Elections

Highlights The collapse in oil prices supercharges the geopolitical risks stemming from the global pandemic and recession. Low oil prices should discourage petro-states from waging war, but Iran may be an important exception. Russian instability is one of the most important secular geopolitical consequences of this year’s crisis. President Trump’s precarious status this election year raises the possibility of provocations or reactions on his part. Europe faces instability on its eastern and southern borders in coming years, but integration rather than breakup is the response. Over a strategic time frame, go long AAA-rated municipal bonds, cyber security stocks, infrastructure stocks, and China reflation plays. Feature Chart 1Someone Took Physical Delivery! Someone Took Physical Delivery! Someone Took Physical Delivery! Oil markets melted this week. Oil volatility measured by the Crude Oil ETF Volatility Index surpassed 300% as WTI futures for May 2020 delivery fell into a black hole, bottoming at -$40.40 per barrel (Chart 1). Our own long Brent trade, initiated on 27 March 2020 at $24.92 per barrel, is down 17.9% as we go to press. Strategically we are putting cash to work acquiring risk assets and we remain long Brent. The forward curve implies that prices will rise to $35 and $31 per barrel for Brent and WTI by April 2021. We initiated this trade because we assessed that: The US and EU would gradually reopen their economies (they are doing so). Oil production would be destroyed (more on this below). Russia and Saudi Arabia would agree to production cuts (they did). Monetary and fiscal stimulus would take effect (the tsunami of stimulus is still growing). Global demand would start the long process of recovery (no turn yet, unknown timing). On a shorter time horizon, we are defensively positioned but things are starting to look up on COVID-19 – New York Governor Andrew Cuomo has released results of a study showing that 15% of New Yorkers have antibodies, implying a death rate of only 0.5%. The US dollar and global policy uncertainty may be peaking as we go to press (Chart 2). However, second-order effects still pose risks that keep us wary. Chart 2Dollar And Policy Uncertainty Roaring Dollar And Policy Uncertainty Roaring Dollar And Policy Uncertainty Roaring Geopolitics is the “next shoe to drop” – and it is already dropping. A host of risks are flying under the radar as the world focuses on the virus. Taken alone, not every risk warrants a risk-off positioning. But combined, these risks reveal extreme global uncertainty which does warrant a risk-off position in the near term. This week’s threats between the US and Iran, in particular, show that the political and geopolitical fallout from COVID-19 begins now, it will not “wait” until the pandemic crisis subsides. In this report we focus on the risks from oil-producing economies, but we first we update our fiscal stimulus tally. Stimulus Tsunami Chart 3Stimulus Tsunami Still Building Drowning In Oil (GeoRisk Update) Drowning In Oil (GeoRisk Update) Policymakers responded to COVID-19 by doing “whatever it takes” to prop up demand (Chart 3). Please see the Appendix for our latest update of our global fiscal stimulus table. The latest fiscal and monetary measures show that countries are still adding stimulus – i.e. there is not yet a substantial shift away from providing stimulus: China has increased its measures to a total of 10% of GDP for the year so far, according to BCA Research China Investment Strategy. This includes a general increase in credit growth, a big increase in government spending (2% of GDP), a bank re-lending scheme (1.5% of GDP), an increase in general purpose local government bonds (2% of GDP), plus special purpose bonds (4% of GDP) and other measures. On the political front, the government has rolled out a new slogan, “the Six Stabilities and the Six Guarantees,” and President Xi Jinping said on an inspection tour to Shaanxi that the state will increase investments to ensure that employment is stabilized. This is the maximum reflationary signal from China that we have long expected. The US agreed to a $484 billion “fourth phase” stimulus package, bringing its total to 13% of GDP. President Trump is already pushing for a fifth phase involving bailouts of state and local governments and infrastructure, which we fully expect to take place even if it takes a bit longer than packages that have been passed so far this year. German Chancellor Angela Merkel has opened the way for the EU to issue Eurobonds, in keeping with our expectations. Germany is spending 12% of GDP in total – which can go much higher depending on how many corporate loans are tapped – while Italy is increasing its stimulus to 3% of GDP. As deficits rise to astronomical sums, and economies gradually reopen, will legislatures balk at passing new stimulus? Yes, eventually. Financial markets will have to put more pressure on policymakers to get them to pass more stimulus. This can lead to volatility. In the US the pandemic is coinciding with “peak polarization” over the 2020 election. Lack of coordination between federal and state governments is increasing uncertainty. Currently disputes center on the timing of economic reopening and the provisioning bailout funds for state and local governments. Senate Majority Leader Mitch McConnell is threatening to deny bailouts for American states with large, unfunded public pension benefits (Chart 4A). He is insisting that the Senate “push the pause button” on coronavirus relief measures; specifically that nothing new be passed until the Senate convenes in Washington on May 4. He may then lead a charge in the Republican Senate to try to require structural reforms from states in exchange for bailouts. Estimates of the total state budget shortfall due to the crisis stand at $500 billion over the next three years, which is almost certainly an understatement (Chart 4B). Chart 4AUS States Have Unfunded Liabilities Drowning In Oil (GeoRisk Update) Drowning In Oil (GeoRisk Update) Chart 4BUS States Face Funding Shortfalls Drowning In Oil (GeoRisk Update) Drowning In Oil (GeoRisk Update) Could a local government or state declare bankruptcy? Not anytime soon. Technically there is no provision for states to declare bankruptcy. A constitutional challenge to such a declaration would go to the Supreme Court. One commonly cited precedent, Arkansas in 1933, ended up with a federal bailout.1 A unilateral declaration could conceivably become a kind of “Lehman moment” in the public sector, but state governors will ask their legislatures to provide more fiscal flexibility and will seek bailouts from the federal government first. The Federal Reserve is already committed to buying state and local bonds and can expand these purchases to keep interest rates low. Washington would be forced to provide at least short-term funding if state workers started getting fired in the midst of the crisis because of straightened state finances – another $500 billion for the states is entirely feasible in today’s climate. Constraints will prevail on the GOP Senate to provide state bailout funds. This conflict over state finances could have a negative impact on US equities in the near term, but it is largely a bluff – McConnell will lose this battle. The fundamental dynamic in Washington is that of populism combined with a pandemic that neutralizes arguments about moral hazard. Big-spending Democrats in the House of Representatives control the purse strings while big-spending President Trump faces an election. Senate Republicans are cornered on all sides – and their fate is tied to the President’s – so they will eventually capitulate. Bottom Line: The global fiscal and monetary policy tsunami is still building. But there are plenty of chances for near-term debacles. Over the long run the gargantuan stimulus is the signal while the rest is noise. Over the long run we expect the reflationary efforts to prevail and therefore we are long Treasury inflation-protected securities and US investment grade corporate bonds. We recommend going strategically long AAA-rated US municipal bonds relative to 10-year Treasuries. Petro-State Meltdown Since March we have highlighted that the collapse in oil prices will destabilize oil producers above and beyond the pandemic and recession. This leaves Iran in danger, but even threatens the stability of great powers like Russia. Normally there is something of a correlation between the global oil price and the willingness of petro-states to engage in war (Chart 5). Chart 5Petro-States Cease Fire When Oil Drops Drowning In Oil (GeoRisk Update) Drowning In Oil (GeoRisk Update) When prices fall, revenues dry up and governments have to prioritize domestic stability. This tends to defer inter-state conflict. We can loosely corroborate this evidence by showing that global defense stocks tend to be correlated with oil prices (Chart 6). Global growth is the obvious driver of both of these indicators. But states whose budgets are closely tied to the commodity cycle are the most likely to cut defense spending. Chart 6Global Growth Drives Oil And Guns Global Growth Drives Oil And Guns Global Growth Drives Oil And Guns Russia is case in point. Revenues from Rostec, one of Russia’s largest arms firms, rise and fall with the Urals crude oil price (Chart 7). The Russians launch into foreign adventures during oil bull markets, when state coffers are flush with cash. They have an uncanny way of calling the top of the cycle by invading countries (Chart 8). Chart 7Oil Correlates With Russian Arms Sales Drowning In Oil (GeoRisk Update) Drowning In Oil (GeoRisk Update) Chart 8Russian Invasions Call Peak In Oil Bull Markets Russian Invasions Call Peak In Oil Bull Markets Russian Invasions Call Peak In Oil Bull Markets Chart 9Turkish Political Risk On The Rise Turkish Political Risk On The Rise Turkish Political Risk On The Rise In the current oil rout, there is already some evidence of hostilities dying down in this way. For instance, after years of dogged fighting in Yemen, Saudi Arabia is finally declaring a ceasefire there. Turkey, which benefits from low oil prices, has temporarily gotten the upper hand in Libya vis-à-vis Khalifa Haftar and the Libyan National Army, which depends on oil revenues and backing from petro-states like Russia and the GCC. Of course, Turkey’s deepening involvement in foreign conflicts is evidence of populism at home so it does not bode well for the lira or Turkish assets (Chart 9). But it does highlight the impact of weak oil on petro-players such as Haftar. However, the tendency of petro-states to cease fire amid low prices is merely a rule of thumb, not a law of physics. Past performance is no guarantee of future results. Already we are seeing that Iran is defying this dynamic by engaging in provocative saber-rattling with the United States. Iran And Iraq The US and Iran are rattling sabers again. One would think that Iran, deep in the throes of recession and COVID-19, would eschew a conflict with the US at a time when a vulnerable and anti-Iranian US president is only seven months away from an election. Chart 10US Maximum Pressure On Iran US Maximum Pressure On Iran US Maximum Pressure On Iran Iran has survived nearly two years of “maximum pressure” from President Trump (Chart 10), and previous US sanction regimes, and has a fair chance of seeing the Democrats retake Washington. The Democrats would restart negotiations to restore the 2015 nuclear deal, which was favorable to Iran. Therefore risking air strikes from President Trump is counterproductive and potentially disastrous. Yet this logic only holds if the Iranian regime is capable of sustaining the pain of a pandemic and global recession on top of its already collapsing economy. Iran’s ability to circumvent sanctions to acquire funds depended on the economy outside of Iran doing fine. Now Iran’s illicit funds are drying up. This could lead to a pullback in funding for militant proxies across the region as Iran cuts costs. But