Economy

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

Dear client, Next Monday, October 19, we will be hosting our quarterly webcast, “From Alpha To Omega With Anastasios”, at 10am EST; Matt Gertken, BCA’s Geopolitical Strategist will be our guest on the eve of the US Presidential Election. Our regular weekly publication will resume on Monday October 26, 2020. Kind Regards, Anastasios Highlights Portfolio Strategy Homebuilders are more than fully priced, discounting high margins as far as the eye can see and no end to demand. The specter of higher interest rates, lumber inflation, stealing demand from the future, unfriendly bankers and uncertainty with regard to a fresh stimulus package more than offset the positives, and compel us to issue a downgrade alert for the S&P homebuilding index. While the price of credit, loan growth prospects and credit quality all weigh on relative bank performance. A fiscal stimulus bill, depressed valuations and a Fed induced resumption of dividend hikes and share buybacks keep us on the sidelines in the S&P banks index.  Recent Changes There are no changes to our portfolio this week. Table 1 Feature Equities seesawed last week as President Trump returned to the White House (WH) and injected fresh volatility in markets signaling that there will be no fiscal deal prior to the elections. The SPX immediately gapped down and we cannot stress enough the importance of our newly configured Fiscal Policy Loop: fiscal hawkishness causes skittishness in markets culminating to a classic BCA riot point and then policymakers relent and fiscal dovishness restores the equity bull market (Figure 1). While we cannot rule out a slimmed-down stimulus package deal by later this month, fiscal policy- and election-related uncertainties remain elevated. The daily back-and-forth on where Congress and the WH stand with passing a new stimulus bill coupled with the prospects of a contested election that would drag on the presidential race likely into December, have caused investor fatigue. The sooner both of these uncertainties recede, the quicker the SPX will climb to fresh all-time highs (Chart 1). Figure 1The Fiscal Policy Loop Chart 1Receding Uncertainty Will Boost Stocks   We have shown in recent research, and update today, that the fourth year of presidential cycles finds the SPX ending the year on average in the green with a calendar return in the high single digits (Chart 2). Peering back in 2016 is instructive as that presidential election cycle year was in some ways similar to the current one. The economy, in particular, was fighting off a manufacturing recession that spread and infected the services sectors as the vast majority of S&P GICS1 sectors saw profit contraction and more importantly revenue declines. Chart 3 shows a number of asset classes and compares 2016 with 2020. The 10-year US Treasury yield appears poised to rebound significantly, especially if Congress passes a fresh fiscal package that aides the parts of the economy that need the stimulus checks most. Fiscal easing uncertainty remains a thorny issue across different markets and if history is an accurate guide, the SPX could glide lower into the November election before rallying into year-end. Chart 2Back Up Near The Average Profile Meanwhile, a number of investors we talk to also experience COVID-19 fatigue (Chart 4). For the better part of the last 10 months media has constantly bombarded the world with pandemic news, and rightly so. However, all this seems dystopian by now, and we cannot wait for a semblance of normality to make a comeback, which a vaccine will definitively bring about. The equity market has been indurated to this news-flow and has shaken-off the recession. When the vaccine does arrive likely next year, profits will also return back to trend, as we have been arguing for some time, because the global economy will fully reopen. Chart 32016 Versus 2020 Already, if we juxtapose leading soft economic data surprises with lagging hard economic data surprises, it is clear that a stellar profit recovery looms (second panel, Chart 5). Similarly, within soft the data universe, the ISM new orders-to-inventories ratio paints a rosy picture for an earnings recovery in 2021 (third panel, Chart 5). Even within hard economic data, a simple liquidity indicator we have used in the past comparing industrial production (IP) with M2 money stock signals that S&P profits have troughed (IP vs. M2 shown advanced, bottom panel, Chart 5) Chart 4COVID Fatigue Finally, the US Equity Strategy’s four-factor macro profit growth model has slingshot higher recently and signals that a return to $162 level of EPS in calendar 2021 is a high probability outcome (Chart 6). Netting it all out, we are in the tail end of the equity market correction and as election and fiscal policy uncertainties ebb, they will pave the way for a robust SPX rally. Chart 5Profit Recovery On Track   Chart 6EPS Model Concurs This week, we continue with our strategy of preferring beaten-down cyclicals to defensives and steer the portfolio away from another safe haven staples industry via downgrading a consumer goods subgroup to underweight. We also delve deeper into the banking industry highlighting some cracks in small commercial banks. Put Homebuilders On Downgrade Alert Homebuilders have had a monster run since the depths of the recession back in March and the question a lot of our clients are now asking is: does it make sense to chase them higher at the current juncture? The short answer is no. Before we get into the details of our analysis a brief recap of our recent residential real estate-related moves is in order. Going into the March carnage we were cyclically underweight the niche homebuilding index. Moreover, last December we had identified homebuilders as a high-conviction underweight in our annual Key Views report. We monetized relative gains of 41% and 43%, respectively from both positions and lifted exposure to a benchmark allocation. While in retrospect we should have upgraded all the way to overweight, we did manage to participate in the V-shaped housing-related returns by opting to go overweight the mega cap home improvement retail index instead. In addition, this summer we eked out another 10% return from a long homebuilders/short REITs pair trade. Homebuilders are enjoying the single family home renaissance as the pandemic has turbo-charged the work from home movement and employees are rushing to move into comfortable spaces in the suburbs as the traditional office is literally declared dead. Indeed, housing starts and permits have renormalized, the drubbing in interest rates has boosted affordability and caused a knee jerk reaction in the mortgage application purchase index, and sell-side analysts are fighting hand-over-fist to upgrade profit projections for the homebuilding group (Chart 7). The