccines developed by Pfizer-BioNTech and Moderna using mRNA technology have demonstrated efficacy rates of around 95%. AstraZeneca’s vaccine, produced in collaboration with Oxford University, showed an efficacy rate of 90% in one of its clinical arms. Russia and China have also launched vaccines. The Russian vaccine, Gamaleya, displayed an efficacy rate of 91% based on 22,000 test participants. Such high efficacy rates are on par with the measles and smallpox vaccines, and well above the typical 30%-to-50% success rate for the seasonal flu vaccine (Chart 1). Inoculating most of the world’s population will not be easy. Nevertheless, large-scale vaccine production has already begun. More than half of the professional forecasters enrolled in the Good Judgement Project expect enough doses to be available to vaccinate 200 million Americans (about 60% of the US population) by the end of the second quarter of 2021 (Chart 2). Chart 2Mass Distribution Of Covid-19 Vaccines Expected By Mid-2021 According to opinion polls, public concern about the potential side effects from the vaccines, while still high, has diminished over the past few weeks (Chart 3). Most countries will start by vaccinating health care workers and other at-risk groups. Assuming no major side effects are reported, the successful deployment of the vaccines among health care professionals should bolster confidence within the general public. Chart 3The Public Is Slowly Becoming Less Worried About Covid-19 Vaccines Vaccines And Growth: A Short-Term Paradox? There is no doubt that the availability of a safe and effective vaccine will bolster economic activity over the medium-to-long term. The short-term impact, however, is ambiguous. On the one hand, vaccine optimism could reduce household precautionary savings. It could also prompt more firms to invest in new capacity. On the other hand, the expectation that a vaccine is coming could motivate people to take even greater efforts to avoid getting sick in the interim. Think about what happens when you take cover under a tree after it starts to rain. Your decision to stay under the tree depends on how long you expect the rain to continue. If the rain will last for only 10 minutes, staying put makes sense. However, if it will rain continuously for the next two days, you are better off going home. You are going to get wet anyway. Who wants to get sick just as the pandemic is winding down? It is like being the last soldier killed on the battlefield. Growth In Europe Suffering More Than In The US… So Far The number of new daily cases has declined by 45% in the EU from the highs reached in the second week of November. That said, progress on the disease front has come at a cost. As Covid infections surged, European governments were forced to reimplement a variety of lockdown measures (Chart 4). Correspondingly, growth indicators have weakened across the region (Chart 5). At this point, it looks highly likely that GDP will contract in the euro area and the UK in the fourth quarter. Chart 4The Latest Viral Surge Led To Lockdowns In Europe In contrast to Europe, the US economy should expand in the fourth quarter. The Atlanta Fed’s GDPNow model is pointing to growth of 11.2% in Q4, led by a recovery in personal consumption, strength in residential and nonresidential investment, and inventory restocking. Nevertheless, dark clouds are forming. After a short-lived dip in late November, the number of new daily cases in the US is on the rise again. The 7-day average of confirmed new cases has jumped to around 200,000. The Centers for Disease Control (CDC) estimates that for every single case that is caught, seven go undiagnosed.1 This implies that over 11 million people are being infected each week, or about 3% of the US population. With the weather getting colder and the Christmas holiday season approaching, a further viral surge looks probable. Just as in Europe, we may see more lockdowns and more voluntary social distancing in the US over the coming weeks. Building A Fiscal Bridge To A Post-Pandemic World Lockdowns would be less of a problem if governments provided enough income support to struggling households and businesses. Unfortunately, at least in the US, considerable uncertainty remains about whether such support will be forthcoming. After a burst of stimulus earlier this year, US fiscal policy has tightened sharply. Since peaking in April, real disposable personal income has dropped by 9%, reflecting a steep decline in government transfer payments (Chart 6). The latest data suggest that real disposable income will be down in Q4 compared to the preceding quarter. Chart 5Renewed Lockdowns Are Weighing On Economic Activity In The Euro Area Chart 6Less Transfers Mean Less Income President Trump tried to offset some of the sting from the expiration of emergency unemployment benefits in the CARES Act by diverting funds from the Federal Emergency Management Agency (FEMA) to support jobless workers. However, this money has now run out (Chart 7). Likewise, the resources in the Paycheck Protection Program for small businesses have been depleted, and many state and local governments are facing a cash crunch. Chart 7Drastic Drop In Unemployment Insurance Payments Chart 8People Are Eager For More Stimulus The US Congress has been squabbling over a new stimulus bill since May. Ultimately, we think a bill will be passed, potentially as part of a year-end omnibus spending package. Public opinion still very much favors maintaining stimulus. A survey conducted by Pew Research after the election found that about 80% of respondents supported passing a new stimulus package (Chart 8). Similarly, according to a recent NY Times/Siena College poll, 72% of voters supported a hypothetical $2 trillion stimulus package that would extend emergency unemployment insurance benefits, distribute direct cash payments to households, and provide financial support to state and local governments (Table 1). Such a package is basically what the Democrats are proposing. Strikingly, when this package is described in non-partisan terms, even the majority of Republicans are in favor of it. Table 1Even Republicans Want More Stimulus Peak Chinese Stimulus Even though it originated there, China has weathered the pandemic better than any other major country. Chinese export growth accelerated to 21.1% year-over-year in November. The Caixin manufacturing PMI rose to 54.9 on the month, the strongest reading since November 2010. The service sector PMI increased to a healthy 57.8. The “official” PMIs published by the National Bureau of Statistics also rose. Chinese growth will moderate over the coming months. The magnitude of China’s policy support has peaked, as evidenced by the rise in bond yields and interbank rates (Chart 9). The authorities have also permitted more corporate issuers to default, while tightening rules on online lending. Turning points in Chinese domestic demand and imports tend to lag policy developments by about 6-to-9 months (Chart 10). Thus, the tailwind from Chinese stimulus should fade by the middle of next year, hopefully just in time for the baton to be passed to a more organic, vaccine-driven global growth recovery. Chart 9China: Bond Yields And Interbank Rates Have Been Rising Chart 10Tailwind From Chinese Stimulus Will Fade By The Middle Of Next Year Japan: Near-Term Wobbles Japan is in the midst of its third wave of the pandemic. While not as bad as the latest waves in the US and Europe, it has still been disruptive enough to slow the economy. Although it did tick up in November, the manufacturing PMI remains below the crucial 50 boom/bust line, notably weaker than in other APAC countries. The outlook component of the Economy Watchers Survey fell to 36.5 in November (from 49.1), while the current situation component slid to 45.6 (from 54.5). Nevertheless, there are some encouraging signs. The number of new Covid cases seems to be stabilizing. Machine tool orders rose to 8% year-over-year in November, the first positive print since September 2018. Retail sales have recovered from a low of -14% year-over-year in April to around +6% in October. Broad money growth has reached a record high. The Japanese government is also considering a new ¥73 trillion fiscal stimulus package to fight the pandemic. Global Monetary Policy To Stay Accommodative Chart 11Service And Shelter Inflation Tend To Be Largely Determined By Labor Market Slack Could a vaccine-led economic recovery cause central banks to remove the punch bowl? We think not. Inflation is likely to rise in the first half of 2021 as the “base effects” from the pandemic-induced drop in prices reverse. However, central banks will see through these short-term oscillations in inflation. Inflation in modern economies is largely driven by services and shelter (goods account for only 25% of the US core CPI and 37% of the euro area core CPI). Both service inflation and shelter inflation tend to be largely determined by labor market slack (Chart 11). In its October 2020 World Economic Outlook, the IMF projected that the unemployment rate in the main developed economies would fall back to its full employment level by around 2025 (Chart 12). While this is too pessimistic in light of the subsequent progress that has been made on the vaccine front, it is probable that unemployment will remain too high to generate an overheated economy for the next 2-to-3 years. Chart 12Unemployment Rate Is Projected To Decline Towards Pre-Covid Lows In The Coming Years Chart 13Long-Term Inflation Expectations Are Still Subdued Moreover, despite vaccine optimism, long-term inflation expectations are still below target in most of the major economies (Chart 13). Not only do central banks want inflation to return to target, they want inflation to overshoot their targets in order to make up for the shortfall in inflation in the post-GFC era. Had the core PCE deflator in the US risen by 2% per year since 2012, the price level would be about 3.3% higher than it currently is. In the euro area, the price level is about 9.5% below where it would have been if consumer prices had risen by 2% over this period. In Japan, the price level is 11.6% below target (Chart 14). Chart 14Central Banks Have Missed Their Inflation Targets II. Financial Markets A. Global Asset Allocation Remain Overweight Equities Versus Bonds On A 12-Month Horizon Equities have run up a lot since the start of November. Bullish sentiment has surged in the American Association of Individual Investors weekly bull-bear poll, while the put-to-call ratio has fallen to multi-year lows (Chart 15). This makes equities vulnerable to a short-term correction. Nevertheless, rising odds of an effective vaccine and continued easy monetary policy keep us bullish on stocks over a 12-month horizon. Stronger economic growth should lift earnings estimates. Stocks have usually outperformed bonds when growth has been on the upswing (Chart 16). Chart 15A Lot Of Bullishness Chart 16Stocks Rarely Underperform Bonds When The Global Economy Is Strengthening Valuations also favor stocks. As Chart 17 illustrates, the global equity risk premium – which we model by subtracting real bond yields from the cyclically-adjusted earnings yield – remains quite high. Along the same lines, dividend yields are above bond yields in the major markets. Even if one were to pessimistically assume that nominal dividend payments stay flat for the next 10 years, real equity prices would have to fall by 24% in the US for stocks to underperform bonds (Chart 18). In the euro area, real equity prices would need to tumble 32%. In Japan, they would have to drop 20%. Chart 17Equity Risk Premia Remain Elevated Chart 18Stocks Would Need To Fall A Lot For Equities To Underperform Bonds As such, investors should overweight global equities relative to bonds. We recommend a neutral allocation to cash to take advantage of any short-term dip in stock prices. Our full suite of asset allocation and trade recommendations are shown at the back of this report. B. Equity Sectors, Regions, Styles This Year’s Losers Will Be Next Year’s Winners The “pandemic trade” is giving way to the “reopening trade.” We are still in the early innings of this transition. Hence, going into next year, it makes sense to favor stocks that were crushed by lockdown measures but could thrive once restrictions are lifted. Chart 19 shows relative 12-months forward earnings estimates for US/non-US, large caps/small caps, and tech/overall market. In all three cases, the tables have turned: Estimates are now rising more quickly for non-US stocks, small caps, and non-tech sectors. Non-US Stocks To Outperform Stocks outside the US are significantly cheaper than their US peers based on price-to-earnings, price-to-book, price-to-sales, and dividend yields (Chart 20). The macro outlook also favors non-US stocks, which tend to outperform when global growth is strengthening and the US dollar is weakening (Chart 21). Chart 19Relative Earnings Expectations For Non-US Stocks, Small Caps, And Non-Tech Are Improving Chart 20Non-US Stocks Are Cheaper Chart 21Non-US Equities Tend To Outperform Their US Peers When Global Growth Is Improving And The Dollar Is Weakening As we discuss below, the dollar is likely to depreciate further over the next 12 months. A weaker dollar benefits cyclical sectors of the stock market more than defensives (Chart 22). Deep cyclicals are overrepresented outside the US (Table 2). Being more cyclical in nature, small caps usually outperform when the dollar weakens (Chart 23). Chart 22Cyclicals Tend To Outperform Defensives In A Falling Dollar Environment Table 2Financials Are Overrepresented In Ex-US Indices, While Tech Dominates The US Market Chart 23Small Caps Also Tend To Outperform When Global Growth Strengthens And The Dollar Weakens Chart 24Banks’ Net Interest Margins Will Receive A Boost Buy The Banks Banks comprise a larger share of non-US stock markets. Stronger growth in 2021 will put upward pressure on long-term bond yields. Since short-term rates will stay where they are, yield curves will steepen. Steeper yield curves will boost banks’ net interest margins (Chart 24). In addition, faster economic growth will put a lid on defaults. Banks have set aside considerable capital for pandemic-related loan losses. Yet, the wave of defaults that so many feared has failed to materialize. According to the American Bankruptcy Institute, commercial bankruptcies are lower now than they were this time last year (Chart 25). Personal loan delinquencies have also been trending down. The 60-day delinquency rate on credit card debt fell to 1.16% in October from 2.02% a year earlier. The delinquency rate for mortgages fell from 1.54% to 0.98%. Only auto loan delinquencies registered a tiny blip higher (Table 3). Chart 25Commercial Bankruptcies Are Well Contained Table 3Personal Loan Delinquencies Have Also Been Trending Lower Just A “Value Bounce”? In our conversations with clients, many investors are open to the idea that value stocks are due for a cyclical bounce. However, most still believe that growth stocks will fare best over a longer-term horizon. Such a view is understandable. After all, profit growth is the principal driver of equity returns. If, by definition, growth companies enjoy faster earnings growth, does it not stand to reason that growth stocks will outperform value stocks over the long haul? Well, actually, it doesn’t. What matters is profit growth relative to expectations, not absolute profit growth. If earnings rise quickly, but by less than investors had anticipated, stock prices could still go down. Historically, investors have tended to extrapolate earnings trends too far into the future, which has led them to overpay for growth stocks. Chart 26 demonstrates this point analytically. It features the results of a study by Louis Chan, Jason Karceski, and Josef Lakonishok. The authors sorted companies by projected five-year earnings growth and then compared the analysts’ forecasts with realized earnings. For the most part, they found that there was no relationship between expected profit growth and realized profit growth beyond horizons of two years. In general, the higher the long-term earnings growth estimates, the more likely actual earnings were to miss expectations. Chart 26Investors Tend To Overpay For Growth The Paradox Of Growth Given the difficulty of picking individual stocks that will consistently surpass earnings estimates, should investors simply allocate the bulk of their capital to sectors such as technology that have the best long-term growth prospects while eschewing structurally challenged sectors such as energy and financials? Again, the answer is not as obvious as it may seem. As Chart 27 illustrates, stocks in industries that experience a burst of output growth do tend to outperform other stocks. However, over the long haul, companies in fast growing industries do not outperform their peers (Chart 28). In other words, stock prices seem to respond more to unanticipated changes in industry growth rather than to the trend level of growth. Chart 27Stocks In Industries That Experience A Burst Of Output Growth Do Tend To Outperform Other Stocks … Chart 28… But Over The Long Haul, Companies In Fast-Growing Industries Do Not Outperform Their Peers Explaining Tech Outperformance In this vein, it is useful to examine what has powered the performance of US tech stocks over the past 25 years. Chart 29 shows that faster sales-per-share growth explains less than half of tech’s outperformance since 1996 and none of tech’s outperformance in the period up to 2011. The majority of tech’s outperformance is explained by greater margin expansion and an increase in the P/E ratio at which tech stocks trade relative to the rest of the stock market. Chart 29Decomposing Tech Outperformance What accounts for the significant increase in tech profit margins? In two words, the answer is “monopoly power.” Tech companies are particularly susceptible to network effects: The more people who use a particular tech platform, the more attractive it is for others to use it. Facebook is a classic example. Second, tech companies benefit significantly from scale economies. Once a piece of software has been written, creating additional copies costs almost nothing. Even in the hardware realm, the marginal cost of producing an additional chip is tiny compared to the fixed cost of designing it. All of this creates a winner take-all environment where success begets further success. Normally, structurally fast-growing industries attract more competition, which increases the odds that up-and-coming firms will displace incumbents. The growth of tech monopolies has subverted that process, allowing profits to rise significantly. A Tougher Path Forward For Tech A key question for investors is how much additional scope today’s tech monopolies have to expand profits. While it is difficult to generalize, two broad forces are likely to curtail future earnings growth. First, many tech titans have become so big that their future growth will be driven less by their ability to take market share from competitors and more by the overall size of the markets in which they operate. As it is, close to three-quarters of US households have an Amazon Prime account. Slightly over half have a Netflix account. Nearly 70% have a Facebook account. Google commands 92% of the internet search market. Together, Google and Facebook generate about 60% of all online advertising revenue. Second, the monopoly power wielded by tech companies makes them vulnerable to governmental action, including higher taxes, increased regulation, and stronger anti-trust enforcement. Importantly, it is not just the left that wants greater scrutiny of tech companies. According to a recent Pew Research study, more than half of conservative Republicans favor increasing government regulation of the tech sector (Chart 30). Chart 30Conservatives Favor Increased Government Regulation Of Big Tech Companies We do not expect tech stocks to decline in absolute terms since they still have a variety of tailwinds supporting them. Nevertheless, our bet is that the cyclical shift in favor of value stocks we are seeing now will usher in a period of outperformance for value names that could last for much of this decade. Not only are value stocks exceptionally cheap compared to growth stocks (Chart 31), but as we discuss below, bond yields likely reached a secular bottom this year. This could set the stage for a period of lasting outperformance for value plays. Chart 31Value Stocks Are Extremely Cheap Relative To Growth Stocks C. Fixed Income Position For Steeper Yield Curves As discussed earlier, central banks are unlikely to raise rates over the next 2-to-3 years. In fact, short-term real rates will probably decline further in 2021 as inflation expectations rise towards central bank targets. What about longer-term bond yields? Chart 32 displays the expected path of policy rates in the major developed economies now and at the start of 2020. The chart suggests that there is still scope for rate expectations in the post-2023 period to recover some of the ground they have lost since the start of the pandemic. This implies that bond investors should position for steeper yield curves, while keeping duration risk at below-benchmark levels. They should also favor inflation-linked securities over nominal bonds. Chart 32Policy Rate Expectations Remain Below Pre-Pandemic Levels Avoid “High Beta” Government Bond Markets The highest-yielding bond markets tend to have the highest “betas” to the general direction of global bond yields (Chart 33). This means when global bond yields are rising, higher-yielding markets such as the US usually experience the biggest selloff in bond prices. Chart 33High-Yielding Bond Markets Are The Most Cyclical This pattern exists because faster growth has a more subdued impact on rate expectations in economies such as Europe and Japan where the neutral rate of interest is stuck deep in negative territory. For example, if stronger growth lifts the neutral rate in Japan from say, -4% to -2%, this would still not warrant raising rates. In contrast, if stronger growth lifts the neutral rate from -1% to +1% in the US, this would eventually justify a rate hike. As such, we would underweight US Treasurys in global government bond portfolios. We expect the 10-year Treasury yield to increase to around 1.3%-to-1.5% by the end of 2021, which is above current expectations of 1.15% based on the forward curve. Conversely, we would overweight European and Japanese government bond markets. After adjusting for currency-hedging costs, US Treasurys offer only a small yield pickup over European and Japanese bonds but face a much greater risk of capital losses as rate expectations recover (Table 4). Table 4Bond Markets Across The Developed World BCA’s global fixed-income strategists have a neutral recommendation on Canadian and Australian bonds. While Canadian and Australian yields are also “high beta,” both the BoC and the RBA are very active purchasers in their domestic markets. Stay Overweight High-Yield Developed Market Corporate Debt In fixed-income portfolios, we would overweight corporate debt relative to safer government bonds. In an economic environment where monetary policy remains accommodative and growth is rebounding, corporate default rates should remain contained, which will keep spreads from widening. Within corporate credit, we favor high yield over investment grade. Geographically, we prefer US corporate bonds over euro area bonds. The former trade with a higher yield and spread than the latter (Charts 34A & B). Chart 34AFavor High-Yield Bonds Over Investment-Grade ... Chart 34B… And US Corporates Over Euro Area One way to gauge the attractiveness of credit is to look at the percentile rankings of 12-month breakeven spreads. The 12-month breakeven spread is the amount of credit spread widening that can occur before a credit product starts to underperform a duration-matched, risk-free government bond over a one-year horizon. For US investment-grade corporates, the breakeven spread is currently in the bottom decile of its historic range, which is rather unattractive from a risk-adjusted perspective. In contrast, the US high-yield breakeven spread is currently in the 62nd percentile, which is quite enticing. In the UK, high-yield debt is more appealing than investment grade, although not quite to the same extent as in the US. In the euro area, both high-yield and investment-grade credit are fairly unattractive (Chart 35). Chart 35Corporate Bond Breakeven Spread Percentile Rankings Outside the corporate sector, our US bond strategists like consumer ABS due to the strength of household balance sheets. They also see value in municipal bonds. However, they would avoid MBS, as prepayment risks are elevated in that sector. EM credit should also benefit from the combination of stronger global growth and a weaker US dollar. Long-Term Inflation Risk Is Underpriced As noted earlier in the report, inflation is unlikely to rise significantly over the next three years. Beyond then, a more inflationary environment is probable. Chart 36 shows that the wage-version of the Phillips curve in the US is alive and well. It just so happens that over the past three decades, the labor market has never had a chance to overheat. Something always came along that derailed the economy before a price-wage spiral could develop. This year it was the pandemic. In 2008 it was the Global Financial Crisis. In 2000 it was the dotcom bust and in the early 1990s it was the collapse in commercial real estate prices following the Savings and Loan Crisis. Admittedly, only the pandemic qualifies as a true “exogenous” shock. The prior three recessions were endogenous in nature to the extent that they were preceded by growing economic imbalances, laid bare by a Fed hiking cycle. One can debate the degree to which the global economy is suffering from imbalances today, but one thing is certain: no major central bank is keen on raising rates anytime soon. Central banks want higher inflation. They are likely to get it. D. Currencies, Commodities, And Yes, Bitcoin Dollar Bear Market To Continue In 2021 The dollar faces a number of headwinds going into next year. First, interest rate differentials have moved significantly against the greenback. At the start of 2019, US real 2-year rates were about 190 basis points above rates of other developed economies; today, US real rates are around 60 basis points lower than those abroad. In fact, as Chart 37 shows, the trade-weighted dollar has weakened less than one would have expected based on the decline in interest rate differentials. This suggests that there could be some “catch-up” weakness for the dollar next year even if rate differentials remain broadly stable. Chart 36Is The Phillips Curve Really Dead? Chart 37A Relatively Muted Decline In The Dollar Given The Move In Real Yield Differentials Second, the US dollar is a counter-cyclical currency, meaning that it tends to move in the opposite direction of the global business cycle (Chart 38). If the global economy strengthens next year thanks to an effective vaccine, the dollar should weaken. Chart 38The Dollar Is A Countercyclical Currency Chart 39USD Remains Overvalued Third, the US dollar remains about 13% overvalued based on Purchasing Power Parity (PPP) exchange rates (Chart 39). This overvaluation is also