it also removes the constraint on Iran taking bolder actions. If the economy is collapsing anyway then Iran can take bigger risks. Furthermore if Iran is teetering, there may be an incentive to initiate foreign conflicts to refocus domestic angst. This could be done without crossing Trump’s red lines by attacking Iraq or Saudi Arabia. With weak oil demand, Iran’s leverage declines. But a major attack would reduce oil production and accelerate the global supply-demand rebalance. Iran’s attack on the Saudi Abqaiq refinery last September took six million barrels per day offline briefly, but it was clearly not intended to shut down that production permanently. Threats against shipping in the Persian Gulf bring about 14 million barrels per day into jeopardy (Chart 11). Chart 11Closing Hormuz Would Be The Biggest Oil Shock Ever Drowning In Oil (GeoRisk Update) Drowning In Oil (GeoRisk Update) Iran-backed militias in Iraq have continued to attack American assets and have provoked American air strikes over the past month, despite the near-war scenario that erupted just before COVID. Iranian ships have harassed US naval ships in recent days. President Trump has ordered the navy to destroy ships that threaten it; Iranian commander has warned that Iran will sink US warships that threaten its ships in the Gulf. There is a 20% chance of armed hostilities between the US and Iran. Why would Iran be willing to confront the United States? First, Iran rightly believes that the US is war-weary and that Trump is committed to withdrawing from the Middle East. But this could prompt a fateful mistake. The equation changes if the US public is incensed and Trump’s election campaign could benefit from conflict. Chart 12Youth Pose Stability Risk To Iran Youth Pose Stability Risk To Iran Youth Pose Stability Risk To Iran Second, the US is never going to engage in a ground invasion of Iran. Airstrikes would not easily dislodge the regime. They could have the opposite effect and convert an entire generation of young, modernizing Iranians into battle-hardened supporters of the Islamic revolution (Chart 12). This is a dire calculation that the Iranian leaders would only make if they believed their regime was about to collapse. But they are quite possibly the closest to collapse that they have been since the 1980s and nobody knows where their pain threshold lies. They are especially vulnerable as the regime approaches the uncharted succession of Supreme Leader Ali Khamanei. Since early 2018 we have argued that there is a 20% chance of armed hostilities between the US and Iran. We upgraded this to 40% in June 2019 and downgraded it back to 20% after the Iranians shied from direct conflict this January. Our position remains the same 20%. This is still a major understated risk at a time when the global focus is entirely elsewhere. It will persist into 2021 if Trump is reelected. If the Democrats win the US election, this war risk will abate. The Iranians will play hard to get but they are politically prohibited from pursuing confrontation with the US when a 2015-type deal is available. This would open up the possibility for greater oil supply to be unlocked in the future, but sanctions are not likely to be lifted till 2022 at earliest. Russia Russia may not be on the verge of invading anyone, but it is internally vulnerable and fully capable of striking out against foreign opponents. Cyberattacks, election interference, or disinformation campaigns would sow confusion or heighten tensions among the great powers. The Russian state is suffering a triple whammy of pandemic, recession, and oil collapse. President Vladimir Putin’s approval rating has fallen this year so far, whereas other leaders in the western world have all seen polling bounces (even President Trump, slightly) (Chart 13). Putin postponed a referendum designed to keep him in office through 2036 due to the COVID crisis. In other words, the pandemic has already disrupted his carefully laid succession plans. While Putin can bypass a referendum, he would have been better off in the long run with the public mandate. Generally it is Putin’s administration, not his personal popularity, that is at risk, but the looming impact on Russian health and livelihoods puts both in jeopardy (Chart 14) and requires larger fiscal outlays to try to stabilize approval (Chart 15). Chart 13Putin Saw No COVID Popularity Bump Drowning In Oil (GeoRisk Update) Drowning In Oil (GeoRisk Update) Chart 14Russian Regime Faces Political Discontent Russian Regime Faces Political Discontent Russian Regime Faces Political Discontent Moreover, regardless of popular opinion, Putin is likely to settle scores with the oligarchs. The fateful decision to clash with the Saudis in March, which led to the oil collapse, will fall on Igor Sechin, Chief Executive of Rosneft, and his faction. An extensive political purge may well ensue that would jeopardize domestic stability (Chart 16). Chart 15Russia To Focus On Domestic Stability Russia To Focus On Domestic Stability Russia To Focus On Domestic Stability Chart 16Russian Political Risk Will Rise Russian Political Risk Will Rise Russian Political Risk Will Rise Russian tensions with the US will rise over the US election in November. The Democrats would seek to make Russia pay for interfering in US politics to help President Trump win in 2016. But even President Trump may no longer be a reliable “ally” of Putin given that Putin’s oil tactics have bankrupted the US shale industry during Trump’s reelection campaign. The American and Russian air forces are currently sparring in the air space over Syria and the Mediterranean. The US has also warned against a malign actor threatening to hack the health care system of the Czech Republic, which could be Russia or another actor like North Korea or Iran. These issues have taken place off the radar due to the coronavirus but they are no less real for that. Venezuela We have predicted Venezuela’s regime change for several years but the oil meltdown, pandemic, and insufficient Russian and Chinese support should put the final nail in the regime’s coffin. Hugo Chavez’s rise to power, the last “regime change,” occurred as oil prices bottomed in 1998. Historically the Venezuelan armed forces have frequently overthrown civilian authorities, but in several cases not until oil prices recovered (Chart 17). Chart 17Venezuelan Coups Follow Oil Rebounds Venezuelan Coups Follow Oil Rebounds Venezuelan Coups Follow Oil Rebounds The US decision to designate Nicolas Maduro as a “narco-terrorist,” to deploy greater naval and coast guard assets around Venezuela, to reassert the Monroe Doctrine and Roosevelt Corollary, and to pull Chevron from the country all suggest that Washington is preparing for regime change. Such a change may or may not involve any American orchestration. Venezuela is an easy punching-bag for President Trump if he seeks to “wag the dog” ahead of the election. Venezuela would be a strategic prize and yet it cannot hurt the US economy or financial markets substantially, giving limited downside to President Trump if he pursues such a strategy. Obviously any conflict with Venezuela this year is far less relevant to global investors than one with Iran, North Korea, China, or Russia. Regime change would be positive for oil supply and negative for prices over the long run. But that is a story for the next cycle of energy development, as it would take years for government and oil industry change in Venezuela to increase production. The US election cycle is a critical aggravating factor for all of these petro-state risks. Shale producers are going bankrupt, putting pressure on the economy and some swing states. The risk of a conflict arises not only from Trump playing “wag the dog” after the crisis abates, but also from other states provoking the president, causing him to react or overreact. The “Other Guys” Oil producers outside the US, Canada, gulf OPEC, and Russia – the “other guys” – are extremely vulnerable to this year’s global crisis and price collapse. Comprising half of global production, they were already seeing production declines and a falling global market share over the past decade when they should have benefited from a global economic expansion. They never recovered from the 2014-15 oil plunge and market share war (Chart 18). Angola (1.4 million barrels per day), Algeria (one million barrels per day), and Nigeria (1.8 million barrels per day) are relatively sizable producers whose domestic stability is in question in the coming years as they cut budgets and deplete limited forex reserves to adjust to the lower oil price. This means fewer fiscal resources to keep political and regional factions cooperating and provide basic services. Algeria is particularly vulnerable. President Abdelaziz Bouteflika, who ruled as a strongman from 1999, was forced out last year, leaving a power vacuum that persists under Prime Minister Abdelaziz Djerad, in the wake of the low-participation elections in December. An active popular protest movement, Hirak, already exists and is under police suppression. Unemployment is high, especially among the youth. Neighboring Libya is in the midst of a war and extremist militants within Libya and North Africa would like to expand their range of operations in a destabilized Algeria. Instability would send immigrants north to Europe. Oil production will be reduced involuntarily as well as voluntarily this year due to regime failures. Brazil is not facing the risk of state failure like Algeria, but it is facing a deteriorating domestic political outlook (Chart 19). President Jair Bolsonaro’s popularity was already low relative to most previous presidents before COVID. His narrow base in the Chamber of Deputies got narrower when he abandoned his political party. He has defied the pandemic, refused to endorse social distancing or lockdown orders by local governments, and fired his Health Minister Luiz Henrique Mandetta. Chart 18Petro-States: 'Other Guys' Face Instability Petro-States: 'Other Guys' Face Instability Petro-States: 'Other Guys' Face Instability Chart 19Brazilian Political Risk Rising Again Brazilian Political Risk Rising Again Brazilian Political Risk Rising Again Brazil has a high number of coronavirus deaths per million people relative to other emerging markets with similar health capacity and susceptibility to the disease. This, combined with sharply rising unemployment, could prove toxic for Bolsonaro, who has not received a bounce in popular opinion from the crisis like most other world leaders. Thus on balance we expect the October local elections to mark a comeback for the Worker’s Party. The limited fiscal gains of Bolsonaro’s pension reform are already wiped out by the global recession, which will set back the country’s frail recovery from its biggest recession in a century. The country is still on an unsustainable fiscal path. Bolsonaro does not have a strong personal commitment to neoliberal structural reform, which has been put aside anyway due to the need for government fiscal spending amid the crisis. Unless Bolsonaro’s popularity increases in the wake of the crisis – due to backlash against the state-level lockdowns – the economic shock is negative for Brazil’s political stability and economic policy orthodoxy. Bottom Line: Our rule of thumb about petro-states suggests that they will generally act less aggressive amid a historic oil price collapse, but Iran may prove a critical exception. Investors should not underestimate the risk of a US-Iran conflict this year. Beyond that, the US election will have a decisive impact as the Democrats will seek to resume the Iranian nuclear deal and Iran would eventually play ball. Venezuela is less globally relevant this year – although a “wag the dog” scenario is a distinct possibility – but it may well be a major oil supply surprise in the 2020s. More broadly the takeaway is that oil production will be reduced involuntarily as well as voluntarily this year due to regime failures. Investment Takeaways