end result has been a boom in new home sales that are trouncing existing home sales, and the NAHB’s survey of prospective homebuyers continues to paint a rosy picture for additional demand for new single family homes especially given the low inventory of homes (top & third panels, Chart 8). Chart 7Housing Tailwinds Chart 8Price Concessions Generate Volume This is where all the good news ends. With respect to selling prices, homebuilders are making price concessions compared with existing homes and also in absolute terms new home prices are deflating (second & bottom panels, Chart 8). Therefore, at close to 15%, homebuilding profit margins are near all-time highs and under threat especially from a firming industry wage bill (second & third panels, Chart 9). Tack on surging lumber inflation and a profit margin squeeze is a high probability outcome (bottom panel, Chart 9). As a reminder framing lumber, on average, comprises 15% of a new single family home’s total input costs. While the NAHB survey points to brisk demand for new homes, the sister Conference Board survey shows that consumers’ appetite for a new home has crested (second & third panels, Chart 10). With consumers rushing to move to the suburbs due to the pandemic, there is an element of bringing housing demand forward. Chart 9Beware Margin Squeeze Chart 10Good News Fully Priced Worrisomely, if the economy continues to open up then interest rates should continue to back up. From all the major asset classes the 10-year Treasury yield is the one that has yet to discount a V-shaped economic recovery. The implication is that rising interest rate would dent affordability and at the margin weigh on housing demand (10-year Treasury yield shown inverted, top panel, Chart 10). Moving on to the credit backdrop, while demand for residential real estate loans has recovered, bankers refuse to extend mortgage credit (second & third panels, Chart 11). According to the latest Fed H8 weekly credit release, residential real estate loans are on the verge of contraction (bottom panel, Chart 11). Finally, the tug-of-war on the fiscal package front is also threatening to sustain the unemployment rate near double digits, which could jeopardize the housing recovery. Historically, housing starts have been near perfectly inversely correlated with the unemployment rate and the current message is for a leveling off in residential construction activity (middle panel, Chart 12). The recent homebuilding run has pushed relative valuations from undervalued to overvalued. The relative P/S ratio trades roughly 30% above the historical mean (a three-year high), and leaves no cushion for any mishaps (bottom panel, Chart 12). Chart 11Bankers Refusing To Dole Out Loans Chart 12In Desperate Need Of Fiscal Help Netting it all out, homebuilders are more than fully priced, discounting high margins as far as the eye can see and no end to demand. The specter of higher interest rates, lumber inflation, stealing demand from the future, unfriendly bankers and uncertainty with regard to a fresh stimulus package more than offset the positives, and compel us to issue a downgrade alert for the S&P homebuilding index. Bottom Line: Stay neutral the S&P homebuilders index, but it is now on our downgrade watch list. The ticker symbols for the stocks in this index are: BLBG: S5HOME – LEN, PHM, DHI, NVR. A Few Words On Banks Pundits around the globe focus on Eurozone and pan-European banks and argue that these outfits have been value destroyers since the history of the data series in late-1986 (bottom panel, Chart 13). Similarly, US banks relative share prices peaked in the mid-1970s and have never looked back, and very recently have tumbled to fresh all-time lows whether one uses monthly, weekly or daily data (top panel, Chart 13). Meanwhile, the recent drubbing in relative share prices suggests that loan loss provisioning is not over. In fact, Q3 loan loss reserves will surpass the level hit in the GFC, and likely close in on the $300bn mark (provisions shown inverted, Chart 14). Chart 13Banks, The World Over, Are Value Destroyers Chart 14More Loan Losses Loom… Historically, loan loss provisions are the mirror image of bank net operating income and most importantly bank profits decline as provisioning increases (Chart 15). Worrisomely, the longer the new stimulus checks take to arrive, the longer it will take banks to rebound. Banks have been semi-sheltered from the recession courtesy of eviction/foreclosure moratorium as well as mortgage forbearance agreements. Absent a fresh stimulus package, the unemployment rate will remain elevated, warning that lagging non-performing loans will skyrocket (bottom panel, Chart 16). Chart 15…Which Will Weigh On Profits Chart 16Fiscal Policy Easing To The Rescue? Tack on the year-to-date more than halving in the 10-year US Treasury yield and the earnings outlook remains grim for banks (top & middle panels, Chart 17). The transmission mechanism is through net interest margins (NIMs). The fourth panel of Chart 17 highlights that the pair have been joined at the hip and all-time lows in the 10-year US Treasury yield have sank bank NIMs below 3%, which is another all-time low since the history of the FDIC data. Credit growth has crested and our loans and leases model suggests that loan growth will continue to decelerate into 2021 (second panel, Chart 17). Not only is there lack of appetite for new overall loan uptake, but bankers are stringent with extending credit to businesses and consumer alike, according to the most recent Fed Senior Loan Officer survey (Chart 18). Chart 17Credit Growth Blues Chart 18Lack Of Loan Demand And Tightening Credit Supply However, there are three significant offsets to all these stiff headwinds that prevent us from downgrading banks to an underweight stance. First, the 10-year US Treasury yield is one of the few assets that has yet to discount any economic recovery. Thus, as uncertainty lifts post the November election, the economy continues to open up and Congress and the new President manage to pass a fresh fiscal stimulus bill, all this could catalyze a catch up phase in the long bond yield. Second, valuations offer a deep enough discount to absorb a little bit of more negative news as analysts and investors alike have thrown in the towel in banks (bottom panel, Chart 19). Finally, the credible Fed’s stress test loom by year-end and assuming banks pass them with flying colors a resumption of shareholder friendly activities will boost the allure of owing banks and unwind extremely oversold conditions (middle panel, Chart 19). In sum, while the price of credit, loan growth prospects and credit quality all weigh on relative bank performance. A fiscal stimulus bill, depressed valuations and a Fed induced resumption of dividend hikes and share buybacks keep us on the sidelines in the S&P banks index. Chart 19Unloved And Under-owned Bottom Line: Stay neutral the S&P banks index, but keep it on the downgrade watch list. The ticker symbols for the stocks in this index are: BLBG: S5BANKX – JPM, BAC, C, WFC, USB, TFC, PNC, FRC, FITB, MTB, KEY, SIVB, RF, CFG, HBAN, ZION, CMA, PBCT.   Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com Current Recommendations Current Trades Strategic (10-Year) Trade Recommendations Size And Style Views July 27, 2020 Overweight cyclicals over defensives April 28, 2020  Stay neutral large over small caps June 11, 2018 Long the BCA Millennial basket  The ticker symbols are: (AAPL, AMZN, UBER, HD, LEN, MSFT, NFLX, SPOT, TSLA, V). January 22, 2018 Favor value over growth