reflected in the large US current account deficit, which rose in the second quarter to the highest level since 2008 and is on track to swell even further in the second half of the year. Technicals Are Dollar Bearish Admittedly, many investors are now bearish on the dollar. Shouldn’t one be a contrarian and adopt a bullish dollar view? Not necessarily. In most cases, being contrarian makes sense. However, this does not apply to the dollar. The dollar is a high-momentum currency (Chart 40). When it comes to trading the dollar, it pays to be a trend follower. Chart 40The Dollar Is A High Momentum Currency One of the simplest and most profitable trading rules for the dollar is to go long the greenback when it is trading above its moving average and go short when it is trading below its moving average (Chart 41). Today, the trade-weighted dollar is trading below its 3-month, 6-month, 1-year, and 2-year moving averages. Along the same lines, the dollar performs best when sentiment is bullish and improving. In contrast, the dollar does worse when sentiment is bearish and deteriorating, as it is now (Chart 42). Chart 41Being A Contrarian Doesn’t Pay When It Comes To Trading The Dollar (I) Chart 42Being A Contrarian Doesn’t Pay When It Comes To Trading The Dollar (II) The bottom line is that both fundamental factors – interest rate differentials, global growth, valuations, current account dynamics – and technical factors – moving average rules and sentiment – all point to dollar weakness next year. Top Performing Currencies In 2021 EUR/USD is likely to rise to 1.3 by the middle of next year. The ECB does not want a stronger currency, but with euro area interest rates already in negative territory, there is not much it can do. The Swedish krona, as a highly cyclical currency, should strengthen against the euro. In contrast, the Swiss franc, a classically defensive currency, will weaken against the euro. It is more difficult to forecast the direction of the pound given uncertainty about ongoing Brexit talks. The working assumption of BCA’s geopolitical team is that Prime Minister Boris Johnson has sufficient economic and political incentives to arrive at a trade deal, a parliamentary majority to get it approved, and a powerful geopolitical need to mollify Scotland. This bodes well for sterling. The yen is a very defensive currency. Thus, in an environment of strengthening global growth, the yen is likely to trade flat against the dollar, and in the process, lose ground against most other currencies. We are most bullish about the prospects for EM and commodity currencies going into next year. China is likely to let its currency strengthen further in return for a partial rollback of tariffs by the Biden administration. A stronger yuan will allow other currencies in Asia to appreciate. Stay Bullish On Commodities And Commodity Currencies The combination of a weaker US dollar and stronger global growth should support commodity prices in 2021. Industrial metals outperformed oil this year, but the opposite should be true next year. Chart 43Oil Prices Are Expected To Recover While the long-term outlook for crude is murky in light of the shift towards electric vehicles, the near-term picture remains favorable due to the cyclical rebound in petroleum demand and ongoing OPEC and Russian supply discipline. BCA’s commodity strategists expect the average price of Brent to exceed market expectations by about $14 in 2021, which should help the Norwegian krone, Canadian dollar, Russian ruble, Mexican peso, and Colombian peso (Chart 43). Favor Gold Over Bitcoin As An Inflation Hedge Gold has traditionally served as the go-to hedge against inflation. These days, however, there is a new competitor in town: bitcoin. In traditional economic parlance, money serves three purposes: as a medium of exchange; as a unit of account; and as a store of value. Both gold and bitcoin flunk the test for the first two purposes. Few transactions are conducted in either gold or bitcoin. It is even rarer for prices of goods and services to be set in ounces of gold or units of bitcoin. Gold arguably does better as a store of value. It has been around for a long time and if all else fails, it can always be melted down and turned into nice jewelry. Bitcoin’s Achilles Heel Bitcoin’s defenders argue that the cryptocurrency does serve as a store of value because one day, it will reach a critical mass that will make it a viable medium of exchange and a functional unit of account. Yet, this argument is politically naïve. Countries with fiat currencies derive significant benefits from their ability to create money out of thin air that can then be used to pay for goods and services. In the US, this “seigniorage revenue” amounts to over $100 billion per year. The existence of fiat currencies also gives central banks the power to set interest rates and provide liquidity backstops to the financial sector. Bitcoin’s ability to facilitate anonymous transactions is also its Achilles heel. The widespread use of bitcoin would make it more difficult for governments to tax their citizens. All this suggests that bitcoin will never reach a critical mass where it becomes a viable medium of exchange or functional unit of account. Governments will step in to ban or greatly curtail its usage before then. And without the ability to reach this critical mass, bitcoin’s utility as a store of value will disappear. Hence, investors looking for some inflation protection in their portfolios should stick with gold. Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1 Heather Reese, A. Danielle Iuliano, Neha N. Patel, Shikha Garg, Lindsay Kim, Benjamin J. Silk, Aron J. Hall, Alicia Fry, and Carrie Reed, “Estimated incidence of COVID-19 illness and hospitalization — United States, February–September, 2020,” Clinical Infectious Diseases (Oxford Academic), November 25, 2020. Global Investment Strategy View Matrix Special Trade Recommendations This table provides trade recommendations that may not be adequately represented in the matrix on the preceding page. Current MacroQuant Model Scores
Mr. X and his daughter, Ms. X, are long-time BCA clients who visit our office toward the end of each year to discuss the economic and financial market outlook for the year ahead. This report is an edited transcript of our recent conversation, which we held remotely due to the COVID-19 pandemic. Mr. X: As always, I welcome the opportunity to discuss the economic and financial outlook with you. The past year has been truly ghastly with the wretched COVID-19 disease wreaking extraordinary economic and social havoc. I take comfort from the hope that a vaccine will allow a gradual return to more normal conditions in 2021, but my concerns about the longer-run outlook have increased. The extreme monetary and fiscal responses to the virus-related economic collapse may have been necessary but will leave most developed economies much more vulnerable down the road. Risk assets have been propped up by easy money, but I fear that simply means lower returns in the future. Ms. X: The social impact of the virus has weighed heavily on me, making me quite depressed about the outlook. I can only hope that my normal optimism will return when a vaccine ends the pandemic. Of course, I am happy that equities have done much better than might have been expected in the past year, but I share my father’s concerns about long-term returns. I look forward to discussing ideas about how to position our portfolio. BCA: The past year has indeed been grim on many levels. The economic disruption has been severe, but the social toll of the virus has been even more damaging for many people in terms of being forcibly isolated from family and friends. It is very encouraging that vaccines should start to become widely available early in the year, but the return to normality likely will take time. During the northern hemisphere winter months, the pandemic may even get worse before it gets better. As far as the longer run outlook is concerned, the policy response to the crisis will indeed have consequences. Government debt has soared in most countries and this raises the issue of how this will be dealt with in the years ahead. Meanwhile, central bank support to the markets cannot continue indefinitely, which raises the prospect of severe withdrawal pains at some point. Furthermore, both fiscal and monetary trends pose the question of whether higher inflation is inevitable. It is therefore unlikely that voters will reward politicians who impose upon them the painful deflationary pressures. Markets are forward looking and one could take the view that the strength of equity markets in the past eight months has reflected optimism about the economic outlook. However, a more plausible explanation is that hyper-stimulative monetary policies have been the main driving force behind asset prices. If that is the case, then there is some cause for optimism because central banks have made it clear that they will not be tightening policy for quite some time. While you are both right to be concerned about low returns over the long run, risk asset prices seem likely to rise further in the coming year with equities continuing to outperform bonds. We can get into that in more details later. Ms. X: Before we get into our discussion of the outlook, let’s briefly review your predictions from last year. BCA: That will be a humbling experience given that we never built a global pandemic into our forecasts! A year ago, our key conclusions were that: Global equities would enter the end game of their nearly 11-year bull market. Stocks were expensive, but bonds were even more so. As a result, if global growth could recover and the US could avoid a recession in 2020, earnings would not weaken significantly and stocks would again outperform bonds. Low rates reflected the end of the debt super cycle in the advanced economies. However, the debt super cycle was still alive in EM, particularly in China. The global economic slowdown that began more than 18 months prior to our meeting started when China tried to limit debt growth. If Beijing continued to push for more deleveraging, global growth would continue to suffer as the EM debt super cycle would end. Nonetheless, we expected China to try to mitigate domestic deflationary pressures in 2020. As a result, a small wave of Chinese reflation, coupled with the substantial easing in global monetary and liquidity conditions should have promoted a worldwide reacceleration in economic activity. Policy uncertainty would recede in 2020. Domestic constraints would force China and the US toward a trade détente. The risk of a no-deal Brexit was seen as marginal, and President Trump was still the favorite in the election. A decline in policy risk would foster a global economic rebound. That being said, some pockets of geopolitical risk remained, such as in the Middle East. Global central banks were highly unlikely to remove the punch bowl. Not only would it take some time before global deflationary forces receded, monetary authorities in the G-10 would want to avoid the Japanification of their economies. As a result, they were already announcing that they would allow inflation to overshoot their 2% target for a period of time. This would ultimately raise the need for higher rates in 2021, which would push the global economy into recession in late 2021 or early 2022. These dynamics were key to our categorization of 2020 as the end game. US growth would reaccelerate. The US consumer was in good shape thanks to healthy balance sheets as well as robust employment and wage growth prospects. Meanwhile, corporate profits and capex should have benefited from a decline in global uncertainty and a pickup in global economic activity. China would continue to stimulate its economy but would not do so as aggressively as it did over the past 10 years. Consequently, EM growth would also bottom but was unlikely to boom. Europe and Japan would reaccelerate in 2020. Bond yields would continue to grind higher in 2020. However, Treasury yields were unlikely to break above the 2.25% to 2.5% range until much later in the year. Inflationary pressures would not resurface quickly, so the Fed was unlikely to signal its intention to raise interest rates until late 2020 or later. European bonds were particularly unattractive. Corporate bonds were a mixed offering. Investment grade credit was unattractive owing to low option-adjusted spreads and high duration, especially as corporate health was deteriorating. Agency mortgage-backed securities and high-yield bonds offered better risk-adjusted value. Global stocks would enjoy their last-gasp rally in 2020. As global growth would recover, we favored the more cyclical sectors and regions which also happened to offer the best value. US stocks were the least attractive bourse; they were very expensive and loaded with defensive and tech-related exposure, two groups that would suffer from higher bond yields. We were neutral on EM equities. We recommended that investors pare exposure to equities only after inflation breakevens had moved back into their 2.3% to 2.5% normal range and the Fed fund rates had moved closer to neutral. We anticipated this to be a risk in 2021. The dollar was likely to decline because it is a countercyclical currency. Balance of payment dynamics and valuation considerations were also becoming headwinds. The pro-cyclical European currencies and the euro were expected to be the main beneficiaries of any dollar depreciation. We anticipated oil and gold to have upside. Crude would benefit from both supply-side discipline and a recovery in oil demand on the back of the improving growth outlook. Gold would strengthen as global central banks would limit the upside to real rates by allowing inflation to run a bit hot. A weaker dollar would boost both commodities. We expected a balanced portfolio to generate an average return of only 2.4% a year in real terms over the next decade. This compares to average returns of around 6.5% a year between 1982 and 2018. Obviously, our forecasts were undone by the defining event of the year: the pandemic. Nonetheless, in February we warned that asset prices did not embed enough of a risk premium to protect investors against the threat that the pandemic could terminate the global business cycle. The more deflationary risk we confront today, the more inflation we will face in the future. At the beginning of the second quarter, we were quick to recommend buying stocks back, so we participated in the rally that followed. We erred in preferring foreign to US equities, which turned out to be key winners of the pandemic thanks to their heavy exposure to growth stocks (Table 1). The economic downturn meant that bond yields fell rather than rose. They have remained exceedingly low in response to exceptionally accommodative monetary conditions, a surge in savings and deeply negative output gaps. We were right to favor peripheral bonds, which benefited from the ECB’s purchases and the European Commission’s Recovery Fund (Table 1). Finally, the market rewarded our negative stance on the dollar and our bullish view on gold. However, we were offside on oil, where the continued impact of the pandemic on global transport has left crude prices at very depressed levels. Table 12020 Asset Market Returns A Brave New World Mr. X: You mentioned that you prefer stocks over bonds for 2021. I can accept this view; while stocks are expensive, their valuations are less demanding than that of bonds. Moreover, I agree that policymakers around the world are very afraid of the deflationary consequences of removing accommodation too early but they cannot ease monetary policy much from here. This creates an asymmetric payoff in favor of stocks versus safe-haven securities. However, my favorite asset class for the near future is cash. Granted, I enjoy the luxury of not having to track a benchmark and my core focus is capital preservation. With both stocks and bonds richly valued, I see no margin of safety and I would rather stand on the sidelines. The longer-term outlook is particularly concerning. The extraordinary accommodation implemented this year was unavoidable, but its future consequences worry me greatly. Real rates have never been so low and we are leaving unprecedented public debt loads to our children and grandchildren. Moreover, I fear further adoption of populist policies because inequalities have risen in the wake of the crisis. The worst affected families stand at the bottom of the income distribution while people like me have benefited from inflated asset prices. Therefore, I am inclined to believe that we will suffer a large inflation shock in the coming decade. The global broad money supply has exploded and it is very unlikely that central banks will normalize interest rates in due time because of the burden created by gigantic public debt loads and the spectrum of further populism. My worries extend beyond these obvious concerns. Last year I was already anxious about the incredibly large stock of global debt with negative yields. This situation has only worsened since. Moreover, the various programs implemented by the Federal Reserve, the European Central Bank and other major monetary authorities to provide liquidity directly to the private sector at the apex of the crisis have prevented the purge of unhealthy firms necessary under a capitalist system. Instead of creative destruction, zombification has become the norm. Thus, I fear that more capital is misallocated than at any point in the past 10 years. Putting it all together, my expectations are that real returns will be poor for years to come, if not outright negative. I therefore believe that gold should stand at the core of my family’s portfolio. Ms. X: I share many of my father’s concerns. It is difficult to see how monetary and fiscal authorities will normalize policy. Hence, I agree that we will face the painful legacy of a large debt overhang and poor long-term returns. Moreover, the poor demographic profile in most advanced economies as well as China bodes ill for trend growth. I do see opportunities within this bleak picture. Healthcare stocks should benefit from an aging of the world’s population and tech equities will remain a source of disruption, innovation and profit growth in the coming decades. Thus, an equity portfolio built around these themes should generate positive real returns. In light of the positive vaccine news, next year will offer investors with both rapidly expanding profits and low discount rates and it is hard to imagine equities performing poorly. BCA: Clearly, we have many things to discuss. We should start with the COVID-19 pandemic. The news that vaccines developed by Pfizer/BioNTech and Moderna are around 95% effective is very encouraging. The Oxford/AstraZeneca announcement also is a source of optimism, even if the trial results have been less clear-cut. Moreover, other vaccines are currently in the mass-testing stage. By next winter, approximately 1.5 billion people globally should have been vaccinated. These positives hide many issues. First, transporting the Pfizer and Moderna vaccines (particularly the one produced by Pfizer, which needs to be kept at -70°C) will be challenging, especially for poorer countries. Second, the mRNA technology used in these vaccines is new and its long-term impact is unknown. Hence, many people will be reluctant to take this shot, especially as the confidence in the safety of vaccines has declined among the general public. Only 58% of Americans said they would probably take a COVID-19 vaccine, a number that will rise once the vaccine is demonstrated but which still highlights the challenge (Chart 1). Third, the virus could mutate and render the current generation of vaccines ineffective. The recent news of such mutations in mink farms in Denmark is worrisome, especially as the new strain of the virus has already jumped back into the human population. Chart 1The Vaccine Blues Our base case is that the vaccines will allow a progressive reopening of the economic sectors currently still under lockdown. They will lead to a further improvement in employment, consumer and business sentiment, and aggregate demand. With less fear of getting infected, consumers will return to shops, restaurants, hotels, etc. This will have a very beneficial impact on capex and profit growth. It will result in higher stock prices, especially for value stocks, cyclical stocks, as well as higher yields and commodity prices. Despite this optimistic base case, investors must have contingencies ready. The three aforementioned risks around the vaccines suggest that additional waves of infections cannot be entirely ruled out and that lockdowns may continue in 2021. Thus, we could still face periods of downward pressure on activity, yields, and value stocks. For now it remains prudent not to tilt portfolios fully toward a post-COVID bias. In contrast to the past 40 years, a 60/40 portfolio will fare poorly once we account for higher inflation. Even if the vaccines enjoy widespread adoption, near-term threats to economic activity remain. The realization that the end of the pandemic is close may prompt a temporary period where households hunker down and behave in a very conservative fashion. After all, few consumers will want to contract the virus just before a vaccine becomes available. Moreover, the sight of the end of the lockdowns reduces the fiscal authorities’ urgency to provide additional support to the population and small businesses. These two dynamics could prompt a deep contraction in spending in the first quarter of 2021, which would hurt stock prices. Mr. X: Thank you. While these near-term dynamics are crucial, the emergence of the vaccine increases the importance of discussing the long-term implications of the extreme policy conducted in recent months. BCA: The long-term implications of aggressive policy stimulus tie into the evolution of the debt super cycle. As a share of US GDP, total private debt has spiked near a record high and total nonfinancial debt has surged to new all-time highs (Chart 2). This reflects two phenomena. First, the denominator of the ratio – GDP – has collapsed. Second, total nonfinancial debt also highlights the rapid increase in government deficits. Hence, climbing leverage was a consequence of the necessary dissaving by the public sector to alleviate the deflationary forces created by the crisis. This problem is repeated around the world. As Chart 3 demonstrates, nonfinancial debt levels across the G10 are rapidly rising. Moreover, debt loads in emerging markets are also extremely elevated. Chart 2COVID-19 Boosted Debt Ratios Chart 3Elevated Debt Everywhere Going forward, either rising savings or faster nominal GDP growth will cause the debt ratios to decline. The first option is difficult; increasing savings is deflationary and it could worsen the debt arithmetic by keeping real interest rates stubbornly high. Moreover, it is politically unpopular, especially when the public sector has been the borrower. Here, we echo the words of Keynes from his 1923 Tract On Monetary Reform: "The progressive deterioration in the value of money through history is not an accident, and has had behind it two great driving forces – the impecuniosity of governments and the superior political influence of the debtor class (…). No state or government is likely to decree its own bankruptcy or its own downfall so long as the instrument of taxation by currency depreciation through the creation of legal tender (money) still lies at hand… The active and working elements (i.e., debtors) in no community, ancient or modern will consent to hand over to the rentier or bond holding class more than a certain proportion of the fruits of their work. When the piled up debt demands more than a tolerable proportion, relief has usually been sought in (…) repudiation (…) and currency depreciation." Nominal rates cannot fall further, while large inequalities and social immobility are fomenting populism (Chart 4). Moreover, the recent COVID-19 crisis has deepened the angst of the general population and its dissatisfaction with policymakers. It is therefore unlikely that voters will reward politicians who impose upon them the painful deflationary pressures that result from the high savings necessary to reduce public sector debt loads. Even a Republican-controlled US Senate will have to allow larger deficits than usual in today’s climate. Chart 4Inequalities And Immobility Are The Roots Of Populism Instead, we expect fiscal and monetary policy to work in tandem to lift inflation and deflate the global debt load. The rising popularity of Modern Monetary Theory fits within this paradigm shift. MMT posits that as long as governments issue debt in their own currency, central bank money printing can finance the deficit. The only constraint on policymakers becomes the level of inflation that society tolerates. Society is likely to tolerate a rise in inflation. MMT is unpalatable to savers, but the majority of citizens are debtors, not lenders. In an MMT framework where the median voter is a borrower, the tolerance for inflation will likely be high, which will hurt the value of financial assets. Moreover, the corporate sector is unlikely to fight strongly against large deficits funded by central banks. If we accept the Kalecki Equation of Profits, which can be simplified as: Profits = Investment – Household Savings – Government Savings – Foreign Savings + Dividends then business profits will suffer if deleveraging takes hold, whether in the public or private sector. Instead, MMT-like policies, which will keep savings at low levels and prevent deleveraging, offers a way to keep nominal profits afloat. For businesses too, the path of least resistance steers toward higher inflation. Different countries will vary in their ability to pass MMT-like policies, but the policy shift toward inflationary policies is clear. The specter of rising populism should result in heavier regulation, at least in the EU and the US under the incoming Biden administration. Regulation further hurts the growth rate of the supply-side of the economy. It limits competition, it protects workers and it increases the cost of doing business. We expect additional fiscal stimulus will come through in the coming months. Beyond political forces, the demographic deterioration highlighted by Ms. X points in the same direction. An aging population means that the dependency ratio (the number of dependents per worker) is increasing. Moreover, analysis by the UN underscores that in old age, consumption increases due to rising spending on healthcare (Chart 5). We are therefore likely to witness a slowing expansion of the supply side relative to the demand side of the economy. By definition, this process is inflationary. In the second half of the decade, inflation could average as high as between 3% and 5%. Keep in mind that inflation is not a linear process. Once it starts to rise, it becomes very hard to control. In this regard, the experience of the late 1960s is extremely instructive. Through the 1960s boom, inflation was well behaved, contained between 0.7% and 1.2%. Then it started to rise in 1966, and quickly hit 6.1% by 1970 (Chart 6). While the average-inflation target the Fed recently adopted is well intentioned, in an environment where governments are unlikely to curtail deficits as fast as