Obviously any conflict with Iran could affect the range of Middle Eastern OPEC supply, not just the portion already shuttered due to sanctions on Iran itself. Any Iran war risk is entirely separate from the risk of supply destruction from more routine state failures in Africa. These shortages have been far less consequential lately and have plenty of room to grow in significance (Chart 20). The extreme lows in oil prices today will create the conditions for higher oil prices later when demand recovers, via supply destruction. Chart 20More Unplanned Outages To Come Drowning In Oil (GeoRisk Update) Drowning In Oil (GeoRisk Update) Chart 21European Political Risk No Longer Underrated European Political Risk No Longer Underrated European Political Risk No Longer Underrated An important implication – to be explored in future reports – is that Europe’s neighborhood is about to get a lot more dangerous in the coming years, as the Middle East and Russia will become less stable. Middle East instability will result in new waves of immigration and terrorism after a lull since 2015-16. These waves would fuel right-wing political sentiment in parts of Europe that are the most vulnerable in today’ crisis: Italy, Spain, and France (Chart 21). This should not be equated with the EU breaking apart, however, as the populist parties in these countries are pursuing soft rather than hard Euroskepticism. Unless that changes the risk is to the Euro Area’s policy coherence rather than its existence. Finally Russian domestic instability is one of the major secular consequences of the pandemic and recession and its consequences could be far-reaching, particularly in its great power struggle with the United States. We are reinitiating a strategic long in cyber security stocks, the ISE Cyber Security Index, relative to the S&P500 Info Tech sector. Cyberattacks are a form of asymmetrical warfare that we expect to ramp up with the general increase in global geopolitical tensions. The US’s recent official warning against an unknown actor that apparently intended to attack the health system of the Czech Republic highlights the way in which malign actors could attempt to capitalize on the chaos of the pandemic. We also recommend strategic investors reinitiate our “China Play Index” – commodities and equities sensitive to China’s reflation – and our BCA Infrastructure Basket, which will benefit from Chinese reflation as well as US deficit spending. China’s reflation will help industrial metals more so than oil, but it is positive for the latter as well. Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com   Footnotes 1 John Mauldin, "Don't Be So Sure That States Can't Go Bankrupt," Forbes, July 28, 2016, forbes.com.   Section II: Appendix : GeoRisk Indicator China China: GeoRisk Indicator China: GeoRisk Indicator Russia Russia: GeoRisk Indicator Russia: GeoRisk Indicator UK UK: GeoRisk Indicator UK: GeoRisk Indicator Germany Germany: GeoRisk Indicator Germany: GeoRisk Indicator France France: GeoRisk Indicator France: GeoRisk Indicator Italy Italy: GeoRisk Indicator Italy: GeoRisk Indicator Canada Canada: GeoRisk Indicator Canada: GeoRisk Indicator Spain Spain: GeoRisk Indicator Spain: GeoRisk Indicator Taiwan Taiwan: GeoRisk Indicator Taiwan: GeoRisk Indicator Korea Korea: GeoRisk Indicator Korea: GeoRisk Indicator Turkey Turkey: GeoRisk Indicator Turkey: GeoRisk Indicator Brazil Brazil: GeoRisk Indicator Brazil: GeoRisk Indicator Appendix Table 1 The Global Fiscal Stimulus Response To COVID-19 Drowning In Oil (GeoRisk Update) Drowning In Oil (GeoRisk Update) Section III: Geopolitical Calendar

Highlights Over the past year we have discussed “peak polarization” for the United States with many clients. We have held the contrarian view that political animosities within the US are nearing their peak. Feature Prior to COVID-19 we argued that polarization would either peak this year, with the US election, or in roughly two years – a scenario in which President Donald Trump won reelection and an epic partisan battle ensued with House Democrats over his second-term policy priority (probably the southern border wall). The global pandemic and recession have changed things. They are accelerating the peaking process, as a domestic consensus is forming on Big Government, border controls, and protectionism against China. It is also less likely that President Trump will scrape through with a narrow victory in November – rather, he will win or lose decisively. Policy consensus and a decisive electoral outcome should reduce polarization in the coming years. The risk to this view is that President Trump is reelected for a second time without a majority of the popular vote and then attempts major cuts to social spending to correct the country’s gargantuan budget deficits. This risk is vastly overrated. A corollary of our view is that US polarization will hit a boiling point in this election year. Polarization will remain extreme until the election results are confirmed, settled, and done. The conflict between Trump and the Democratic governors over when to reopen the virus-plagued economy is case in point. For investors, this view implies that, in the very near term, the dollar and global safe-haven flows will remain strong, defensive plays have further to run, and US equities will continue to outperform global. But over the long run, the dollar is already at extreme highs and global equities outside the US offer better value. The COVID Confederacy When we chose our theme for this year’s presidential election, “Civil War Lite,” we argued that the US faced a host of social and political challenges that would come to head by November 3. These challenges could manifest in violent social unrest or in an electoral or constitutional crisis that harmed government legitimacy. We did not expect COVID-19, but it has created exactly what our Civil War Lite theme implies: a clash between federal and state governments over who has the final say in the American system. Specifically, the Democratic-led states on the east and west coast are quarreling with the Trump administration over how and when to reopen their economies in the wake of tough “shelter in place” measures that have ground the economy to a halt in order to stem the pandemic. For the first time since the great realignment of US politics in the 1930s, the US is having an historic nationwide crisis in which the Republicans are asserting an overriding federal government and the Democrats are insisting on states’ rights. United States governors have formed two coalitions to determine when and how to reopen. On the West Coast, California Governor Gavin Newsom joined with the governors of Oregon and Washington states to set up a working group. On the East Coast – the epicenter of the pandemic in the US – Andrew Cuomo, Governor of New York, joined with his counterparts from New Jersey, Massachusetts, Connecticut, Delaware, Rhode Island, and Pennsylvania to set up a similar working group. Governor Cuomo fought a war of words with President Trump over who has the authority to invoke and revoke emergency health and security actions. President Trump declared, “When somebody is the president of the United States, the authority is total.” Cuomo rebuked him by saying, “we have a constitution … we don’t have a king.” Trump replied by suggesting that Cuomo and his fellow governors were engaging in “mutiny” and implied that he could use his enormous powers and funds as head of the federal government to decide the conflict. The conflict between President Trump and the “COVID Confederacy” heightens uncertainty in the near term. All parties have since softened their tone. Cuomo said he did not want confrontation, President Trump said that he would “authorize” all fifty governors to reopen their economies, and Newsom asserted his executive authority over California without addressing Trump’s comments directly. This conflict may be overrated from the point of view of long-term American stability – President Trump is not about to impose a naval blockade like Abraham Lincoln. But it is not overrated in the near term for financial markets. That is because the reopening plan remains undecided. The “COVID Confederacy,” as we facetiously call it, makes up a combined 38% of US gross domestic product (Table 1), which is shown here in our flow-based cartogram of the United States (Map 1). Each state is colored red or blue according to its Republican or Democratic Party Electoral College vote in 2016, and it is sized proportionally to its economic output. Map 1The COVID Confederacy: States That May Break With Federal Government Over Quarantines US: Peak Polarization US: Peak Polarization Table 1The COVID Confederacy As Share Of GDP US: Peak Polarization US: Peak Polarization We think this conflict matters because it heightens the uncertainty over the duration of quarantine measures, and hence the sufficiency of fiscal stimulus and the length of time until economic normalization. Markets do not like uncertainty. Second, the conflict could still escalate, given that President Trump could still try to push for an earlier economic opening than the Blue States are ready for. Third, even assuming that all sides recognize they need to cooperate amid crisis, the US election still hangs in the balance and the decision to open the economy will increase the death count and thus hypercharge the political contest. Bottom Line: We expect US politics to weigh on US and hence global equities in the near term, as they have already rallied by 24% since their trough in March. When And How Will The US Reopen? How will Trump’s conflict with the Democratic governors be resolved? President Trump is in an impossible situation. Reopening the economy earlier will lead to an increase in deaths – the US will move toward or past Sweden in Chart 1. This is in an election environment in which each death will be heavily politicized while the dangers of deeper recession will be more abstract. Not reopening the economy will add to the US’s historic losses in employment, production, and retail sales (Chart 2). Chart 1Reopening Will Improve Economy But Increase Deaths Per Million US: Peak Polarization US: Peak Polarization Chart 2Delayed Reopening Will Weigh On Stocks Delayed Reopening Will Weigh On Stocks Delayed Reopening Will Weigh On Stocks Even in the best-case scenario, in which the economy starts to reopen in May, mitigation efforts succeed, and deaths are limited, Trump will still be left with large-scale unemployment and recession. Historically unemployment is the best indicator for which direction the president’s approval will ultimately go (Chart 3). And bear in mind that interior Republican states will be at risk of subsequent outbreaks because they are on a later time frame for the virus peak and yet are most likely to comply with Trump’s reopening plan. The implication is that Trump is constrained and will ultimately decide to maintain the lockdowns longer than he is implying (May 1), and longer than the market expects. He would not want to be seen as losing the fight to the virus. As we go to press, Trump is finalizing “Opening Up America Again” guidelines. Leaving decisions to governors could mean accepting longer lockdowns. Chart 3AUnemployment Rate Leads The Way For Presidents Unemployment Rate Leads The Way For Presidents Unemployment Rate Leads The Way For Presidents Chart 3BUnemployment Rate Leads The Way For Presidents Unemployment Rate Leads The Way For Presidents Unemployment Rate Leads The Way For Presidents Meanwhile the Democratic governors who make up the COVID confederacy have a perverse incentive to hold out longer in maintaining strict social distancing. If they reopen too soon, deaths go up and they suffer the political consequences. Yet in normalizing the economy they risk helping Trump get reelected. To be sure, the governors cannot cut off their own economies to spite Trump. But they can continue to drag their feet. First, to show that they are “more competent” leaders who “rely on science” and