Highlights Hopes for another round of fiscal stimulus before the election were apparently torpedoed last week, … : The White House’s 180-degree turn to abandon stimulus talks may initially have been meant as a negotiating ploy, but it pushed House leadership to dig in, and a major stimulus agreement ahead of the election appears to be slipping out of reach. … but stocks rose anyway, … : Financial markets seem to have decided that a failure to reach agreement on a stopgap stimulus measure now increases the chances for a no-holds-barred package after the new year. … and they just may be getting it right: There are some indications that households have stored up enough nuts to make it through a fourth quarter with nothing more than automatic fiscal stabilizers. If they can get by until a torrent of new stimulus is released in February, equities may well be the place to be. We Need More Stimulus … We have been talking about fiscal stimulus ever since the pandemic arrived on US shores. It and monetary accommodation are the economic tools policymakers have to combat the virus and fiscal stimulus has loomed increasingly larger given that the Fed has done nearly all it can. Our constructive view on risk assets and the economy stems from our conviction that fiscal policymakers have the power to bridge the pandemic’s economic gap and will eventually summon the will to exercise it. We have not previously delved into why the stimulus is needed, however, so we highlight the primary reasons now. Labor market hysteresis: The longer an individual is out of the work force, the greater the probability that his/her skills will erode to the point that s/he may become unemployable. If enough workers suffer this fate, America’s labor pool will be appreciably diminished. Since long-run economic growth is simply the sum of the growth of the working-age population and growth in productivity, a shrunken labor force will crimp potential economic growth. Slower economic growth would lead to weaker earnings growth and more difficulty servicing private- and public-sector debt, signaling trouble for risk assets and Treasuries. Although the unemployment rate retreated very quickly from the postwar high it established in April (Chart 1, top panel), the ranks of the long-term unemployed, defined as workers out of work for at least 27 weeks, are poised to swell. The share of the unemployed who have been out of work for at least 15 weeks is extremely high relative to its postwar history, just shy of early 2010’s 60% record (Chart 1, bottom panel). Once layoffs recede, the mass of long-term unemployed workers will eventually be whittled down, but the process did not begin for a full year after initial jobless claims peaked after the great recession (Chart 2). With claims’ four-week moving average having stalled well above its GFC peak and fresh layoff announcements from businesses in the virus’ crosshairs like Disney, Regal Cinemas and several airlines, the pipeline of the newly unemployed will remain full without additional aid. Chart 1The Unemployment Rate Is Falling, But Its Average Duration Is Rising Chart 2It Takes A While For Claims To Recede ... State and local governments, which account for over 13% of nonfarm payrolls, are also poised to swell the ranks of the unemployed. Hamstrung by balanced-budget laws, many public entities have no choice but to reduce headcount in the face of plummeting tax revenues. The difficulty of calibrating seasonal adjustment factors with this year’s shuffled school calendar may have distorted summer payroll data, but the empirical record suggests that state and local government payrolls do not bottom until well after recessions end (Chart 3). Without generous infusions of federal aid, state and local government layoffs are likely to be a lingering drag. Chart 3... And State And Local Governments Keep Shedding Workers Until They Come Way Down Self-reinforcing bankruptcies: Diminished potential long-run growth would be a drag for investors, but the most acute near-term concern is a wave of bankruptcies. In the absence of CARES Act provisions that expanded eligibility for unemployment insurance (UI) benefits, extended the period over which laid-off workers could collect UI benefits and granted the $600 weekly federal UI benefit supplement, along with various measures encouraging banks and forcing mortgage servicers to establish lender forbearance programs, consumer credit performance would have been significantly worse. Despite the pandemic shock, TransUnion reports that delinquencies across all consumer loan categories, ex-autos, have been steadily falling since March, and only auto loan delinquencies were higher (by a mere 7 basis points) in August 2020 than they were in August 2019. Bankruptcies beget bankruptcies. If policymakers can keep some creditworthy borrowers in viable industries out of the path of the falling dominoes, the economy will bounce back faster once the virus is contained.  If consumer delinquencies (Chart 4) were to rise anything close to the level implied by the unemployment rate, the effects would reverberate across the banking system and the credit markets. Reported delinquencies have been held down by forbearance measures, which have had the cosmetic effect of removing many of the most vulnerable loans from the delinquency ratios, but through the second quarter the biggest banks uniformly reported that most borrowers enrolled in their forbearance programs were making at least some payments on their loans and that a far greater share than they had expected were exiting the programs without requesting extensions. We will hear later this week if that surprisingly benevolent trend held across the third quarter, most of which unfolded after the expiration of key CARES Act provisions, but management comments in public appearances last month suggest that it did. Without another round of federal aid, state and local government layoffs will continue. Chart 4The CARES Act Worked Rising delinquencies and widening bond spreads typically sap banks’ and bond investors’ ardor for making new loans, establishing a vicious circle in which weak credit performance leads to reduced credit availability and more onerous terms. Banks have tightened lending standards on cue (Chart 5), but ultra-accommodative monetary policy and unprecedentedly generous fiscal policy have blunted tighter bank standards’ impact. The former made bond investors forget their fears, paving the way for a bonanza of investment grade and high yield issuance (Chart 6), while households’ transfer windfall supported consumer credit performance and made it possible for consumers to pay down a good chunk of their outstanding credit card balances (Chart 7). In 2020's hall of mirrors, household income rises, and personal loan delinquencies decline, despite a vicious recession. Chart 5Banks Tightened Lending Standards, ... Chart 6... But The Bond Market Welcomed Large Corporate Borrowers With Open Arms The result is that emergency policy measures have so far staved off defaults and bankruptcies by viable creditworthy borrowers but reduced credit availability could undo those victories going forward.     