Economy

Highlights Chart 1Spending Held Up In August The bulk of the CARES act’s income support provisions expired at the end of July and Congress has still not reached consensus on a follow-up package. Unsurprisingly, consumer spending responded by growing much more slowly in August, but at least so far, absolute calamity has been avoided (Chart 1). The failure of consumer spending to collapse has caused some, like St. Louis Fed President Jim Bullard, to question whether more stimulus is even necessary.1 We are less optimistic. The most recent personal income report shows that households still received $867 billion (annualized) of CARES act stimulus in August and the recovery in consumer confidence has been tepid at best (see page 12), suggesting that the savings rate will not drop quickly. We expect Congress to ultimately deliver more fiscal support, which will lead to a bear-steepening Treasury curve and spread product outperformance on a 6-12 month horizon. But continued brinkmanship warrants a more cautious near-term stance. Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment grade corporate bonds underperformed the duration-equivalent Treasury index by 40 basis points in September, dragging year-to-date excess returns down to -394 bps. Last month’s sell-off caused some value to return to the sector. The overall index’s 12-month breakeven spread is back up to its 31st percentile since 1995 and the equivalent Baa spread is at its 38th percentile (Chart 2). Both levels appear somewhat expensive at first blush. However, considering the strong tailwinds from the Fed’s extraordinarily accommodative interest rate policy and emergency lending facilities, we see a lot of room for further spread tightening. Corporate bond issuance was up in August, but nowhere near the extreme levels seen in the spring (panel 4). The fact that the Financing Gap – the difference between capital expenditures and retained earnings – turned negative in the second quarter suggests that firms have sufficient cash to cover their investment needs, and that further debt issuance is unnecessary (bottom panel). At the sector level, we continue to recommend overweight allocations to subordinate bank bonds,2 Healthcare and Energy bonds.3 We also advise underweight allocations to Technology4 and Pharmaceutical bonds.5   Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Table 3BCorporate Sector Risk Vs. Reward* High-Yield: Neutral Chart 3High-Yield Market Overview High-Yield underperformed the duration-equivalent Treasury index by 107 basis points in September, dragging year-to-date excess returns down to -455 bps. Oddly, Ba-rated was the worst performing credit tier on the month and the lowest-rated (Caa & below) credits actually beat the Treasury benchmark by 42 bps. As we wrote last week, this suggests that there remains scope for low-rated junk to sell off in the event of a shock to economic growth expectations.6 Such a development could arise if Congress fails to pass a new stimulus bill. In terms of value, if we assume a 25% recovery rate on defaulted debt and a minimum required spread of 150 bps in excess of default losses, then the High-Yield index is priced for a default rate of 4.8% during the next 12 months (Chart 3). Such a large drop in the default rate would necessitate a rapid economic recovery and we are not yet confident that such a recovery can be achieved. Job Cut Announcements – a variable that correlates tightly with the default rate – ticked higher in September and they remain well above pre-COVID levels (bottom panel). At the sector level, we advise overweight allocations to high-yield Technology7 and Energy bonds.8 We are underweight the Healthcare and Pharmaceutical sectors.9   MBS: Underweight Chart 4MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 14 basis points in September, dragging year-to-date excess returns down to -51 bps. The conventional 30-year MBS index option-adjusted spread (OAS) widened 4 bps on the month, and it continues to trade at a premium compared to other similarly risky sectors. The MBS index OAS is currently 80 bps. This compares to an OAS of 79 bps for Aa-rated corporate bonds, 66 bps for Agency CMBS and 30 bps for Aaa-rated consumer ABS. Despite the OAS advantage, we are concerned that the elevated primary mortgage spread is a warning that refinancing risk could flare during the next few months (Chart 4). Even if Treasury yields are unchanged, a further 50 bps drop in the mortgage rate due to spread compression cannot be ruled out. Such a move would lead to a significant increase in prepayment losses. With that in mind, we are concerned about the low level of expected prepayment losses (option cost) priced into the MBS index (panel 3). A fourth quarter refi wave would undoubtedly send that option cost higher, eating into the returns implied by the OAS. The recent spike in the mortgage delinquency rate does not pose a near-term risk to spreads as it is being driven by households that have been granted forbearance from the federal government (panel 4). The risk for MBS holders only comes into play if many households are unable to resume their regular mortgage payments when the forbearance period expires early next year. But even in that case, further government intervention to either support household incomes or extend the forbearance period would mitigate the risk.   Government-Related: Underweight Chart 5Government-Related Market Overview The Government-Related index underperformed the duration-equivalent Treasury index by 18 basis points in September, dragging year-to-date excess returns down to -313 bps. Sovereign debt underperformed duration-equivalent Treasuries by 99 bps on the month, dragging year-to-date excess returns down to -562 bps. Foreign Agencies underperformed the Treasury benchmark by 13 bps in September, dragging year-to-date excess returns down to -706 bps. Local Authority debt underperformed Treasuries by 4 bps in September, dragging year-to-date excess returns down to -341 bps. Domestic Agency bonds outperformed by 15 bps, bringing year-to-date excess returns up to -39 bps. Supranationals underperformed by 3 bps, dragging year-to-date excess returns down to -12 bps. US dollar weakness is usually a boon for Emerging Market (EM) Sovereign and Foreign Agency returns. However, most of this year’s dollar depreciation has occurred against other Developed Market currencies, not EMs (Chart 5). Added to that, dollar weakness against all trading partners helps US corporate sector profits, and Baa-rated corporate bonds continue to offer a spread pick-up versus EM Sovereigns (panel 4). We looked at EM Sovereign valuation on a country-by-country basis two weeks ago and concluded that Mexican and Russian Sovereigns offer the most compelling risk/reward trade-offs relative to the US corporate sector.10 Of those two countries, Mexican debt offers the best opportunity as the peso is on an appreciating trend versus the dollar. The Russian Ruble has been depreciating versus the dollar, and is vulnerable in the case of a Democratic sweep in November.     Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal bonds underperformed the duration-equivalent Treasury index by 12 basis points in September, dragging year-to-date excess returns down to -503 bps (before adjusting for the tax advantage). Short-dated municipal bond spreads versus Treasuries were stable in September, but long-maturity spreads widened. The entire Aaa muni curve remains above the Treasury curve, despite municipal debt’s tax-exempt status (Chart 6). Municipal bonds also remain attractively priced relative to corporate bonds across the entire investment grade credit spectrum. Aaa munis offer more after-tax yield than Aaa corporates for investors facing an effective tax rate above 15%. The breakeven effective tax rates for Aa, A and Baa-rated munis are 11%, 13% and 17%, respectively. Extremely attractive valuation causes us to stick with our municipal bond overweight, even as state and local governments face a credit crunch. State & local government payrolls shrank in September and, without federal support, cutbacks will no doubt continue (bottom panel). However, we expect that the combination of austerity measures and all-time high State Rainy Day Fund balances will be sufficient to prevent a wave of municipal ratings downgrades. Treasury Curve: Buy 5-Year Bullet Versus 2/10 Barbell Chart 7Treasury Yield Curve Overview The Treasury curve bull-flattened somewhat in September, though even the 30-year yield only fell 3 bps on the month. The 2/10 and 5/30 Treasury slopes flattened 2 bps and 3 bps, reaching 56 bps and 118 bps, respectively. One easy way to think about nominal Treasury yields is as the market’s expectation of future changes in the fed funds rate.11 With that in mind, the Fed’s recent shift toward a regime of average inflation targeting will likely lead to nominal yield curve steepening on a 6-12 month horizon. That is, the Fed will keep a firm grip on the front-end of the curve but long-maturity yields will rise as investors price-in eventual Fed tightening in response to higher inflation. We recommend positioning for this outcome by owning the 5-year Treasury note and shorting a duration-matched barbell consisting of the 2-year and 10-year notes. This position is designed to profit from 2/10 curve steepening. We expect the economic recovery to be maintained over the next 6-12 months, allowing this steepening to play out. However, we also see near-term risks related to the passage of a follow-up stimulus bill. Those not already invested in steepeners are advised to wait until a deal is struck. Valuation is a concern with our recommended curve steepener, as the 5-year yield is below the yield on the duration-matched 2/10 barbell (Chart 7). However, the 5-year yield looked much more expensive during the last zero-lower-bound period between 2010 and 2013 (bottom 2 panels). We anticipate a return to similar valuation levels. TIPS: Overweight Chart 8TIPS Market Overview TIPS underperformed the duration-equivalent nominal Treasury index by 54 basis points in September, dragging year-to-date excess returns down to -130 bps. The 10-year and 5-year/5-year forward TIPS breakeven inflation rates fell 18 bps and 16 bps on the month. They currently sit at 1.65% and 1.83%, respectively. Core CPI printed a strong +0.4% in August and the large divergence between core and trimmed mean inflation measures leads us to conclude that inflation will continue to rise quickly during the next few months (Chart 8). For this reason, we recommend maintaining an overweight allocation to TIPS versus nominal Treasuries for the time being, even though the 10-year TIPS breakeven rate is no longer cheap according to our Adaptive Expectations Model (panel 2).12 We could see inflation pressures moderating once core and trimmed mean inflation measures re-converge.13 This could give us an opportunity to reduce our exposure to TIPS sometime later this year. We also recommend holding real yield curve steepeners and inflation curve flatteners. With the Fed now officially targeting an overshoot of its 2% inflation goal, we would expect the cost of 2-year inflation protection to rise above the cost of 10-year inflation protection (panel 4). With the Fed also exerting more control over short-dated nominal yields than over long-term ones, this means that short-maturity real yields will come under downward pressure relative to the long end (bottom panel). ABS: Overweight Chart 9ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 10 basis points in September, bringing year-to-date excess returns up to +63 bps. Aaa-rated ABS outperformed the Treasury benchmark by 7 bps on the month, bringing year-to-date excess returns up to +53 bps. Non-Aaa ABS outperformed by 32 bps, bringing year-to-date excess returns up to +128 bps. Aaa ABS are a high conviction overweight, given