the private sector cuts its savings, it could easily unleash a long-term inflationary trend. Chart 5Aging Doesn't Spell Less Spending Chart 6Inflation Is Stable Until It Is Not Ms. X: Why won’t technological advancements such as AI and automation cause low inflation to prevail for the rest of the decade? Chart 7Low Productivity BCA: The great paradox of this crisis is that the more deflationary risk we confront today, the more inflation we will face in the future. This relationship is the consequence of financial repression. Debt arithmetic will only stay manageable as long as real interest rates remain low; consequently, central banks will only be able to increase interest rates if nominal growth rises significantly from its low average of the past decade. Both workforce and productivity growth are low, thus quicker inflation is the only solution. As you hinted, technology is a risk to our long-term inflation view. However, technology has most often been a deflationary force. The key question is whether we are experiencing a greater impact than normal on productivity from current technological developments. So far, the answer seems to be no. Even if the statistical estimation methods for GDP overestimate inflation and thus underestimate productivity, we are still nowhere near the kind of productivity gains registered in the post-WWII period or at the turn of the millennium. We remain much closer to the productivity recorded in the 1970s or early 1980s (Chart 7). As a result, we expect technology not to be enough of a game changer to undo the inflationary effect of the shift away from the pro-capital, deregulatory, pro-global-trade consensus that prevailed for the past forty years. Ms. X: Your view rests on an assessment that political forces are structurally moving toward populism. Doesn’t the most recent US election counter this argument? Was it not a victory of centrism over populism? Chart 8AValuations Point To Poor Long-Term ReturnsChart 8BValuations Point To Poor Long-Term ReturnsChart 8CValuations Point To Poor Long-Term ReturnsChart 8DValuations Point To Poor Long-Term Returns BCA: It was a victory of moderation over populism, but it was a narrow victory that reveals powerful populist undercurrents, particularly the strong demand for economic reflation. Despite a pandemic and recession in the election year, President Trump narrowly lost in the key swing states, and managed to garner roughly 74 million votes, the second highest tally in history. Moreover he led the Republican Party to gain seats in the House of Representatives and (likely) to retain control of the Senate. Exit polls reveal that the economy was still the number one issue on voters’ minds – they rejected Donald Trump’s personality but embraced his “growth at any cost” approach. By the same token, the Democratic Party lost elections down the ballot because they became associated with lockdowns and revolutionary social causes. President-Elect Joe Biden won the election, first, by not being Donald Trump, and second, by campaigning on a larger government spending program, a moderately liberal social stance, and a less belligerent protectionism on trade and China. The fact that both candidates wanted large stimulus packages and infrastructure programs tells us something about the median voter’s stance on economic policy: it is reflationary. Going forward, if Republicans control the Senate then the Biden administration will have to appeal to moderate Republican senators to get enough votes for COVID relief and economic recovery. If Democrats gain control of the Senate on January 5, they will have a one-vote majority and their legislative agenda will depend on winning over moderate Democratic senators. The Republican scenario is less reflationary but more likely, while the Democratic scenario is more reflationary but less likely. What investors can count on in 2021 is that the US government will not enact the mammoth splurge of government spending but that Republican senators will also be cognizant of the need for some fiscal support. Mr. X: If you expect inflation to rise structurally, how should we position our portfolio on a long-term basis? Bonds will obviously suffer, but so will an extremely expensive equity market that requires low bond yields to justify current prices. It seems like there is nowhere to hide but gold. BCA: The next one to two decades will not look like the past four, which were extraordinarily rewarding for investors. The taming of inflation, the broadening of globalization and far-reaching deregulation both cut interest rates and boosted profit margins. These trends stimulated demand and lifted asset valuations. These dynamics fed exceptional returns for all financial assets. However, these tailwinds have dissipated. The Fed will look through next year’s temporary inflation rebound. This change has many important implications for portfolio construction. You are correct that it will be hard for equities to generate decent real returns in the coming decade. Valuations may be a poor gauge of immediate stock returns, but they are clearly correlated with long-term returns (Chart 8). The odds of higher inflation in the second half of the decade will eventually cause policymakers to raise interest rates and force a normalization of equities multiples. Moreover, greater regulation and rising populism will raise the share of GDP absorbed by wages. Profit margins are likely to decline from here (Chart 9). Chart 9Profit Margins Under Threat? Despite the poor long-term outlook for real stock returns, equities should still outperform bonds. Over the past 150 years, shares beat bonds in each episode of cyclically rising inflation, even if stocks generate paltry inflation-adjusted returns (Table 2). This time will not be different. Equities are significantly cheaper than bonds. Based on the current level of bond and dividend yields, US, Eurozone, UK and Japan bourses need to fall in real terms 23%, 32% 50% and 20%, respectively, over the next 10-year to underperform local government bonds (Chart 10). Additionally, the duration of bonds is very high due to their extremely low yields, which means that bond prices are exceptionally sensitive to rising rates. Table 2Stocks Beat Bonds, Part I In contrast to the past 40 years, a 60/40 portfolio will fare poorly once we account for higher inflation. During the period from 1965 to 1982, when US core CPI inflation rose from 1.2% to 13.6%, the 60/40 portfolio lost 30% of its value in real terms (Chart 11). Moreover, the portfolio started to suffer poor inflation-adjusted returns well before inflation moved into double digits. As soon as CPI accelerated in 1966, the standard portfolio began to lose value. This time, inflation will not reach the dizzying height of the late 70s, but equities are trading at price-to-sales, price-to-book or Shiller P/E 33% above that of 1965 and Treasury yields stand at 0.88%, not 4.65%. Chart 10Stocks Beat Bonds, Part II Chart 11The 60/40 Portfolio Doesn't Like Inflation The problematic long-term outlook for the 60/40 portfolio will demand greater creativity from investors than over the past 40 years. We like assets such as farmland, timberland, and natural resources as inflation hedges. We also like precious metals. Silver is particularly attractive; like gold it thrives from rising inflation, but unlike its yellow counterpart, silver trades at a discount to its fair value implied by the long-term trend in consumer prices (Chart 12). Industrial metals are also interesting; the effort to reduce carbon emissions will hurt fossil fuel prices but will require greater reliance on electricity. Hence, the demand for copper will stay robust while investments in extraction capacity have been poor for the last decade. Silver, a great electricity and heat conductor, will also benefit from this trend. Chart 12Silver Is Cheaper Than Gold Within equity portfolios, winners and losers will also change. Empirically, technology, utilities and telecom services underperform when inflation rises durably. On the other hand, healthcare, materials and real estate outperform. The first group does not possess much pricing power in an accelerating CPI environment while the second does, justifying the bifurcated relative performances. We recommend tilting long-term equity exposure this way. Finally, this sectoral view implies a structural overweight in Europe and Japan at the expense of the US and emerging markets. Mr X: Thank you. This discussion about long-term risks and portfolio construction was very useful. That being said, the thought of MMT becoming more mainstream leaves me extremely uncomfortable. The Economic Outlook Ms. X: From your observations on the vaccine rollout, I presume you expect the recovery to remain robust next year. Aren’t you concerned that a big part of the G-10 could experience a double dip recession in the first half of the year? BCA: Near-term risks are very elevated and it is likely that Europe is experiencing a renewed slump in activity as we speak. In response to the recent violent second wave of infections, consumers have avoided public spaces and governments across the continent and in the UK have implemented increasingly stringent lockdowns. Various high-frequency indicators and live trackers for the regions already indicate that another contraction in activity is taking place (Chart 13). The US is not immune to a slowdown. The country is in the thrall of its third wave of infections and local governments are increasingly imposing lockdowns. Just look at New York City, which is somewhat of a canary in the coalmine for the nation, where schools have closed. This development is happening as the economy was already slowing down after a blistering recovery in the third quarter. Naturally, the US economic surprise index is quickly declining, which indicates that economic data is falling short of expectations (Chart 14). Chart 13The European Economy Is Slowing Right Now Chart 14The US Economy Is Decelerating Growth is slowing but the level of US GDP is not doomed to contract. First, inventory restocking could add as much as 3.5% to current quarter GDP. Second, consumer spending is still robust. This summer, household savings jumped massively in response to both the large transfers created by the CARES act as well as the low marginal propensity to spend caused by depressed consumer confidence. Now, consumers are deploying this large pool of funds, which is buttressing expenditures. Despite these short-term headwinds, growth in 2021 should be well above trend in the US and in Europe. The ECB Target II balance permanently attaches Germany to its weaker neighbors. Mr. X: What about the risk that a lack of fiscal stimulus could scuttle the recovery? BCA: We are not overly concerned about that as we expect additional fiscal stimulus will come through in the coming months. Chart 15Borrowing Costs Are Not A Constraint To Spending In Europe, the case for additional fiscal support is clear. All the major euro area countries, including Greece, can borrow at negative interest rates, depending on the maturity (Chart 15). This too is true for Sweden, Switzerland and even the UK. Within the Eurozone, the issuance linked to the European Commission’s Recovery Fund represents the first wave of common-debt issuance. It is an embryonic tool for fiscal risk sharing, one that goes further than the European Stability Mechanism, and it is an important driver of the spread compression in the European bond market. European governments are under little pressure to apply any fiscal brake because of these low borrowing costs. Moreover, the various European central banks are buttressing government bond markets. Thus, fiscal authorities have a free hand to provide additional support if they choose to do so while lockdowns remain in place. The loose fiscal setting will allow activity to recover quickly. In the US, the situation is more complex, but we expect at least a minimal level of support. The gridlock in Washington prevents the large stimulus that would have passed under a unified Democratic control of Congress. However, a Biden administration faced with a Senate controlled by the GOP also cannot increase taxes significantly. Meanwhile the Republicans are willing to provide additional help as long as it targets households and small businesses. Netting these forces out, we expect a stimulus package of $500 billion to $1 trillion. This is smaller than the various offers on the table prior to the election, but the more concrete eventuality of a vaccine deployment in the first half of 2021 also means that the economy needs help for a shorter period. While the risk to the forecast is that the Democrats and the Republican reach a larger compromise, investors may have to wait months for a deal. This delay could magnify the underlying weakness in the US economy. Chart 16The Chinese Locomotive Is Intact In Japan, the law prescribes a negative fiscal thrust of –7.1% of GDP. We doubt this will transpire. Prime Minister Suga does not want to kill a nascent recovery and feed powerful deflationary pressures. Hence, supplementary budgets will provide more support to growth. Ms. X: Last year, we spoke a lot about China as an important driver of the global manufacturing cycle and growth. Is this still the case? BCA: China remains an important factor supporting our positive stance on global growth in 2021. Thanks to the aggressive use of testing and tracing, China has contained the virus, which is letting the economy heal and respond normally to monetary policy. On this front, the lagged impact of the easing enacted since 2019 will continue. Total social financing flows have rebounded to 33% of GDP and are consistent with a further improvement in our China Activity Indicator (Chart 16). Strengthening Chinese cyclical spending will lift imports of raw materials and machinery. The uptick in the Chinese credit and fiscal impulse suggests that China will remain a positive force for the rest of the world until the second half of 2021. After the summer, the positive impact of China on global growth will ebb. The PBoC is already allowing market interest rates to increase, which suggests that the apex of the credit easing was reached in Q4. Nonetheless, President Xi Jinping cannot tolerate any kind of instability ahead of the 100th anniversary of the CCP in October 2021. Thus, the fiscal and monetary policy tightening will be calibrated before that date and will only become a major risk afterwards. As a result, global growth will enjoy its maximum contribution from Chinese demand around Q2 2021. After that, Chinese activity will still be high enough to keep global industrial production elevated, but not enough to cause a further acceleration. Chart 17China's Marginal Propensity To Consume Augurs Well Another good news for the Chinese and global economies is the recent pickup in China’s marginal propensity to consume (MPC), as approximated by the gap between the growth rate of M1 and M2 money supply (Chart 17). When M1 accelerates faster than M2, demand deposits are growing quicker than savings deposits, which highlights that economic agents are positioning their liquidity for increased spending. The MPC’s uptick will reinforce the positive signal for global economic activity from China’s credit trend. It also creates upside risk for China’s economy in the second half of the year compared to what policy dynamics imply. Ms. X: Beyond China and fiscal policy, do you foresee any other tailwinds for the global business cycle? BCA: Yes, there are plenty. As we already mentioned, the vaccine should allow the service sector to normalize progressively over the course of the year. Households’ healthy balance sheets will underpin US consumer spending next year. At the end of 2019, debt to disposable income stood at an 18-year low and the debt servicing-costs ratio was near generational troughs. In addition, both of these measures of financial health only improved during the crisis. Collapsing interest rates allowed households to refinance their mortgages and government transfers boosted disposable income. Likewise, after a very negative shock in Q1, household net worth quickly rebounded in Q2 when asset prices surged and household savings grew (Chart 18). The wealth effect will therefore help consumption, especially because employment continues to improve. The odds of higher yields are most pronounced for longer maturities. The outlook for capex is also bright. Capex intentions have been surprisingly robust in recent months and core durable goods shipments have reached all-time highs (Chart 19). Admittedly, capex is a lagging economic variable – companies take their cues from the behavior of households. But, this means that, as household spending continues to recover, so will capital investment. Another way to approach this topic is to think about the link between capex and corporate profitability. In capital budgeting, the pecking order theory argues that retained earnings are the preferred source of financing for corporate investments. This theory is echoed by empirical evidence. Business capital formation follows operating profits by roughly six months (Chart 20). The positive outlook for profits therefore bodes well for capex. Chart 18Solid Household Balance Sheets In The US Chart 19Surprising Capex Rebound Chart 20Earnings Drive Capex A major concern for the US economy is commercial real estate. This sector’s losses will likely be very large because many buildings are now uneconomical. Even if vaccines normalize daily activities, post-pandemic life has in some ways been reshaped. Workers are likely to conduct more of their job from home and shoppers have become used to the convenience of E-commerce. As a result, the need for office and retail space will decrease, which falling rents are already reflecting. The hit to the US banking system is still unknown. While CRE accounts for 13% of bank assets, this exposure is concentrated within smaller regional banks, which are much frailer than their SIFI counterparts (Chart 21). We could therefore see some localized troubles within a banking system that is tightening credit standards already (Chart 22). This danger warrants close monitoring. Chart 21CRE Is A Threat For Small Banks Chart 22Another Tightening In Standards Would Be Dangerous Chart 23Europe Is More Exposed To Chinese Demand It is not clear whether the US or the euro area will enjoy the sharpest growth improvement in 2021. Normally, Europe benefits the most during a manufacturing upswing, especially when China’s marginal propensity to consume is expanding (Chart 23). The European economy is more cyclical than that of the US because exports and manufacturing constitute a larger share of employment and gross value added (Chart 23, bottom panel). Moreover, the fiscal drag in Europe is likely to subtract roughly 3% from GDP next year while it could subtract 5% to 7% from the US GDP. However, an important handicap will counterbalance these advantages for Europe; the biggest source of economic delta next year should be the service sector because spending on goods began to recover in earnest in 2020. There is simply more pent-up demand left in services than goods and the service sector accounts for a larger share of output in the US than in Europe. Three additional factors could also favor the US against both Europe and Japan. First, residential activity is rebounding more quickly in North America. Historically, residential investment makes a large contribution to cyclical expenditures and it galvanizes additional spending on durable goods. Second, the Fed was able to engineer deeper declines in real interest rates than the ECB or the BoJ while Washington expanded the deficit faster than Tokyo or most European capitals. Finally, the weak dollar is creating another relief valve unavailable to Japan and Europe. In fact, the euro’s strength is potentially the greatest dampener of the European recovery in the coming quarter. Finally, emerging economies face important domestic hurdles that will handicap them significantly versus advanced economies in the first half of the year. EM banking systems remain fragile after the violent capital outflows witnessed in the first half of 2020. Thus, their ability to expand credit is comparatively limited. Moreover, EM economies have yet to withstand the inevitable second wave of infections, and their healthcare systems are even weaker than in advanced economies. The logistical complications associated with the rollouts of the vaccine will be most acute in poorer countries. Mr. X: I share your worries about long-term inflation, but where do you stand regarding near-term dynamics? A faster inflation recovery would amount to the kiss of death for asset markets. BCA: You are correct that faster inflation would threaten asset markets. It would force a rapid re-pricing of the Fed’s policy path and lift yields higher. Expensive stocks would buckle under this impulse. However, while it is a risk we monitor closely, it is far from our base case. We particularly like real yield curve steepeners. To begin with, both the output gap and the unemployment gap will remain meaningful in 2021. Our US Composite Capacity Utilization Indicator is not consistent with higher inflation (Chart 24). Additionally, at 6.9%, the US unemployment rate understates the amount of slack in the labor market. The employment-to-population ratio for prime-age workers offers a more accurate read of the labor market because it accounts for discouraged workers. This labor market indicator points toward limited inflation in the Employment Cost Index (Chart 25). Chart 24Limited Immediate Inflationary Pressures Chart 25The Labor Market Is Replete With Slack Inflation is still likely to spike in the first half of the year, but this jump will prove temporary. In the second quarter, both the core CPI and the core PCE inflation will incorporate a strong base effect when annual comparisons include the extremely depressed numbers that prevailed at the nadir of the recession. Moreover, once the service sector reopens in response to broadening vaccination programs, service sector inflation could pop higher, as goods prices did once the goods sector reopened last summer. The base effect will quickly ebb and the initial surge in service inflation should also dissipate because shelter inflation will remain dampened by stubborn permanent unemployment (Chart 26). The Fed will look through next year’s temporary inflation rebound. Its new average inflation target officialized last September is designed to avoid this kind of premature response and Fed officials are currently more afraid of committing deflationary errors than inflationary ones. Markets understand this well. Hence, as long as inflation breakeven rates remain below the 2.3% to 2.5% band consistent with market participants believing in the Fed’s ability to achieve 2% inflation durably (Chart 27), market wobbles caused by higher inflation will create buying opportunities. Chart 26Shelter Inflation Will Remain Downbeat Chart 27The Fed Monitors Inflation Expectations One factor could cause inflation to start moving durably higher than our base case anticipates. So far, money supply is behaving very differently than in the wake of the GFC. Back then, the Fed aggressively expanded its balance sheet, but the private sector’s deleveraging compressed money demand. Consequently, the Fed’s money injections stayed trapped in the banking system where excess reserves swelled. Broad money growth was tepid and the money multiplier collapsed. Today, the private sector is not deleveraging and M2 has surged at its fastest pace since 1944. Thanks to this lack of monetary bottlenecks, real interest rates fell much faster than in 2008/9 even if the nominal Fed Funds rate dropped to zero in both instances (Chart 28). Monetary conditions are therefore much more accommodative than they were 12 years ago. Another consequence of a functioning monetary system is that the broad money supply’s advance is outstripping the Treasury’s issuance. Historically, when money supply grows quicker than government debt, inflation emerges (Chart 29). We are tracking the velocity of money closely to gauge whether this risk is morphing into reality. Chart 28Policy Is More Accommodative Than During the GFC Chart 29An Inflationary Risk Ms. X: Before we move on to asset market forecasts for 2021, I would like to hear your thoughts on Brexit and the extraordinary showing of European unity last summer. BCA: We came very close to ending the Brexit transition period without a free-trade agreement between the UK and the EU. First, PM Boris Johnson had been under attack from the right wing of the Conservative party. In response, his government ramped up the hard rhetoric in recent months. However, the negative impact on the British economy in the absence of a free trade agreement with the EU was always a binding constraint on the PM. Hence, the tough rhetoric was mostly bluster and negotiation tactic with Brussels. Second, the electoral defeat of President Donald Trump in the US means that the UK is unlikely to receive preferential treatment from the US if it cannot reach a trade deal with the EU. The UK would be on its own, especially because President-Elect Joe Biden is likely to side with the EU, with whom he wants to rebuild a relationship. On the EU side, it is highly unlikely that Berlin will let French demands on fishing rights threaten its capacity to sell to its 5th export market. Thus, we expect a deal to come to fruition imminently. The move toward fiscal integration in Europe is also crucial beyond its near-term bullish impact on Italian, Spanish or Portuguese bonds. Jean Monnet, one of the architects of the 1951 Treaty of Paris that created the European Coal and Steel Community (the EU’s embryo), famously wrote in his memoirs that: “Europe will be forged in crises, and will be the sum of the solutions adopted for those crises.” We witnessed these dynamics last summer. The EUR750 billion Recovery Fund created by the European Commission to help economies struggling with the pandemic will issue its own bonds. It is the first step toward a permanent common bond issuance mechanism and fiscal risk sharing in the euro area. As expensive as stocks may be in absolute terms, the monetary and yield backdrop creates a large enough buffer for now. The experience of last decade’s euro crisis shows that temporary solutions often become permanent features of the EU, even if its treaties originally forbade them. The latest move will be no exception. The euro is popular; it is supported by 83%, 60%, 72%, 76% and 82% of the Spanish, Italian French, Dutch and German populations, respectively (Chart 30). Moreover, German support for the euro is particularly important. Germany’s current account surplus equals 7% of GDP because of the euro. The euro is a lot weaker than the Deutsche mark would be, which boosts German exporters’ competitiveness in international markets and within the euro area. Without the common currency, German cars would be much more expensive in France, Italy or China than they are today. Chart 30The Glue That Binds Europe Together Likewise, the ECB Target II balance permanently attaches Germany to its weaker neighbors. Italy and Spain owe EUR 1 trillion to this settlement system while Germany is owed EUR915 billion. If Italy or Spain were to go bankrupt or to leave