Chart 7Consumer Loan Balances Typically Rise At The Onset Of A Recession … But Do We Need It Right Away? Though they differ on their proposals for the ideal size and composition of a new package, mainstream economists unanimously support an additional round of stimulus. A stickier question we’ve been mulling over is when that package is needed. According to former Obama Council of Economic Advisers chairman Jason Furman, “The answer is, two months ago.”1 Furman’s formidable public policy credentials notwithstanding, financial markets do not share his sense of urgency. Given that the National Multifamily Housing Council’s Rent Tracker showed that residential rent collections haven’t missed a beat since CARES Act provisions expired in late July, markets may be on to something. September collections were a tick better than August’s and were within a percentage point of year-ago collections, while October is off to a better start than all of the last three months and has matched last year’s pace (Table 1). The rent collection data provide a real-world example of the ongoing impact of generous fiscal transfers. Despite the expiration of the federal UI supplement in July, August personal income exceeded February’s pre-pandemic level. Table 1Apartment Tenants Are Paying Their Rent Even without that key pillar of the CARES Act, households were able to add another $100 billion of savings to the $1 trillion cache they amassed from March to July over and above the savings they would otherwise have accumulated if income had grown in line with nominal trend GDP growth and the savings rate had remained constant at its pre-pandemic level. Some vulnerable households will surely suffer, but it looks to us like the aggregate savings stash may be able to see the economy through the rest of the year from a consumption perspective (Table 2). That would suggest that the salubrious effect on household wealth from consumer belt tightening and CARES Act transfers may give policymakers some extra leeway to cobble together the next round. Table 2Savings Might Be Able To Plug The Stimulus Gap Markets apparently reached that conclusion themselves, as they now seem to be rooting for the Democrats to take both the Senate and the White House. That outcome would likely postpone the next round of fiscal stimulus until February but would ultimately result in much more aid. The way that stocks swiftly shrugged off their initial disappointment over the termination of the latest stimulus talks suggests that they’re happy to forego a band-aid now for more significant assistance later. The situation is fluid, and Republicans may come around to providing immediate aid that would boost their electoral prospects, but we think markets could survive a fourth quarter without new fiscal stimulus, especially when it would increase the prospects of installing a Congress that shares the Fed's determination to err on the side of doing too much. Delayed Gratification In a now famous experiment, early childhood researchers at Stanford University seated a series of nursery school children at a table with a marshmallow, telling each child s/he could eat it, but if s/he held off until the researcher returned to the room (after an interval of several minutes), s/he would get a second marshmallow. The study’s subsequent conclusion that a child’s ability to delay gratification was an excellent predictor of his/her future success has since been questioned, but investors seem perfectly willing to forego modest stimulus now for a much richer reward in 2021. That perspective applies to the SIFI banks as well. Delaying the provision of additional support to households, businesses and state and local governments may cause a little near-term pain, but it’ll be well worth it to get a super-sized package promising much more long-term gain. The excess savings households built up across the spring and summer are large enough to cover projected consumption shortfalls, though it remains to be seen if they will be willing to part with them while the virus continues to spread. Our overweight recommendation is rooted in our conviction that extraordinary fiscal support will keep the SIFI banks’ ultimate credit losses well below market expectations. No support would force us to close out our recommendation, a skinny package now with uncertain follow-up later would undermine it, and a CARES Act sequel early next year would make it even more robust. A Democratic sweep would pave the way for Congress to match the Fed’s whatever-it-takes approach, greatly relieving the distress of consumers and small businesses as well as those who have lent to them. No one can be sure of how the election dynamics will unfold over the next three weeks, but it would be a mistake to walk away from SIFIs while the Democrats’ prospects are improving. We are therefore staying the course, further heartened by the SIFIs’ bombed-out valuations, which continue to imply gaping credit losses, and their failure to stay down in response to last week’s ostensibly bad news items. Investors would do well to heed our geopolitical strategy team’s admonition that single-party control of the White House and Capitol Hill contains risks that markets are currently overlooking, but our endorsement of the SIFIs has always been a cyclical call, not a tactical one. If Congress is eventually poised to join the Fed in a whatever-it-takes campaign, the SIFIs’ credit losses will be far smaller than feared and their stocks will have a long runway for unwinding their 2020 losses (Chart 8). Chart 8The SIFIs Would Benefit More From Supersized Stimulus Than The Overall Equity Market   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 Casselman, Ben and Tankersley, Jim, "Anxious for a Lifeline, the U.S. Economy Is Left to Sink or Swim," New York Times, accessed October 8, 2020.