that spreads remain elevated compared to historical levels and that the sector benefits from Fed support through the Term Asset-Backed Loan Facility (TALF). However, spreads are even more attractive in non-Aaa ABS (Chart 9) and we recommend owning those securities as well. This is despite the fact that only Aaa-rated bonds are eligible for TALF. We explained our rationale for owning non-Aaa consumer ABS in a June report.14 We noted that stimulus received from the CARES act caused disposable income to increase significantly between February and July. Then, faced with fewer spending opportunities, households used much of that windfall to pay down consumer debt (panel 4). Granted, further income support from fiscal policymakers is needed now that the CARES act’s enhanced unemployment benefits have expired. But given the substantial boost to savings that has already occurred, we are confident that more stimulus will arrive in time to prevent a wave of consumer bankruptcies. Non-Agency CMBS: Neutral Chart 10CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 63 basis points in September, bringing year-to-date excess returns up to -259 bps. Aaa Non-Agency CMBS outperformed Treasuries by 46 bps on the month, bringing year-to-date excess returns up to -63 bps. Non-Aaa Non-Agency CMBS outperformed by 119 bps, bringing year-to-date excess returns up to -803 bps (Chart 10). We continue to recommend an overweight allocation to Aaa Non-Agency CMBS and an underweight allocation to Non-Aaa CMBS. Our reasoning is simple. Aaa CMBS are eligible for TALF, meaning that spreads can still tighten even as the hardship in commercial real estate continues. Without Fed support, Non-Aaa CMBS will struggle to deal with a climbing delinquency rate (panel 3).15 Agency CMBS: Overweight Agency CMBS underperformed the duration-equivalent Treasury index by 9 basis points in September, dragging year-to-date excess returns down to -12 bps. The average index spread widened 2 bps on the month to 68 bps, well above typical historical levels (bottom panel). The Fed is supporting the Agency CMBS market by directly purchasing the securities as part of its Agency MBS purchase program. The combination of strong Fed support and elevated spreads makes the sector a high conviction overweight. Appendix A: Buy What The Fed Is Buying The Fed rolled out a number of aggressive lending facilities on March 23. These facilities focused on different specific sectors of the US bond market. The fact that the Fed has decided to support some parts of the market and not others has caused some traditional bond market correlations to break down. It has also led us to adopt of a strategy of “Buy What The Fed Is Buying”. That is, we favor those sectors that offer attractive spreads and that benefit from Fed support. The below Table tracks the performance of different bond sectors since the March 23 announcement. We will use this to monitor bond market correlations and evaluate our strategy’s success. Table Performance Since March 23 Announcement Of Emergency Fed Facilities Appendix B: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of October 2nd, 2020) Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 5Butterfly Strategy Valuation: Standardized Residuals (As Of October 2nd, 2020) Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of 63 bps in the 5 over 2/10 cell means that we would only expect the 5-year to outperform the 2/10 if the 2/10 slope steepens by more than 63 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) Appendix C: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Chart 11Excess Return Bond Map (As Of October 2nd, 2020)   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1https://www.bloomberg.com/news/articles/2020-09-30/fed-s-bullard-says-debate-on-fiscal-aid-can-be-delayed-to-2021?sref=Ij5V3tFi 2 Please see US Bond Strategy Weekly Report, “The Case Against The Money Supply”, dated June 30, 2020, available at usbs.bcaresearch.com 3 Please see US Bond Strategy Special Report, “The Outlook For Energy Bonds Part 1: A Model Of Energy Bond Excess Returns”, dated July 14, 2020 and US Bond Strategy Special Report, “The Outlook For Energy Bonds Part 2: Buy The Dip In High-Yield Energy”, dated July 21, 2020, available at usbs.bcaresearch.com 4 Please see US Bond Strategy Weekly Report, “Take A Look At High-Yield Technology Bonds”, dated June 23, 2020, available at usbs.bcaresearch.com 5 Please see US Bond Strategy Weekly Report, “Assessing Healthcare & Pharma Bonds In A Pandemic”, dated June 9, 2020, available at usbs.bcaresearch.com 6 Please see US Bond Strategy Weekly Report, “Out Of Bullets”, dated September 29, 2020, available at usbs.bcaresearch.com 7 Please see US Bond Strategy Weekly Report, “Take A Look At High-Yield Technology Bonds”, dated June 23, 2020, available at usbs.bcaresearch.com 8 Please see US Bond Strategy Special Report, “The Outlook For Energy Bonds Part 1: A Model Of Energy Bond Excess Returns”, dated July 14, 2020 and US Bond Strategy Special Report, “The Outlook For Energy Bonds Part 2: Buy The Dip In High-Yield Energy”, dated July 21, 2020, available at usbs.bcaresearch.com 9 Please see US Bond Strategy Weekly Report, “Assessing Healthcare & Pharma Bonds In A Pandemic”, dated June 9, 2020, available at usbs.bcaresearch.com 10 Please see US Bond Strategy Weekly Report, “Trading Bonds In A Dollar Bear Market”, dated September 22, 2020, available at usbs.bcaresearch.com 11 For more details on this forecasting framework please see US Bond Strategy Weekly Report, “Positioning For Reflation And Avoiding Deflation”, dated August 11, 2020, available at usbs.bcaresearch.com 12 For more details on our model please see US Bond Strategy Weekly Report, “How Are Inflation Expectations Adapting?”, dated February 11, 2020, available at usbs.bcaresearch.com 13 Please see US Bond Strategy Weekly Report, “Positioning For Reflation And Avoiding Deflation”, dated August 11, 2020, available at usbs.bcaresearch.com 14 Please see US Bond Strategy Weekly Report, “No Holding Back”, dated June 16, 2020, available at usbs.bcaresearch.com 15 For a deeper dive into the outlook for US commercial real estate please see Global Investment Strategy Special Report, “Working From Home, Urban Flight, And Commercial Real Estate Loans: How Bad Can Things Get?”, dated August 28, 2020, available at gis.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation

Highlights Portfolio Strategy Buybacks are down but not out. While financials have been weighing heavily on the S&P buybacks index, we would not write off the artificial engineering of higher EPS via equity retirement, especially in a world of ZIRP likely for the next five-to-seven years. COVID-19 has permanently scarred demand while non-residential construction is elevated. This combination will deflate commercial real estate (CRE) prices further, which risks unraveling a CRE debt deflation spiral. Continue to avoid the S&P real estate sector. Recent Changes There are no changes to our portfolio this week. Table 1 Feature Equities sunk late last week, as diminishing chances of fiscal easing coupled with news that the POTUS and the First Lady tested positive for COVID-19 more than offset buyers taking advantage of oversold conditions. Our sense is that the SPX will bounce around key moving averages during October (Chart 1), until the election outcome breaks the stalemate. In the back half of the month, banks also kick-start Q3 earnings season, which is important because banks’ wellbeing rests on a fresh stimulus bill. Peering over at the bond market is instructive in order to try to make sense of these crosscurrents. Two weeks ago, we first highlighted that the corporate bond market was waving a yellow flag. The selloff in the LQD ETF will continue to weigh on equities (top panel, Chart 2) and corroborates our view that the Fed is now a bystander, which puts added pressure on fiscal authorities to act. It is not a coincidence that the Fed’s balance sheet impulse peaked first and soon thereafter so did the LQD. Chart 1Trapped Between Moving Averages Worrisomely, the total return stock-to-bond ratio failed to break out to fresh all-time highs and has likely formed a head and shoulders pattern. The implication is that stocks are not out of the woods yet (bottom panel, Chart 2). Chart 2Bond Market… Junk spreads are also firing a warning shot. The high-yield option-adjusted spread (OAS) was in a tight range between 2017 and 2019. Then spreads exploded higher because of the pandemic. However, unlike the SPX making new all-time highs, junk spreads failed to make new all-time lows and more importantly have not settled back down to the 2017-2019 range (middle panel, Chart 3). The VIX index is following a similar pattern to the high-yield OAS, which is quite unnerving for equity bulls. Put differently, still elevated VIX futures in the 30s warn that in the near-term more turbulence lies ahead for the SPX (bottom panel, Chart 3). As a reminder, we first recommended buying the December VIX futures on July 27 in a joined Special Report with our sister Geopolitical Strategy service, and we continue to recommend such a hedge to long equity exposure. Chart 3…And VIX Signal Trouble For Stocks Bye-Bye Buybacks? According to the flow of funds data, a large dichotomy has taken shape between corporate debt issuance and net equity retirement. Up to very recently, the two moved in tandem. But now, the pandemic has caused a knee jerk reaction in non-financial corporate businesses that are tapping their credit lines and issuing debt at a breakneck pace. Worryingly, very little of these funds are used for equity retirement, which is a big break from recent past behavior (Chart 4). Not only does the Fed’s flow of funds data signal that buybacks have nearly ground to a halt, but also Standard and Poor’s data show that SPX buybacks collapsed to $88bn in Q2, from roughly $200bn in Q1. Crudely put, SPX buybacks have fallen by a whopping 67% quarter-over-quarter. Such a corporate buyer’s strike is negative for the near-term prospects of the S&P 500 (top panel, Chart 5). Chart 4Unsustainable Dichotomy Chart 5Buybacks Are Down… True, buybacks have come under intense scrutiny especially for bailed out sectors of the economy, nevertheless, the V-shaped economic recovery all but guarantees a rebound in depressed share buybacks sometime in 2021 (Chart 6). While our conservative $125/quarter buyback estimate proved overly optimistic in Q2, we maintain such an estimate for the next year (which it is the past decade’s average). On a cyclical 9-12 month horizon we have high conviction that SPX profits will return close to trend EPS of $162, and recovering CEO confidence should pave the way for a resumption of shareholder friendly activities, including equity retirement (middle panel, Chart 6). Drilling deeper beneath the surface is revealing. When we disaggregate the headline buybacks number into GICS1 sectors, we observe that once again the tech titans (comprising the S&P technology and the S&P communication services indexes) are doing all the heavy lifting accounting for 70% of the overall number (Chart 7). Q2 was the first time in recent memory where tech accounts for more buybacks that all the other sectors put together (bottom panel, Chart 5)! Chart 6But Not Out Chart 7GICS1 Sector Buyback Breakdown: Q1 & Q2 Chart 8 shows the ebbs and flows of sectoral SPX buybacks since late-2006. In order for our estimate to prove accurate in 2021, the Fed will have to allow financials to resume their buybacks, which collapsed from over $45bn in Q1 to just above $5bn in Q2 (Chart 7). Chart 8GICS1 Sector Buyback Breakdown: An Historical Perspective With regard to investable buyback indexes, financials dominate both the S&P 500 buyback index (Chart 9) and the NASDAQ US buyback achievers index. However, if the Fed does not relent and sustains a tight noose around banks’ shareholder friendly activities next year, then this index composition will change significantly in the 2021 rebalancing. While financials have been weighing heavily on the S&P 500 buyback index, its equal weighting methodology also partially explains why it has trailed the market cap weighted SPX by roughly 20% year-to-date (YTD). Nevertheless, in the long-haul buyback achievers come out on top. In fact, the S&P 500 buyback index has more than doubled the SPX’s return since the turn of the century (top panel, Chart 10) and such a portfolio tilt typically manages to shake off recession-related wobbles. Chart 9S&P 500 Buyback Index Sector Composition Bottom Line: We would not write off the artificial engineering of higher EPS via equity retirement, especially in a world where ZIRP is likely for the next five-to-seven years. Already buyback announcements have troughed (bottom panel, Chart 10) and factors are falling into place for a sizable resumption of buybacks in 2021 as the economy stands back on its own feet. Chart 10Buyback Comeback? Is CRE The Next Shoe To Drop? Last December in our 2020 Key Views report, the S&P real estate sector was one of our high-conviction underweight sectors for the year. However, frenetic trading in March compelled us to close out all our high-conviction trades and cement average relative gains of 3.4% in our eight high-conviction calls including 1.1% in the high-yielding S&P real estate sector. Nevertheless, we remained bearish on the prospects of this sector levered to commercial real estate (CRE) because the aftermath of the pandemic would leave this niche sector badly bruised. Already, YTD relative share prices are down 10%, and were it not for the tech/communications-laden – tower and digital storage – REITs that the S&P specialized REITs subgroup houses, then the relative underperformance would sink to 25% (Chart 11). In other words, the resilience of these mega cap tech-related REITs masks the carnage ongoing beneath the surface. Chart 11Specialized REITs Masking True Picture Charts 12 & 13 break down the YTD relative performance of the real estate sector’s sub-groups and it is clear that most REITs categories are in distress with the exception of specialized and industrial REITs. Chart 12REITs Are Weak… Chart 13…Across The Board Not only will the long-term negative ramifications due to the pandemic scar office-, apartment- and mall-exposed REITs, but also uncertainty surrounding the fiscal stimulus bill risks a fresh down-leg in the S&P real estate sector. According to the latest Q2 Fed release, CRE delinquencies are on the rise (not shown) and CRE prices are on the verge of contracting (bottom panel, Chart 14). A fresh stimulus bill could transfer funds directly to unemployed consumers and to cash-strapped business owners and extend the eviction/foreclosure moratorium as well as mortgage forbearance agreements. Absent this help, CRE will remain distressed. Refinancing risk is another threat that could cause a gap down in CRE prices, as bankers remain unwilling to dole out CRE loans despite a collapse in interest rates. Once the underlying asset gets repriced lower, then the debt related house of cards comes crumbling down (top & middle panels, Chart 14). Recent news that “Cerberus repackaged near junk rated CMBS paper into a AAA rated CDO” (effectively creating a AAA security out of thin air) is eerily reminiscent of the subprime crisis in 2008 and a stark warning that CRE excesses have yet to fully flush out.1 Chart 14More Pain Looms Chart 15Deflation Warning The downdraft in demand for CRE is already showing up in declining occupancy rates (Chart 15). We fear that there are more skeletons hiding in the closet. First the “amazonification” of the economy is still wreaking havoc on retail/shopping center REITs. Second the new “work from home” reality is putting strains on office landlords. Lastly, lodging will remain in distress at least until a vaccine is readily available. As a result, REITs cash flow growth will remain elusive, which will further dampen prospects of a recovery in the relative share price ratio (Chart 15). Finally, the relentless increase in supply is not showing any signs of abating. Non-residential construction is hovering near previous highs, and multi-family housing starts are perched close to prior cyclical peaks of 400K/annum (Chart 16). Undoubtedly, this excess supply backdrop will continue to weigh on CRE prices. Chart 16Mind The Supply Overhang Chart 17Valuations Have Yet To Fully Flush Out Despite all this dour news and near all-time lows in relative performance, valuations have only corrected down to the neutral zone, leaving ample room for an undershoot phase (middle panel, Chart 17). Encouragingly, persistent recent selling has pushed our relative Technical Indicator deep in oversold territory signaling that a near-term reflex rebound may be forthcoming. Netting it all out, COVID-19 has permanently scarred demand while non-residential construction is elevated. This combination will deflate commercial real estate (CRE) prices further, which risks unraveling a CRE debt deflation spiral. Continue to avoid the S&P real estate sector. Bottom Line: Stay underweight the S&P real estate sector. The ticker symbols for the stocks in this index are: BLBG: S5RLST-AMT, EQIX, PLD, CCI, DLR, PSA, SBAC, AVB, WELL, ARE, O, SPG, WY, CBRE, EQR, ESS, FRT, PEAK, VTR, BXP, DRE, EXR, MAA, UDR, AIV, HST, IRM, KIM, REG, SLG, VNO.   Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com       Footnotes 1     https://www.bloomberg.com/news/articles/2020-10-01/cerberus-is-repackaging-near-junk-cmbs-into-top-rated-securities   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 Aggregate household net worth reached an all-time high in the second quarter and likely rose further in the third quarter: The first quarter’s record quarter-on-quarter decline was completely unwound in the second quarter and resurgent financial and housing markets should have pushed wealth higher in the third quarter. Rising household net worth bodes well for consumption: Increases in household net worth lead increases in personal consumption expenditures by one or two quarters. Spending will roll over at some point in the fourth quarter without a new round of fiscal aid, but households retain some CARES Act support in the form of an enormous buildup of savings. Households do not appear to be overinvested in equities: Aggregate equity allocations are elevated relative to history, but the longstanding trend favoring corporate heft and consolidation may skew comparisons across time. Feature Chart 1A Ginormous Fiscal Response The Fed’s latest quarterly Flow of Funds report reinforced the view that the pandemic provided households with an opportunity to shore up their financial positions. Shock-and-awe monetary and fiscal stimulus (Chart 1), combined with an inability to spend at shuttered businesses, turned out to be a heady brew for household finances. Surging financial markets boosted the value of wealthier households’ investment portfolios; a tidal wave of fiscal transfers produced an income surge for households in the lower half of the distribution; consumer confidence was dented by the myriad uncertainties posed by COVID-19, encouraging increased savings; and even those inclined to spend some of their windfall were hindered by the difficulty of finding an outlet for doing so. Testifying to the roller coaster nature of 2020, household net worth made a new all-time high at the end of the second quarter, thanks to a record three-standard-deviation quarter-over-quarter gain that unwound the first quarter’s record four-standard-deviation decline (Chart 2). Household net worth should make another new high on September 30, given the S&P 500’s 8.5% third-quarter advance, tighter corporate bond spreads, rising home prices and still-surging savings. It is unclear when or even if the wealth increase will translate to more consumption, given that spending ultimately comes down to fickle preferences, though we are confident that income gains will aid credit performance, helping the economy dodge a vicious circle of defaults and bankruptcies. Chart 2Yet Another 2020 Extreme Wealth And Consumption There is no assurance that the formidable amount of wealth that households have amassed since the first quarter via a combination of fiscal transfers and investment gains will be directed to consumption. It is entirely possible that the savings rate will remain elevated for an extended period. Uncertainty still runs rampant for businesses disrupted by the pandemic and their employees, vendors, landlords and lenders. The travel, hospitality, food service, entertainment and real estate industries have a broad reach and their fates will ripple across much of the rest of the economy. There is a clear relationship between wealth gains and spending gains, ... In the past, however, smoothed year-over-year changes in household net worth have reliably correlated with smoothed year-over-year changes in personal consumption expenditures (PCE). The simple regression equation linking PCE and household net worth moves is nearly identical whether the lag between the two series is one or two quarters, as is the share of PCE’s variability that is explained by changes in wealth (r-squared). We show the scatterplot of household net worth growth (x-axis) lagged by two quarters with PCE growth (y-axis) in Chart 3, which reveals how rarely the four-quarter moving average of nominal PCE fails to grow from one year to the next. Every previous smoothed consumption decline occurred in the wake of the GFC in 2009-10 after having been preceded by significant wealth declines. At 6.6 percentage points below the best-fit regression line, the current observation is a notable outlier and suggests that households have stored up considerable dry powder. Chart 3Wealth Gains Typically Lead To Spending Gains When and if that dry powder will be deployed is a mystery. The 62-year history of the savings rate, which is simply savings divided by disposable, or after-tax, income does not suggest a powerful pull toward mean reversion. Rather, the series has been characterized by three long waves: a steadily, albeit modestly increasing trend from inception until the mid-seventies; an extended decline well into the aughts; and a post-GFC increase back to the levels that prevailed in the late-eighties and early-nineties (Chart 4). Regardless of the savings rate’s ultimate normalized range, we view the pandemic levels as an anomaly. Once households become more comfortable inhabiting a post-COVID world, income hoarded this spring and summer will provide a tailwind for consumption. ... but it may not take hold until the savings rate, which rose to record levels in the spring, settles back into a normalized range. Chart 4It Is Not Clear When Or Where The Savings Rate Will Normalize Bottom Line: Capricious sentiment will ultimately dictate when households deploy their pandemic savings, but there is a clear relationship between wealth gains and consumption. The second quarter Flow of Funds report buttresses the conclusion from the monthly personal income data that household wealth has benefited from pandemic policies so far. Are Households Overinvested In Equities? The Flow of Funds report also provides insight into the composition of aggregate household investment, grouping financial assets into five broad categories: Deposits (cash), Fixed Income, Corporate Equity, Life Insurance and Pensions, and Equity in Noncorporate Businesses. (The remainder of household wealth is concentrated in equity in homes and the property inside them.) Leaving out the value of life insurance and pension benefits, we reviewed the financial asset data for signs that households may have gotten over their skis in terms of their aggregate equity allocation. If they have, it might indicate that stocks are ripe