the euro and redenominate their debt in lira or pesetas, the resulting hit would threaten the viability of the German banking system (Chart 30, bottom panel). Chart 31Competitiveness Convergence The past competitiveness problems of the European periphery are also steadily diminishing. Compared to Germany, harmonized unit labor costs in Italy or Spain have fallen 15% since 2009 and are not far from the levels prevailing at the introduction of the euro in 1999 (Chart 31). Consequently, current account deficits in Spain and Italy are narrowing considerably. Germany’s euro benefits, the tie created by the Target II imbalances and the periphery's improved competitiveness only bring Europe together and they allow the COVID-19 crisis to force a closer union. While these developments have little implication for Europe’s growth next year, they constitute a major long-term positive because they will curtail the cost of capital in the periphery and permit the sharing of funds necessary to build a lasting monetary union. Ms. X: To summarize; at the beginning of 2021, global growth should remain volatile. However, the recovery will ultimately strengthen over the remainder of the year thanks to the rollout of vaccines, the sustained fiscal support across major economies, the continued positive impact of China’s economic healing, and the strength of household balance sheets. Capex will remain robust as well, even if commercial real estate is a dangerous spot that we must monitor. Moreover, it is too early to ascertain whether the US or the EU will experience the strongest recovery in 2021, but emerging economies should lag behind. In addition, while you are concerned about the long-term inflation risk, consumer prices should not experience a durable pickup this year. Likewise, you foresee a benign outcome to the UK-EU trade negotiations and are positive on European integration. BCA: Yes, you summed it up nicely. Bond Market Prospects Ms. X: I find the Treasury market very puzzling right now. On the one hand, demanding valuations of US government bonds worry me, particularly in light of the upbeat economic outlook for 2021. On the other hand, if inflation remains low and the Fed is unlikely to push up rates until 2022 at the earliest, the upside for yields should be limited. BCA: We recommend a below-benchmark duration for fixed-income portfolios with an investment horizon of 12 months or so. Valuations partially underpin this recommendation. Our Global and US Bond Valuation Indices highlight that government bonds are at the level of overvaluation that, over the past 30 years, often produce a negative return in the following 12 months (Chart 32). However, valuations only indicate the degree of vulnerability of an asset but they rarely trigger price moves. Instead, timing most often relies on cyclical and technical factors. Favor cyclical equities relative to defensive ones. Cyclical forces are increasingly negative for bonds. In the US, our BCA Pipeline Inflation Indicator has perked up. It is not pointing toward an imminent rise in inflation but it suggests that deflationary risks are ebbing, something BCA’s Corporate Pricing Power Proxy also captures (Chart 33). A removal of the left-tail risk in CPI should push up yields, especially as our BCA Nominal Cyclical Spending Proxy is also firming, which normally happens ahead of meaningful yield pickups (Chart 33, bottom panel). Chart 32Pricey Bonds Chart 33Cyclical Risks For Bond Prices Chart 34Investors Will Want Protection Against Inflation Uncertainty The odds of higher yields are most pronounced for longer maturities. First, our central forecast expects a significant rise in inflation in the latter part of the decade. Second, monetary and fiscal policy will remain very accommodative over the coming years even as private demand increases, which will lift medium- to long-term inflation uncertainty. Rising inflation uncertainty usually facilitates a steepening of the yield curve (Chart 34). Despite these forces, the upside to yields will prove limited in 2021. The Fed’s new inflation target means that it will be patient, and waiting for core PCE inflation to move sustainably above 2% could take time. The US central bank is therefore unlikely to increase interest rates for many years. This inertia limits the immediate upside in Treasury yields, but does not preclude it. While the Fed will not be quick to lift off, its forward interest rate guidance is not going to get any more dovish and the bond market is already pricing-in the first rate hike for late 2023. This expected liftoff date will be brought forward as the economy recovers, meaning that long-maturity nominal yields, real yields and inflation breakeven rates all have moderate upside. The recent equity market leadership of growth stocks is another limiting factor for higher yields. Growth stocks are extremely sensitive to long bond yields. If the latter back up too fast, it will scuttle bourses and unleash risk aversion and deflationary pressures. This creates an upper bound on the speed at which yields can move up. Mr. X: Even with their limited room to fall in the near term, the meaningful long-term and valuation risks of bonds make them so unappealing to me that I refrain from using them as near-term portfolio hedges. How can I protect my equity holdings right now? BCA: Hedging near-term risks to stocks has become one of the most hotly discussed topic with our clients because investors are witnessing the increasingly asymmetric payoffs of bonds. When equity prices rise, bond prices typically decline, but when stocks correct, bond prices barely rally. This newfound behavior of safe-haven bonds is a consequence of global policy rates having moved to or near their lower bound. We increasingly like small-cap firms relative to large-cap ones. For non-US based investors, there is a simple solution to this problem: parking some funds in US cash because the USD still acts as an effective hedge against market corrections. For US-based investors, finding adequate protection is more challenging. Those who can short and use leverage should sell currency pairs with an elevated sensitivity to changes in risk aversion, such as the EUR/CHF, AUD/JPY or MXN/JPY, to achieve some protection. Otherwise, holding cash to buy back stocks at lower levels remains an appropriate strategy. Mr. X: Which government bond market do you like most, or more accurately, which one should I avoid most right now? BCA: At the moment, we prefer the European periphery. The valuation ranking we often use when we see you is clear: Portuguese, Greek, Italian or Spanish bonds are the cheapest while German Bunds and US T-Notes are exceptionally expensive (Chart 35). Real bond yields confirm this estimation. Additionally, the nascent fiscal risk-sharing created by the European Commission’s Recovery Fund should result in declining breakup risk premia embedded in peripheral bonds. Furthermore, the ECB’s asset purchases are set to rise in response to Frankfurt’s efforts to fight off the deflationary effect of both the euro’s appreciation and the second wave’s lockdowns. Chart 35The Value Is In Europe’s Periphery We are more negative on US Treasuries than Bunds. The valuation difference between the two safe havens is minimal. However, in 2020 the US has been more reflationary than Europe and the recent decline in the USD should lift US inflation relative to Germany’s, which will widen yield differentials in favor of Bund prices (Chart 36). Besides, the US economy has a higher potential GDP growth than Europe, which warrants a superior neutral rate of interest. Consequently, investors should expect US real yields to rise relative to the euro area’s benchmark. Outside of these markets, dedicated fixed-income investors should also overweight JGBs within their portfolio. JGBs have a low yield beta, which will limit their price declines if global yields move up. If the global recovery peters off, this feature will not create a major handicap because global yields have limited room to fall from here. Moreover, Japanese bonds are the cheapest safe haven (Chart 37). Chart 36Bunds vs Treasuries: Follow The Inflation Gap Chart 37JGBs Are The More Attractive Safe Haven We are neutral Canadian and Australian bonds. Historically, Canadian and Australian yields tend to have high betas to US T-Note yields. However, the BoC and the RBA are very active purchasers in their domestic markets, which will dampen the volatility of Canadian and Australian bonds. Ms. X: Considering the limited scope for major interest rate moves next year, what are your high-conviction trades for fixed-income portfolios? BCA: Within US government bond markets, we like curve steepeners. We also recommend positioning for rising inflation expectations by going overweight TIPS relative to nominal Treasuries. We particularly like real yield curve steepeners (within the TIPS curve). The cost of short-maturity inflation protection is below that of long-maturity protection, which means that short-term inflation breakeven rates have more upside as core PCE returns to the Fed’s target. A TIPS-curve steepener benefits from both a flattening of the inflation breakeven curve and a steepening of the nominal Treasury curve. It is therefore a high-octane play on both our favored strategies. We like both Europe and Japan. Within US corporate credit, we are currently overweight investment grade and Ba-rated high-yield bonds. However, valuation at the upper-end of the credit spectrum heavily favors tax-exempt municipal bonds over corporates. Investors that can take advantage of the tax exemption should prefer munis over investment grade corporates. Elsewhere, we are underweight MBS as pre-payment risk is elevated, but we like consumer ABS due to the strong position of household balance sheets. Ms. X: Before we moved on to equities, where do you stand on EM credit? Do you expect any global search for yield to push EM bond prices higher? BCA: With a few exceptions like Mexico and Russia, we prefer US corporate bonds to dollar denominated EM bonds of similar credit quality. EM bonds offer poorer value, but EM spreads will continue to evolve in line with US corporate spreads. Because of this directional correlation, our preference for US investment grade bonds translates to EM bonds as well. Our more circumspect attitude toward EM high-yield bonds also reflects our more conservative stance on US high-yield bonds. For local-currency rates, we are receivers in the swap market because the near-term outlook for EM currencies is difficult. Most EM countries have a deflation problem, not inflation troubles. Hence, real and nominal rates in emerging economies will fall as central banks try to stimulate their economies. These declines will be positive for the local-currency performance of EM bonds but it will hurt their currencies. Over the next twelve months, this challenge will be most pronounced against non-US DM currencies. In the short-term, this hindrance will also exist against the USD because the Greenback should rebound temporarily, something we can discuss in more detail in our chat about the currency and commodity markets. Our favorite bets are to receive Mexican, Colombian, Russian, Indian, Chinese and Korean swap rates. Mr. X: I agree that the case to make a major duration bet next year is limited, but risks are slightly skewed toward upside for yields. I am a little surprised that you like European peripheral bonds so much and yet prefer Bunds to Treasuries. I will have to digest your view on EM bonds because I would have bought EM currencies outright. Finally, I find your real yield curve steepener idea extremely intriguing. Thank you for giving me ideas to ponder. Now, shall we move to next year’s equity outlook? Equity Market Outlook Chart 38The Bubble Can Grow Mr. X: I am a firm believer that growth stocks, tech in particular, are in a massive bubble. My daughter tries to convince me that we cannot generalize. Yet, both my gut and my brain tell me to seek refuge in value stocks. I appreciate that the outlook for tech stocks hinges on the evolution of monetary policy. Nonetheless, I think that any small shock can topple the so-called FANGs because they are so expensive and over-owned. I fear that where the FANGs go, so will the market. BCA: We have recently published a report broaching the question of bursting bubbles. When real interest rates are negative, when money supply is expanding at a double digit pace and when the Fed is extremely reluctant to tighten policy, the chances that a bubble will deflate are extremely low, even if stocks are furiously expensive (Chart 38). Beyond monetary tightening, an escalation in the supply of financial instruments also caused some bubbles to deflate. For example, an increase in the number of tulips following a harvest contributed to the end of the tulip mania. Bubbles from the eighteenth century, such as the South Sea Bubble and the Mississippi Company Bubble, followed stock issuances or regulatory changes. Even during the tech bubble, the large IPOs of the late 1990s added to the supply of securities available to investors. Right now, we are not witnessing this surge in supply. Buybacks, which are a contraction in supply, have acted as a key fuel to the bubble in the tech sector. Moreover, dominant tech titans have built large moats around their businesses because they often rely on pronounced network effects, if they are not a network themselves. These monopolistic behaviors account for their large profit margins, but they also prevent the emergence of viable competitors in the near term. Meanwhile, the mushrooming of Special Purpose Acquisition Companies (SPACs) is worrisome in the long-term. They are mostly vehicles to conduct backdoor IPOs of private firms. For now, they remain too small to topple the bubble. The real worry for tech investors is the eventual resurgence of inflation. During the tech bubble at the turn of the millennium, the rise in core CPI in early 2000 forced investors to discount more rate hikes, which toppled tech equities (Chart 39). As we discussed already, the outlook for inflation is benign for 2021, but if it were to change, tech stocks could fall in absolute terms. We expect tech names to underperform the S&P 500 over the next 12 months, but not to fall outright. This is akin to the experience of Japanese banks in the 1980s. In the first half of that decade, Japanese lenders stood at the forefront of the equity bubble. However, in the late 1980s, they lagged behind the rest of the Nikkei, even if they generated positive absolute returns (Chart 40). Chart 39Inflation Is The Threat To Tech Stocks Chart 40Without Falling, Bubble Leaders Can Still Lag Ms. X: I agree, it is hard to be too negative on stocks next year with the Fed standing firmly on the sidelines. What do you see as the market’s main driver in 2021 and what is the biggest risk to the outlook? BCA: Many important factors underpin global equities. First, we still are in the early innings of a new business cycle upswing. Statistically, bull markets most often end when earnings permanently decline. This observation means that equity bear markets rarely develop in the absence of recession (Chart 41). Chart 41Recessions And Bear Markets Travel Together Second, as expensive as stocks may be in absolute terms, the monetary and yield backdrop creates a large enough buffer for now. The combination of our Valuation and Monetary Indicators remains in low-risk territory, which historically is consistent with positive absolute returns for the S&P 500 over the coming 12 to 18 months (Chart 42). However, the gap between the two indicators is narrower than it was last spring, which suggests that the easy market gains lie behind us. Another tool to think about valuations is the Equity Risk Premium. Our measure, which adjusts for the lack of stationarity of the ERP’s mean as well as for the expected growth of cash flows, is not as wide as it was in Q2 or Q3, but it remains congruent with positive prospective equity returns (Chart 43). Chart 42Monetary Policy Beats Valuations, For Now Chart 43The ERP Points To Positive Stock Returns in 2021 Third, forward earnings estimates will rise further. The gap between the Backlog of Orders and the Customers’ Inventories subcomponents of the ISM survey indicates that earnings revisions will continue to climb from here (Chart 44). Additionally, our Corporate Pricing Power Proxy is back into neutral territory after having flashed dangerous deflationary pressures. Thanks to the operating leverage embedded in equities, improving selling prices can quickly push the bottom line higher (Chart 45). The rollout of vaccines next year will only feed these dynamics and help profit growth even further. Chart 44Room For Positive Earnings Revisions Chart 45Less Deflation Is Good For Earnings Fourth, our benign expectations for the credit market is consistent with both higher multiples and earnings. A well-functioning credit market is essential to risk taking and multiples. It also allows capex to remain well sustained and cyclical spending to expand. Both these forces are bullish for profits. Fifth, our negative stance on the dollar will ease global financial conditions. A weaker dollar pushes down the global cost of capital, which strengthens the global industrial cycle. Global stock markets overweight the industrial and goods sectors relative to the economy. Therefore, global bourses benefit from a weaker dollar. The greatest risk for stocks is an uncontrolled jump in bond yields, where 10-year Treasury yields climb above 1.2% in a short period, especially if real rates drive the leap. Too quick an adjustment in the cost of capital would threaten the ERP and it would hurt the multiples of growth stocks that are highly sensitive to fluctuations in the discount rate. Moreover, a rapid rise in borrowing costs would likely force a more precipitous deceleration in the housing sector, which is a key locomotive of the recovery. Another risk is that vaccine rollouts are delayed, which would rapidly sap growth expectations. Mr. X: Rather than taking a large net long exposure in equities, I would favor value stocks at the expense of growth stocks. The valuation gap between both styles is exceptionally wide, and value equities have not been this cheap on a relative basis since at least 2000, or more, depending on the indices used . As a result, they embed a much greater margin of safety than growth stocks, which makes me rest easier because I am less comfortable than you are about this equity bubble’s near-term prospects. Chart 46Favor Cyclicals Over Defensives Ms. X: As I mentioned at the beginning of our chat, I, however, prefer growth stocks. The sectors most represented in the value indices face secular headwinds such as low rates, a move away from carbon, and the increasing role of software, not goods, as the source of value added in our economies. Meanwhile, growth stocks also benefit from the aging of the population, the historically low trend growth rate of the global economy, and the network effects, which protect the profit margins of large tech firms. As you can see, my father and I have been clashing on this topic. Where do you stand? BCA: Within the firm, we have had our disagreements on this topic as well. One thing we all agree upon is that the growth-versus-value debate amounts to a sector call. One common preference we share is to favor cyclical equities relative to defensive ones. Over the coming 12 months, a weak dollar, rising inflation expectations, the strengthening of the Chinese and global economy and improving capex will all conspire to boost the profit and multiples of cyclical stocks at the expense of defensive sectors (Chart 46). Nonetheless, if the Chinese economy starts to slow in the second half of 2021, we will have to evaluate if this bet remains valid. Within the cyclicals, we prefer the more traditional ones, like industrials and materials at the expense of the tech sector. The expected growth rate embedded in tech stocks is extremely elevated compared to the rest of the market in general and other cyclicals in particular (Chart 47). This aggressive pricing is rooted in the recent experience, whereby tech earnings significantly outperformed the rest of the market. However, this outperformance mirrored strong sales of techs goods and services during the pandemic, when households and firms prepared for long lockdowns and remote working. Gravity-defying sales in the midst of the deepest recession in 90 years stole demand away from the future. Now that the economy recovers, pent-up demand for tech goods is smaller than for other categories of cyclical spending. Thus, the current pricing of tech earnings growth leaves room for disappointments. Within traditional cyclicals, financials are a question mark. The broadening of the economic reopening subsequent to the rollout of the vaccines is positive for the quality of banks’ loan books. However, the scope for yields to rise is restricted, which will limit how steep the yield curve will become and how wide net interest margins will swell. Thus, for 2021, industrials and materials remain our favored sectors. Chart 47Too Much Earnings Optimism For Tech Stocks We also favor a basket of “back to work” stocks at the expense of “COVID-19 winners”. With vaccines coming through next year, this trade has further to run. The first group includes some airlines, hotels, oil producers, restaurant operators, capital goods manufacturers, credit card companies, automobile manufacturers and a steel producer.1 The second basket includes a bankruptcy consultant, a software company, some grocers, some biotech names, a Big Pharma company, a large e-commerce business, an online streaming service, a teleconferencing company and two household products leaders.2 For the next 12 to 18 months, we favor value stocks at the expense of growth stocks, which is a consequence of our preference for traditional cyclical names and of the “back to work” names. Moreover, since 2008, periods of economic acceleration correspond to quicker earnings growth of value stocks compared to growth equities (Chart 48). Additionally, if bond yields move up – even if not much, the multiples of value stocks should expand relative to growth firms (Chart 48, bottom panel). We also increasingly like small-cap firms relative to large-cap ones. Small cap indices have substantial underweights in healthcare and tech names, which contrasts with the S&P 500 or the S&P 100. Accordingly, the Russell 2000 both has a cyclical and value bend relative to large-cap benchmarks. Moreover, small call equities outperform the S&P 500 when the dollar declines and when commodity prices appreciate (Chart 49). Additionally, the recent sharp rebound in US railroad freight volumes will support the more-cyclical Russell 2000. Besides, greater shipments lead to upgrades of junk-bond credit ratings, which decreases the perceived riskiness of the heavily levered small cap firms (Chart 50). Chart 48Value Investors Will Like 2021 Chart 49The Case For Small Cap Stocks, Part I Chart 50The Case For Small Cap Stocks, Part II The long-term picture is less clear. Many key supports for growth stocks remain in place. Principally, the aging of the population and the risk of rising inflation in the second half of the decade should flatter healthcare stocks. In addition, the wide profit margins of tech stocks are unlikely to fully mean-revert because firms like Amazon, Google or Microsoft benefit from monopolistic positions that have decoupled their profitability from their capital stock. For now, the biggest risk to these sectors would be a regulatory onslaught from Washington and Brussels. Meanwhile, the sectors composing value indices suffer from the structural headwinds that Ms. X already noted. Counterbalancing this narrative, the extreme relative overvaluation of growth stocks suggests that their prices reflect these long-term forces already. On a very near-term basis (next two to three months), the rapid rise in investor sentiment as well as the collapse in the put-call ratio are consistent with a correction or sideways move in equities (Chart 51). When this correction materializes, no meaningful trend in growth relative to value stocks should emerge. Therefore, we recommend tactical traders play relative value within growth stocks and within value equities, where overextended sectors should correct. Within growth, we would like to rotate away from tech into healthcare. Within value, the next three months should reward financials at the expense of materials. Chart 51Near-Term Risks For Stocks Ms. X: Based on these sectoral views, I gather you would underweight the US market. But where do you stand on emerging markets? BCA: You are correct, in 2021, we expect US equities to underperform the rest of the world. Their large weight in healthcare combined with the low beta of the US economy to global growth gives a defensive twist to the S&P 500. In addition to healthcare, the most significant overweight in the US equity benchmark is tech, which reinforces the growth style of US stocks. The US’s tech overweight is greater than appears because US communication services and consumer discretionary sectors are mostly tech names such as Facebook, Google, Netflix or Amazon (Table 3). Finally, our bearish outlook on the USD creates an additional hurdle for US equities relative to the rest of the world (Chart 52). Table 3Sector Representation In Various Regions While we like both Europe and Japan, the latter stands out for 2021. Japanese stocks have particularly large allocations to the most attractive deep cyclicals (industrial and consumer discretionary equities) and are very cheap, even on a sector-to-sector comparison (Chart 53). To like Japan, we do not need to bet on a multiples convergence. This equity market’s low valuations mean that we are buying each unit of profit growth at a discount to the same sectors in the rest of the world. As a result, Japanese equities are more levered to our positive view on the earnings of deep cyclicals than any other major bourse. Chart 52US Stocks Underperform When The Dollar Weakens Chart 53Japan Offers The Right Exposure At The Right Price Finally, we are neutral on EM stocks. We like them more than US equities but less than Japan or Europe. EM stocks will benefit from a weaker dollar, but they have become tightly correlated to the NASDAQ due to the leadership of a few large tech names in Asia. Essentially, like the US, EM stocks have a very large weighting in the tech sector. If our view is correct that growth underperforms value next year, North Asian EM, which have driven EM stocks since March, will lag behind Latin America in 2021. Mr X: Thank you for your thoughts on equities. I agree that a monetary shock normally is needed to burst bubbles, but I also worry that the current extreme overvaluation of tech stocks could lead to gravity taking hold without the help of the Fed. This means that I am slightly less confident than you are that equities will rise this year. However, I agree with you that value stocks should beat growth stocks and that US equities should become the laggards after years of leadership. Ms. X: Should we move on to the currency and commodity markets? Currencies And Commodities Chart 54The Dollar Is Vulnerable Technically Mr. X: I was skeptical last year, but your bearish dollar view panned