thus ensure that Trump takes the blame for the increase in deaths. Second, because Trump’s declaration of “total authority” forces them to defend their power and prerogative as governors – this is a constitutional constraint on President Trump. A major problem for Trump is that, unlike Abraham Lincoln, he is asserting total authority over the states not to fight and win the war (in this case, against the virus), but to ease the recession. This is a risky position because subsequent outbreaks will hurt him. Public opinion polling suggests that 64% of voters think the government should prioritize fighting the virus while 29% think it should prioritize rebooting the economy – and this split is 51% versus 43% among Republicans (Chart 4). Chart 4Voters More Afraid Of Virus Than Recession US: Peak Polarization US: Peak Polarization Business leaders at the first meeting of Trump’s “Great American Economic Revival Industry Groups” testified that premature opening is counterproductive if virus testing is inadequate. It is risky for their employees, threatens dire legal consequences down the road, and may need to be reversed. To be sure, economic pressure will change voters’ and business leaders’ minds eventually. The Democratic governors will capitulate as demand for loosening grows. They may be bickering over a one or two week difference in reopening timelines. Testing is improving markedly, and New York is on track to be much better equipped to handle the required testing in the month of May. Still, there is a great risk that the governors delay at least two weeks beyond Trump’s timeline. And a two-week delay with these states costs, at minimum, $237 billion, or 3% of their GDP this year. There is also a risk that the dispute escalates and Trump resorts to coercion to pressure the states to reopen sooner, creating more uncertainty. If the federal government loosens guidance and Trump uses the “bully pulpit” to speed up reopening, the overall effectiveness of the state lockdowns will decline. This could cause the governors to tighten controls before they loosen them, or it could even cause the federal government to reverse course. House Democrats have cooperated on fiscal stimulus (see Appendix) with President Trump and Senate Republicans because they would not dare delay relief for households merely to undermine the president. But the political logic works differently for Democratic state governors when it comes to reopening the economy – they benefit politically from saving lives and opposing President Trump. Bottom Line: Ultimately the COVID confederacy of Democratic states will suffer immense pressure to reopen, so their contest with Trump may only amount to one or two weeks’ difference. But this “Civil War Lite” can get worse before it gets better. Investors face rising uncertainty over the coming month over the pace and extent of US reopening. Peak Polarization Chart 5Why We Called 2020 ‘Civil War Lite’ US: Peak Polarization US: Peak Polarization We chose our election theme because of the extreme levels of polarization in US politics. These will come to a head with the November 3, 2020 general election. It cannot be overstated that today’s polarization is empirically extreme – this is not subjective. Our quantitative election model shows that more and more states have a near-certain probability of sending their Electoral College votes to the party they already favor – meaning that these states are uncompetitive in the election due to the fixed opinion of voters (Chart 5, top panel). The difference in Republican and Democratic approval of the president is soaring far above the high points of the past forty years (Chart 5, bottom panel), a very simple sign of polarization. The most rigorous measure of polarization in American political science shows that polarization is the highest since the Civil War in the 1860s (a time when these data lose applicability). It is comparable to the Reconstruction era in the 1870s and the populist era in the early 1900s (Chart 6). Our quantitative model relies on leading economic indicators as of February and thus still gives President Trump victories in New Hampshire and Wisconsin. It predicts him winning the White House with 273 Electoral College votes, only a three-seat margin over the required 270 to win the Oval Office.1 The economic collapse will hurt his odds as data come in, as is clear when we “shock” our model with a 2008-sized slowdown (Chart 7). Chart 6US Polarization The Highest Since The Civil War US Polarization The Highest Since The Civil War US Polarization The Highest Since The Civil War Chart 7Our US Election Quant Model Shows A Tight Race US: Peak Polarization US: Peak Polarization The clearest and simplest sign of polarization is the long-term decline in presidential approval ratings and increase in disapproval ratings. Approval has not hit the low point, when George W. Bush presided over a financial meltdown on top of a foreign military quagmire, but it is near Truman and Nixon-era lows (Chart 8A). Chart 8AA Very Simple View Of US Political Polarization US: Peak Polarization US: Peak Polarization The lesson from this last chart is that Americans most approve of their presidents during times of prosperity at home and peace abroad, such as the late 1950s and early 1960s, the late 1980s (as the Soviets collapsed), and the late 1990s, during the post-Cold War “peace dividend.” Yet Trump’s first three years in office, despite peace and prosperity, did not witness a huge increase in approval. Extreme polarization will come to a head with the November election. Disapproval is even more telling. Historically, the disapproval rating peaks at a crisis point and then dramatically subsides – with a series of lower and lower peaks – in the subsequent years. This was true after the Korean War and Truman administration scandals, the Watergate scandal and Nixon’s resignation, and the first Iraq war and 1990-91 recession. But in the case of the Great Recession, polarization only briefly declined before it rapidly began mounting again, reaching a post-2008 peak under President Trump (Chart 8B). Chart 8BA Very Simple View Of US Political Polarization US: Peak Polarization US: Peak Polarization The last point suggests that the US was building toward a new crisis point and COVID-19 has created that moment. The question is whether Trump’s approval ultimately goes up or down as a result, and whether the nation bands together in the wake of the election as it did after past crisis elections (e.g. 1932, 1952, 1968, 1976). House Democrats and Republicans have cooperated on stimulus packages, as mentioned, but this cooperation will give way to cut-throat competition as the acute crisis subsides and the election approaches. Bottom Line: US polarization is historically extreme and will intensify ahead of the election. Election And Reconstruction Prior to COVID there were three main scenarios for polarization to escalate further in the 2020-22 period: Trump Narrowly Reelected: It is inherently rare for a president to win the Electoral College vote without winning the popular vote. It happened in 2000 and 2016, marking the polarized times. If it happened again it could easily be accompanied with vote recounts or Supreme Court intervention, like in 2000, or foreign meddling. Such a crisis would push polarization higher, once again emphasizing the parallel with the 1870s, such as the 1876 “Stolen Election.” Trump Narrowly Defeated: The same could be said if Trump were to lose narrowly. Disputed vote recounts, or faithless electors in the Electoral College, or other unexpected incidents would give rise to accusations of a Deep State coup d'état against President Trump, leaving his supporters disaffected. Wag The Dog: It is also conceivable that an international crisis could occur in which the President is accused of “wagging the dog,” orchestrating a rally-around-the-flag effect to get reelected. Our top contenders for such an event are Venezuela, Iran, or North Korea. The crisis has Iran even closer to the brink and it is continuing to spar with the US in the Gulf and in Iraq (Charts 9A & 9B). A war of choice would heighten polarization, particularly at a time when the public is war-weary. (Obviously a genuine, non-manipulated war could also occur, but it would reduce not heighten polarization.) Chart 9AIran Was Extremely Vulnerable … Iran Was Extremely Vulnerable... Iran Was Extremely Vulnerable... Chart 9B… Even Prior To COVID-19 US: Peak Polarization US: Peak Polarization COVID-19 has changed the outlook because it is much more likely now that Trump loses the election – yet it is also more likely that if he wins, he wins the popular vote. Chart 10Public View Of Trump’s Handling Of Pandemic Unclear Thus Far US: Peak Polarization US: Peak Polarization Trump is more likely to lose because he faces recession and charges of mishandling the pandemic. The “bounce” in his approval rating has already subsided (Chart 10). The bounce in his and Republican support have subsided faster than that of other comparable world leaders and ruling parties. Trump’s polling bounce was also extremely small relative to other major presidential bounces in modern history – especially bounces derived from an exogenous crisis that was not the president’s fault, like COVID. “Enemy” shocks tend to create a 20%-30% boost to approval (Table 2). This is especially worrisome evidence for Trump. Table 2Trump’s Crisis Polling Bounce Compared To Previous Presidential Bounces US: Peak Polarization US: Peak Polarization And yet Trump is more likely than he was prior to COVID to see his approval rise above 50% and win the popular vote. He briefly polled above 50% during the bounce. Look at Chart 10 again – his approval bounce is bottoming at 45%, higher than last year’s lows. There is still a 35% chance that Trump guides the country through the crisis and is rewarded at the voting booth. There are four reasons we still give Trump a 35% chance of winning. First, COVID itself is obviously not Trump’s fault (nor is it Xi Jinping’s). Second, the economy is going to benefit from historic stimulus. Third, COVID reinforces Trump’s major policy themes: tighter borders and more domestic manufacturing. Fourth, Biden is a weak challenger. Most importantly, a new national consensus is forming regardless of the US election outcome. The crisis has led to border shutdowns and highlighted the risk of globalization and border insecurity. Note that US policy on immigration first tightened under President Obama (Chart 11). In the post-COVID environment, candidate Biden will not be willing to be accused of wanting open borders. So this likely is an abiding theme in US politics – Biden will be more pro-immigration than Trump, but he will have to have some limits to protect against any future Trumpian populists. Chart 11AUS Will Tighten Immigration Laws One Way Or Another US: Peak Polarization US: Peak Polarization Chart 11BUS Will Tighten Immigration Laws One Way Or Another US: Peak Polarization US: Peak Polarization The COVID crisis has also exacerbated US-China tensions, urging “decoupling” and calling attention to US reliance on China to make testing kits, protective equipment, and key pharmaceuticals (Chart 12). As we have argued before, the US containment policy toward China began under President Obama’s “Pivot to Asia” and is likely to continue under a Biden administration, particularly in the wake of COVID. Biden will be less tariff-happy than Trump, but he cannot win the Rust Belt, and keep it, if he is soft on China. What about fiscal policy? The great debate is over taxes and spending. And yet COVID has laid the starkest divisions to rest. Trump was never a “limited government” Republican, but if he wins reelection on this basis there is very little chance that he will revert to a pre-COVID Republican position of slashing social spending and taxes. First, Democrats may still keep the House. Second, like Boris Johnson in the UK, Trump would need to solidify the new conservative beachhead among the working class. This would require fiscal accommodation, i.e. limited spending retrenchment, despite the extraordinary stimulus of the pandemic. Biden, for his part, will raise taxes but not as much as Democrats may desire due to the need for economic recovery. Thus polarization is much more likely to fall in the wake of COVID and the US election on a new policy consensus of more secure borders, trade protectionism, and greater government spending. This new consensus will be reinforced by the more left-leaning ideology of the Millennial generation, which will reinforce the shift toward Big Government that is occurring under a Baby Boomer Republican president (Chart 13). Chart 12US Will Diversify Supply Chain Away From China US Will Diversify Supply Chain Away From China US Will Diversify Supply Chain Away From China Chart 13The Democratic Party Ascendancy US: Peak Polarization US: Peak Polarization In the meantime the election conflict, rather than this new consensus, will dominate the national scene. Bottom Line: If Trump loses because of his handling of the pandemic and recession, it will likely be a landslide. Polarization will decrease, just as after earlier boiling points. His followers will be discouraged, leaving only a rump of loyalists. A new Democratic consensus is likely to emerge that incorporates policies that Obama and Trump had in common on borders and manufacturing. Polarization is likely to fall on a new policy consensus of more secure borders, trade protectionism and greater government spending.  