for a reversal. Relative to the Flow of Funds’ 70-year history, the aggregate allocation to cash is a little low (Chart 5, top panel). With deposits sure to generate negative real income in a ZIRP world, however, a low cash allocation is rational and follows the historical pattern of moving with short rates (Chart 5, bottom panel). The fixed income allocation is lower, though not extreme (Chart 6, top panel). Households may tend to be backward-looking when allocating between stocks and bonds (Chart 6, bottom panel), but the currently elevated equity risk premium provides forward-looking support for preferring the former. Chart 5Cash Balances Were Low Before The Pandemic, But So Were Short Rates Chart 6Mirror Image On its face, households’ equity allocation looks somewhat frothy at one-and-a-half standard deviations above the mean (Chart 7, top panel). Like the forward P/E ratio, the household share of financial assets invested in equities has only ever been higher in the 1999-2000 crescendo to the dot-com boom. The household share of equity in noncorporate businesses has been plunging since the early eighties, however, and when all equity stakes are considered holistically, households don’t look overinvested (Chart 7, bottom panel). An investor could have reached that conclusion in 1999 to his/her subsequent regret, but household allocations to publicly traded holdings should have increased to reflect secular trends favoring concentration. This indicator is surely yellow, but we do not yet view it as red. Chart 7The Proceeds From Family Business Sales Have To Go Somewhere Bottom Line: Individual investors tend to make allocation decisions based on the action in the rear-view mirror, but the aggregate household exposure to public equities does not appear worrisome after considering the secular decline in noncorporate businesses’ importance. Income And Credit Performance Changes in aggregate wealth do not link cleanly to credit performance. Households service debt out of their income, because if they didn’t need to augment or smooth out incoming cash flows they wouldn’t have borrowed in the first place. While there must be some link between the recent paydowns of credit card balances and increased household wealth, changes in wealth have far less bearing than changes in income when it comes to explaining consumer credit performance. Risk assets will eventually suffer in the absence of an additional fiscal aid package because cracks will start showing up all over the economy without more transfers. Current income in the form of generous fiscal transfers have made it possible for households to take the unprecedented step of paying down their credit card balances at the outset of a recession. Those transfers have also bolstered apartment rent collections and held down consumer loan delinquencies. Much of the transfer income has been saved and could be deployed to continue to service debt and prop up consumption, but the savings are not a panacea. Although August’s personal income release reflected an additional $85 billion in excess savings over what would have occurred under our baseline no-pandemic estimate, bringing the total excess savings from March through August to over $1.1 trillion (Table 1), it cannot plug the income gap indefinitely. Making several generous assumptions to support a back-of-the-envelope calculation, we estimate the average laid-off worker could at most go one more quarter without work before s/he fully ran down the cushion accumulated under the CARES Act (Table 2). Table 1Household Savings, With And Without The Pandemic Table 2How Long Can The Average Worker Hold Out? More help from Washington is needed, then, if the economy is to escape a potentially nasty downdraft. Our base-case scenario still holds that help will come this month, but Republican and Democratic negotiators had not reached an agreement before this report went to press. If they fail to do so before the election, all hope is not yet lost. If our average laid-off worker could hold out for September, October and November, s/he might avoid missed rent and loan payments as long the flow of aid resumed by December under a post-election bill. Investment Implications Since the pandemic arrived in the United States in full flower in March, we have viewed the big-picture economic and market backdrop as a contest between policymakers and the virus. Absent any monetary and fiscal stimulus, the US would have suffered a crippling recession in which cascading defaults and bankruptcies would have dented the economy’s growth capacity well into the long term. No modern policymaker would prescribe a Mellonian course of emetics to “purge the rottenness from the system,” but since no one knows how long COVID-19 will pose an acute threat to public health, no one can know for sure if the Fed and Congress will have the capacity and the will to provide the support to bridge the economic crater it will leave in its wake. Only Congress appears to have meaningful untapped capacity, and we expect it will regain its resolve to deploy it in time to make final campaign appeals. If no unexpected materially adverse virus development occurs – mortality and hospitalization rates remain subdued, testing capacity continues to expand, treatment protocols keep progressing and a vaccine is developed sometime in the first half of 2021 – it looks to us like a bill within the range of the latest proposals from the administration ($1.6 trillion) and the House ($2.2 trillion) would be enough to prevent the self-reinforcing wave of bankruptcies that have always been our worst-case-scenario fear. The devil is in the details, especially on Capitol Hill, but helping vulnerable businesses and workers, and reeling state and local governments, until a vaccine is in hand would support our constructive cyclical (12-month) view on risk assets. It would also support the SIFI banks, a prime beneficiary if the economy can slip the pandemic’s knockout credit punch. The market does not appear ready to embrace the SIFIs any time soon, but we will continue to recommend overweighting them as long as Congress eventually provides another sizable round of fiscal aid. The news of the president’s positive COVID-19 test could quite plausibly shake consumer and business confidence, undermining consumption and investment and making the need for fiscal aid even more acute. If he and other members of his circle recovery fully and quickly, however, economic participants might conclude that they have less to fear, helping to smooth the path of the recovery. His experience with the virus may well reshuffle election probabilities and our geopolitical strategists will be keeping a close eye on all the developments.1 As we go to press, we do not see a clear-cut market implication from the president’s illness and will stand pat with a tactically neutral equity allocation, an underweight bond allocation and an overweight cash position as we await further developments.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 Please see the October 2, 2020 Geopolitical Strategy Special Alert, "Trump’s Illness Alone Not A Game Changer" available at gps.bcaresearch.com.

Highlights President Trump’s contraction of COVID-19 will buy him some voter sympathy but it will not change the game in the US election unless he perishes from the disease (unlikely), or Senate Republicans agree to a new relief package in the face of heightened national attention to the pandemic. Our quantitative election model gives Republicans a 49% chance of winning the White House. We think the odds are much lower, at 35%, but we will upgrade them if the Senate GOP approves a new fiscal relief package. A relief package would remove the risk of financial turmoil in the final month of the campaign, which would be the death knell for Republicans.  The election is ultimately about the pace of de-globalization and the disruptiveness of US political polarization. If Trump wins, these forces will intensify. If not, global uncertainty will get a reprieve … though US-China conflict will persist in the long run.  Feature United States President Donald J. Trump is reported to have contracted COVID-19 and to be showing minor symptoms. Vice President Mike Pence has tested negative. The office of the president will not be vacant. The Republican Party election campaign will likely benefit from some sympathy, but a failure to pass new fiscal stimulus in Congress would hurt the Republican bid anyway via market turmoil. Foreign powers have mostly avoided antagonizing President Trump as the election approaches. The US would react aggressively if threatened by another state during a period of heightened vulnerability. But while the US is distracted, other powers can pursue their interests within their region more aggressively. In this report, we explore the implications of Trump’s sickness, including the worst case for the president. We are a non-partisan and non-normative investment strategy and have no intention of doing anything other than investigating the scenarios that could arise. Step Back – What Is Trump’s Personal Impact? What is the US election really about, from an investment point of view? It is about whether global policy uncertainty will continue its dramatic ascent in recent years. Huge increases in uncertainty have exacerbated the dollar bull market and US equity outperformance, as the US is an insulated market and the dollar is a safe haven currency (Chart 1). Chart 1US Election Is About Relative Policy Uncertainty If Trump is elected, uncertainty will spike again on Trump’s erratic conduct of foreign and trade policy, particularly the likelihood of a “Phase Two” trade war with China and potentially a global trade war. If not, US trade and foreign policy will moderate. It will not return to the status quo ante 2016, but it will be more predictable, more responsive to the input of presidential advisers, less erratic. This is more or less the case if Democratic Party candidate Joe Biden wins or if Trump should be succeeded by Pence, who is a conventional Republican and would continue Trump’s policies with less aggression. The US election is also about political polarization within the United States. Trump has exacerbated this long-spiraling trend because he is not nationally popular but depends on regional appeal, so his presidency splits the popular vote from the Electoral College vote. He is also extremely controversial when it comes to voters’ deepest-held values.  Polarization has contaminated US fiscal policy as well as foreign policy (e.g. the Middle East). The US debt ceiling crises of 2011-13 and the current standoff over COVID fiscal relief have global market consequences but are the result of US partisanship. The Tax Cut and Jobs Act injected steroids into the US economy, while its partial repeal under Biden would weigh on animal spirits. Chart 2Election Is About US Polarization, Which Raises Risks To RoW US polarization, like US protectionism, has fed into global uncertainty in recent years and aggravated the dollar’s strength, US equity outperformance, US tech outperformance, and the downward trend in US treasury yields (Chart 2).   Given the above, if Trump is not awarded a second term the world will see a reprieve in uncertainty – at least once a new administration takes shape. Trade risk will decline, and polarization and fiscal risk could decline depending on the outcome in the Senate.  However, uncertainty will not collapse to pre-2016 levels. The world will still face geopolitical multipolarity, which comes from the US’s relative loss of economic and military power. Ultimately the US conflict with China will continue under Biden or Pence or any other American president. Sans Trump, it is unlikely that the US would expand the trade war to the European Union or the rest of the world. The US would also be more cooperative with NATO and other international institutions under Biden and even Pence.   