out very well. However, you did not get its cause correctly. For one, you were constructive on global growth and consequently, negative on the dollar. I am skeptical that the dollar will depreciate much further in 2021 because it possesses a considerable yield advantage over other G-10 currencies. BCA: Today, the dollar sits at a critical spot. As you mentioned, we were negative on the USD last year; since then, it has breached all the major trend lines that have defined its bull market over the past nine years (Chart 54). This technical configuration suggests that more weakness is in store. One thing is very clear, dollar bulls have gone missing. Speculators are heavily selling the USD. Bullish sentiment on the euro is at its most elevated level in a decade. Historically, when it faces such one-sided negativity, the dollar enjoys temporary rebounds. Nonetheless, the DXY’s upside should be limited, at 2-4%, not more. A few forces cap the dollar’s upside. The currencies with the most upside against the dollar in 2021 are the European currencies. The liquidity crunch that handicapped global markets in March is over. Most foreign central banks have ample access to dollar liquidity and do not rely on the Fed anymore, as its outstanding swap lines stand close to zero (Chart 55). In 2009, this was a clear signal that the dollar liquidity shortage was behind us. The Fed has increased its supply of domestic currency more aggressively than other central banks. Today, interest rates around the world are at zero. Therefore, central banks’ balance sheet policy and forward guidance are the main tools to communicate the future path of interest rates. Chart 56 shows that other G-10 central banks have been lagging the Fed in terms of their balance sheet expansion. This has hurt the dollar and benefitted other currencies. Chart 55No More Liquidity Crunch Chart 56Currencies Respond To Balance Sheets US growth is lagging the rest of the world. This might not last, but growth differentials will continue to drive the performance of currencies, as they did in recent years. The November PMIs showed that the US economy held up well, but 2021 growth expectations from the IMF and other agencies favor the Eurozone. Finally, we are also deeply uncomfortable with negative interest rates. However, negative rates are the symptom and not the disease. China has positive interest rates because its domestic demand is strong. Europe or Japan are very sensitive to Chinese growth, which could cause the US rate advantage to evaporate. Ms. X: Earlier, you mentioned that the dollar is the perfect hedge for non-US based investors, which is a view I share. Are there any other currencies outside the dollar that we should hold that provide some safety? BCA: The currencies with the most upside against the dollar in 2021 are the European currencies, especially the Norwegian krone and the Swedish krona. They are the most undervalued currencies within the G-10, and they offer some margin of safety. While less attractive than the Scandinavian currencies, the pound will nonetheless appreciate more than the euro next year. Even if most currencies should gain against the USD, the yen is the one that will offer the most protective ability in a portfolio. It would be an excellent defensive complement to the dollar for investors looking to hedge portfolio risk. Gold will not perform effectively as a deflation hedge, but its ability to protect portfolios against long-term inflation risks remains intact. First, the yen is cheap. Over the years, falling Japanese price levels have tremendously improved the value of the yen. This cheapness makes Japanese equities an attractive investment, especially on an unhedged basis. These unhedged flows into Japan are very positive for the yen. Second, Japan offers the highest real interest rates in the G10. This attribute will incite investors to purchase JGBs. Moreover, Japanese investors could represent a major source of fixed-income flows into the country because of a large proportion of US Treasuries will mature, which will invite repatriation flows. Chart 57The Yen Likes A Weaker USD Finally, the yen is a low beta currency versus the USD. Both the DXY and the USD/JPY are positively correlated, thus when the dollar declines, the yen rises, but less so than other currencies (Chart 57). This means that when global equity markets enter risk-off phases, the yen appreciates against non-dollar currencies, but it loses less value against these same currencies when markets are rallying. This places the yen in a very enviable “heads I win, tails I don’t lose too much” position, which is what we need out of a portfolio hedge. Mr. X: I find it difficult to share your enthusiasm for the yen, but I agree that it is an interesting portfolio hedge. Nonetheless, my precious metals still provide me with a lot more comfort than any fiat currencies. Moving to commodities; it has been a remarkable year. Oil was crushed by the COVID-19 pandemic – more so than other commodities. Crude now appears to be attempting a comeback. Gold did well this year, but it recently dipped below $1,800/oz., and seems to be struggling to get back above that level. Let’s start with oil. Where do you see it going and how should we play it? BCA: Oil is about one principle: Supply and demand have to clear the market. Even more than with other commodities, the COVID-19 pandemic clobbered oil demand, especially those segments of the market tied to transportation, such as motor fuels (gasoline and diesel fuel), jet and marine fuels. While the news around vaccines are encouraging, it will be months before these treatments are available on the massive scale required to revive transportation demand. Chart 58Crude Forecasts Ms. X: Are you saying the oil prices will remain depressed in 2021? BCA: Not really. We expect demand to recover following local – as opposed to national – lockdowns in the US and Europe. This process will become evident even before the vaccines have been rolled out on a large-enough scale to affect transportation demand. The impact on energy demand of the vaccines themselves should become visible toward the end of the first half of 2021. On the supply side, we believe the producer coalition lead by Saudi Arabia and Russia will continue to adjust supply to meet demand. Hence, global oil inventories will fall further, which will tighten the market. Based on these supply/demand dynamics, Brent crude-oil prices will average $63/bbl next year, which is above the forward curve in oil markets (Chart 58). Mr. X: Oil-market risk seems very difficult to pin down right now. Do you expect downside or upside risks to dominate prices next year? BCA: At the current juncture, risks to the oil market are exceptionally two-sided. On the downside, with the exception of China, most major economies have been unable to control the rapid spread of COVID-19. If the health crisis lingers, oil demand could remain weaker than our base case anticipates. On the upside, Big Pharma has acted with unprecedented speed in developing vaccines to combat this coronavirus. Netting all these forces out, the balance of risks, in our view, favors the upside, as our price forecast indicates. Mr. X: Thank you. I would like to move on to gold. You mentioned that the dollar was your favourite hedge against equity risk for non-US based investors. As I mentioned earlier, I tend to prefer gold. BCA: Gold and the US dollar are both safe-haven assets; when risk aversion and uncertainty increase, investors buy both these assets to hedge their portfolios. Typically, a weaker dollar is good for gold, and vice versa. The past four or five years have been extraordinarily uncertain – trade wars, political uncertainty, the global rise of nationalist populism, the COVID-19 pandemic, you name it. All of these factors drove investors to hold dollars and gold at the same time. While the bullish dollar forces are dissipating, we cannot say the same for gold. The Fed is committed to maintaining an ultra-accommodative monetary policy indefinitely, which, along with the US government’s ever-expanding budget deficits, will keep the supply of money and credit extremely high for years. As we already argued, this policy setup will have a positive impact on inflation expectations. On the geopolitical front, even if the Sino-US tensions become less acute in the near-term, an undercurrent of distrust and rivalry will prevail. This combination will let bullion prices reach $2,000/oz. next year. Despite these positive fundamentals, gold will not hedge portfolios well against temporary deflationary shocks. Stuck at their lower bound, interest rates cannot decline any more. Consequently, negative growth shocks weigh on inflation expectations, which lifts real interest rate and the dollar, albeit briefly. This process is bearish for gold. Thus, gold will not perform effectively as a deflation hedge, but its ability to protect portfolios against long-term inflation risks remains intact. Mr. X: Thank you. Any other natural resource you would highlight for 2021? BCA: In our research, we heavily focus on the evolution of the global economy toward a low-carbon regime. Hence, we have opened up a whole line of investigation on CO2 markets, particularly in the EU, which is the largest such venue in the world. We are expecting it to become a leading indicator of global efforts to price carbon going forward. On a related note, we are very interested in the buildout and modernization of China’s electric grid as it embarks on its 14th Five-Year Plan in 2021. Similar efforts are arising globally. We think this will be very important for base metals prices, particularly copper and aluminium. Geopolitics Mr. X: Before we conclude, let us talk about global geopolitical risks. The past two years were replete with tensions, many stocked by the Trump administration. Does a change of leadership in the US will fundamentally alter global relations, especially between the US and China? Chart 59Peak US Polarization BCA: The fundamental geopolitical dynamic at the outset of the 2020s is the division of the United States and the rise of China. The sharp increase in US political polarization began with the decline of a common enemy, the Soviet Union, in the 1980s. Pro-growth policies that widened the wealth gap, and a series of political, military, economic, and financial shocks in the twenty-first century, drove polarization to levels not witnessed since the late nineteenth and early twentieth centuries. The anti-establishment Trump administration marked the latest peak in polarization (Chart 59). Now, in 2020, the Democratic Party-led political establishment has reclaimed the White House, but only narrowly. The popular vote was roughly evenly divided (47% to 51%) and the Republicans have likely retained the Senate. Because the popular vote and Electoral College vote are now aligned, and because Biden looks limited to center-left policies, polarization is likely to come off its highs. But it will remain elevated due to gridlock in Congress and persistent socio-economic disparities. President Xi Jinping’s “New Era” has led to a backlash from foreign powers. Polarization is globally relevant because it increases uncertainty over the US’s role in the world, particularly on fiscal policy and foreign policy. At home, gridlock produces periodic budget crises that weigh on global risk appetite. Abroad, partisanship causes new presidents to reverse the foreign policies of their predecessors (see President Obama on Iraq and President Trump on Iran). These dramatic reversals increase global policy uncertainty and geopolitical risk (Chart 60). Chart 60A Bull Market In Policy Uncertainty As the US descended into internal partisan conflict, China expanded its global influence. In the wake of the 2008 crisis, the Communist Party was forced to change its national strategy to better handle demographic decline, structural economic transition, rising social ills, and foreign protectionism. Slower trend growth increases long-term risks to single-party rule, forcing the CCP to shift the basis of its legitimacy from rapid income growth to Chinese nationalism. Hence Beijing has aggressively sought a technological “Great Leap Forward” to improve productivity while adopting a much more assertive foreign policy to build a sphere of influence in Asia Pacific. President Xi Jinping’s “New Era” has led to a backlash from foreign powers, most markedly with COVID-19 but also with the removal of Hong Kong’s autonomy, saber-rattling in neighboring seas, and politically motivated boycotts of neighboring countries like Australia. The sharp decline in China’s international image has occurred despite the damage that President Trump did to America’s image at the same time (Chart 61). The Xi administration is not likely to change course anytime soon as it seeks to consolidate power even further ahead of the critical 2022 leadership transition. Chart 61A Broadening Distrust Of China American polarization and Chinese nationalism are a dangerous combination. China is increasingly fearful of US containment policy and is adopting a new five-year plan built on accelerating its quest for economic self-sufficiency and technological leadership. The US is fearful of China as the first peer competitor that it has faced since the Soviet Union, and one of the few sources of national unity is the bipartisan agenda of confronting China over its illiberal policies. The Biden administration will mark the third US presidency in a row whose foreign policy will be preoccupied with how to handle Beijing. With Biden likely facing gridlock at home, and likely a one-term president due to old age, his administration will largely amount to restoring the Obama administration’s policies. Internationally, this means an attempt to rejoin or renegotiate the Iranian nuclear deal of 2015 so that the US can reduce its involvement in the Middle East and pivot to Asia. Assuming that any American or Israeli action against Iran in the waning days of the Trump administration is limited, Biden will probably achieve a temporary solution with Iran, which otherwise faces economic collapse just ahead of a critical presidential election and eventual succession of the supreme leader. But the process could involve force or the threat of force before a solution is reached, and this would temporarily trouble markets. The greatest geopolitical opportunity in 2021 lies in Europe. Biden will also seek to re-engage China to manage the dangerous rise in tensions, while making amends with US allies for Trump’s “America First” approach. There is already a tension between Biden’s commitment to multilateralism and his need to get things done. The Trump tariffs are viewed as illegal according to the WTO but give Biden leverage over China. Biden is forced to confront China and Russia over their authoritarian actions, but he also needs their assistance on Iran and North Korea. Meanwhile unforeseen crises will emerge, likely in emerging markets badly shaken by this year’s deep recession. Chart 62The Taiwan Strait Is The Top Geopolitical Risk In 2021 The greatest geopolitical risk in 2021 lies in the Taiwan Strait. If China becomes convinced that Biden is not attempting a real diplomatic reset, but is instead pursuing a full-fledged containment policy and technological blockade, then it will be increasingly aggressive over rising Taiwanese pro-independence sentiment (Chart 62). A fourth Taiwan Strait crisis is still possible and would have a cataclysmic impact on markets. But Biden will start by trying to lower tensions with Beijing, which is positive for global equity markets until otherwise indicated. China’s long-run strategy has paid off in Hong Kong so it will likely think long-term on Taiwanese matters as well. Ms. X: In your opinion, which region will experience the greatest geopolitical tailwind next year? The greatest geopolitical opportunity in 2021 lies in Europe. The UK will likely be forced to accept a trade deal with the EU for the sake of the economy and internal unity with Scotland. Meanwhile Trump will not be able to impose sweeping unilateral tariffs on Europe and his maximum pressure policy on Iran will dissipate, reducing the risk of a major war in the Middle East. Germany’s transition from the era of Chancellor Angela Merkel will bring debates and concerns, but Germany is fundamentally stable and its agreement with France to upgrade European solidarity puts a lid on Italian political risk as well (Chart 63). Russia remains aggressive, but it is increasingly worried about domestic stability, and now faces an onslaught of democracy promotion from the Biden administration. Chart 63EU Solidarity Is The Top Geopolitical Opportunity In 2021 Investors are rightly optimistic about 2021 because of the vaccine for COVID-19 are the reduction in global policy uncertainty and geopolitical risk as a result of the change in the White House. But a lot of optimism is being priced as we go to press, whereas the US-China and US-Russia rivalries have gotten consistently more dangerous since 2008. While geopolitical risk is abating from the extreme peaks of 2019-20, it will remain elevated in 2021 and the years after. Conclusions Mr. X: This is a good place to conclude our discussion. We have covered a lot of ground but I remain deeply concerned. On the one hand, the global reflationary policies forced through the system this year remains positive for risk assets. On the other, valuations of both stocks and bonds are uncomfortably stretched for my taste. Moreover, the pandemic is still not under control and while the news on the vaccine front is encouraging, the economy still has ample room to negatively surprise next year. Furthermore, I find the long-term picture particularly concerning, especially if inflation and populism rear their ugly heads. As a result, while I feel like I must be invested in equities rights now, I prefer to slant my portfolio toward value stocks and to keep generous holdings of cash and gold to protect myself. Ms. X: I agree with my father that the uncertain nature of the evolution of the pandemic, especially when contrasted with the demanding valuations of equities, creates many risks for investors. Nonetheless, I do not expect inflation to come back anytime soon. Thus, monetary policy will not become a threat in the near future. Moreover, I am quite optimistic on the earnings outlook. Accordingly, I am more comfortable than my father is with taking some risk in our portfolio this year, even if a slightly larger-than-normal allocation to cash and gold is reasonable. Unlike the BCA team, I believe growth stocks, not value stocks, will generate excess returns from equities in the coming years. Thus, I favor US markets and I am less negative on the US dollar than you are. BCA: Your family debate mirrors our own internal discussions. There is always a trade-off between maximizing short-term returns and taking a longer-term approach to investing. Nonetheless, many assets have become more expensive this year and long-term inflation risks are increasing. Thus, real long-term returns are likely to be uninspiring compared to recent history. Table 4 shows our baseline calculations of what a balanced portfolio will earn over the coming decade. We estimate that such a portfolio will deliver average annual returns of 4.0% over the next ten years, or 1.0% after adjusting for inflation. That is a deterioration from our inflation-adjusted estimate of 2.4% from last year, and also still well below the 6.1% real return that a balanced portfolio earned between 1990 and 2020. Table 4Lower Long-Term Returns The uncertainty around the base case scenario for the global economy and asset markets remains very large. Hence, as we did last year, we recommend a list of guideposts to evaluate whether global markets stay on track to generate gains in 2021: The rollout of the vaccines: Much of the outlook will depend on the global health crisis. As the recent weeks have shown, the subsequent waves of COVID-19 are still debilitating and deadly, even if recent lockdowns are not as stringent as in the spring. Thus, if the vaccines take longer to be distributed, the economy will suffer a greater risk of relapse, which will hurt asset prices. Realized and expected inflation: If both realized and expected inflation rise quickly, the market will price in a faster withdrawal of monetary accommodation. The market is too expensive to withstand this shock, which would prove more painful than another wave of lockdowns. A stronger dollar and a flattening yield curve: If these two phenomena develop in tandem, this will indicate that the global economy is suffering another deflationary shock. Because fiscal and monetary authorities remain on guard, this may not force any meaningful equity correction. However, growth stocks and defensive names will outperform the rest of the market. US diplomacy: Starting January 20, a new president will occupy the Oval Office. Markets have rejoiced at the anticipation of a more conciliatory approach by the US toward its allies and commercial partners. If the US proves colder than expected, markets will have to reprice their optimistic take on global relations. Bank health: We expect sour commercial real estate loans to create limited damage to the banking system. If we are wrong, credit standards will tighten further instead of easing. This would be a bad omen for global demand and would suggest that yields have downside and that growth stocks would beat value stocks. Fiscal policy: We expect fiscal policy to remain accommodative next year, even if less so than in 2020. An absence of a deal in Washington and a quicker return to fiscal rectitude in the rest of the world would mean that global growth will be weaker than we expect. This would impact equities negatively, especially value stocks. Ms. X: Thank you for this list of variables to monitor. As always, you have left us with much to think about. We look forward to these discussions every year. Before we conclude, it would be helpful to have a recap of your key views. BCA: It would be our pleasure. The key points are as follows: In 2021, stocks will outperform bonds thanks to the global economic recovery, the lack of immediate inflationary pressures and the prospects of a resolution to the pandemic. Imbalances in the global economy are growing, and the explosion in debt loads witnessed this year will carry significant future costs. Rising inflation is the most likely long-term consequence because of rising populism and the meaningful chance of financial repression. This change in inflation dynamics will generate poor long-term returns for a 60/40 portfolio, especially because asset valuations are so expensive. Compared to the past two years, geopolitical uncertainty will recede in 2021, but will remain elevated by historical standards. China and the US are interlocked in a structural rivalry, which means that flashpoints, such as Taiwanese independence, will remain a source of tensions. Europe will enjoy geopolitical tailwinds next year. For now, no central bank or government wants to remove economic support too quickly. Monetary policy will remain very stimulative as long as inflation is low, which means no tightening until late 2022, at the earliest. Fiscal deficits will narrow, but more slowly than private savings will decline. The US will grow faster than potential thanks to this policy backdrop. Moreover, household finances are robust and industrial firms are taking advantage of low interest rates as well as surprisingly resilient goods demand to increase their capex plans. Outside of the US, China’s stimulus and an inventory restocking will fuel a continued upswing in the global industrial cycle that will push 2021 GDP growth well above trend. However, at the beginning of the year, we will likely feel the remnants of the lockdowns currently engulfing Western economies. The uncertainty around the base case scenario for the global economy and asset markets remains very large. Bond yields can rise next year, but not by much. Ebbing deflationary pressures and the global industrial cycle upswing will lift T-Note and T-Bond yields. However, the extremely low probability of monetary tightening in 2021 and 2022 will create a ceiling for yields. We favor peripheral European bonds at the expense of German Bunds and US Treasuries. Corporate spreads should stay contained thanks to a very easy policy backdrop and the positive impact on cash flows and defaults of the ongoing recovery. We also like municipal bonds but worry about pre-payment risks for MBS. Global stocks should enjoy a robust advance in 2021, even if the market’s gains will be smaller and more volatile than from March 2020 to today. Easy monetary conditions will buttress valuations while recovering economic activity will support earning expectations. Within equities, we favor cyclical versus defensive names and value stocks relative to growth stocks. As a corollary, we prefer small cap to large cap and foreign DM-equities to US equities. We are neutral on EM equities due to their large tech sector weighting. The dollar bear market is set to continue, and high-beta European currencies will benefit most. The yen remains an attractive portfolio hedge. Oil and gold have upside next year. Crude will benefit from both supply-side discipline and a recovery in oil demand. Gold will strengthen as global central banks will maintain extremely accommodative conditions and global fiscal authorities will remain generous. A weaker dollar will flatter both commodities. A balanced portfolio is likely to generate average returns of only 1.0% a year in real terms over the next decade. This compares to average returns of around 6.1% a year between 1990 and 2020. We sincerely hope that next year, we will get to see each other in person instead of via computer screens. Finally, we would like to take this opportunity to wish you and all of our clients a very peaceful, healthy and prosperous New Year. The Editors November 30, 2020 Footnotes 1 The tickers of the stocks in the “back to work” basket are: LUV, DAL, MAR, HLT, CVX, EOG, SBUX, MCD, CAT, HON, AXP, COF, NUE, GM. 2 The tickers of the stocks in the “COVID-19 winners” basket are: TDOC, FCN, ZM, CTXS, JNJ, AMGN, REGN, CLX, RBGLY, WMT, COST, KR, NFLX, AMZN.