If Trump wins because of his handling of the crisis, he is not likely to squeak by narrowly in the election. In this scenario he has by definition received a swell of support for his conduct amid a historic crisis. He would grow his mandate. This will reduce polarization under a new Big Government Republican consensus. Investment Takeaways Tactically we remain long defensive plays. We see no immediate end to dollar strength, safe haven flows, and US equity outperformance until the US pandemic stabilizes and a clear path for economic reopening begins to unfold. Even if US equities fall because of US political uncertainty this year, they can outperform international equities at least until Chinese and global growth stabilize and turn up. Strategically, we remain overweight global equities relative to US equities on the basis of relative valuations and looming US policy headwinds arising from more government intervention, more redistribution, and more on-shoring. China’s stimulus should help lift international equities over a one-year horizon. Note that in the near term this US equity underweight may continue to be offside. Housekeeping We are throwing in the towel on our long EUR-USD trade, which has lost 2% since inception, and our long German consumer services trade, which is down 6%. We are also closing our long Thai bonds trade relative to Malaysia for a miniscule gain of 1.4 basis points. We still recommend both of these markets as strong emerging market plays. Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com Footnotes 1 Over the past several months the model showed a tie, 269-269, which would have given Trump the victory through an arcane congressional process for selecting the president. Appendix: The Global Fiscal Stimulus Response To COVID-19 US: Peak Polarization US: Peak Polarization

Highlights The near-term is fraught with risk for US equities and global risk assets. Investors concerned over uncertainty, a slow recovery, and economic aftershocks must also guard against geopolitics. COVID-19 is not a victory for dictatorship over democracies. Democracies face voters and will ultimately improve government effectiveness. President Trump is likely to lose the US election. As this becomes increasingly likely, his policy will turn more aggressive, increasing geopolitical risks – particularly in US-China relations. Stay short CNY-USD. Stay long defense stocks. Feature Chart 1Another Downdraft Is Likely Geopolitics Is The Next Shoe To Drop Geopolitics Is The Next Shoe To Drop US equity prices have risen 26% since their March 23 low point, but our review of systemic global crises suggests that a re-test of the bottom would not be surprising (Chart 1). A range of mitigating health policies – plus still-growing policy stimulus – will most likely prevent a depression. But a longer than expected economic trough, due to some persistent level of social distancing pre-vaccine, and negative second-order effects, such as emerging market crises, could trigger another wave of selling. Moreover we expect another shoe to drop: geopolitics. A Light At The End Of The Tunnel Governments are starting to get a handle on the COVID-19 pandemic. The number of daily new cases in the European Union, which is most clearly correlated with global equities, has subsided (Chart 2). Chart 2Any Setbacks Will Hit Equity Market Hard Any Setbacks Will Hit Equity Market Hard Any Setbacks Will Hit Equity Market Hard The US is also seeing new cases crest. To be safe one should count on a subsidiary spike that could easily set back US equities after a notable stock market rally (Chart 2, second panel). But Europe has shown that social distancing works, which US investors will recognize. Italy’s Prime Minister Giuseppe Conte is expected to begin the gradual loosening of social controls to restart the economy. Since Italy is the hardest hit of the western nations (second only to Spain), its leaders will not relax lockdown measures unless they are sure they can do so safely (Chart 2, bottom panel). Still, if governments loosen controls too soon, they may have to tighten them again. Uncertainty will therefore persist regarding the pace of economic normalization, which is bound to be slow due to the fact that discretionary spending will remain suppressed, as it is today in China, and the special precautions that at-risk populations like the elderly will have to take. Economic stimulus measures are still growing in size. Japan’s stimulus, which we count at 16% of GDP, is smaller than the headline 20% but still very large. We have long argued that Japan was on the forefront of the move toward debt monetization among developed markets, but COVID-19 has accelerated the paradigm shift. The United Kingdom has now explicitly stated that the Bank of England will directly finance government debt. The Spanish government is proposing Universal Basic Income (UBI), which it hopes to make permanent, rather than merely for the duration of the pandemic. The jury is still out on whether the weak Pedro Sanchez government will be able to pass it but the current is in favor of “whatever it takes.” Italy’s Five Star Movement has long advocated universal basic income and is part of a ruling coalition that has received a wave of popular support to combat the crisis. At present only a more limited “income of emergency” is being legislated, in keeping with the more centrist Democratic Party, a coalition partner. But Italy’s devastation creates the impetus for bolder moves, either by this government or a subsequent government in 2021 or after. The European institutions are backstopping these states, at least for now, so any deeper disagreements about climbing down from stimulus will have to wait until the coming years. The EU itself is likely to announce additional fiscal measures, via the European Stability Mechanism, whose austerity requirements will be waived, and the European Investment Bank. We can see a token agreement on “coronabonds” (joint debt issuance by the Euro Area), but investors should not fixate on the eurobond debate. These would require a new mechanism, which is inexpedient, whereas the existing mechanisms are already sufficient to bankroll the huge deficit spending plans that the member states are already rolling out. The United States is negotiating an additional “phase four” package that could range between $500 billion and $2 trillion, meaning anywhere from 2.5% to 10% of GDP in new measures (Chart 3). Our estimate would err on the high side because it will largely consist of the same key elements as the “phase three” $2.3 trillion package: unemployment benefits and cash to households, plus a larger dollop for local governments than in the last package. Chart 3Fiscal Tsunami Is Still Building Geopolitics Is The Next Shoe To Drop Geopolitics Is The Next Shoe To Drop Congress is scheduled to return to vote the week of April 20, but an early return is entirely possible if the pandemic worsens. If the infection curve is flattening, then Republican Senators may hold out longer in negotiations. Squabbling would cause temporary agitation in equity markets. The Democrats and the Republicans still have a mutual interest in spending profusely: the Republicans to try to salvage their seats through economic improvement by November; the Democrats to prove their election proposition that a larger role for government is necessary. Finally, China is preparing to announce more stimulus. So far Chinese measures amount to only 3% of GDP but this is insufficient given the weakness in China’s economic rebound thus far. The expansion in quasi-fiscal spending (government-controlled credit expansion) is an open question, but we would guesstimate a minimum of 3% of GDP. Dramatic measures should be expected because China is undergoing the first recessionary environment since the Cultural Revolution and President Xi Jinping risks a monumental economic destabilization if he hesitates to shore up aggregate demand, which would ultimately threaten single-party rule. We see little chance of him making this mistake. The problem is that animal spirits and external demand will remain weak regardless, an occasion for disappointments among bullish equity investors. Moreover US-China geopolitical risks are rising again, as discussed below. Our updated list of fiscal measures for 25 countries can be found in the Appendix. Bottom Line: The pandemic is peaking in the US and EU, while more stimulus is coming. This is positive for equity investors with a 12-month time frame but the near-term remains vulnerable to another selloff. Democracies Are Not Less Effective Than Dictatorships The pandemic has given rise to wildly misleading narratives in the financial community and mainstream media about the political ramifications for different nations. Getting these narratives right is important for one’s investment strategy. The most popular is that China “won” – is expanding its global influence – while the United States “lost” – is failing at global leadership. More broadly the authoritarian eastern model is said to be triumphing over the western democratic model. The real distinction among states is whether they were familiar with pandemics emanating from China, the unreliability of China’s transparency and communications, and the need to track and trace infections from the beginning. Thus South Korea, Taiwan, Singapore, Vietnam, and Japan have all had relatively benign experiences and all but Vietnam are democracies, with varying degrees of representation and contestation. Nor is COVID-19 an “eastern” versus “western” thing. Germany did an effective job testing, tracking, and tracing infections as well. Germans are relatively law-abiding and trust Chancellor Angela Merkel and the state governments to “do the right thing.” Canada, with its experience of SARS, has also reacted effectively. Denmark, Austria, and the Czech Republic are already tentatively reopening their economies. Yet the number of new confirmed cases per million people shows that Germany is not wildly different from the US and Italy (Chart 4). The truth is that Italy’s bad fortune alerted the US and G7 states to take the threat more seriously – the US has had good outcomes in Washington State but bad outcomes in highly populated New York. Nor is it true that the American health care system is uniquely terrible in treating patients, as is so widely claimed. US deaths per million are worse than Germany but better than Italy (Chart 5) – and Italy’s health