Bottom Line: US monetary policy will be ultra-dovish over most of the next presidency. Hence faster US growth will cause real interest rates to fall, which is ostensibly negative for the dollar and positive for risk-on currencies and commodities. Hence the election raises risks due to fiscal and trade policy. On fiscal policy, the Senate race is key, discussed below. On trade policy, either Biden or Pence would be less hawkish than Trump, but not dovish, meaning that the EU and the euro would become the ultimate beneficiaries of a change of president while China and the renminbi face risks over the medium- and long-term regardless. So How Will Trump’s Illness Affect The Election? The immediate impact of Trump’s illness on global financial markets is volatility due to election uncertainty: Trump’s sickness underscores that COVID cases are reemerging both in the US and Europe, which will discourage economic activity as households and firms practice distancing. This is market negative. Unless a fiscal stimulus package is passed promptly, that is. It remains unclear whether Senate Republicans will agree to a fiscal package prior to the election. We think they will, but our view is under pressure. The odds have probably gone up due to the president’s sickness and the resurgence of the COVID crisis. If Republican Senators prove pragmatic, then the fiscal outlook for the next two years improves because they could retain a majority of the Senate. If Biden wins, a Republican Senate will be obstructionist – a clear fiscal risk for the next two years – but it is still immensely important to determine if they are pragmatic enough to concede to more spending when a crisis becomes acute, as that would reduce the risk. Chart 3Trump’s Handling Of COVID Has Been A Major Liability Republican odds of winning the White House and Senate should increase somewhat due to Trump’s illness, which in turn reduces the odds of tax hikes and re-regulation. A major liability for the party has been Trump’s handling of COVID but his own sickness may clear them of some blame (Chart 3). Our quantitative election model already gives the Republican Party a 49% chance of election based on the V-shape economic recovery (Chart 4). Typically elections are a referendum on the incumbent party, and the Republican Party may receive a sympathy boost. In modern times the incumbent party has won the election in every instance in which the president died in office, though this is not the most likely outcome (Table 1). Chart 4Trump Has 49% Chance of Victory According To Our US Election Quant Model Table 1In Modern Times, Incumbent Party Wins After Presidents Who Died In Office Conservative British Prime Minister Boris Johnson received a popular opinion bounce and survived COVID-19 but the election took place before his illness. The period between April 5 and 12, when he left the hospital, was a harrowing time. While Boris received only a temporary boost in opinion polls, for President Trump any boost would be convenient given that the election is right around the corner if he recovers in mid-October (Chart 5). Chart 5Boris Got A Sympathy Bounce For COVID Any boost for Republicans this month increases the risk of a closely fought election whose results are contested. That in turn will prolong volatility though it will be resolved by December or worst-case end of January. If Republicans lose steam the Democrats will win a clean sweep in November. Bottom Line: Trump’s COVID-19 October surprise highlights the rise in volatility which can last through the next few months, likely motivating a counter-trend bounce in the dollar and weakness in risky assets. The main market outcomes depend on whether Trump survives (most likely he will), whether a fiscal deal is passed now or later (we think it will be passed but risks are rising), and whether Republicans retain the White House and Senate (neither is our base case at present). How Would The Market Respond To Trump’s Passing? Table 2COVID-19 Death Rates By Age Cohort Investors cannot shy away from difficult questions. Tables 2 and 3 highlight that the mortality rates for males infected by COVID-19 according to age and body mass index. We do not want to jump to any conclusions regarding his illness, but like many Americans, the president faces a serious risk – between 2%-8% odds of death – though he will get the best treatment. Table 3COVID-19 Mortality Risk Increases With Body Mass Index Trump is more likely to survive, but if he should pass away then the market’s direction, whatever it is, will ultimately be unaffected outside of the trade issues discussed above. The experience of all previous American presidents who have died in office during the history of the S&P 500 demonstrates this point (Chart 6). Hence the fate of the fiscal relief bill, the election itself, and other pandemic and economic data are more important than the president for the short-term direction of stocks.    Chart 6SPX Returns On Death Of US President Chart 7SPX Returns For Presidents Seeking Re-Election After H1 Recession Only three presidents have been re-elected when a recession occurred during the election year. Prior to Trump’s illness, the stock market was sending mixed signals about whether Trump would follow in their footsteps (Chart 7). Interestingly, two of these three were “takeover presidents” who succeeded the death of a president in office: Theodore Roosevelt (1904) and Calvin Coolidge (1924).  Opinion polls showed a tightening race in the critical swing states prior to the first debate on September 29 and today’s news of Trump’s illness (Chart 8). Polls will tighten temporarily if Trump does get sympathy, namely from independents and undecided voters. Trump is viewed as having lost the first presidential debate to Biden, but public opinion on the debates is not an accurate predictor of the presidency (Chart 9). Today’s news will neutralize the first debate. It may also result in the cancellation of the October 15 debate. There is already criticism from top Democrats and Republicans about the debates. They could matter, but most likely they will not determine the final result.  Chart 8Polling Shows A Tightening Race Chart 9Debates Do Not Predict Election Outcomes Bottom Line: The rapid economic recovery is the critical reason that the Republican Party’s odds of winning the election have shot up to 49% in our quantitative model. Whether sentiment continues to recover depends on stimulus. We have not yet upgraded our subjective odds of President Trump’s election (35%) due to the fiscal fiasco in Congress. Insofar as Republican Senators move faster to get a fiscal deal, the economic recovery will continue and we will upgrade GOP odds of winning the White House and Senate. While Trump may receive a sympathy bounce for his illness, it will be fleeting, so the economy is the key factor. However, if Trump fails to recover, then the Republican Party as a whole will receive a sympathy boost, at least according to past precedent. Pence could lead the party to victory if the economy and markets do not collapse. US equities will outperform global if Republicans retain the White House and Senate, especially if they do so without compromising on a fiscal deal. The dollar would see a counter-trend rally. Investment Takeaways Global equities will outperform American equities if Democrats win the election (Diagram 1). If they win the Senate, however, tax hikes will have to be discounted which introduces short-term downside, particularly for US equities.  Diagram 1Scenarios For US Election Outcomes And Market Impacts Global policy uncertainty will fall if Trump is defeated or if Pence replaces him. US polarization will fall if the election results are decisive either way. Falling uncertainty and polarization will accelerate the US dollar’s decline and favor global equities and commodities. Government bonds will remain well bid during the volatile short term but will sell off once stimulus is passed and the global economic recovery advances, particularly if the result is a Democratic sweep.   Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com   Appendix Appendix Table 1Calendar Of US Election 2020 APPENDIX TABLE 2US Line Of Succession If Presidency Vacant   Footnotes  

Special Report

Highlights Latin America faces a deep economic contraction and a new surge of social unrest and political unrest. However, the risks are increasingly priced into financial markets – especially if global monetary and fiscal stimulus continue. A looming global cyclical upturn, massive US and Chinese stimulus, a weaker dollar, and rising commodity prices will lift Latin American currencies and assets. Mexico faces lower trade risk and lower political risk. Colombia’s fundamentals are sound and political risk is contained. Chile’s political risk is significant but will benefit from the macro backdrop. Brazil will remain volatile. We are bearish on Argentina. Venezuela’s regime will be replaced before long. Our tactical positioning is defensive on COVID-19 and US political risk, but we see Latin America as an opportunity over the long run. Feature Cracks in the edifice of this year’s global stock market recovery are emerging with COVID-19 cases rebounding and US political risks rising. Emerging markets that rallied earlier this year have fallen back. This includes Latin America, where the pandemic’s per capita death toll is comparable only to Europe and the United States (Chart 1). Latin America is a risky region for investors because the past decade was a lost decade, particularly after the commodity bust in 2014. Poor macro fundamentals, deep household grievances, heavy dependency on commodity prices, and preexisting political polarization and social unrest have weighed on the region’s currencies and government bonds. Latin American equities have underperformed emerging markets over the period (Chart 2). Chart 1Pandemic Adds To Latin America’s Many Woes Chart 2Global Reflation Needed For LATAM To Outperform Looking beyond near-term risks, however, global economic recovery and gargantuan monetary and fiscal stimulus hold out the prospect of a sustained recovery in growth and trade, a weakening US dollar, and a boost to commodity prices (Chart 3). This outlook is favorable for Latin American economies and companies. Chart 3Global Stimulus Keeps Up Commodity Prices In this report, we analyze the coronavirus outbreak and its likely political impact in six Latin American markets: Argentina, Brazil, Colombia, Chile, and Mexico. The crisis is exacerbating the region’s longstanding problems and freezing attempts at supply-side reforms. However, a lot of political risk is already priced, particularly in Mexico and Colombia. Bullish Mexico: Trade War And Leftism Already Peaked As it stands, Mexico has over 740,000 confirmed cases and over 77,000 deaths, with new cases increasing daily (Chart 4). Testing occurs at a rate of 15,300 tests per 1 million people, one of the lowest rates of any major country. Hence the true number of cases is likely well higher than the official count. The health care system is overwhelmed. Chart 4Mexico Not Too Bad On Virus Death Toll The crisis has been a rude awakening for President Andrés Manuel López Obrador (AMLO), but we see Mexico as an investment opportunity rather than a risk. Chart 5Mexico: Left-Wing Unlikely To Outdo 2018 Win AMLO and his National Regeneration Movement (MORENA) swept to power in 2018 as champions of the poor fed up with the country’s corrupt political establishment. Two tailwinds fueled MORENA’s rise: First, the failure of Mexico’s ruling elites. The 2008 financial crisis knocked one of the dominant parties out of power, while the brief comeback of the traditional ruling party (the Institutional Revolutionary Party or PRI) faltered amid the slow-burn recovery of the 2010s. Second, AMLO’s