Highlights Both public opinion polls and betting markets suggest that Joe Biden will become President, with the Democrats gaining control of the Senate and retaining the House of Representatives. Such a “blue wave” would have mixed effects on the value of the S&P 500. On the one hand, corporate taxes would rise under a Biden administration. On the other hand, trade relations with China would improve. The Democrats would also push for more fiscal stimulus, which the stock market would welcome. The odds of Republicans and Democrats agreeing on a major new stimulus deal before the November elections look increasingly slim. In a blue wave scenario, the Democrats will enact $2.5-to-$3.5 trillion in pandemic relief shortly after Inauguration Day. Joe Biden‘s platform also calls for around 3% of GDP in additional spending on infrastructure, health care, education, climate, housing, and other Democratic priorities. Unlike in late 2016, the Fed is in no mood to raise interest rates. Large-scale fiscal easing will push down the value of the US dollar, while giving bond yields a modest boost. Non-US stocks will outperform their US peers. Value stocks will outperform growth stocks. Looking further out, Republicans will move to the left on economic issues, leaving corporate America with no clear backer among the two major parties. As such, while we are constructive on equities over the next 12 months, we see grave dangers ahead later this decade. Look, Here's The Deal: Joe Biden Is In The Lead With four weeks remaining until the US presidential election, Joe Biden remains on course to become the 46th president of the United States. According to recent public opinion polls, the former vice president leads Donald Trump by 10 percentage points nationwide, and by 4 points in battleground states (Chart 1). Far fewer voters are undecided today compared to 2016. This suggests that there is less scope for President Trump to narrow his deficit in the polls. Betting markets give Biden a 68% chance of prevailing in the race for the White House (Chart 2). They also assign a 67% probability that the Democrats will take control of the Senate and 89% odds that they will retain their majority in the House of Representatives. Chart 1Opinion Polls Favor Biden ... Chart 2.... As Do Betting Markets   Mixed Impact On The S&P 500 What would the market implications of a “blue wave” be? Our sense is that the overall impact on the value of the S&P 500 would be small, largely because some negative repercussions from a Democratic sweep would be offset by positive repercussions. On the negative side, Biden has pledged to raise the corporate income tax rate from 21% to 28%, bringing it halfway back to the 35% rate that prevailed in 2017. He has also promised to introduce a minimum of 15% tax on the income that companies report in their financial statements to shareholders, raise taxes on overseas profits, and lift payroll taxes on households with annual earnings in excess of $400,000. Together, these measures would reduce S&P 500 earnings-per-share by 9%-to-10%. On the positive side, while geopolitical tensions will persist, US trade relations with China would likely improve if Joe Biden were to become the president. Biden has roundly criticized Trump’s tariffs, saying that they are “crushing farmers” and “hitting a lot of American manufacturing… choking it to within an inch of its life.”1 He has pledged to honor multilateral agreements. The World Trade Organization concluded on September 15 that Trump’s tariffs violated international trade rules. This judgement and the desire to turn the page on the Trump era could give Biden the impetus to eventually roll back some of the tariffs. In contrast, having been stricken by what he has called the “China virus,” Trump could take things personally and retaliate with a flurry of new punitive measures.  Fiscal policy would be further loosened in a blue wave scenario, an outcome that the stock market would welcome. Voters would also applaud more pandemic relief. Table 1 shows that 72% of Americans, including the majority of Republicans, support the broader contours of the $2 trillion stimulus package that President Trump has rejected. Table 1Voters Support A New $2 Trillion Coronavirus Stimulus Package By A Fairly Wide Margin At this point, the odds of Republicans and Democrats agreeing on a major new stimulus deal before the November elections look increasingly slim. If Biden wins and the Republicans lose control of the senate, the Democrats would likely enact a stimulus package worth $2.5-to-$3.5 trillion shortly after Inauguration Day on January 20. In addition to pandemic-related stimulus, Joe Biden has called for around 3% of GDP in spending on infrastructure, health care, education, climate, housing, and other Democratic priorities. Only about half of those expenditures would be matched by higher taxes, implying substantial net stimulus for the economy. A Weaker Dollar And Modestly Higher Bond Yields The greenback jumped on Tuesday after President Trump said he is breaking off negotiations with the Democrats over a new stimulus bill. This suggests that the dollar will weaken if fiscal policy is loosened. If that were to happen, it would be different from what transpired following Trump’s victory in 2016 when the dollar strengthened. Why the disconnect between now and then? The answer has to do with the outlook for monetary policy. Back then, the Fed was primed to start raising rates again – it hiked rates eight times beginning in December 2016, ultimately bringing the fed funds rate to 2.5% by end-2018 (Chart 3). This time around, the Fed is firmly on hold, with the vast majority of FOMC members expecting policy rates to stay at rock-bottom levels until at least 2023. This suggests that nominal bond yields will rise less than they did in late 2016. Since inflation expectations will likely move up in response to more stimulative fiscal policy, real yields will rise even less than nominal yields. Over the past 18 months, US real rates have fallen a lot more in relation to rates abroad than what one would have expected based on the fairly modest depreciation in the US dollar (Chart 4). If US real rates remain entrenched deep in negative territory, while the US current account deficit widens further on the back of strong domestic demand, the dollar will continue to weaken. Chart 3Trump Victory Was Followed By Rising Interest Rates Chart 4A Relatively Muted Decline In The Dollar Given The Move In Real Yield Differentials   Favor Non-US And Value Stocks Non-US stocks typically outperform their US peers when the dollar is weakening (Chart 5). This partly stems from the fact that cyclical stocks are overrepresented in stock markets outside of the United States. It also reflects the fact that cash flows denominated in say, euros or yen, are worth more in dollars if the value of the dollar declines. Chart 5A Weaker Dollar Tends To Benefit Cyclical And Non-US Stocks Financial stocks are overrepresented outside the US (Table 2). They are also overrepresented in value indices (Table 3). While a Biden administration would subject the largest US banks to additional regulatory scrutiny, the impact on their bottom lines would likely be small. US banks have been living under the shadows of the Dodd-Frank Act for over a decade. Today, banks operate more as stable utilities than as cavalier casinos. Table 2Financials Are Overrepresented In Ex-US Indexes, While Tech Dominates The US Market Table 3Financials Are Overrepresented In Value, While Tech Dominates Growth Indexes Stronger stimulus-induced growth next year will allow many banks to release some of the hefty provisions against bad loans that they built up this year, while modestly steeper yields curves will boost net interest margins. Tech stocks are overrepresented in growth indices. Better trade relations would help US tech companies, as would a weaker dollar. That said, Joe Biden’s plan to increase taxes on overseas profits would hit tech companies disproportionately hard since the tech sector derives over half its revenue from outside the United States. Stepped up antitrust enforcement and more stringent privacy rules could also weigh on tech profits. On balance, while there are many moving parts, a Democratic sweep would favor non-US equities over US equities, and value stocks over growth stocks. Trumpism Transcends Trump Chart 6Trump Targeted Socially Conservative Voters In 2016, we bucked the consensus view that Hillary Clinton would win the election. On September 30, 2016, we predicted that “Trump will win and the dollar will rally,” noting that “Trump has seen a huge (yuge?) increase in support among working-class whites. If the so-called “likely voters” backing Clinton are, in fact, less likely to turn out at the polls than those backing Trump, this could skew the final outcome in Trump's favor.”2 Right-wing populism was the $1 trillion bill lying on the sidewalk that no mainstream Republican politician seemed eager to pick up. According to the Voter Study Group, only 4% of the US electorate identified as socially liberal and fiscally conservative in 2016, compared to 29% who saw themselves as fiscally liberal and socially conservative (Chart 6). The latter group had no political home, at least until Donald Trump came along. Rather than waxing poetically about small government conservatism – as most establishment Republicans were wont to do – Trump railed against mass immigration, unfair trade deals, rising crime, never-ending wars, and what he described as out-of-control political correctness. While Trump was able to carry out parts of his protectionist agenda, most of his other actions fell well short of what he had promised. His only major legislative achievement was a massive tax cut for corporations and wealthy individuals – something that the vast majority of his base never asked for. The Rich Are Flocking To The Democratic Party How did corporations and wealthy Americans reward Trump for lowering their taxes? By shifting their allegiances towards the Democrats, that’s how. According to the Pew Research Center, households earning more than $150,000 favored Democrats by 20 percentage points during the 2018 Congressional elections, a 13-point jump from 2016. Households earning between $30,000 and $149,999 favored Democrats by only 6 points in 2018. The only other income group that strongly favored Democrats were those earning less than $30,000 per year (Table 4). Table 4Democratic Candidates Had Wide Advantages Among The Highest-And-Lowest Income Voters Chart 7Democratic Districts Have Fared Better Over The Past Decade Other data tell a similar story. Median household income in Democratic congressional districts rose by 13% between 2008 and 2017. It fell by 4% in Republican districts. Today, on average, Republican districts have a median income that is 13% below Democratic districts (Chart 7). Campaign donations have shifted towards the Democrats. The latest monthly fundraising data shows that the Biden campaign received three times more large-dollar contributions in total than the Trump campaign. The nation’s CEOs have not been immune from this transformation. Seventy-seven percent of the business leaders surveyed by the Yale School of Management on September 23 said they would be voting for Joe Biden.3   As elites desert the Republican Party, will the Democratic Party start championing lower taxes and less regulation? That seems unlikely. According to the Voter Study Group, higher-income Democrats are actually more likely to support raising taxes on families earning more than $200,000 per year than lower-income Democrats (83% versus 79%). Among Republicans, the opposite is true: 45% of lower-income Republicans are in favor of raising taxes, compared to only 23% of higher-income Republicans.4  There used to be a time when companies tried to steer clear of the political limelight. This is starting to change. As the relative purchasing power of Democratic voters has risen, many companies have become emboldened to adopt overtly political stances on a variety of hot-button social and cultural issues, even if those stances alienate many conservative customers.  What does this imply for investors? If big business abandons conservative voters, conservative voters will abandon big business. Corporate America will be left with no clear backer among the two major parties. Over the long haul, this is likely to be bad news for equity investors. As such, while we are constructive on equities over the next 12 months, we see grave dangers ahead later this decade.   Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1  “Biden Takes On ‘Trump’s Tariffs’,” The Wall Street Journal, June 12, 2019. 2 Please see Global Investment Strategy Special Report, “Three (New) Controversial Calls,” dated September 30, 2016. 3 “CEO Caucus Survey: Business Leaders Fault Trump Administration on COVID and China,” Yale School of Management, September 24, 2020. 4 Lee Drutman, Vanessa Williamson, Felicia Wong, “On the Money: How Americans’ Economic Views Define — and Defy — Party Lines,” votersstudygroup.org, June 2019. Global Investment Strategy View Matrix Current MacroQuant Model Scores