system is also not to blame. Failure of ruling parties to spring into decisive action is the main differentiator. Chart 4US In Line With Italy In New Cases … Geopolitics Is The Next Shoe To Drop Geopolitics Is The Next Shoe To Drop Chart 5… But Better In Limiting Deaths Geopolitics Is The Next Shoe To Drop Geopolitics Is The Next Shoe To Drop Chart 6Dictatorships Good At Halting Freedoms Geopolitics Is The Next Shoe To Drop Geopolitics Is The Next Shoe To Drop Dictatorships have had fewer cases and deaths, if their statistics can be trusted – which is a big if.1 This does not suggest that their governance model is better, but rather that they are better at halting freedoms, such as free movement (Chart 6). North Korea has zero cases of COVID-19. People were already under lockdown. Variation within the dictatorships stems from their policy responses and experience fighting pandemics. China, the origin of several recent outbreaks, has extensive experience. It also has a functional health system, fiscal resources, and a heavily centralized power structure. Iran, however, has less experience and capability. The question now is Russia, which was slow to react and has a growing outbreak, yet has a heavily centralized power structure to flatten the curve. Incidentally domestic risk is an important reason for Russia to cooperate with OPEC on oil production cuts, as we have argued. These points can be demonstrated by comparing COVID-19 deaths per million to each nation’s health capabilities and underlying vulnerability to the disease. Note that our intention is to highlight the role of policy in outcomes, not to attempt a full explanation of an epidemiological phenomenon. In Chart 7A, we judge health capacity by health spending per head and life expectancy at the age of 60. Nations that spend a lot per person, and whose people live longer, have better health systems. Yet many of these states are seeing the highest number of deaths because they are European and Europe was the epicenter of the outbreak. Chart 7ARich, Healthy Countries Got Hit Hardest Because Unprepared Geopolitics Is The Next Shoe To Drop Geopolitics Is The Next Shoe To Drop The US ranks right along with Germany and Sweden.2 Policy responses – early testing, tracking, and tracing – explain why South Korea has far fewer deaths than Italy and Spain on a population-weighted basis. However, the underlying conditions still matter, as the US’s health system, travel bans, and distance from the crisis produced better outcomes than its other policy responses would have implied. These data will be more accurate once the infection curve has flattened across the world. The situation is changing rapidly. If the US rises up in deaths per capita, it will be because of its slow responses, or subsequent policies. The same goes for emerging market economies that are ranking low in deaths but either have not seen the full effect of the pandemic, or had more time to adjust policy due to the crisis in Europe. Emerging market economies have lower health capacity, but also younger and hence healthier populations. The older the society, and the higher proportion of severe illnesses like heart and lung disease, the more susceptible to COVID-19 deaths, as Chart 7B shows. But yet again, the policy response still proves decisive. China has more deaths than some countries that are more vulnerable, because it got hit first. If Brazil and Turkey rise higher and higher above China in deaths, as is likely, it is because of policy failure, not basic vulnerability. Chart 7BEurope And US: Vulnerable Populations, Governments Slow To React Geopolitics Is The Next Shoe To Drop Geopolitics Is The Next Shoe To Drop Russia stands out as especially vulnerable in this Chart 7B. Here is where authoritarian measures may pay off, as with China, but only in the short term – since Russia will still be left with an elderly population highly prone to severe illness and a creaking health system. As mentioned above, the risk to Russian stability is a factor pushing for geopolitical cooperation in oil market cartel behavior to push prices up and improve the fiscal outlook to enable better domestic stability management. Bottom Line: Government policy, particularly preparedness and rapid action, have been the decisive factors in containing COVID-19, not dictatorial or democratic government types. The richest countries have the most freedoms and the most vulnerable elderly demographics. Within the rich countries, southern Europe reacted slowly and got hit hardest, with some exceptions. The US’s incompetence has been overrated, based on deaths, probably because of President Trump’s general unpopularity. These results are preliminary but they suggest that the US and EU will experience political change to address their lack of rapid action. Non-democracies will still have to deal with the recession and the consequences on social stability. Democracies Face Voter Blowback Democracies will face the wrath of voters once the immediate crisis dies down. The crisis has driven people to rally around the flag, creating polling bounces for national leaders and ruling parties. In some cases the trough-to-peak increase in popular support is remarkable – President Trump's approval reached 10 percentage points briefly, and he rose over 50% approval in some polls for the first time in his presidency (Chart 8A). Yet these initial bounces are already subsiding, as in Trump’s case (Chart 8B). Chart 8ADemocracies Are Accountable To Voters Geopolitics Is The Next Shoe To Drop Geopolitics Is The Next Shoe To Drop Chart 8BAnd Polling Bounces Are Fading Geopolitics Is The Next Shoe To Drop Geopolitics Is The Next Shoe To Drop By this measure, the US, Italy, France, and Spain all face serious political reckonings going forward. Trump is the first in the firing line. Our quantitative election model relies on state-level leading economic indicators that are lagging and show him still winning with 273 Electoral College votes (Chart 9A). However, if we introduce a 2008-magnitude economic shock to these indexes, the Democrats flip Michigan, Wisconsin, Pennsylvania, and New Hampshire, yielding 334 Electoral College votes for former Vice President Joe Biden (Chart 9B). This is assuming Trump’s approval rating stays the same, which, at 46%, is strong relative to the whole term in office. Chart 9AOur Quant Election Model Will Turn Against Trump When Data Catches Up Geopolitics Is The Next Shoe To Drop Geopolitics Is The Next Shoe To Drop Chart 9BA 2008-Style Shock To States Gives Democrats The White House Geopolitics Is The Next Shoe To Drop Geopolitics Is The Next Shoe To Drop Our qualitative judgement reinforces our election model. Historically, US elections are referendums on the ruling party. An incumbent president helps the party win reelection. But a recession is usually insurmountable. George Bush Sr lost in 1992 despite a shallow recession that ended the year before. While Joe Biden is a flawed candidate in numerous ways, the question voters face in November is whether they are better off than they were four years ago. With thousands of deaths and an unemployment rate at or above 20%, it is hard to see swing state voters answering “yes.” Not impossible, but we subjectively put the odds at 35%, and that could easily be revised downward if Trump’s polling falls back down to the 42% range. Trump will also be responsible for the handling of the pandemic itself. His administration obviously made several policy mistakes. A paper trail will highlight intelligence warnings as early as November, and warnings from his inner circle as early as January, that will hurt him.3 Objectively, the Republican Party’s greatest policy flaw, prior to COVID-19, was health care – and this will connect with COVID-19 even if the Affordable Care Act (Obamacare) has little to do with crisis response. Bottom Line: The first and most important political casualty of the pandemic will be Trump’s presidency. Not because the US is uniquely incompetent in the face of the pandemic – although it obviously could have done better, judging by several of the other democracies – but because this year happens to be an election year and democracies hold governments accountable. Major Risk Of Clash With China Chart 10China Likely To Depreciate The Renminbi China Likely To Depreciate The Renminbi China Likely To Depreciate The Renminbi There are two downside geopolitical risks that follow directly from the above. First, while the Democratic candidate Joe Biden is a “centrist,” his position will move to the left of the political spectrum. This is to energize the progressive faction of the party – which is already energized. The market will be taken aback if Biden produces major leftward shifts, in the direction of Senator Bernie Sanders, on taxes, regulation, health care, pharmaceuticals, banks, energy, or tech. This is not a problem when the market is down 36%, but as the market rallies, it becomes more relevant. While US taxes and regulation will go up, Biden will still have to win over the Midwestern Rust Belt voter through trade protectionism, a la Trump and Bernie. This will be exacerbated by the pandemic, which has supercharged American popular enmity toward China and fear of supply chain vulnerability toward China. When Biden reveals that he is protectionist too, US equities will react negatively. Second, more immediately, the clash with China may happen much sooner. As President Trump comes to realize he is losing his grip on power, he will have an incentive to retaliate against China for its mishandling of the pandemic, shift the blame, and achieve long-term strategic objectives as well. This makes Trump’s approval rating a critical indicator – not only of his reelection odds, but of whether he determines he has lost and therefore adopts more belligerent foreign or trade policy. We view the danger zone as anything less than 43%. If Trump becomes a lame duck, he could target China, or other countries, such as Venezuela. The advantage of the latter is that it could have the desired political effect without threatening the economic restart. A conflict with Iran would have bigger consequences – particularly negative for Europe. But in the COVID-19 context, Venezuela and Iran are not relevant to American voters. A conflict with North Korea, however, is part of the strategic conflict with China and would be hard to keep separate from broader tensions. This is only likely if Kim Jong Un stages a major provocation. At present, Washington and Beijing are keeping a lid on tensions. Presidents Trump and Xi are in communication. Beijing has rebuked the foreign minister who accused the US military of bringing COVID-19 to Wuhan. Trump has stopped using inflammatory rhetoric about the “Chinese virus.” China is not depreciating the renminbi, it is upholding other aspects of the trade deal, and it is sending face masks and ventilators to assist the US with the health crisis. But this could change. With its economy under extreme pressure, Beijing must take greater moves to stimulate. An obvious victim will be the renminbi, which is arguably stronger than it should be, especially if China cuts interest rates further, no doubt in great part because of the “phase one” trade deal with the United States (Chart 10). If and when Beijing decides that it must ease the downward pressure on exports and the economy, the renminbi will slide. This will provoke Trump. If he is convinced he cannot salvage the economy anyway, then he has an incentive to channel American anger toward China into new punitive measures over currency manipulation. Finally, the ingredients for our “Taiwan black swan” scenario are falling into place. Taiwan has long attempted to gain representation in the World Health Organization but has been blocked by Beijing’s assertion of the One China principle. However, Taiwan is now caught in an escalating tussle with the WHO leadership that involves both Washington and Beijing. Taipei warned the WHO as early as December that COVID-19 could