victory was an answer to the populist and protectionist turn in the United States under President Trump, who had vowed to build a wall and make Mexico pay for it as well as to renegotiate NAFTA to be more favorable to the United States. Mexicans voted to fight fire with fire. Neo-liberalism and supply-side structural reform seemed discredited in a blaze of Yankee imperialism and AMLO and his movement offered the only viable alternative. AMLO became Mexico’s first left-wing populist president in recent memory, while MORENA won an outright majority in the Senate and, with its coalition partners, a three-fifths majority in the Chamber of Deputies (Chart 5). From this back story it is clear that investors interested in Mexican assets faced two primary structural risks: (1) a left-wing “revolution,” given AMLO’s lack of legislative roadblocks (2) American protectionism. About 29% of Mexico’s GDP consists of exports to the US (Chart 6). Chart 6Mexico Will Benefit From US Mega-Stimulus Investors took these risks seriously, judging by the relative performance of Mexican energy and industrial equities (Chart 7). Trade war threatened exporters while AMLO aimed to revitalize the moribund state-owned energy company at the expense of foreign investors admitted by his predecessor’s structural reforms Chart 7Investors DisappointedAfter AMLO Election Rally However, the left-wing revolution threat was always overstated: Mexico has become the largest fiscal hawk in the region under AMLO. Moreover, monetary policy had remained overly tight before the pandemic. Indeed, AMLO’s track record as mayor of Mexico City in the early 2000s showed his penchant for fiscal frugality. His left-wing policies have been focused on reviving the state-owned oil company PEMEX and increasing signature social programs, which have been funded by slashing other government expenditures, even during the COVID-19 outbreak. Going forward, Mexico’s orthodox economic policy is a major positive relative to emerging markets with out-of-control debt dynamics, often exacerbated by populist leaders, such as Brazil (Chart 8). MORENA will face greater constraints going forward. AMLO’s approval rating has normalized at around 60%, roughly the average for Mexican presidents (Chart 9). MORENA’s support rate has fallen from 45% to below 20%. With midterm elections looming in July 2021, MORENA is unlikely to outperform its 2018 landslide. So while AMLO will win his proposed 2021 presidential “referendum,” he will do so with a smaller share of the vote and a weakened parliament. Reality has set in for Mexico’s new ruling party. Chart 8Mexico’s Low Debts A Boon Chart 9AMLO’s Approval Rating Solid, But Normalizing AMLO and MORENA are likely to be chastened but not to fall from power, which means there is unlikely to be a wholesale reversal in national policy. The crisis has killed AMLO’s honeymoon but not his presidency. He still has 60% approval and his term in office lasts until 2024. The main opposition parties are still floundering (Chart 10). The creation of six new parties since 2018 will help MORENA either by adding to its coalition or taking votes away from the opposition. US fiscal stimulus and shift away from China benefit Mexico over the long run. Second, we now know that the US protectionist threat was also overstated: President Trump’s first term demonstrates that even if the US elects a populist and protectionist president who pledges to take an aggressive approach toward Mexico, the ties that bind the two countries will not be easily broken. One of the few times Senate Republicans openly defied President Trump was their refusal in June 2019 to allow sweeping 5%-25% unilateral tariff rates on Mexican imports. Hence even if Trump wins and the GOP retains the Senate, Mexico has some safeguards here. Trump would also be constrained by House Democrats on the issue of building a border wall and reforming the US immigration system. AMLO visited Trump in Washington to sign the USMCA ahead of the election. The trade deal is part of Trump’s legacy so Trump is more likely to attack other trade surplus countries than Mexico. Former Vice President Joe Biden and the Democratic Party are more likely to win the US election. In that case, US policy toward Mexico will turn more dovish. House Democrats helped negotiate the USMCA deal and voted to pass it. Biden is unlikely to impose large tariffs on Mexico. It is still possible that US-Mexico tensions will reignite later, if immigration swells under Biden, but the latter is not guaranteed. Two additional macro and geopolitical factors also play to Mexico’s favor over the long run: First, the US’s profligate fiscal policy will benefit its neighbor and trading partner. Massive American monetary and fiscal stimulus – about to receive another dollop of around $2-$2.5 trillion in new spending – will total upwards of 20% of US GDP in 2020 (Chart 11). This is especially likely in the event of a Democratic clean sweep. Yet Democrats are likely to retain the House, preventing Republicans from slashing spending too much even if they convince Trump to adopt their fiscal hawkishness in any second term. Chart 10MORENA’s Approval Comes Down To Earth Chart 11Mexican Exports Will Benefit From US Stimulus Chart 12US Leaving China Will Boost Mexico Industrialization Second, the US is leading a global movement to diversify supply chains away from China. This shift is rooted in US grand strategy and began under the Obama administration, and it is highly likely to continue whether Trump or Biden wins. A Biden victory will result in a more multilateral approach that is more beneficial for global trade, but still penalizes China – which is good for Mexico. No country has suffered a greater opportunity cost from China’s industrialization than Mexico (Chart 12). Both Biden and Trump are advertising a policy of on-shoring that will, in effect, benefit US trading partners ex-China. US current account deficits stem from its domestic savings-investment balance and therefore will persist even if China is cut out, driving production elsewhere. Bottom Line: We are optimistic about Mexico. Trade risk from the US is unlikely to rise higher than during 2017-19, while legislative hurdles facing AMLO and MORENA cannot get much lower than they are today. The currency is fairly valued and equities are not too pricey. Gargantuan US stimulus and a shift away from China dependency will boost growth and investment in Mexico. We will look for opportunities to go long the Mexican peso and assets. Volatile Brazil: Fiscal Restraint Is Gone While much of the world is focused on a second wave of Covid-19, Brazil has struggled to hurdle its first. The country has over 4.8 million confirmed cases (23 000 cases per 1 million people), and 143,000 deaths, second only to the United States. Coronavirus testing in Brazil stands at 73,900 tests per 1 million people, i.e. higher than Mexico’s but not enough to paint a complete picture of the virus’ course (Chart 13). The Brazilian government’s response has been chaotic. With a nearly universal health care system, albeit one that is under-funded, Brazil was not as poorly prepared as some countries. However, like his populist counterparts in Mexico and the United States, Bolsonaro chose to prioritize the economy over the virus response. Brazil was one of the few major countries in the world not to impose a national lockdown. The Ministry of Health, consumed with political turmoil, failed to develop a nationwide plan of action.1 Bolsonaro quarreled with governors who imposed state lockdown measures. With conflicting state and federal messages, Brazilians were unsure about the benefits of social isolation, hand washing, and face coverings, leading to a widespread lack of compliance and a major outbreak of the disease. Bolsonaro’s approach has led to some benefits, however, and the government implemented the largest fiscal response in the region at a whopping 16% of GDP. The economy is recovering faster than that of neighboring countries (Chart 14). Bolsonaro’s approval rating has also improved. The polling looks like a short-term “crisis bounce,” but Bolsonaro is now ahead of his likeliest rivals in 2022, including former President Lula Da Silva and former Justice Minister Sergio Moro. The crisis has catapulted Bolsonaro back into the approval range of other Brazilian presidents, at least for the moment (Chart 15). Chart 13Bolsonaro And Trump Prioritize Recession Over Pandemic Chart 14Bolsonaro's Economy Roaring Back All eyes will next turn to the municipal elections slated for November 15, 2020. The first elections since Bolsonaro came to power will be a test of whether the left-wing opposition can recover. One of the key pillars of Bolsonaro’s political capital was the collapse of the Worker’s Party after the economic crisis and Car Wash corruption scandal of the 2010s. The local government election will also reflect public views of the pandemic. Local governments are important when it comes to combating COVID-19. On April 15, Brazil’s Supreme Federal Court gave them the power to set quarantine restrictions and rules with regard to public transit, transport, and highway use. They are in charge of utilizing numerous rounds of aid from the federal government to mitigate the health and economic effects of the virus. Many have rejected Bolsonaro’s cavalier attitude, imposed stricter health measures, and established local teams comprised of medical professionals, public officials, and private donors to monitor the outbreak. If the Worker’s Party fails to recover from the shellacking it suffered in Brazil’s local elections in 2016, then Bolsonaro’s polling bounce would be reinforced and his administration would get a new lease on life. The opposite is also true: a strong recovery will undercut his political capital, especially because it is still possible that Da Silva will be cleared of corruption charges and capable of running for office in 2022. Bolsonaro also faces a test on another pillar of his political capital: the fight against corruption. A criminal investigation of the administration emerged after the resignation of popular justice Minister, Sergio Moro, who accuses the president of wrongdoing. There is an additional pending investigation for his team’s use of “fake news” during the 2018 campaign, which many deem illegal. So far, however, talk of impeachment has not hurt the president. Only about 46% of Brazilians support impeachment (Chart 16), which is not enough to get him removed from office. Any future impeachment push will depend on the following factors: Chart 15Bolsonaro Enjoys Popularity Boost Amid Pandemic Chart 16Nowhere Near Enough Support For Bolso Impeachment First, the president has allied with an alliance of center-right parties, called the Centrao, that controls 40% of seats in the Chamber of Deputies and has played a historic role in the rise and fall of Brazilian presidents (Chart 17). The Centrao can shield Bolsonaro from impeachment just as its opposition ultimately led to former President Dilma Rousseff’s removal in August 2016. By the same token, if these allies turn on him, removal will become the likely outcome. Second, powerful politicians like House Speaker Rodrigo Maia are reluctant to impeach because it would add “more wood in the fire,” i.e. worsen political instability. It would be bad politics for the impeachment directors as well. But this could change. The other two pillars of Bolsonaro’s political capital are law and order and structural economic reform. Bolsonaro has maintained his law-and-order image through cozy relations with the military, as well as through a slight decline in homicides (Chart 18). Chart 17Brazil: Presidential Parties Small, Need Support From ‘Centrists’ Chart 18Bolsonaro's "Law And Order" Message Works So Far Structural reform is the critical factor for investors, but the crisis has slowed