Highlights COVID-19: Markets are trading off the longer-term positive news on COVID-19 vaccines, rather than the shorter-term negative news of surging numbers of new virus cases in Europe and North America. This will continue as long as the vaccine results stay promising, further boosting global equity and credit market performance, especially versus government bonds, as investors price in a return to “normalcy”. FX & Monetary Policy: An increasing number of central banks have raised concerns about unwanted currency appreciation. With interest rates stuck near-zero, asset purchases and balance sheet expansion will be the marginal policy tool used to limit currency moves, especially vs the US dollar. The greater impact will be on bond yield spreads versus US Treasuries with the Fed being less aggressive on QE. Stay underweight the US in global government bond portfolios. Feature Chart of the WeekMarkets Reacting Calmly To This COVID-19 Surge With US election uncertainty now fading away on a stream of failed Trump legal challenges, investors have turned their attention back to COVID-19. On that front, there has been both good and bad news. New cases and hospitalizations have surged across the US and Europe, leading to renewed economic restrictions to slow the spread at a time when governments are dragging their heels on fresh fiscal stimulus measures. Yet markets are seeing past the near-term hit to growth, focusing on the positive news from both Pfizer and Moderna about their COVID-19 vaccine trials with +90% success rates. With markets looking ahead to a possible end to the pandemic, growth sensitive risk assets have taken off. The S&P 500 is now at an all-time high, with beaten-up cyclical sectors outperforming. Market volatility is calm, with the VIX index back down to the low-20s. The riskier parts of the corporate bond universe are rallying hard, with CCC-rated US junk bond spreads tightening back to levels last seen in May 2019. Even the US dollar, which tends to weaken alongside improving global growth perceptions, continues to trade with a soggy tone - the Fed’s trade-weighted dollar index has fallen to a 19-month low (Chart of the Week). Expect more non-US quantitative easing (QE) over the next 6-12 months, to the benefit of non-US government bond performance. The weakening trend of the US dollar has already become a monetary policy issue for some central banks that do not want to see their own currencies appreciate versus the greenback at a time of depressed inflation expectations. Expect more non-US quantitative easing (QE) over the next 6-12 months, to the benefit of non-US government bond performance. There Is Room For Optimism Amid More Lockdowns The latest wave of coronavirus spread has dwarfed anything seen since the start of the pandemic. The number of daily new cases in the US, scaled by population, has climbed to 430 per million people in the US, setting a sad new high for the pandemic. The numbers are even worse in Europe, led by France where the number of new cases reached a high of 757 per million people on November 8 (Chart 2A). COVID-19 related hospitalization rates have also surged in the US and Europe, straining the capacity of health care systems to care for the newly sickened. In Europe, governments have already imposed severe restrictions on activity to limit the spread of the virus. According the data from Oxford University, the so-called “Government Response Stringency Index”, designed to measure the depth and intensity of lockdown measures such as school closures and travel restrictions, has returned to levels last seen during the first lockdowns back in March and April (Chart 2B). Chart 2AA Huge Second Wave of COVID-19 Chart 2BEconomic Restrictions Weighing On European Growth Vs US Oxford data on spending on sectors most impacted by lockdowns, like retail and recreation, also show declines in Europe and the UK similar in magnitude to those seen last spring. The data in the US, on the other hand, shows no nationwide pickup in lockdown stringency, or decline in spending. While economic restrictions are starting to be imposed in parts of the US, the hit to the overall domestic economy, so far, has been limited compared to what has taken place on the other side of the Atlantic. To be certain, the positive headlines on the vaccines will limit the ability of US local governments to impose unpopular restrictions anywhere near as severe as was seen earlier this year. Yet even if a vaccine ready for mass inoculation arrives relatively quickly, it will not be a smooth path to getting widespread public acceptance of the vaccine. According to a Pew Research survey conducted in late September, only 51% of Americans would take a COVID-19 vaccine as soon as it was available (Chart 3). This was down from 72% in a similar survey conducted in May during the panic of the first US wave of the virus. The declines in willingness to take the vaccine were consistent across groupings of age, race, education and political leanings. Of those who said they would not take a vaccine right away, 76% cited a concern about potential side effects as a major reason. Chart 3Most Americans Are Wary Of A COVID-19 Vaccine So even with an effective vaccine now on the horizon, it may take some time to convince people that it is safe to take it. What is clear now, however, is that economic sentiment took a hit from the surge in COVID-19 cases before the vaccine news arrived. The latest ZEW survey of economic forecasters, published last week, showed a decline in growth expectations across the developed economies in the early days of November (Chart 4). The decline occurred for all countries, including the US, but was most severe for the UK, where there are not only new COVID-19 lockdowns but also the looming risk of a messy upcoming resolution to the Brexit saga. Yet the net balance of survey respondents was still positive for all countries in the survey, suggesting that underlying economic sentiment remains robust even in the face of more COVID-19 cases and increased lockdowns in Europe. The ZEW survey also asks questions on sentiment for other factors besides growth. Expectations for longer-term bond yields have moved moderately higher in recent months, as have inflation expectations, although both took a slight dip in the latest survey (Chart 5). No changes for short-term interest rates are expected, consistent with most central banks promising to keep policy rates near 0% for at least the next couple of years. Chart 4COVID-19 Surge Weighing On Global Growth Expectations While global bond yield expectations have clearly bottomed, the ZEW survey shows that expectations for global equity and currency markets have also shifted in what appears to be pro-growth fashion. Chart 5Global Interest Rate Expectations Have Bottomed Survey respondents expect both the US dollar and British pound to weaken versus the euro. At the same time, expectations for future equity market returns have improved, even for European bourses full of companies whose profitability would presumably suffer with a stronger euro (Chart 6). As the US dollar typically trades as an “anti-growth” currency, depreciating during global growth upturns and vice versa, greater bullishness on global equities and more bearishness on the US dollar are not inconsistent views – especially with bond yield and inflation expectations also rising. Greater bullishness on global equities and more bearishness on the US dollar are not inconsistent views – especially with bond yield and inflation expectations also rising. Chart 6Bullish Equity Sentiment, Bearish USD Sentiment The big question that investors must now grapple with is if the near-term hit to growth from the latest COVID-19 surge will be large enough to offset the more medium-term improvement in economic sentiment with a vaccine now more likely to be widely distributed in 2021. Given the message from bullish equity and corporate credit markets, and with US Treasury yields drifting higher even with US COVID-19 cases surging, investors are clearly viewing the vaccine news as more significant for medium-term growth than increased near-term economic restrictions. We agree with that conclusion. We continue to recommend staying moderately below-benchmark on overall duration exposure, with an overweight tilt towards corporate credit versus government bonds, in global fixed income portfolios. A more comprehensive breakdown of the US dollar would be a signal that investors have grown even more comfortable with the economic outlook for 2021. Chart 7A New Leg Of USD Weakness On The Horizon? A more comprehensive breakdown of the US dollar would be a signal that investors have grown even more comfortable with the economic outlook for 2021. The DXY index now sits at critical downside resistance levels, while a basket of commodity-sensitive currencies tracked by our foreign exchange strategists is approaching upside trendline resistance (Chart 7). While emerging market (EM) currencies have generally lagged the US dollar weakness story of the past several months, the Bloomberg EM Currency Index is also approaching a potentially important breakout point. The US dollar is very technically oversold now, so some consolidation of recent moves is likely needed before a new wave of weakness can unfold. Any such breakout of non-US currencies versus the US dollar will open up a whole new assortment of problems for policymakers outside the US, however – particularly those suffering from depressed inflation expectations. Bottom Line: Markets are trading off the longer-term positive news on COVID-19 vaccines, rather than the shorter-term negative news of surging numbers of new virus cases in Europe and North America. This will continue as long as the vaccine results stay promising, further boosting global equity and credit market performance, especially versus government bonds, as investor’s price in a return to “normalcy”. Currency Wars 2.0? On the surface, more US dollar weakness should be welcome by policymakers around the world. Much of the downward pressure on global traded goods prices over the past decade can be traced to the stubborn strength of the greenback. With the Fed’s trade-weighted dollar index now -1.9% lower on a year-over-year basis, global export prices and commodity indices like the CRB Raw Industrials are no longer deflating (Chart 8). While a weaker US dollar would help mitigate the downward pressure on global inflation rates from traded goods prices, such a move would hardly be welcomed everywhere. Within the developed world, some countries are currently suffering from more underwhelming inflation rates than others. The link between currency swings and headline inflation is particularly strong in the US, euro area and Australia (Chart 9). While a weaker dollar has helped lift headline US CPI inflation over the past few months, a stronger euro and Australian dollar have dampened euro area and Australian realized inflation. It should come as no surprise that both the European Central Bank (ECB) and Reserve Bank of Australia (RBA) have recently cited currency strength as a factor weighing on their latest dovish policy choices. Chart 8An Inflationary Impulse From A Weaker USD There is not only a link between exchange rates and inflation for policymakers to worry about – currencies represent an important part of financial conditions, and therefore growth, in many countries. Chart 9Currency Impact On Inflation Greater In Some Countries Chart 10Biggest Currency Impact On Financial Conditions Outside The US Financial conditions indices, which combine financial variables like equity prices and corporate bond yields, typically place a big weighting on trade-weighted currencies in countries with large export sectors like the euro area, Japan, Canada and Australia (Chart 10). This makes sense, as a strengthening currency represents a meaningful drag on growth via worsening export competitiveness. In the US with its relatively more closed economy and greater reliance on market-based corporate finance, the dollar is a less important factor determining financial conditions. So what can central banks do to limit appreciation of their currencies? The choices are limited when policy rates are at 0% as is the case in most developed countries. Negative policy rates are a possible option to help weaken currencies, but seeing how negative rates have destroyed the profitability of Japanese and euro area banks, central bankers in other countries are reluctant to go down that road. It is noteworthy that the two central banks that have made the loudest public flirtation with negative rates in 2020, the Bank of England (BoE) and the Reserve Bank of New Zealand (RBNZ), have not yet pulled the trigger on that move. Both have chosen to go down a more “traditional” route doing more QE to ease monetary policy at a time of weak domestic inflation. The ECB is set to do the same thing next month, increasing its balance sheet via asset purchases and cheap bank funding in an attempt to stem the dramatic decline in euro area inflation expectations. Currencies represent an important part of financial conditions, and therefore growth, in many countries. Can more QE help weaken currency levels in any individual country? Like anything involving currencies, it must be considered on a relative basis to developments in other countries. In Chart 11, we plot the ratio of the Fed’s balance sheet to other developed economy central bank balance sheets versus the relevant US dollar currency pair. The thick dotted lines denote the projected balance sheet ratio based on current central bank plans for asset purchases.1 The visual evidence over the past few years suggests a weak correlation between balance sheet ratios and currency levels. At best, more QE can help mitigate currency appreciation that would otherwise have occurred – which might be all that the likes of the RBA and RBNZ can hope for now. There is a more robust correlation is between relative balance sheets and cross-country government bond spreads. Where there is a more robust correlation is between relative balance sheets and cross-country government bond spreads (Chart 12). This is reasonable since expanding QE purchases of government bonds can dampen the level of bond yields - either by signaling a desire to push rate hikes further into the future (forward guidance) or by literally creating a demand/supply balance for bonds that is more favorable for higher bond prices and lower yields. Chart 11Relative QE Matters Less For Currencies Chart 12Relative QE Matters More For Bond Yield Spreads This is the critical point to consider for investors: the more efficient way to play the relative QE game is through cross-country bond spread trades, not currency trades. On that basis, favoring government bonds of countries where central banks have turned more aggressive with expanding their QE programs – like the UK, Australia and Canada – relative to the debt of countries where the pace of QE has slowed – like the US, Japan and Germany – in global bond portfolios makes sense (Chart 13). Although in the case of Germany (and euro area debt, more generally), we see the ECB’s likely move to ramp up asset purchases at next month’s policy meeting moving euro area bonds into the “expanding QE” basket of countries. Chart 13More Non-US QE Will Support Non-US Bond Outperformance Chart 14Central Banks Are Increasingly 'Funding' Government Spending One final note: central banks that choose to expand their QE buying of government bonds may actually provide the biggest economic benefit by “funding” fiscal stimulus and limiting the damage to bond yields from rising budget deficits (Chart 14). This may be the most important factor to consider as governments contemplate more stimulus measures to offset any short-term hit to growth from the rising spread of COVID-19. Bottom Line: With interest rates stuck near-zero, asset purchases and balance sheet expansion will be the marginal policy tool used to limit currency moves, especially versus the US dollar. The greater impact will be on bond yield spreads versus US Treasuries with the Fed being less aggressive on QE. Stay underweight the US in global government bond portfolios. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 The projections incorporate the following: by June 2021, the Fed grows its balance sheet by US$840 billion, the ECB by €600 billion, the BoJ by ¥80 trillion, the BoE by £150 billion, the BoC by C$180 billion, and the RBA by A$100 billion. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
Highlights The vaccine promises an eventual return to “normal” life – just as Americans voted to “return to normalcy.” Markets are cheering and hinting at an eventual rotation into value stocks. The contested US election can still cause volatility even though Trump is highly unlikely to change the result. The fiscal stimulus cliff is still a risk to the normalcy rally in the short run. But gridlock is the best political outcome over the coming 12-24 months. Stay strategically long global stocks over bonds. Tactically maintain safe-haven positions, add risk gradually, and stay short China/Taiwan. Feature The news of Pfizer’s success in developing a COVID-19 vaccine galvanized financial markets this week. America’s leading public health official Anthony Fauci also predicted that Moderna’s vaccine candidate would be similarly effective. It will take time to distribute these vaccines but the world can look toward economic recovery next year. Stocks rallied, bonds sold off, and value outperformed growth on the back of the news (Charts 1A and 1B). Chart 1ABiden: Return To Normalcy Chart 1BVaccine: Return To Normalcy The vaccine announcement super-charged the “return to normalcy” rally that followed the US election. The election’s likeliest policy outcome is that President Elect Joe Biden will not raise sweeping tariffs while Republican senators will not raise taxes next year, the best-case scenario for markets. This is genuinely positive news. The benefits are very clear over the next 12 months. But the risks are also very clear over the next three months: the virus will remain a problem until the vaccine is widely distributed, the US is in the midst of a contested election that could still cause negative surprises, the Republican senators are less likely to agree to fiscal relief, and President Trump will take aggressive actions to cement his legacy during the “lame duck” period of his last 68 days in office. The takeaway is that the US dollar will see a near-term, counter-trend rally and developed markets will outperform emerging markets for a while longer. We are only gradually adding risk to our strategic portfolio as we keep dry powder and maintain tactical safe-haven trades. Is The Election Over Or Not? Yes, most likely the election is over. But our definitive guide to contested US elections will teach any reader to be sensitive to the tail risks. The counting of ballots is not finished and the Electoral College does not vote until December 14. First, it is still possible that President Trump could pull off a victory in Georgia, which will now recount ballots by hand. Biden’s margin of victory of 14,045 votes is not so large there as to make it impossible that Trump would come back with a win (though history suggests recounts only change hundreds, not thousands, of votes). Trump is also narrowing the gap in Arizona, where counting continues, though the latest reports suggest he is still falling short of the roughly 60% share of late ballots that he needs to close the 11,635 vote gap and win the state. Second, there is a 50/50 chance that the Supreme Court will rule that Pennsylvania must stick to the statutory November 3 deadline, i.e. not accept mail-in ballots that arrived in the three days after that date. While the high court would prefer to let Pennsylvania settle its own affairs, this case is of the sort that the court could feel compelled to weigh in. The constitution is crystal clear that legislatures, not courts, decide how a state’s electors are chosen. Such a ruling probably would not reverse Biden’s projected victory in Pennsylvania. Trump is currently trailing Biden by 53,980 votes in this state. State officials say that the ballots that arrived late amount to only 7,800 and would not be able to change the outcome.1 This may be understating the risk but it is probably accurate in the main. Table 1 shows the share of mail-in votes that arrived late in this year’s primary elections. The share was 1.07% in Pennsylvania and up to 3% in other states. Applying the high water mark of 3% to the November 3 general election mail-in ballots, it is possible that 77,187 votes arrived late and would be excluded by a Supreme Court ruling. However, 85% of those ballots would have to have gone to Biden in order for Trump to come out the winner. This is far-fetched. Table 1Share Of Ballots Arriving Late In Primary Election Extrapolated To General Election It is also unlikely that Republican legislatures will take matters into their own hands and defy the election boards of their state by nominating their own slate of Republican electors – a scenario we entertained in our definitive guide. If Biden leads the statewide vote, then a state legislature would be politically suicidal to appoint the state’s electors to vote for Trump. It would invite a popular backlash. In the case of Pennsylvania, Republican leaders of the lower and upper chambers have explicitly denied any willingness or ability to choose electors other than those entailed by the popular vote. Thus the 1876 “Stolen Election” scenario is extremely unlikely in this critical state. It is just as unlikely in Arizona, Nevada, or Georgia.2 Nevertheless, if President Trump wins in Georgia or gets a favorable Supreme Court verdict, investors will have to increase the probability that the election result will be overturned, which currently stands at 16% (Chart 2). This will cause a bout of volatility even if it changes nothing in the end. If somehow Trump pulls off a Rutherford B. Hayes and overturn the result, markets should sell off. Yes, Trump is an exclusively commercial and reflationary president, but his election on a constitutional technicality would create nearly unprecedented social and political instability in the United States and it would presage major instability globally. Chinese, European, and Canadian assets would be hardest hit (Chart 3). Chart 2Trump’s Tiny Chance Of Reversing Election Otherwise Trump and the Republicans are trying to do four things with their litigation: (1) probing for weaknesses that can delay or change the Electoral College math (2) conducting due diligence in case fraud really did tip over one of the states (3) saving face for President Trump and his allies, who otherwise would be exposed as failures (4) keeping their base motivated for the showdown in Georgia on January 5, which will determine control of the Senate. Chart 3Trump's Loss Favors Euro, Renminbi, Loonie In Georgia, opinion polls show Republican David Perdue slightly leading Democrat Jon Ossoff, in keeping with his superior showing on November 3. However, Republican Kelly Loeffler is trailing Democrat Raphael Warnock (Charts 4A and 4B). Last week we argued that the odds of Democrats winning both races stood around 20%. If anything this view is generous – given that Perdue already beat Ossoff, and Warnock will continue to suffer attacks for associating with Fidel Castro – but it is in line with online betting markets (Chart 5). Chart 4AVoters Split On Georgia Senate Runoffs Chart 4BVoters Split On Georgia Senate Runoffs Chart 5Democrats Have ~20% Chance To Win Senate Investors should plan on the US government being gridlocked unless something occurs that fundamentally changes the Georgia race. Gridlock is positive, so if Trump’s election disputes keep the Republican political base spirited for the Georgia runoffs, then Trump’s activities have an ironic upside for markets. That is, as long as he doesn’t succeed in overturning the election result and the flames of discontent do not break out into a significant violent incident. Other fears about the transition period are less concerning. Several clients have asked us what should happen if President Elect Biden came down with COVID-19 or were otherwise incapacitated. The answer is that Vice President Elect Kamala Harris would take his place, as she now has popular consent to do exactly that. Prior to the Electoral College voting on December 14, the Democratic National Committee would have to nominate a candidate to replace Biden, almost certainly Harris. After December 14, the regular succession would apply under the twentieth amendment and Harris would automatically fill Biden’s shoes. Harris is only slightly more negative for equities than Biden: her regulatory pen would be more anti-business, but like Biden her main policies depend entirely on control of the senate. Bottom Line: It ain’t over till it’s over. The big picture is positive for risk assets but a surprise from ongoing election disputes or the unusually rocky transition of power would trigger a new bout of volatility. Stay long Japanese yen and health stocks on a tactical time frame. Trump’s Lame Duck Risk An investor in the Wild West has often criticized us for arguing that Trump would become a “war president” as he became a political lame duck at home. This war president view did pay off with Iran in January 2020, but otherwise the criticism is valid (see Trump’s Abraham Accords). Now Trump is almost certainly a lame duck so we will find out what he intends to do when unshackled from election concerns. Stay long Japanese yen and health stocks on a tactical time frame. Since losing the election, Trump has fired Defense Secretary Mark Esper, several defense officials have resigned, and CIA Director Gina Haspel is rumored to be next on the chopping block. Most of the officials to depart had broken with the president over the course of the election year, so he may just be dishing out punishment now that the campaign is over. But it is possible that Trump is planning a series of final actions to cement his legacy and that these officials were removed because they got in the way. Chart 6Trump's Lame Duck Risk To China And Taiwan Strait First, there is no doubt that Trump is already tightening sanctions on China and Iran. China was the origin of the coronavirus pandemic and Trump has called for reparations, which could mean more tariff hikes. His outstanding legacy in US history will be his insistence that the US confront China. We are fully prepared for this outcome and remain short the renminbi and Taiwanese equities, despite their strong performance year-to-date (Chart 6). Trump could also raise tariffs on Europe. However, investors should be used to tariffs and sanctions by now. The impact would be fleeting and the next administration could reverse it. In the case of the renminbi, or any tariffs that weigh on the euro, investors should buy on the dips. By contrast, there are some conceivable actions – we are speculating – that would be extremely destabilizing and possibly irreversible. These would include: Extending diplomatic recognition to Taiwan, potentially provoking a war with China. Sending aircraft carriers into the Taiwan Strait, like Bill Clinton did during the Third Taiwan Strait Crisis, to shore up US deterrence. Launching surgical strikes against Iran’s ballistic missile and nuclear facilities or critical infrastructure. A prominent official has already denied that Trump intends anything of the sort. Launching surgical strikes against North Korea’s ballistic missile and nuclear facilities. No sign of this, but Kim Jong Un did enhance his capabilities after his meetings with Trump, thus embarrassing the president on a major foreign policy initiative ahead of the election. Providing intelligence and assistance to US allies like Israel who may seek to sabotage or attack Iran now or in future to prevent it from acquiring nuclear weapons. Withdrawing US troops from Germany or South Korea – which is much more consequential than hasty withdrawals from Afghanistan or Syria, which Trump clearly intends. War actions are largely infeasible. The bureaucracy would refuse to implement them. Assuming the Department of Defense would slow-walk any attempts to reduce troops in important regions like Germany or Korea, it would almost certainly avoid instigating a war. Withdrawing troops from Afghanistan or Syria is manageable, and fitting with