be transmitted by humans and that the pandemic risk was high.4 Both China and the WHO leadership are simultaneously under pressure from the Trump administration for failing to share information and sound the alarm to prepare other nations. Bottom Line: If President Trump decides to prosecute China for its handling of the virus, and/or promote US-Taiwan relations in a way that aggravates China, then the trigger for a major geopolitical incident will have arrived. Investment Implications It is impossible to predict the precise catalyst or timing of such a crisis. We observe that the US and China are each experiencing historic economic dislocation, their strategic relationship has broken down over the past decade, and their populations are incensed at each other over grievances relating to the trade war, COVID-19, and various disinformation campaigns. Taiwan is at the epicenter of this conflict, due to its defense relationship with the United States and renewed political tensions with China under Xi Jinping. But the Chinese tech sector, North Korea, the South and East China Seas, Xinjiang, and Iran are also potential catalysts. Geopolitics is the other shoe to drop in the wake of COVID-19. Presidents Trump and Xi Jinping are the biggest sources of geopolitical risk, as we outlined in our 2020 forecast. They are cooperating in the immediate crisis, but in the aftermath there will be recriminations. A worsening domestic situation, a loss of prestige for either leader, or a foreign policy provocation could trigger punitive measures, saber rattling, or even military incidents. Risk assets are rallying on the light at the end of the tunnel. We are reaching and in some countries passing the peak intensity of the (first wave of the) pandemic. But the economic aftermath is extremely uncertain and the political fallout has hardly begun. In the US, the implication is clearly negative for Trump. But if that implication is realized, it points to much higher geopolitical risks within 2020 than are currently being considered as the world focuses on the virus. If President Trump chooses to wag the dog with Venezuela, that is obviously a much more positive outcome for global risk assets than if he attempts to achieve American strategic objectives of curbing China’s global assertiveness. Tactically, we remain defensive and recommend defensive US equity sectors and the Japanese yen. On a 12-month and beyond time frame we are more bullish on global growth and are long gold and oil. We remain strategically short CNY-USD and short Taiwanese equities relative to Korean.   Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com   Appendix Appendix TableThe Global Fiscal Stimulus Response To COVID-19 Geopolitics Is The Next Shoe To Drop Geopolitics Is The Next Shoe To Drop Footnotes 1 Given that one of Iran’s top health officials has criticized China for its questionable data and lack of transparency, one does not need to trust the US Intelligence Community’s assessment that China misled the world in the early days of the outbreak. See Matthew Petti, "Even Iran Doesn't Believe China's Coronavirus Stats," April 6, 2020. 2 Readers accustomed to the apocalyptic view of the US health system may wonder that the US comes out looking very well on health capacity. This is because we combine and standardize the scores for per capita spending and longevity. However our data also show that the US is inefficient on health: its life expectancy scores are slightly lower than those of the Europeans, yet it spends more per head. 3 See Josh Margolin and James Gordon Meek, "Intelligence report warned of coronavirus crisis as early as November: Sources," ABC News, April 8, 2020, and Maggie Haberman, "Trade Adviser Warned White House in January of Risks of a Pandemic," New York Times, April 6, 2020. 4 See "Taiwan says WHO failed to act on coronavirus transmission warning," Financial Times, March 19, 2020.

  Feature We are downgrading US President Donald Trump’s odds of winning election. We now consider him an underdog. Since November 2018 we had given Trump a 55% chance of victory – and when former Vice President Joe Biden clinched the nomination in the midst of the virus crisis we argued that the election was “too close to call.” Now, subjectively, we would say Trump has a 35% chance of winning. This is generous relative to history, but seems appropriate to us due to the unpredictable nature of the coronavirus pandemic (which could claim either presidential candidate), the massive US and global stimulus, and the weakness of his opponent. Trump’s approval rating has fallen, albeit slightly, amid the coronavirus pandemic (Chart 1). It is now deviating from the rising approval rating of President Barack Obama at this stage in the 2012 election cycle. Since Trump has been generally less popular than the average president (Chart 2), including Obama, this is a very worrying sign for Trump. Chart 1Virus Knocked Trump Off Track Downgrading Trump's Odds Of Reelection Downgrading Trump's Odds Of Reelection Chart 2Trump Has Zero Buffer For Loss Of Popularity Downgrading Trump's Odds Of Reelection Downgrading Trump's Odds Of Reelection It is also a worrying sign for global risk assets despite their recent collapse. Chart 3To Boost Economy, Trump Must Allow Outbreaks To Boost Economy, Trump Must Allow Outbreaks To Boost Economy, Trump Must Allow Outbreaks The risk that Trump becomes a “lame duck” president was one of our top two geopolitical risks for the year. The pandemic and recession have laid the groundwork for this risk to materialize (Chart 3).  Trump becomes a liability for the stock market if he concludes that he cannot win reelection. If he seems destined to lose, he has an incentive to use the powers of the presidency in his final months to “turn the tables” and change the narrative, or to cement his legacy by achieving long-term US national interests that have negative economic consequences. For now Trump apparently believes he can still salvage the economy in time to win reelection. He is softening his tone on the need for stringent social distancing policies that are designed to “flatten the curve” of the coronavirus burden on the health system. His administration will review the tough policies on Monday, March 30 before determining whether they should be extended. Individual states have leeway to maintain lockdowns, but a loosening of federal scrutiny would allow more workers to go back to work. While Trump’s desire to restart the economy is self-interested, it is true that too long of a shutdown could create negative feedback loops in the economy. A deeper slump might have worse consequences than the virus outbreak with targeted measures to mitigate the most vulnerable populations (e.g. those over 60, those with heart disease or type-2 diabetes). The problem for Trump is that if he runs on an economic ticket, he is already doomed. Unemployment is bound to rise and laid off workers tend to show up at polls to vote against the party in power. Otherwise Trump’s only option is to run as a “war president” and try to capitalize on the population’s general unwillingness to change leaders in the thick of a crisis. This strategy could work, but then Trump must tighten rather than loosen quarantines, at least over the next month. President George W. Bush benefited from the “war president” effect: his popularity surged after the September 11, 2001 terrorist attacks and the invasion of Iraq. It fell beneath 50% over the following three years, but it recovered as the election approached and the country decided not to “change horses in mid-stream.” Franklin Delano Roosevelt after Pearl Harbor is another analogy, albeit less applicable. Richard Nixon in 1972 is only roughly analogous because the recession began the year after his reelection. For President Trump to benefit from a similar dynamic we would need to see two things. First, his approval rating would need to hold steady through the worst of the crisis – from today throughout the spring – and then improve over the summer on the back of perceived progress in handling the outbreak. Second, we would need to see the economy improve from the deep contraction expected to occur in H1, so that by October voters feel the situation is improving and the future is brightening. Loosening vigilance against the virus and causing new outbreaks jeopardizes the first imperative, while maintaining or increasing vigilance jeopardizes the second part.   Few presidents have survived a recession – Trump is asking to do what no president has done since Teddy Roosevelt in 1904. Our quantitative US election model will shift decisively against Trump in April when new data becomes available for state economic indicators (Chart 4). Chart 4Quantitative Election Model Will Show Trump Defeat When Q1 Data Arrive Downgrading Trump's Odds Of Reelection Downgrading Trump's Odds Of Reelection This implies that Trump should double down on the painful isolation measures today to try to secure a victory in the battle against the virus. But then the recession is deeper – and the buck still stops with him for the initial mismanagement of the outbreak. Of course, the virus is not Trump’s fault, but it is a nationwide health crisis, and neither he nor his party can defend their record on health care. True, Biden is a weak opponent. Nevertheless a pandemic and recession would favor any opposition candidate. The burden is on Trump to surprise the world a second time. If the public becomes accustomed to the virus and the 8% of GDP US stimulus package kicks in, Trump might just pull it off, which is why we still give him a 35% chance. The silver lining for financial markets is that the 29% selloff in US equities from their peak earlier this year has already largely discounted any negative implications of a Democratic ascendancy, such as tougher regulation and higher corporate and individual tax rates. The fact that the Democratic candidate is Biden, not democratic socialist Bernie Sanders, is important because the Democrats are highly likely to take the Senate if they take the White House.  Biden would reduce some aspects of Trumpian populism and rehabilitate US alliances (e.g. with Europe). However, as with Trump, trade protectionism and great power competition with China and Russia will intensify.   A major underrated risk to markets this year is that Trump, running as a “war president” and facing a recessionary defeat, could adopt an aggressive foreign policy or trade policy, especially once the coronavirus outbreak subsides and a scapegoat is sought. A clash with China – including proxy battles over North Korea or Taiwan – is not out of the question. Bottom Line: We are downgrading Trump’s chances of winning reelection. However, a Biden presidency is no longer market-negative because the worst is discounted.    Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com    