Highlights President Trump is waffling on fiscal relief. Our constraints-based framework still points to a deal, but the odds have clearly fallen. US and global stocks have rallied despite the fiscal failure. Markets evidently believe stimulus is coming regardless, particularly if Democrats win a blue sweep – our base case election scenario. However, our quantitative election model has boosted Republican odds, flagging a major risk to the blue sweep scenario. Moreover a blue sweep will remove checks and balances on the new administration and thus bring negative surprises that the market is underrating. We maintain our tactical risk-off positioning on the expectation of another leg of election-related volatility. Over a 12-month time horizon we remain invested in reflation plays. Feature Financial markets came around to our “blue sweep” base case for the US election this week. Betting markets shifted sharply after the first presidential debate (Chart 1). Support for Biden surged in national opinion polls while Trump dropped off, albeit to a lesser extent in swing states. Worryingly for the White House, the few polls taken since Trump took ill with COVID-19 on October 2 do not show a sympathy bounce for the president (Chart 2). Chart 1Consensus Forms Around ‘Blue Sweep’ Base Case Chart 2Trump Takes A Dive With Little Time On Clock In a very dangerous turn for the president’s re-election chances, Trump discontinued negotiations with House Democrats over a fiscal relief bill, promising to pass a large new stimulus after the election. Partially walking back those comments, he said he would sign any targeted stimulus bills that Congress sends him in the meantime (such as a new round of $1,200 rebates for households). House Speaker Nancy Pelosi shot down the option of a skinny bill, as we have argued she would. Now they are going back and forth. While the S&P 500 rallied on the news, other reflation trades like US cyclicals, oil, and silver show the risk of premature fiscal tightening (Chart 3). Investors may have to wait until late January until getting a new infusion of government support. Chart 3Lack Of Stimulus Still A Risk To Reflation Trades Chart 4Market Rally Not Based On Blue Sweep Odds True, a fiscal deal could be passed in the lame duck session in November or December, but Republican Senators unwilling to pony up around $500 billion to bail out blue states – when they face a possible wipeout in a historic election – will be even less willing if they lose the election. They will be more hawkish since they will want to pin deficits on the Democrats in future. If Republicans retain control of the Senate despite the latest news – which is possible, especially given the Democratic candidate’s new vulnerability in the North Carolina race due to a sex scandal – then investors have two years of fiscal hawkishness to contend with. Diagram 1 highlights the market implications of this Senate risk. Diagram 1Scenarios For US Election Outcomes And Market Impacts So we need to look elsewhere to explain why the market rallied when odds of a fiscal deal fell. The above reasoning leaves us with the following options: The economy is recovering so robustly that new fiscal stimulus is unnecessary. This is not the view of Federal Reserve Chairman Jay Powell, who all but pleaded for Congress to conclude a deal to secure the recovery, or of other mainstream economists. Stimulus is coming regardless of election outcome. Congress will be forced to support the country during a slump. Debt monetization is the relevant point, even if there is a month-or-two delay in stimulus. Financial markets are cheering the higher odds of a Democratic clean sweep of Congress and the White House since it implies fiscal largesse. The market may already have discounted some of the impending tax hikes over the past month. The second explanation is the best but the third is rapidly becoming the new consensus on Wall Street. Chart 4 suggests there is no connection between the S&P rally and the odds of a blue sweep. With the Fed pursuing “maximum employment” and average inflation targeting, it makes sense that the real mover in the macro landscape has become fiscal policy. Hence the outcome that produces the most proactive fiscal policy is positive for financial markets. A blue sweep is verification of the shift toward debt monetization, which is missing from option two above. The problem is that a blue sweep also brings downside risks. Domestic policy uncertainty will only fall temporarily after the election if there is a blue sweep. Checks and balances will vanish. Eventually Democrats will become overweening in their policy agenda, delivering negative surprises to financial markets. A “New Deal”-style policy agenda would weigh on the corporate earnings outlook. For example, Democrats have refused to forswear removing the filibuster or stacking the Supreme Court, both of which would lie in their power and either of which would enable them to pass an ambitious “New Deal”-style policy agenda that would bring unforeseen consequences – largely in the direction of wealth redistribution away from corporations. Table 1What EPS Hit To Expect? Redistribution would start to correct US social and economic imbalances, improve middle class spending power, and boost consumption – but it would first weigh on the corporate earnings outlook. Net profit growth, which grew by 16% above what was otherwise expected due to the Trump tax cuts (Chart 5), could suffer more than the expected 11% one-off contraction (Table 1), as our US equity strategist Anastasios Avgeriou has shown. Chart 5Partial Repeal Of Trump Tax Cut Bad For Earnings New proposals will also emerge that the market is not taking account of. To take just the latest example, former Fed Chair Janet Yellen recently stated that the US could adopt a $40 per ton tax on carbon emissions under a Biden administration.1This proposal is not part of Biden’s official plan, hence not priced by markets along with Biden’s expected tax hikes (Table 2). But control of the Senate would make it a real option given Biden’s ambitious climate goals. Table 2Biden Needs Senate To Raise Taxes Consumer confidence in the US will suffer from political polarization. Recall that in 2016, the economy was in fine shape but Republicans did not believe it, weighing down the average until President Trump won the election. Today the economy is in a slump but Republicans may not recognize the bad news until President Trump loses. Democrats, for their part, will suddenly abandon their doom and gloom if Biden wins the election. Applying a comparable partisan shock to consumer confidence for 2021 would suggest that