Trump’s legacy, but it would not be disruptive for financial markets. A diplomatic upgrade or a show of force to demonstrate the American commitment to defend Taiwan is possible and highly disruptive for global financial markets. The critical risk may come from US allies or partners that are threatened by the impending Biden administration and have a window of opportunity to act with full American support while Trump still inhabits the Oval Office. The likeliest candidate would be Israel and Saudi Arabia on the Iranian nuclear program. Trump’s onetime national security advisor, H. R. McMaster, has already warned that Israel could act on the “Begin Doctrine,” which calls for targeted preventive strikes against hostile nuclear capabilities.3 Even here, Israel is unlikely to jeopardize its critical security relationship with the United States, so any actions would be limited, but they could still bring a major increase in regional tensions. Saudi Arabia can do little on its own but President Trump could willingly or unwilling encourage provocative actions. Chart 7Big Tech Is Not Priced For Surprises Any number of incidents or provocations could occur in this risky interregnum between Trump and Biden. Some suggest Trump will release a treasure trove of documents to discredit Washington and the Deep State. If that is all that occurs, then investors will be able to give a sigh of relief, as revelations of government intrigue would have to be truly consequential for future events in order to cause a notable market impact. Last-minute executive orders on regulating domestic industries are just as likely to shock markets as any international moves. We speculate that Big Tech is in Trump’s sights for censoring his comments during the election. In the wake of the Supreme Court’s decision in Department of Homeland Security versus Regents of the University of California, the Trump administration is positively incentivized to issue a flurry of executive orders and write them in a way that makes them hard for the Biden administration to rescind them.4 Tech is priced for perfection, despite ruffles due to the vaccine this week, and investors expect Biden-Harris to maintain Obama’s alliance with Silicon Valley, not least because Biden has named executives from Facebook and Apple to his transition team and is considering putting former Google chief Eric Schmidt in charge of a Big Tech task force (Chart 7).5 Ultimately we have no idea what the Trump administration will do in its final two months. A lot of Trump’s attention will be focused on contesting the election. Drastic or reckless decisions will likely be obstructed by the bureaucracy. But the president still retains immense powers and there are executive orders that are legitimate and would benefit the US’s long-term interests even if disruptive for financial markets – and these would be harder for officials to disobey. Trump is an anti-establishment player who intends to shake up Washington, stay involved in politics, and cement his legacy. There is a reason for investors to take political risk seriously rather than to assume that the transition to a more market-friendly administration will be smooth. Bottom Line: Stay long gold on geopolitical risk, despite the potential for a counter-trend rise in the US dollar. We are neutral tech: polarization and fiscal risks are positive for tech shares but reopening and Trump lame duck risks are negative. Biden’s Cabinet Picks This “lame duck Trump” risk explains why we are not overly concerned about Biden’s cabinet picks. Insofar as Biden’s choices affect the market at all, they will confirm the “return to normalcy” theme and hence will be market-friendly. Take for example Biden’s just-announced chief of staff, Ronald Klain, who was chief of staff when Biden served as vice president from 2009- 16. The current transition is obstructed by election disputes, as occurred in November-December of 2000, but the cabinet picks are not likely to bring negative surprises. Already Biden has announced a coronavirus advisory board, a bipartisan transition team, and is pondering other picks, some of which will be known by Thanksgiving. None of the choices are in the least disruptive or radical – and most are acceptable to Wall Street. Biden will pick experts and technocrats who are known from his political career, the Obama administration, the Clinton administration, the Democratic Party, and academia. The market will invariably approve of establishment nominations after four years of anti-establishment picks and spontaneous firings. Since the Senate will remain in Republican hands, the cabinet members will have to be centrist enough to be confirmed. While Biden will inevitably nominate a few progressives, they will either fail in the Senate or take up marginal posts. Stay long gold on Trump “lame duck” geopolitical risks. Biden may have the opportunity to appoint three or even four members to the Federal Reserve’s board of governors. The Trump administration failed to fill two seats, while Fed Chair Jerome Powell’s term will expire in February 2022 (Diagram 1). If Biden appoints Lael Brainard to another post, such as Treasury Secretary, he will have a fourth space to fill. Diagram 1Biden Could Have Three-To-Four Fed Picks Chart 8Facing Gridlock, Biden Will Re-Regulate The implication will be a further entrenchment of dovish policy, with greater attention to new concerns that fall outside of traditional monetary policy such as climate change and racial inequality. The Fed has already committed to pursuing “maximum employment,” refraining from rate hikes till the end of 2023, and targeting average inflation – all a major boon to the Biden administration as it attempts to revive the economy. What is negative for markets is that Biden will re-regulate the economy – after Trump’s deregulatory shock – and that this will bring about political risks for small business and key industries like health, financials, and energy (Chart 8). Biden has little other option given that his legislative agenda will be largely stymied. Nevertheless, the sectors most likely to be heavily impacted are attractively valued and stand to benefit from economic normalization if not from Biden’s version of normalcy. Bottom Line: Stay long health and energy. Yes, Gridlock Is Best For Markets Some clients have asked us about our view that gridlocked government is truly the best for financial markets. Wouldn’t Democrats winning control of the Senate in Georgia be better, as it would usher in greater political certainty and larger fiscal spending? We have addressed this issue in previous reports so we will be brief. First, yes, gridlock has higher returns than single-party sweep governments on average over the past 120 years (Chart 9). Clearly the normalcy rally can go higher, but it is equally clear that it will get caught by surprise when the political reality hits home. Second, however, the stock market’s annual returns are roughly average under single-party sweeps during this period (Chart 10). Chart 9Gridlock Best For Markets Chart 10Single-Party Sweeps Generate Average Annual Returns So while investors can cheer gridlock, it is not as if they should sell everything if Democrats do win control of the Senate on January 5. Chart 11Sweeps As Good As Gridlock Over 70 Years Indeed, looking at the period after World War II, sweep governments have witnessed average annual returns that are the same or slightly better than under gridlock (Chart 11). Whereas limiting the study to the post-Reagan era, gridlocks are clearly favored. If greater fiscal resources are needed then gridlock will quickly become a market risk rather than an opportunity. It is notable that over the past 120 years, there is not an example of a Democratic president presiding over a Republican senate and a Democratic House. There was only one case of the inverse – a Republican President, a Democratic senate, and a Republican House – which occurred in 2001-02 and coincided with a bear market. In fact, this episode should be classified as a Republican sweep, as in Table 2, since a sweep was the result of the 2000 election and the context of the key market-relevant legislation in 2001.6 Table 2Average Annual Equity Returns And Gridlock Government Chart 12Market Predicted Gridlock In 2020 In 2020 the stock market clearly anticipated a gridlocked outcome – the market’s performance matches with the historical profile of divided government (Chart 12). We argued that this was the best case for the market because it meant neither right-wing populism nor left-wing socialism. But we also highlighted that any relief rally on election results (reduced uncertainty) would be cut short by the major near-term implication of gridlock: a delay of fiscal support for the economy in the near term. This was the only deflationary scenario on offer in this election. Hence bad news in winter 2020-21 would precede the good news over the entire 2020-22 period. This is still largely our view, but we admit that the vaccine announcement erodes near-term risk aversion even further. There is little substance to the discussion of whether Americans will take the vaccine or not. Evidence shows that Americans are no less likely to take vaccines than other developed country citizens – assuming they are demonstrated to be safe and effective (Chart 13). Chart 13Yes, Americans Take Vaccines So gridlock looks even better now than it did previously. Yet we still think the near-term fiscal risks will hit markets sometime soon. Senate Republicans have been emboldened by the fact that their relative hawkishness paid off in the election on November 3. If they would not capitulate to House Speaker Nancy Pelosi prior to the election, they are even less likely to do so after gaining seats in the House, retaining the Senate, and crying foul over the presidential election. McConnell could agree to a $500 billion deal before Christmas – or not. There is no clear basis for optimism. A government shutdown is even possible if the continuing resolution expires on December 12. If the economic data turns sour and/or markets sell off dramatically then the Republicans will be forced to agree to a bigger deal, but as things stand they are not forced to do anything. And that presents a downside risk to the normalcy rally. Investment Takeaways Today’s post-election environment is comparable to the period after 2010, when a new business cycle was beginning and a new President Barack Obama had to face down Republican fiscal hawks in the House of Representatives. Today’s GOP senators may prove somewhat more cooperative with President Elect Biden, but that remains to be seen. Given how tight the election was, Republicans have an incentive to obstruct, slow down the economic recovery, and contest the 2022 midterms and 2024 election on the back of another slow-burn recovery. It worked last time. The debt ceiling crises of 2011 and 2012-13 were different than the fiscal stimulus cliff that Washington faces today but the market implications are similar. At the climax of brinkmanship between the president and the senate, treasuries will rally, the dollar will rally, stocks will fall, and emerging markets will underperform (Charts 14A and 14B). Today there is a greater limit on how far the dollar will rise and how far treasury yields will fall, but a fiscal impasse will still drive flows into these assets. Chart 14AObama’s Debt Ceiling Crises… Chart 14B… Presage Biden’s Fiscal Cliffs This is what we expect over the next three months. The fact that President Trump could bring negative surprises only enhances this expectation. Therefore we are only gradually adding risk to our strategic portfolio and maintaining tactically defensive positions. Clearly the normalcy rally can go higher, but it is equally clear to us that it will get caught by surprise when the political reality hits home. Since this could be anytime over the next two months, we are only gradually adding new risk. We would not deny that the outlook is brighter over the 12-24-month periods due to the vaccine and election results. Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Footnotes 1 See Chris Matthews, "Alleging fraud, GOP seeks to overturn election results in Michigan, Pennsylvania," MarketWatch, November 10, 2020, marketwatch.com. 2 See Senator Jake Corman and Representative Kerry Benninghoff, "Pennsylvania lawmakers have no role to play in deciding the presidential election," Centre Daily, October 19, 2020, centredailly.com. As for the 1876 “Stolen Election,” the initial election results suggested that Democrat Samuel Tilden had won 184 electoral votes while Republican Rutherford B. Hayes had won 165. The amount needed for a majority in the Electoral College at the time was 185, so Tilden fell one vote short while Hayes fell 20 votes short. After partisan litigation, actions by state legislatures, an intervention by the US House of Representatives, and a grand political compromise, Hayes won with 185 votes. 3 See Charles Creitz, "McMaster warns Biden on Iran deal: Don't resurrect 'political disaster masquerading as a diplomatic triumph,’" Fox News, November 12, 2020, foxnews.com. 4 In this ruling, which was decided on a 5-4 split with Chief Justice John Roberts siding with liberal justices, the Supreme Court denied the Trump administration’s effort to overturn the Obama administration’s policy known as Deferred Action on Childhood Arrivals (DACA), which stopped the US from deporting illegal immigrants who came to the US as children. The majority opinion argued that the Trump administration had merely asserted, not demonstrated, that the Obama administration’s executive orders were unconstitutional. In doing so, it established a precedent by which the court can determine whether one president’s executive orders should overrule another’s. While future administrations may follow better procedures in attempting to revoke their predecessors’ orders, this decision likely incentivizes the Trump administration to try to issue decrees that will be difficult to revoke. See John Yoo, "How the Supreme Court’s DACA decision harms the Constitution, the presidency, Congress, and the country," American Enterprise Institute, June 22, 2020, aei.org. 5 See Kiran Stacey, “What can Silicon Valley expect from Joe Biden?” Financial Times, November 8, 2020, ft.com. 6 The election produced a Republican sweep, with a 50-50 balance in the Senate, that led to the Bush tax cuts in May 2001. The business cycle was ending, however. In June, Democrats took the senate majority when Republican Senator Jim Jeffords of Vermont became an independent and began caucusing with Democrats. In September terrorists attacked the World Trade Center causing a market collapse.
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.
Highlights We agree with the market consensus that the long-term dollar outlook is bearish, but caution against chasing the dollar lower in the short term. While the election results remain uncertain, currency markets also continue to ignore risks of a no-deal Brexit and significant escalation in Covid-19 infections. As such, pro-cyclical currencies remain vulnerable to a countertrend reversal, especially as the greenback remains oversold. The Japanese yen stands as a viable portfolio hedge. For longer-term currency investors, a more robust portfolio of US and Chinese paper and precious metals should do better than a pro-cyclical basket. The Bank of England delivered significant stimulus this week. As we argue below, EUR/GBP remains a sell, but we will wait to buy sterling at 1.25. Look to rebuy a basket of Scandinavian currencies versus the USD and EUR at a trailing trigger point of -2%. New trade idea: Go long EUR/CHF. Feature The US election outcome has taken many investors by surprise. Going into election night, former Vice President Joe Biden was widely expected to win in a “blue wave.” This implied that the former Vice President wins the White House while Democrats gain control of the Senate and retain the House. This was not the BCA view. What has become evident is that similar to 2016, the polls have been offside. What we now know is that Republicans will likely keep control of the Senate. In short, the real prospect of a contested election and/or political gridlock in Washington is coming to fruition. President Donald Trump has been telegraphing that he views the results as fraudulent, triggered by some news agencies calling Arizona a Democratic win on Wednesday before all votes were counted. Some legal action is now becoming a real possibility, with Trump threatening to take matters to the Supreme Court and already filing lawsuits contesting the results in Michigan, Georgia and Pennsylvania. Democratic legal teams are surely preparing for retaliation. Cleaner risk-on/risk-off currency measures such as the AUD/JPY exchange rate were tracking 10-year Treasury yields tick-for-tick. The dollar price action has been consistent with our forecast of additional volatility, with wild swings in both the AUD/JPY exchange rate and the Chinese RMB. However, the direction of the DXY has been surprising, simply on the basis that the dollar is seasonally strong in November and, since the Great Financial crisis, the dollar has tended to rally into year-end (Chart I-1). In fact, given the political “certainty” going into elections, one would have expected the dollar to soar on Wednesday on a safe-haven bid. Chart I-1The Dollar Move This Week Was Unusual Chart I-2The Market Made A Shift Cleaner risk-on/risk-off currency measures such as the AUD/JPY exchange rate were tracking 10-year Treasury yields tick-for-tick, consistent with a safe-haven bid, as the election was becoming uncertain. Once it became clear that fiscal gridlock would be a reality, the market focus shifted from fiscal policy to the prospect that the Federal Reserve is likely to deliver additional stimulus (Chart I-2). US real rates have fallen relative to its trading partners. This is also consistent with the surge in technology equities and positive market action. In a recent piece, we also argued that historically, the dollar has not really benefitted from uncertainty when the US is the source of political risk (Chart I-3). We had been, however, cautioning investors against other tail risks that we expect to continue to dominate the FX market narrative: Brexit and the new wave of Covid-19 infections.1 As such, even as the US election uncertainty gets resolved, markets remain vulnerable, and the dollar could still benefit from safe-haven flows. As we have argued, it will be a countertrend bounce rather than a renewed bull market. Chart I-3US Policy Uncertainty And The Dollar An Election “Post-Mortem” It is impossible to tell for sure when we will know the definitive election results, as the political theater is likely to continue in the coming days. What is clear is that the polls were widely offside in this election (Chart I-4). Chart I-4The Polls Were Offside Nevada will continue to accept ballots until November 10 and North Carolina until November 12 if they are postmarked by election day. A decision will have to be made in Pennsylvania, where Trump is still ahead in the polls, if ballots received after November 3 will be valid. As our geopolitical strategists argue,2 it would not be surprising if the Supreme Court ruled that ballots received after election day cannot be accepted, as the original deadline was changed to November 6 by a lower court decision. The two likely outcomes as we go to press are a GOP Senate and Democratic House, with either Biden or Trump in the White House. Betting markets are pricing in the former outcome. Our contention is that both are neutral-to-dollar bullish. Chart I-5The Dollar And Real Yields Democratic leaders have been more aggressive in their demands for a greater government role in the economy. What is clear is that Senate Republicans will block very aggressive stimulus, but will still agree to some spending. However, smaller stimulus may be offset by policies favorable for markets, such as lower taxes3 and lower regulation, remaining in place. This is a bullish outcome for the dollar since on the one hand, US equities continue to enjoy a higher rate of return, and on the other hand, real bond yields are likely to be higher with less-than-expected fiscal stimulus. Should Trump win the White House, the biggest risk down the road is a renewed trade war, not only with China but even with Europe. This was evident in RMB overnight trading, as Trump started to positively surprise in the polls with Florida. Economically, a trade war will lift the price of foreign goods and services. Foreign currencies should depreciate, as demand for their goods adjusts lower to a higher tariff. This will boost the dollar. That said, it is possible that market focus has rapidly shifted from the government to the Fed. For one, foreign policy is unlikely to be the focus in the near term, given the immediate need for fiscal stimulus and a pandemic. Meanwhile, US real rates have been falling relative to its trading partners this week (Chart I-5). Ten-year TIPS yields have also declined relative to similar real rates in Germany or the UK. In short, the bond market may be pricing in that the Fed will offset any decline in inflation expectations by more stimulus later. For now, they remain on hold. The Real Risk To Dollar Short Positions What is becoming clear to market participants is that the US Treasury market continues to maintain its safe-haven properties. This was evident both in the March drawdown and in recent trading sessions. So, the big risk to dollar short positions is economic uncertainty that drives inflows into the US dollar. Chart I-6Japan Has Been Buying Treasurys Chart I-7Capital Outflows From Japan Chart I-6 shows that Japanese investors and officials have remained very active buyers of US Treasurys, despite real rates being higher in Japan. This partly explains why the yen has not been a particularly potent safe haven compared to the dollar this year. In a nutshell, the huge pool of Japanese external assets has not been repatriated home during times of market stress. Japan is the biggest holder of US Treasurys in the world, and looking at portfolio investment, it remains deeply negative in 2020. In short, income receipts have been rapidly re-invested abroad (Chart I-7). Japanese investors and officials have remained very active buyers of US Treasurys, despite real rates being higher in Japan. Overall, the Japanese yen still remains a safe-haven asset. The yen did outperform from the September drawdown in markets, and has proven to be a better hedge than the Swiss franc or the US dollar over the longer term (Chart I-8). Chart I-8The Yen Remains The Perfect Hedge Chart I-9An Explosion In Covid-19 Cases The need for a portfolio hedge is particularly important, since the US presidential elections are not the only source of uncertainty. As we approach the winter season in the northern hemisphere, a new wave of infections is taking hold. Norway and Switzerland, small countries that were able to manage infection rates over the summer, are seeing a resurgence in cases. Even Sweden, where infection rates had dropped significantly, is going through a very severe second wave (Chart I-9). In the case of Sweden, this is seriously questioning the theory of “herd immunity,” since the economy never really shut down. The key variable for the dollar will be global and relative growth. For much of the summer months, the US was under siege from a second wave while the Eurozone and many other countries were well into their reopening phases. Now the reverse is happening, where the reacceleration in cases is somewhat faster outside the US, triggering temporary lockdowns. If this threatens the improvement in relative economic growth between G10 economies and the US, this could catalyze a dollar rally (Chart I-10). Chart I-10The Dollar And Relative Growth Our longer-term bias remains that the potential economic impact from Covid-19 is likely to be much less than what many economies endured for the first half of 2020. The virus is less deadly, as mortality rates across many countries have come down, and there is a potential for a vaccine soon. As global economies recover, the dollar will decline, with portfolio rotation into cheaper markets. That may be the story for 2021. As we argued last week, the market remains due for a reset in the short term, which should benefit the dollar. The BoE, Brexit And The Case For The Pound As both the pandemic and US election risks remain at the fore of investors’ concerns, Brexit uncertainty continues to brew in the background. UK Prime Minister Boris Johnson has been forced to relock the economy as the number of new cases surge. At the same time, negotiations between the EU and the UK continue in their stop-and-go pattern. Both sides failed to reach an agreement this week, and talks should resume on Sunday or Monday. More importantly, key issues such as the treatment of Northern Ireland remain unresolved, with political bickering over other concerns such as fishing access rights, “level playing field” conditions for businesses and energy cooperation. The Bank of England decided today to front-run the impending economic slowdown by aggressively increasing its target for government bond purchases by £150 billion to £875 billion. This was bigger than expected. The target for corporate bond purchases stays at £20 billion. This will balloon the BoE’s balance sheet to over 40% of GDP. This will be at par with the Fed, but still lower than the European Central Bank or the Bank of Japan. With lower estimates for Q3 GDP growth and a double-dip recession baked in the cake for Q4, additional stimulus was warranted. The BoE also expects UK GDP to only return to pre-pandemic levels in 2022, rather than 2021. The reaction in the gilt market was muted, with rates back to yesterday’s levels, and the pound was slightly up on broad-based dollar weakness. Such action is warranted, given the already very low levels of UK interest rates, especially relative to the US. And with the Fed effectively signaling unlimited quantitative easing, the efficacy of other central bank actions on relative monetary policy trends has dramatically fallen. We saw the same reaction from the Aussie dollar earlier this week, even though the Reserve Bank of Australia cut interest rates and expanded its QE program. The UK budget deficit has tended to move in lockstep with central bank purchases. Domestically, the shift by the BoE was important. The UK budget deficit has tended to move in lockstep with central bank purchases (Chart I-11). When domestic demand is low, the right policy is for government to step in and prevent a negative feedback loop of falling prices, rising real rates and higher savings. We, therefore, commend the Chancellor of the Exchequer, Rishi Sunak's, push to extend the furlough scheme and relief to businesses until the end of next March. This should cushion the blow from the lockdown on the economy. The important takeaway is that the BoE’s QE program opens the door for more fiscal stimulus, since the government can issue debt that will be purchased by the central bank. And given the UK borrows in its own currency, this is not a threat to the pound, especially given extremely low financing costs (Chart I-12) and the lack of inflationary pressures in the UK. In fact, this is a key distinction from the prior warfare episodes, where soaring deficits were met with higher inflation that pushed up interest rates and triggered massive devaluations in the currency. Today, the problem is deficient rather than excess demand. Chart I-11UK Debt And Central Bank QE Chart I-12Cheap Debt Financing Costs The key risk for the pound, therefore, remains a “no-deal” Brexit. This possibility is probably higher with a Trump presidency, since former Vice President Joe Biden has opposed Brexit. This limits the potential for a favorable trade deal with the US, should Democrats gain control of the White House. On the positive side, we have noted before that the pound is in an “ugly contest” with all fiat currencies. For example, even though speculators are short the pound today, positioning is much less extreme than in 2016 or 2019, when the Brexit referendum and the election of Prime Minister Johnson led to “maximum pessimism” on cable. Moreover, the pound is cheap. The cheapness of a currency can be measured by the trade balance, since a cheap currency will stimulate exports while imports will be relatively expensive. On this metric, the UK trade balance has violently swung to near balance (Chart I-13). Chart I-13The UK Trade Balance Is Improving As a strategy, we are short EUR/GBP for now as a play on cable strength. Interest rates still favor the UK relative to Germany or France, and the dollar could receive a bid over the next one-to-three months, as we have argued above. We also have a limit-buy on GBP/USD at 1.25. In terms of targets, cable will be between 1.35-1.40 over the next six months. In an optimistic scenario, the pound could go 20-25% higher. Concluding Thoughts We continue to advocate for a prudent strategy when trading foreign exchange markets over the next few weeks: Hold some portfolio protection. Our preferred vehicle is the Japanese yen, as argued above. Longer-term, as the dollar declines, the Chinese yuan will benefit. The Chinese bond market could be becoming the safe-haven in Asia. A basket of Chinese bonds and silver has provided less volatility than procyclical currencies (Chart I-14). Focus on trades at the crosses. An interesting divergence has opened between EUR/CHF and EUR/USD. Either the euro is too high or the franc is too high (Chart I-15). Given more pervasive deflation in Switzerland, our bias is the latter. Go long EUR/CHF for a trade. Buy Scandinavian currencies if they drop another 2% versus an equal weighted basket of the euro and USD. Go short the gold/silver ratio at 80. Chart I-14An Alternative To US Treasurys Chart I-15Buy EUR/CHF Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Please see Foreign Exchange Strategy Weekly Report, "Tail Risks In FX Markets," dated October 2, 2020. 