the reform agenda, particularly on the fiscal front. The main way for Brazil to reform is to reduce the size of government. The government takes up a large share of national output, comparable to Argentina, and public debt is soaring. The country was already hurtling toward a sovereign debt crisis prior to COVID-19 (Chart 19). Bolsonaro’s signature legislative achievement, pension reform, has done little to arrest this trajectory, as it was watered down to gain passage and then the pandemic wiped out the fiscal gains. Ironically, Bolsonaro’s improved popularity is negative for fiscal consolidation, since it will encourage him to play the populist ahead of the 2022 election. Pension reform was never popular and passing it did nothing to boost Bolsonaro’s approval rating. On the contrary, his approval began to rise when the pandemic struck and he loosened fiscal policy. Going forward he will need to maintain fiscal spending to rebuild the economy. He is already jeopardizing Brazil’s key fiscal rules. As for the election, Brazil always increases government spending in the year before and year of a presidential election, as all parties hope to buy votes (Chart 20). Chart 19Brazil's Fiscal Crisis Accelerates Chart 20Brazil Cranks Up Spending Ahead Of Elections The implication is that any fiscal hawkishness will have to wait until Bolsonaro’s second term. Of course, if Bolsonaro loses the vote, left-wing parties may return to power and fiscal profligacy will be the order of the day. So investors do not have a good prospect for fiscal consolidation anytime soon, barring a successful candidacy by the aforementioned Moro on a reformist and anti-corruption ticket. Fiscal expansion and loose monetary policy are positive for domestic demand initially but negative for the out-of-control debt profile and hence ultimately the currency and government bond prices over the long term. Outside Brazil, geopolitical conditions are reasonably favorable. If Trump wins, Bolsonaro’s right-wing populism will gain some legitimacy and he may be able to negotiate good trade relations with the United States. If Trump loses, Bolsonaro will become politically isolated, but Brazil will benefit economically, as Joe Biden is friendlier to global trade than Trump. Brazil’s trade openness has grown rapidly, one area of reform that will continue. China is also interested in closer relations with Brazil as it faces trade conflict with the US and Australia. If Trump wins, Bolsonaro benefits from further Chinese substitution away from the United States. If Trump loses, Beijing will not return to former dependencies on the United States. Also, while China cannot substitute Brazil for Australia entirely, it is likely to increase imports from Brazil on the margin (Chart 21). Chart 21Brazil Benefits If China Diversifies From US And Oz Chart 22Brazilian Political Risk Down From 2015-16 Peak Ultimately Brazil is a country filled with political risk due to extreme inequality and indebtedness. But as long as the global economy and commodity prices recover, Bolsonaro will be able to ride the wave and short-term political risks will continue to subside from the extremely elevated levels of 2016 (Chart 22).   Bottom Line: Bolsonaro’s popularity bounced in the face of the national crisis. Local elections in November are an important barometer of whether his administration and its neoliberal structural reform agenda can survive beyond 2022. Either way, fiscal consolidation is on hold prior to the 2022 election. We are long Brazilian equities as a China play, but the outlook is ultimately negative for the currency. Bearish Argentina: Peronism Restored Argentina has 751,000 cases of coronavirus (16,800 cases per 1 million people) and about 16,900 deaths. Testing stands at 41,700 test per 1 million people. After the federal government eased quarantine restrictions and began reopening most of the country on June 7, total cases followed the general trend of the region (Chart 23). Chart 23Argentina’s COVID-19 Suppression Losing Steam Despite early measures to flatten the curve, Argentina lacks hospital beds, doctors, and medical supplies, especially in the capital of Buenos Aires where 88% of the country’s confirmed cases are found. The coronavirus has exposed stark differences between the rich and poor in terms of access and quality of health care, with about a third of the population uninsured. Politically secure, Fernandez has prioritized the medical crisis over the economy, imposing some of the world’s strictest lockdown measures in mid-March and declaring a one-year national health emergency – the first country in Latin America to do so. However, Argentina’s multi-decade economic mismanagement and recent policy vacillations mean that the crisis came at a bad time. Argentina has been in a deep recession for over two years, with skyrocketing inflation and peso devaluation, excessive budget deficits and external debts, and a 10% poverty rate in 2018 (Chart 24). Former President Mauricio Macri’s badly needed but ultimately failed attempt at supply-side reforms resulted in an economic collapse that saw the left-wing Peronist/Kirchnerista faction regain power in 2019. Argentina’s fiscal problems will continue on the back of populist economic unorthodoxy. Sovereign risk has temporarily fallen. Argentina received a $300 million emergency loan from the World Bank and another $4 billion loan from the Inter-American Development Bank. The country has defaulted on sovereign debt nine times, but the Fernandez government reached a deal with its largest creditors to restructure $65 billion in early August. The government agreed to bring some debt payments forward, thus buying itself immediate debt relief. It now has a little more than five years until the debt pile’s biggest wave of maturities comes due (Chart 25). Chart 24Poverty Rates Spike Amid Crisis, Including In Argentina Chart 25Argentina's Sovereign Risk Will Rise From Here This deal will give President Fernandez a significant boost. He took office in December 2019 so he has time to ride out the crisis before facing voters again in 2023. However, his reliance on populist economic unorthodoxy ensures that Argentina’s fiscal problems will continue. Consider the following: Before Covid-19, in an attempt to regain credibility among international lenders, Fernandez appointed Martin Guzman, as Minister of Economy. Guzman is an academic and a disciple of American Nobel-prize winner Joseph Stiglitz, but has little policy-making experience. Fernandez pushed an Economic Emergency Law through Congress, giving him emergency powers to renegotiate debt terms and intervene in the economy. He re-imposed import-substitution policies, such as large tax increases on agricultural exports, currency controls, and utility price freezes. In Fernandez’s inauguration speech, he justified a return to leftist policies by saying, “until we eliminate hunger we will ask for greater solidarity from those who have more capacity to give it.” This is a traditional trap for Argentina which results in worse economic outcomes over the long run. Chart 26Argentina’s Government Scores Well In Opinion Fernandez’s government has increased fiscal spending on food aid and other safety nets for the unemployed and furloughed. It has required banks to give out loans at reduced interest rates. Initially it pledged 2% of GDP to social and welfare relief programs, but that number has risen since the onset of the pandemic. For now, Fernandez has considerable political capital. The crisis will wipe out the memory of the Kirchneristas’ previous failings. Social spending is now flowing to Fernandez’s political base and the informal sector of the economy, which accounts for almost half of all Argentine workers. Public support for Fernandez has remained strong through the economic woes and pandemic, with his approval rating at around 67%. Over 80% of people polled have confidence in the government’s handling of the virus (Chart 26), according to opinion polls. Profligate spending will likely continue beyond the cyclical demands of the current crisis, adding to Argentina’s unsustainable debt profile. When the pandemic subsides, international lenders will be less willing to extend credit to Argentina and invest, given their record of default and high tax rates. International companies and even small caps have fled the country due to its draconian currency controls. Bottom Line: Argentina has witnessed a fall in uncertainty but going forward political risk will revive. Populist Kirchnerista policies do not create productivity improvements or reduce debt, and the country’s macro fundamentals will underperform in the long run. RIP Venezuela: The Final (Final) Nail In The Coffin For years, Venezuela has suffered an economic crisis with high levels of unemployment, hyperinflation, and mass shortages of food, medical supplies, and even gasoline. Many citizens claim they’re more likely to die from starvation than the coronavirus. Out of the country’s 47 hospitals that are supposedly dedicated to COVID-19, only 57% have a regular water supply, while 43% have a shortage of PPE kits for medical staff and practitioners. Nicolas Maduro – the hapless successor to Hugo Chavez – declared a state of emergency and implemented a nationwide and long-lasting lockdown, enforced by police. The government issued a unique “7 + 7” plan, where strict lockdowns are imposed for seven days, relaxed for another seven days, re-imposed, and so on. Nevertheless, cases have been increasing. Over time the crisis in Venezuela has forced around five million Venezuelans, including skilled workers and medical doctors, to leave the country (Chart 27). Spillover effects are straining neighboring Colombia, which has taken in 1.5 million of the refugees, and Brazil. Although thousands of Venezuelans have returned home during the pandemic, the massive movements will only make the virus more prevalent. In early June, Maduro reopened borders with Colombia after closing them in February when opposition leader (and rival claimant to the presidency) Juan Guaidó tried to import foreign aid. Maduro denied that Venezuela is in humanitarian crisis and warned against a coup d'état by the United States. The political opposition is stymied for now. In January 2019, Guaidó declared himself president of Venezuela over Maduro, whose government has circumvented the constitutional system since losing the parliamentary election of 2015. Guaido receives broad support from the international community, including Europe and the United States, while Maduro is backed by China, Russia, and Iran. Over 18 months later, Guaidó wields nearly no power at home and Maduro remains in place with the army’s top generals still backing him. However, the Trump administration has expanded sanctions throughout its term. Maduro is unable to access international financing from the IMF, after requesting an emergency $5 billion loan to combat COVID-19, partly due to US opposition. Food prices in Venezuela have risen 259% since January. Low worldwide demand for oil – representing 32% of Venezuelan GDP – means the last leg of the economy has weakened. The government has little room to maneuver fiscally or otherwise combat the virus. Maduro has used the crisis to strengthen his domestic security grip. The military, police, and revolutionary militias are enforcing lockdowns to thwart demonstrations. The opposition is divided, with Guaidó now quarreling with former opposition leader Henrique Capriles over whether to contend the parliamentary elections on December 6. The elections will inevitably be rigged; but to boycott them is to allow Maduro officially to retake the key constitutional body that he lost (and then sidelined) back in 2016. Nevertheless, the material foundations of the country have long collapsed (Chart 28). The pandemic and recession will ultimately prove the final (final, final) nail in the coffin. The military is ruling from behind the scenes but will not want to jeopardize its own status when the Bolivarian revolution is finally abandoned. The timing of this denouement is, as always, anybody’s guess. Chart 27Venezuela’s Refugees Show State Collapse Chart 28Venezuela's Regime Cannot Survive   Bottom Line: President Trump will maintain maximum on Maduro and Venezuela as long as he is in office. The regime will struggle to survive long enough to enjoy the benefits of the commodity price upswing next year. Whenever Maduro falls, the prospect of an eventual resuscitation of oil production will open up. Bullish Colombia: Political Risk Contained (For Now) Chart 29Colombia Flattened The Curve The Colombian government responded swiftly to COVID-19. President Ivan Duque shut seven border crossings with Venezuela, declared a state of emergency, and imposed lockdown measures in mid-March. The measures have been stringent and extended. The effect on the spread of the disease is discernible compared to Colombia’s neighbors (Chart 29). The city of Medellin, with 2.5 million residents and only 2,399 coronavirus deaths, became the best-case scenario for combating the virus. Through the use of an online app, the city government connected people with money and food, while obtaining important data to track cases. Despite the lockdowns, fiscal policy has been tight. True, the government provided payroll subsidies for formal and informal workers unable to work during lockdowns.2 But government spending as a whole is limited (Chart 30). This is positive for the country’s currency and government bonds but will exacerbate political tensions later. Chart 30Colombia's Fiscal Hawkishness Good For Currency, But Will Spur Opposition Duque’s approval ratings were low back in February (23%) but nearly doubled when the crisis struck (Chart 31). However, they have since fallen back to around 40% and high unemployment and fiscal restraint will challenge his government in coming years. Chart 31Colombia’s President Struggling, But Has Time To Recover Pre-Election Colombia is relatively politically stable but tensions are building beneath the surface that will challenge the country’s recent improvements in governance and the 2016 peace deal. On August 4, former President Alvaro Uribe was put under house arrest by a section of the Colombian Supreme Court amid an investigation on witness tampering. He was the first ex-president to be detained in Colombia’s history. Subsequently he resigned from the Senate to obtain better treatment at the hands of the more friendly Attorney General’s office. Uribe is powerful. He created Centro Democratico, which is the largest party in the Senate and the second largest in Congress. He also hand-picked President Duque. His case will continue to be a source of political polarization. Right-leaning factions have not yet convinced moderates to oppose the country’s UN-backed 2016 peace deal, which ended decades of fighting between government forces and the Revolutionary Armed Forces of Colombia (FARC), the leading rebel group. If that changes, then domestic security will decline and investor sentiment will decline at least marginally. Colombia’s political polarization will be contained by Venezuela’s collapse – as long as the economy recovers. In the wake of the oil bust in 2014, Colombia saw the left-wing factions unite around a single candidate – Gustavo Petro, an ex-guerilla – who challenged the conservative establishment in the 2018 election, pledging to tackle inequality. Petro was soundly defeated, giving markets reason to cheer. Now, however, inequality is combining with a deep recession, austerity, and the potential for a failed peace process to challenge the conservatives in 2022. Table 1Latin America Is Vulnerable To Social Unrest Chart 32MXN, COL, And CLP Outperform While BRL Lags The saving grace for the conservatives will likely be the global cyclical upswing, combined with Venezuela’s collapse continuing to unite the right and divide the left. However, the Uribe faction’s dominance is getting long in the tooth and Colombia is vulnerable to social unrest based on our COVID-19 Unrest Index (Table 1). The election is not all that soon. The Colombian peso is still relatively cheap and yet has outperformed other emerging market currencies due to the strong COVID-19 response and the oil rally (Chart 32). Bottom Line: Tight fiscal policy combined with a strong pandemic response – and the recovery in oil prices – will benefit the Colombian peso. Equities are attractively valued. Political risk will build as the 2022 election draws closer, however. Volatile Chile: Tactical Buys Hinge On Politics, China Chile has been a hotspot for the coronavirus. Its lackluster response to the pandemic is fanning the embers of the social unrest that erupted last year. Unrest is tied to a larger political crisis unfolding over the constitutional order, which evolved from the 1980 constitution of dictator Augusto Pinochet. Chile is transitioning from a neoliberal economic model to a welfare state, as Arthur Budaghyan and Juan Egaña of BCA’s Emerging Markets Strategy showed in an excellent special report last year. This transition raises headwinds for an currency, equities, and government bonds. The Chilean government, led by President Sebastián Piñera, declared a state of emergency in March and boosted health care spending throughout the country. The government also passed numerous emergency relief packages to small businesses, workers of the informal economy, and local governments. However, high levels of poverty and overcrowding, especially in the capital of Santiago, have hindered efforts to contain the coronavirus (Chart 33). The government imposed strict lockdowns, including a nationwide increase in police and up to five-year prison penalties for violating quarantines. The political opposition argues that Piñera’s extension of the “state of catastrophe” has allowed him to use emergency powers to restrict citizens’ rights in the name of curbing the pandemic. His approval rating has fallen beneath 22% while popular disapproval has surged above 68% (Chart 34). Chart 33Chile’s Handling Of COVID-19 Largely Successful Chart 34Chile’s Govt Embattled Amid Constitutional Rewrite Chart 35Chile: Inequality Falling, But High Level Still Sparks Unrest Chile was already a tinderbox before the pandemic. Beginning with a small hike to subway fares in Santiago in October 2019, pent-up social grievances erupted against the country’s elite. Protests have continued even during lockdowns and morphed into demands for broader social reform (Chart 35). Chile's top rank on our COVID-19 Social Unrest Index belies the fact that it has high wealth inequality, a threadbare social safety net, high debt levels, and now higher unemployment (Table 1). Table 1Latin America Is Vulnerable To Social Unrest In a concession to protesters, the Piñera administration agreed to revise the constitution. A popular referendum will be held on October 25, though it has already been delayed once. The referendum will determine whether to hold a direct constitutional assembly, whose members are drawn from the population as a whole, or a mixed constitutional assembly, in which congress takes up half of the seats. The latter is the more conservative option; the former is more progressive and will deepen political polarization as the political establishment will resist it (Chart 36). The process to revise the constitution is supposed to last until the end of 2022 but it could drag on longer. Moreover it will be complicated by presidential and legislative elections slated for November 2021. The timing of these events ensures that short-term partisan factors will have a major impact on constitutional revision, which bodes ill for resolving structural political problems. The Piñera administration’s goal is to pacify the protesters with some reforms, thus winning his party re-election, while preserving key elements of the current political establishment. But the pandemic has made it harder to do this, requiring either greater government concessions or a new round of unrest. The implication is that political risk will remain elevated over the next few years. Political risk will thus undermine good news on the macro front, including the peso’s strong performance this year so far (Chart 32 above). Of course, there are positive macro factors countervailing this political risk. One of which is China’s recovery. Beijing accounts for 51% of global copper demand, and Chile provides 28% of mine supply, and China is stimulating aggressively. Chilean exports track even more closely with China’s credit impulse than those of other Latin American economies (Chart 37). Chart 36COVID-19 Unrest Index: If Chile Faces Unrest, Then All Latin America Faces Unrest However, the market has partly priced China’s boost whereas Chile’s political risk will erupt again soon. With regard to the US election, Chile stands to benefit from a Democratic victory that improves the outlook for China’s economy and global trade. Like Peru, Chile is a member of the CPTPP and stands to benefit if Biden is elected and eventually rejoins this pact. Chart 37Chile Constitutional Battle Will Increase Political Risk   Bottom Line: A secular rise in domestic political risk as the country is pressured to expand the social safety net is a negative factor for the peso and stock market that will weigh on its otherwise positive macro backdrop. Investment Takeaways The above review reveals some common threads. First, the last decade has not led to lasting neoliberal reforms or major strides in promoting productivity. Attempts at supply-side structural reform have been modest or have failed entirely in Argentina, Brazil, Chile, and Mexico. Colombia’s attempt at a peace deal may falter. Venezuela is a failed state. Second, populism, whether left-wing or right-wing, entails that most governments will pursue economic growth at any cost. Fiscal hawkishness has been put on pause, with the exception of Mexico and Colombia, where it will benefit the currencies. Near-term risks abound in Q4 2020 but the long term is favorable for Latin American financial assets due to global reflation. China is stimulating its economy aggressively. US sanctions will weigh on China, but it will need to stimulate more in response to maintain internal stability. This will boost commodity prices. The dollar will eventually weaken as global growth recovers, the Fed avoids raising rates, and the US maintains large twin deficits. This is ultimately true even if Trump is re-elected. A weaker dollar helps commodities and Latin American countries with US dollar debts. All things considered, Mexico and Colombia will come out looking the best, but we will also look for opportunities when discounts on Chilean assets become excessive. The US’s secular confrontation with China over trade tensions holds out the prospect of Latin American markets reversing their long equity underperformance relative to Asian manufacturers (Chart 38). Latin American manufacturers like Mexico will benefit from American trade diversification. If the US joins the CPTPP, then Chile and Peru will also benefit. Metals producers like Chile will benefit most from China’s stimulus. Chart 38China's Stimulus A Boon For Latin America   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Daniel Kohen Consulting Editor Footnotes 1 The Ministry of Health exemplifies growing fractures across the administration. In mid-May, the Health Minister (Nelson Teich) resigned just four weeks into the job, after Bolsonaro fired the previous one (Luiz Henrique Mandetta) for defending lockdown measures imposed by some mayors and governors. 2 There are about 1.8 million Venezuelan refugees in Colombia. They rely on the informal work, with many falling back into poverty as a result of the mandatory quarantines.