overall confidence will be lackluster (Chart 6). At least this is true until the passage of new stimulus and an advancing recovery outweigh the partisan effect. Chart 6Biden Will Not Recreate Trump Confidence Boost A similar case can be made that small business sentiment will worsen in a blue sweep scenario. Fear of higher regulation and taxes will spike and weigh on animal spirits (Chart 7). Historically the first year after an election sees smaller equity upside and larger downside with unified government as opposed to divided government (Chart 8). If this time is different it is because of the sea change in the US to embrace debt monetization. But that sea change occurred under a Republican administration and is likely to persist due to the output gap. Chart 7SMEs Will Fear Blue Wave Chart 8Stock Market Profile Fits Divided Government, Which Has More Upside A Republican Senate under a Biden presidency would bring higher fiscal risk, but the truth is that neither trade war risks nor corporate taxes would go up, yet Republicans would eventually have to concede to spending bills (just as Democrats did under Trump). Hence divided government is not as negative as it is made out to be as it contains mostly known quantities, whereas a blue sweep would lead the US in a redistributionist direction that is initially disruptive. Relative to divided government, it would be positive for aggregate demand but negative for corporate earnings. Bottom Line: US and global equities will rise over the coming 12 months on the back of eventual US stimulus and ongoing global stimulus. A blue sweep is our base case election outcome but it brings mixed results. Global equities would benefit more than US equities which will face a spike in taxes and regulation. US equities will still rise but they face more upside under a divided government in which Republicans halt tax hikes. Supreme Court Confirmation Looms Of course, a blue sweep outcome is not guaranteed. Indeed the fact that it is now consensus makes us nervous, as there are still 26 days until the election. Our quantitative election model gives the Republicans a 49% chance of winning the White House on the back of the V-shaped recovery in the states, which delivers Florida to the Republican camp, leaving Trump with 259 Electoral College votes (Chart 9). This probability is well above our subjective 35% judgment and the new market consensus on Trump’s odds. Chart 9Quant Election Model Gives Trump 259 Electoral College Votes And 49% Odds Of Victory Trump’s decision to break off the fiscal talks probably sealed his doom, but we would still maintain that a correct reading of the various political and economic constraints point toward a fiscal deal. Hence there is still some chance that a deal will be snatched from the jaws of defeat. At that point we would upgrade Trump’s chances to something closer to our election model. But it would not be bullish, as the market would need to price a higher risk of trade war. Subjectively Trump has a 35% chance of re-election, but our quant model flags a risk to this view. The market also must contend with COVID-19 risks (Charts 10A and 10B). Stimulus is necessary to prevent COVID-19 risks from hitting the market, as more distancing will be necessary in states where cases are rising. Chart 10ACOVID-19 Cases Rising Chart 10BCOVID-19 Hits Swing States The reason President Trump cut short the fiscal talks was to ensure that they would not interfere with the Senate’s ability to confirm his Supreme Court nominee Amy Coney Barrett. The confirmation hearings will go up for a floor vote in the Senate sometime around October 23, ensuring a massive constitutional brawl just ahead of the election. The dollar has more upside if Trump wins. Chart 11Risk: Trump Comeback Boosts The Greenback We do not expect this showdown to change the game, since boosting turnout among Trump’s conservative base will be insufficient in an election fought in the face of major national shocks that affect the median voter (pandemic, recession, social unrest). This election is already going to be a high turnout election – preliminary information suggests it could be the highest since 1908 at 65% of eligible voters2 — which means that Republicans will suffer from the leftward tilt of the median voter. However, if Trump’s polling improves between now and then – and if mFarkets inexplicably rally all month despite the withdrawal of fiscal support – then we could be surprised. Our quantitative model provides a basis for believing that Republicans are now underrated. This implies that the dollar has more upside in the near term as the risk of a contested election and/or a Trump second term, and hence another shock to the US political system and global trading system, must still be guarded against (Chart 11). Investment Takeaways The market faces near-term downside risk and volatility until the US fiscal support is restored. This is particularly the case as long as COVID-19 cases are not subdued. The rising odds of a blue sweep, our base case, is not sufficient to dampen volatility over the coming month. Depending on the election results, volatility will subside in November or January at the latest. Not only is a contested election a non-negligible risk – based on our quant model’s reading – but also President Trump will remain in office till January 20 and could easily dish out some negative surprises, particularly on China relations. Hence we are maintaining our tactical risk-off and safe-haven trades: long US treasuries, Japanese yen, US health care equipment stocks (which will outperform the overall sector amid the Democratic regulatory threat), and EUR-GBP volatility. Over the 12-month time frame, we have little doubt that the US adoption of debt monetization, in keeping with Chinese and global stimulus, will push equities and risky assets higher. The reflation trade remains the core of our strategic portfolio. Global stocks should outperform under a Biden presidency. Biden will be positive for global trade ex-China, as both US electoral politics and grand strategy will drive any administration to take a hard line on China, though Biden will not wield tariffs like Trump.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1 See Matthew Green, "U.S. could adopt carbon tax under a Biden presidency, ex-Fed Chair Yellen says," Reuters, October 8, 2020, reuters.com; see also Group of Thirty, "Mainstreaming The Transition To A Net-Zero Economy," October 2020, group30.org. 2 See John Whitesides, "More than 4 million Americans have already voted, suggesting record turnout," Reuters, October 6, 2020, reuters.com.