2 Please see Geopolitical Strategy Special Report, "Gridlock," dated November 4, 2020. 3 Our Chief Strategist, Peter Berezin, argues that the Trump tax cuts could become permanent. Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data from the US have been mostly positive: The ISM Manufacturing PMI increased from 55.4 to 59.3 in October, while the ISM Services PMI declined from 57.8 to 56.6. Headline PCE increased by 1.4% year-on-year in September. Nonfarm productivity increased by 4.9% quarter-on-quarter in Q3. Initial jobless claims increased by 751K for the week ending on October 30. The DXY index fell by 1.5% this week. The Fed stood on hold as widely expected, but the dollar still witnessed tremendous volatility this week. While we believe that the US dollar will depreciate in the long term, especially in the post-COVID world, we do see near-term volatilities amid the election and rising COVID numbers. Report Links: The Dollar In A Market Reset - October 30, 2020 A Few Market Observations - October 23, 2020 Does The US Save Too Much Or Too Little? - October 16, 2020 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data from the euro area have been positive: GDP recovered by 12.7% quarter-on-quarter in Q3, well above the 9.4% expansion as expected. Headline inflation was unchanged at -0.3% year-on-year in Q3. Core inflation was also unchanged at 0.2% year-on-year. The unemployment rate was unchanged at 8.3% in September. PPI fell by 2.4% year-on-year in September. Retail sales increased by 2.2% year-on-year in September. The euro increased by 0.7% against the US dollar this week. Rising COVID cases in Europe and re-implemented lockdown measures continue to spur worries for the recovery. In a speech on Wednesday, ECB Board Member Isabel Schnabel said that further monetary policy support is required to safeguard favorable financial conditions and underpin economic activity. Report Links: Addressing Client Questions - September 4, 2020 On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Japanese Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan have been mostly negative: Construction orders fell by 10.6% year-on-year in September. Housing starts dropped by 9.9% year-on-year in September. The Jibun Bank Services PMI increased from 46.9 to 47.7 in October. The Japanese yen appreciated by 1% against the US dollar this week amid market volatilities. The BoJ meeting minutes released this week showed divergences among BoJ members. While most members agree that maintaining the existing monetary policy should be sufficient in current conditions, other members mentioned it would be necessary to reconsider the strategy towards achieving price targets. 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 from the UK have been positive: Nationwide housing prices increased by 5.8% year-on-year in October. The British pound increased by 0.8% against the US dollar this week. On Thursday, the BoE kept key interest rates unchanged at 0.1%. However, the Bank increased its bond-buying program by another £150 billion, much larger than expected, bringing the total amount to £895 billion. The increased stimulus plan will help weather further deterioration as the crisis continues to strike the UK’s services sector. Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 A Few Trade Ideas - Sept. 27, 2019 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data from Australia have been positive: Building permits increased by 8.8% year-on-year in September. Exports continued to grow by 3.9% month-on-month in September, while imports fell by 5.9% month-on-month. The trade balance jumped to A$5.6 billion in September from A$2.6 billion in the previous month. The Australian dollar surged by nearly 3% against the US dollar this week. The RBA lowered its interest rate from 0.25% to 0.1% this week to provide further support for job creation and economic recovery. Moreover, the Bank will increase the size of its QE program by purchasing A$100 billion of government bonds over the next six months. Accommodative policies, lower COVID cases and elevated current account surplus all underpin the Aussie dollar. 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 Recent data from New Zealand have been mixed: Building permits increased by 3.6% month-on-month in September. The participation rate marginally increased from 69.9% to 70.1% in Q3, while the unemployment rate ticked up from 4% to 5.3% in Q3. The ANZ Activity Outlook Index was little changed at 4.6% in November. The New Zealand dollar increased by 1.5% against the US dollar this week. The latest ANZ Business Outlook report showed that New Zealand’s business outlook data remained stable. Investment intentions dropped, while employment intentions increased. Following the RBA’s action this week, the RBNZ is likely to carry out more stimulus in its policy meeting next week. 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 been positive: GDP increased by 1.2% month-on-month in August. Exports marginally increased from C$44.9 billion to C$45.5 billion in September, led by higher exports of lumber and aircraft. Imports also slightly increased from C$48.1 billion to C$48.8 billion, mainly on higher crude oil imports. The Canadian dollar increased by 2.4% against the US dollar this week. On a quarter-on-quarter basis, Canada’s exports were up 26.9% in the third quarter, showing a strong recovery over the summer. However, it’s still down 7.5% compared with the same quarter last year. 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 mostly positive: Real retail sales increased by 0.3% year-on-year in September. The KOF Leading Indicator declined from 110.1 to 106.6 in October. Headline inflation increased from -0.8% to -0.6% year-on-year in October. The Swiss franc appreciated by 1.2% against the US dollar this week. The recent SECO survey showed no further recovery of consumer sentiment since the summer. As downside risks continue to loom, the SNB is likely to fight appreciation in the franc. Go long EUR/CHF as trade. 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 There have been no significant data from Norway this week. The Norwegian krone soared by 4% this week, recouping the recent loss. On Thursday, the Norges Bank kept its key interest rate on hold at a record low 0%, as expected, and said that they would maintain policy accommodative until they see clear signs of a recovery. 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 mixed: Manufacturing PMI increased from 55.9 to 58.2 in October. Industrial production declined by 2.6% year-on-year in September. Manufacturing new orders fell by 0.3% year-on-year in September. The Swedish krona increased by 2.8% against the US dollar this week. Statistics Sweden showed that GDP increased by 4.3% quarter-on-quarter in the third quarter in 2020, following an 8% drop in the second quarter. Exports and imports have recovered close to pre-pandemic levels. The labor market has also shown strength. The services industry, however, is still negatively affected by the crisis, although they make up a relatively smaller share in the GDP. Kelly Zhong Research Analyst 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 Our base case of a Biden win with a GOP Senate may come to pass. But the US election is not over yet. Trump still has a chance of victory by winning Pennsylvania and one other state. If the vote count does not settle the outcome clearly this week, a full-fledged contested election will emerge that may not be settled until just before December 14 (or even January). Risk-off sentiment will prevail in the interim, given the importance of the executive-legislative configuration for the pandemic response and the fiscal policy outlook. What we know is that Republicans kept the Senate, in line with our final forecast last week. This means gridlock is assured – which is positive for US stocks beyond near-term fiscal risks. Stay long JPY-USD, short CNY-USD, long stocks over bonds, long health care equipment, and long infrastructure plays. Keep dry powder for the presidential outcome, as global trade hangs in the balance. Feature The US presidential election is unsettled as we go to press, but we know that Republicans will keep control of the Senate and hence that American government will be divided or “gridlocked” for the next two years. As things stand, Democrats picked up two senate seats, Arizona and Colorado, but fell short everywhere else. They may even have lost a seat in Michigan. This leaves the balance of power at ~52-48 in favor of Republicans – which is one seat better than our final 51-49 forecast in their favor (Chart 1).1 Chart 1Our Senate Election Model Correctly Predicted Republican Control Table 1Gridlock Is Inevitable Regardless Of Presidential Outcome Gridlock is the inevitable consequence. If President Trump pulls off a victory in any two of the upper Midwestern states (Michigan, Pennsylvania, Wisconsin), then he will still face a Democrat-controlled House of Representatives. If former Vice President Joe Biden pulls off a victory in two of these states, then he will face a Republican controlled Senate (Table 1). Chart 2Gridlock More Favorable Than Sweep For Wall Street, But Fiscal Risks Abound In Short Run Historically gridlock offers more upside for the S&P 500 than a single-party sweep (Chart 2), and we agree with this expectation when it comes to the long-run impact of this election. However, we have also warned against the fiscal risks of a Biden win with a Republican Senate in the short run. The status quo Trump gridlock is reflationary at first but later problematic due to trade war. The Biden gridlock is deflationary at first but the best outcome for investors over the long run. Consider the following: Trump with Senate Republicans: Trump is a spendthrift and he and his party joined the House Democrats in blowing out the budget deficit from 2018-20. Trump’s victory will force House Speaker Nancy Pelosi to concede to a Republican-drafted ~$1-$1.5 trillion new COVID-19 fiscal relief bill right away. For the second term, Trump will push an infrastructure bill, border security, and make his tax cuts permanent. The fiscal thrust in 2021 will be flat-to-up. The budget deficit will probably end up somewhere between the Republican “high spending” scenario and the Democratic “low spending” scenario in our budget deficit projections (Chart 3). This is positive for US growth and especially corporate earnings, but it comes with a catch: Trump will be emboldened in his trade wars, which could expand beyond China to Europe or others. Tariffs and currency depreciation will weigh on global growth. Still, Trump’s second term will occur in the early stages of the business cycle and the Fed is committed not to hike rates until 2023, so the overall picture is reflationary. Chart 3Trump Gridlock Reflationary, Biden Gridlock Deflationary Over Short Run Biden with Senate Republicans: Since Senate Republicans did not capitulate to large Democratic spending demands prior to the election, when their seats were at risk, they will have less incentive to do so afterwards when the president hails from the opposing party. The only way they will agree to a new fiscal stimulus in the “lame duck” session (November-December) is if the Democrats concede to their skinny proposals for the time being. But Democrats will probably insist on their demands having made electoral gains. In this case, either financial markets will sell off, forcing Republicans to capitulate, or investors will have to wait until early 2021 to receive a new fiscal bill that is uncertain in size and timing. The first battle of Biden’s presidency will be with the GOP Senate. The Republican “low spending” scenario in Chart 3 is most likely. It is not realistic that Congress will allow the baseline scenario, in which the budget deficit contracts by ~7.4% of GDP. Republican senators today are not the Tea Party House Republicans of 2010, who were rabid fiscal hawks. Still, uncertainty will weigh heavily and markets will have to fall before GOP senators wake up to the underlying risk to the economic recovery. The consolation is that beyond this 3-6 month period of negative sentiment and deflationary fiscal risk, the outlook will be fairly positive. Biden will not use broad-based unilateral tariffs the way Trump did, with the possible exception of China later in his term. And the Republican Senate will not agree to tax hikes at any point, making taxes a concern for 2023 or thereafter. This is the best of both worlds for US business sentiment and the corporate earnings outlook over the two-year period. Risk-off sentiment will prevail until the election is decided. This could be in a couple of days if the vote count is clear in Michigan, Pennsylvania, and Wisconsin. Or it could extend until just before December 14, when the Electoral College votes, if the litigation and court rulings in these critical states drag on, which we discuss below. The reason risk-off sentiment will prevail is that the US economy is burning through its remaining stimulus funds rapidly, the fiscal trajectory is unclear until the presidency is decided, Europe is going into partial lockdowns over the pandemic, and a Biden victory would imply more US lockdowns. Diagram 1 outlines the macro and market implications as we see them, depending on the presidential outcome. We never took the view that a Democratic sweep of White House and Senate would be the best outcome for the overall investment outlook, though we conceded that it was the most reflationary and bullish in the short term. But now this point is moot. Investors will have to wait another two years at minimum for the full smorgasbord of Democratic spending proposals to have a chance at passage. Diagram 1Gridlock Rules Out Massive Fiscal Boost Bottom Line: The presidency is indeterminate as we go to press. What is clear is that Republicans retained the Senate. Therefore gridlock will prevail. This is generally market positive, though a Biden win would weigh on risk assets in the near term until financial markets force Republican senators to capitulate to a new fiscal bill. A Controversial Election Or A Contested Election? The critical battleground states are undecided as we go to press. Trump needs to win any two of Michigan, Pennsylvania, and Wisconsin to retain the White House. The vote count will last through Wednesday and possibly beyond. The Republican and Democratic legal teams are preparing for trench warfare. Major legal challenges are highly likely and will delay the final outcome into December or even January. The first thing is to finish counting the absentee and mail-in ballots. Georgia, Michigan, Wisconsin, and Arizona are not accepting ballots after election day, so they will finish counting soon. Then all that remains is to see if any legal disputes arise that prevent the Electoral College members from being settled in these states, which is still possible. For example, Wisconsin is within a percentage point. Nevada will accept ballots by November 10 and North Carolina by November 12 as long as they are postmarked by election day. It is likely but not certain that Democrats will keep Nevada (~75% counted) while Republicans will keep North Carolina (~100% counted). Thus Pennsylvania poses the biggest risk of a contested result – and this was anticipated. The deadline to receive mailed ballots is Friday, November 6, but a legal dispute is already underway as to whether the original November 3 deadline should be reinstated.2 We will not pretend to predict the final court verdict on Pennsylvania, but it would not be surprising at all if the Supreme Court ruled that ballots received after election day cannot be accepted. The constitution grants state legislatures the sole power of choosing a state’s electors. Each state passes its own election laws. The Pennsylvania state legislature clearly stated that ballots must be returned by election day. It was a court decision that extended the deadline. The Supreme Court could easily determine that a lower court does not have the power to change the deadline. But nobody will know until the court rules. The fact that Trump appointed several of the judges has little bearing on their decisions because they serve lifetime appointments. Once election disputes rise above state vote-counting to the federal level, Trump gets a lifeline. First, the two-seat conservative leaning on the Supreme Court should produce strict readings of the law that could favor his bid. Second, the GOP’s victory in the Senate means that Democrats cannot unilaterally settle disputed electoral votes in their own favor at the joint session of Congress on January 6, which they could have done with a united Congress. Third, the Republicans are likely to have maintained a one or two-state majority of state delegations in the House of Representatives (based on results as we go to press), which means that Trump would win if the candidates failed to reach a 270-vote majority on the Electoral College or tied at 269. Note that an Electoral College tie is a distinct possibility in this election. Right now, if Trump loses in Michigan and Wisconsin, but wins Pennsylvania, and nothing else changes, then an Electoral College tie could result at 269-269 electoral votes.3 Polls … And Exit Polls Before condemning the entire profession of opinion pollsters to death it will be important to receive the verified results of the election and compare them with the final polling averages. It is clear that Trump was widely underrated yet again, but it is not yet clear that this was primarily or exclusively the fault of pollsters. Right now Trump is down by 1.8% in the nationwide popular vote, whereas he lagged by 7.2% in the average of the national polls and 2.3% in the battleground average on election day. This is a big 5.4% gap in the national poll, but in the battleground poll it is a minor 0.5% polling gap and as such merely confirms what many observers knew, that the battleground polls were the ones that really mattered due to the Electoral College. Trump’s battleground support average was 46.6% and his approval rating was 45.9% on election day, which respectively is 1.8% and 2.5% below his tentative share of the national vote at 48.4%. These gaps are within the average 3% margin of error – and normally sitting presidents outperform their polling by around 1%. State opinion polling had huge errors like the national poll. Charts 4 and 4B shows the final election polling in the critical swing states along with a “T” or “B” to mark Trump’s and Biden’s tentative vote share as we go to press. Swing state polls showed Trump staging a major rally in the final weeks of the campaign, which is what prompted us to upgrade his odds to 45%. Neither major pundits nor the mainstream media paid enough attention to this shift. Several prominent outlets denied that there was any real tightening in the polls even in late October. Chart 4APundits Overlooked Trump’s Rally In Swing State Polls In Final Weeks Chart 4BPundits Overlooked Trump’s Rally In Swing State Polls In Final Weeks What this demonstrates to us is the power of momentum in opinion polling, especially in the final week before an election when people’s attitudes harden and they bare more of their true opinions. It does not tell us that opinion polling is dead. What about the exit polls? Biden cut into Trump’s lead in key demographic groups just as the Democratic Party machinery anticipated, but it is not clear if it was enough to win the election. Trump lost ground and Democrats gained ground, relative to 2016, with white voters, old folks, and non-college-educated voters. But Trump improved his support among blacks and Hispanics, a signal point that gives the lie to much of this year’s media hype (Charts 5A and 5B). Chart 5ADemocrats Gained Ground With White, Elderly, And Non-College-Educated Voters; GOP Gained Among Blacks And Hispanics Chart 5BDemocrats Gained Ground With White, Elderly, And Non-College-Educated Voters; GOP Gained Among Blacks And Hispanics By far voters cared most about the issues, not personalities, and the biggest issue was the economy (35% of voters versus 20% on racial inequality and 17% on the coronavirus, which was apparently overrated as an issue by Democrats). The economic focus is the only explanation for Trump’s outperformance – the law and order narrative was less popular. Trump’s vote share may end up exactly equal to the number of respondents who said the economy was “good” or “excellent” (48%). Otherwise Trump’s base is well known: it consists predominantly of white people, rural people, those in the Midwest and South, those who have been fairly successful in income, and those who think America needs a “strong leader” more than a unifier with good judgment who seems to care about the average person. If Trump is defeated, the clear implication is that he failed to expand his base. If he wins, the clear implication is that Democrats suffered in the key regions for their aggressive approach to COVID lockdowns, their condoning of lawlessness, and their divisive handling of racial inequality and police brutality. With such a close vote for the White House, sweeping narratives are questionable. It is not clear yet whether liberalism or nationalism won, and at any rate the margin was thin. What is clear is that Democrats substantially disappointed in the Senate and they might even have failed to gain the White House. Given that this year witnessed a recession, pandemic, and widespread social unrest – well-attested historical signs that point to the failure of the incumbent party and recession – Democrats apparently failed to capitalize. National exit polls suggest the fault lay in their relative neglect of bread and butter in favor of the coronavirus or left-wing social theory. This is true not so much in the House of Representatives but in the presidential and senate races. If Trump wins – especially through a contested election – then US political polarization will rise due to the continued divergence of popular opinion and the constitutional system. “Peak polarization” will last another four years at least. But if Trump loses, given that Republicans held the Senate, there is room for compromise that would reduce polarization. But it is too early to say. Investment Takeaways Trade and foreign policy hinge on the presidency. Trump is favored in several of the key states at the moment and he is especially favored in a contested election process, but it is too soon to make investment recommendations on the executive branch other than that US equity outperformance is likely to continue on both of the scenarios at hand. Table 2Earnings Shock From Partial Repeal Of Trump Tax Cuts Has Been Averted For now we recommend investors stay long JPY-USD, short CNY-USD, long health care equipment, and overweight stocks relative to bonds. On the Senate, the key takeaway is that Biden and the Democrats will not be able to raise taxes. This is a big benefit to the sectors that faced the greatest earnings shock from a partial repeal of Trump’s Tax Cuts and Jobs Act – namely real estate, tech, health care, utilities, consumer discretionary, and financials (Table 2). A simple play on these sectoral benefits courtesy of Anastasios Avgeriou, our US equity strategist, would be to go long small caps versus large caps, i.e. S&P 600 relative to the S&P 500, but wait till the fiscal hurdle is cleared. The BCA infrastructure basket should benefit regardless, as infrastructure is one of the few areas of bipartisan agreement, especially amid a large output gap. Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Footnotes 1 We upgraded the Republicans to favored status last week based on our quantitative Senate election model, which showed a 51% chance that Republicans would maintain control, with 51-49 votes. Our presidential model also showed Trump winning with a 51% chance, but we subjectively capped his odds at 45% due to our doubts about his ability to win Michigan given Biden’s 4% lead in head-to-head public opinion polls there. 2 It is possible that Nevada’s November 10 deadline or North Carolina’s November 12 deadline could become relevant, but we doubt it. 3 Precise Electoral College outcomes cannot be predicted due to faithless electors, i.e. electoral college members who vote differently than required based on their state’s popular vote. In 2016 there were seven faithless electors and in 2020 there could be several and they could make the difference. Material punishments may not prevent an elector from making a conscientious decision to stray from his or her state’s results in an election viewed as having historic importance.