Dear Clients, This week we are issuing two Special Alerts on the Russo-Saudi market share war, one of which you have already received. Our weekly publication will proceed as usual on Friday, March 13. In this Special Alert, we update our view of the US election and address the urgent question of US fiscal stimulus. Upcoming reports will address the question of stimulus outside the United States. All very best, Matt Gertken Vice President Geopolitical Strategy Feature Turmoil has engulfed financial markets as a Russo-Saudi market share war erupts at the same time as panic over the coronavirus spreads from China to Europe and the United States. The US and global stock markets are nearing bear market territory while the 10-year Treasury and global bond yields plumb new lows and deeper negatives (Chart 1). Our key risk-off indicators have all broken down (Chart 2). Chart 1The Bear Awakens The Bear Awakens The Bear Awakens Chart 2Global Risk-Off Global Risk-Off Global Risk-Off While the daily new cases of the virus are far from peaking in the US, the Democratic Party nomination process has eliminated the downside risk of a left-wing populist presidency. Political risk in the US will shift to Congress, fiscal stimulus, the general election, and the “lame duck” risk now threatening President Trump. Trump Not Yet Doomed, But No Longer Favored The US election is now “too close to call,” with the risks tilted toward a Trump loss. Bear markets tend to coincide with recessions (Chart 3). Woe betide a president seeking reelection amid a recession. Chart 3Bear Markets Tend To Coincide With Recessions Biden And Stimulus Biden And Stimulus We need to look to a previous era to identify precedents for Trump’s survival. William McKinley hung onto the office in 1900, Teddy Roosevelt in 1904, and Calvin Coolidge in 1924, all despite recessions.1 Rising unemployment will undo Trump’s re-election bid. In today’s terms, it is still possible that the virus panic will subside over the summer while a wave of global monetary and fiscal stimulus will kick in around September, creating a rebound that sends voters to the polls in an optimistic mood. But it is increasingly unlikely. Unemployment will rise as consumer confidence collapses in the face of the virus outbreak (Chart 4). This is deadly to a president with such narrow margins of victory in the key swing states. Chart 4Confidence Will Suffer, Layoffs To Ensue Confidence Will Suffer, Layoffs To Ensue Confidence Will Suffer, Layoffs To Ensue Chart 5Trump’s Approval Heading South Biden And Stimulus Biden And Stimulus Chart 6Republican Revival To Fall Back Republican Revival To Fall Back Republican Revival To Fall Back The coronavirus scare is already derailing President Trump’s approval rating. It had only tentatively recovered from a very low level throughout his first term and is highly unlikely ever to breach 50% (Chart 5). The surge in voters identifying as Republicans – which had recently, remarkably, surpassed Democrats – will reverse (Chart 6). Our quant election model is “too close to call” but will soon signal Trump loss. Our quant model was already flashing that the election is “too close to call,” due to the negative impact of Trump’s trade war on key swing states like Michigan and Pennsylvania. The weight of a feather can shift Wisconsin into the Democratic camp and turn the election against Trump (Chart 7). The model will inevitably show Trump losing the election once state-level data starts to reflect the virus shock. Chart 7Our Quant Election Model Says “Too Close To Call” … But Virus Panic Will Cause Wisconsin To Switch Biden And Stimulus Biden And Stimulus Bottom Line: The US election is too close to call at this point. With eight months to go, many things could still change, but a spike in unemployment will ruin Trump’s reelection bid. Biden, Not Sanders, Waiting In The Wings Chart 8Biden Has All But Clinched The Democratic Nomination Biden And Stimulus Biden And Stimulus The bad news for Trump – but the good news for markets – is that former Vice President Joe Biden has solidified his status as presumptive nominee for the Democratic Party presidential candidate. Biden romped to victory in Michigan and Missouri on March 10 – and is virtually tied with Vermont Senator Bernie Sanders in Washington, a liberal state that should favor the self-professed democratic socialist Sanders. Biden now clearly leads the count of pledged delegates to the Democratic National Convention on July 13 – and voting patterns in the remaining primary elections would have to reverse entirely in order to give Sanders a 1,991-vote majority of delegates in the first round of voting in July (Chart 8). It is unlikely that Sanders can deprive Biden of a majority of delegates even though he will trounce Biden in the final debate on March 15. The important state elections on March 17 are all favorable to Biden: Arizona, Florida, Illinois, and Ohio. Our delegate projections show Biden winning an outright majority by May 12 (Chart 9). Chart 9Biden Set To Win Majority Of Democratic Delegates By Spring Biden And Stimulus Biden And Stimulus Over the past year many clients have argued to us that neither Biden nor Sanders is electable. We have rejected this view on the basis that the economic cycle would most likely determine the election, since Trump had the misfortune of being a late-cycle president. The financial markets have dodged a bullet with Biden’s nomination since Sanders was capable of winning the nomination and now, with an impending recession, would be even odds (or favored) to take the White House. Chart 10Head-To-Head Polls Show Trump Vulnerability Biden And Stimulus Biden And Stimulus Average head-to-head polls show both Biden and Sanders beating Trump in the battleground states. This always suggested that Trump was highly vulnerable. But on the margin Biden is more electable than Sanders: he polls better against Trump than any Democrat, while Trump polls worse against him than any Democrat. Biden has an Electoral College pathway to victory via Florida and Arizona, as well as via the Midwestern states where Sanders is also competitive (Chart 10). Democrats ultimately chose Biden because he seemed the most likely to beat Trump. He also has the best position on the issue most important after the economy, which is health care (Chart 11). This reputation comes from his association with both President Barack Obama and the Affordable Care Act (Obamacare). A contested convention, in which the Democratic Party splits and progressive voters sit out the election, was always unlikely and is now virtually foreclosed. As he clinches the nomination Biden will seek to win over the support of progressives by choosing a progressive running mate and adopting more left-leaning policies on issues like inequality and the environment. Chart 11Democrats Chose Biden To Win And Restore Obamacare Biden And Stimulus Biden And Stimulus Chart 12Democratic Primary Turnout Strong In Vital Midwest Biden And Stimulus Biden And Stimulus Voter turnout in the primary elections suggests that voters are fired up in the Midwest (Michigan, Minnesota) but more complacent in the South (Texas, North Carolina) (Chart 12). Primary elections are different from general elections, but a worsening economy will provoke higher turnout. At minimum these data reinforce the point above that Trump is highly vulnerable in the Midwestern “Blue Wall” that narrowly brought him to power. Bottom Line: Biden is not only electable but at this stage equally likely as Trump to sit in the Oval Office in 2021. This is a market-positive policy outcome compared with the alternative – a Sanders presidency – which was almost equally probable in the event of a recession. Financial markets will see Biden as less negative than Sanders on regulation and taxes, and less negative than Trump on trade and foreign policy. Fiscal Stimulus A major source of uncertainty surrounding the election is fiscal policy, as a Democratic victory implies an increase in taxes on households and businesses. Not only is there a spike in tax provisions set to expire (top panel, Chart 13), but President Trump’s signature Tax Cut and Jobs Act could be repealed if he loses or made permanent if he wins. Chart 13Fiscal Uncertainty Looms Over US Fiscal Uncertainty Looms Over US Fiscal Uncertainty Looms Over US The short-term outlook is also in flux because the Trump administration is frantically trying to piece together an economic stimulus package to respond to the coronavirus shock. Democrats control the House of Representatives and have an incentive to delay and water down Trump’s stimulus proposals. However, they cannot be seen as playing politics with the nation’s health and livelihood and will ultimately agree to fiscal stimulus. This contradiction implies that financial markets will experience ongoing volatility as talks take place. Ultimately, Trump and the Democrats will cooperate, particularly as the financial constraint intensifies through market selling. Trump’s bid will be to stimulate the overall economy while House Speaker Nancy Pelosi and Senate Minority Leader Chuck Schumer will target the virus so as to keep the nation’s attention on health care without granting Trump a re-election fiscal bonus. The most significant short-term stimulus on offer would be a cut to payroll taxes. Trump’s preference may be to eliminate the entire 6% tax levied on worker income permanently, but he is more likely to get something on the magnitude of the 2011-12 temporary payroll tax cut (second panel, Chart 13). This was a two percentage point reduction in the tax (to 4%) for one year that ended up being extended for a second year. The size of the impact is roughly $75 billion for each percentage point for each year ($300 billion for two percentage points over two years). The risk is that the House Democrats may require modifications to Trump’s Tax Cut and Jobs Act that cause an impasse and financial markets to sell off before an agreement is reached.2 The Democrats, for their part, have a wish list of spending programs that they will insist on in exchange for a payroll tax cut. In particular they will seek to expand unemployment insurance for workers who lose their jobs in the impending slowdown, food stamps for unemployed and for children at home amid school closures, and mandatory paid leave (for parents with kids at home as well as sick people). The bill for such items can easily add up to $50-$100 billion in new spending. In addition, Congress and the White House have already approved an $8 billion virus mitigation package and additional packages of this size can happen quickly as the crisis requires. Trump is interested in another round of farm aid, given that China will fall short of its commodity purchases under the “phase one” trade deal, which could amount to $12-$15 billion. And Trump could always unilaterally rollback some of his tariffs on China or other trade partners. The combination of new spending and payroll tax cuts could bring the package to the $300-$400 billion range that Trump’s top economic adviser, Larry Kudlow, disapprovingly said was out of the question. It could easily amount to half of that. If the market continues to tank and the outlook for the US economy grows blacker, it will convince the Democrats that Trump is ruined unless they hurt their own image by appearing blatantly obstructionist amid a crisis. Bear in mind that the market wants a substantial stimulus not only because of the desire for a clear rebound in activity once the virus panic subsides, but also because the increasing odds of a Democratic victory in November mean that US tax rates will go up and corporate earnings will be revised downward. The country now faces a 50% chance of a 1%-2% fiscal tightening for each year in 2021-25 (Chart 14). Chart 14Biden Tax Hike Will Hit Corporate Earnings Biden And Stimulus Biden And Stimulus Chart 15US Fiscal Thrust To Surprise To Upside US Fiscal Thrust To Surprise To Upside US Fiscal Thrust To Surprise To Upside Thus a 1% of GDP fiscal stimulus for 2020 is the minimum necessary to improve sentiment. The US fiscal thrust – the change in the cyclically adjusted budget deficit – has already turned slightly positive this year, from what was expected to be a slight negative, due to a fiscally profligate budget deal between Trump and the Democrats last year (Chart 15). The one thing these blood enemies have in common is the need for more spending. Infrastructure spending is popular and has room to rise. Eventually the US will get stimulus, and it will surprise to the upside, even if the Democrats drag their feet to ensure that maximum political damage is inflicted on Trump this year. Not only is the fiscal setting inherently more dovish than it was in 2008, but Congress is bailing out plague-stricken households, not just Wall Street, this time around. The real game changer would be an infrastructure package. Americans spend about $140 billion or 0.7% of GDP each year on transport infrastructure, but popular opinion in both major political parties supports increases (Chart 16). The proposed sums are very large – Trump is proposing $1 trillion over a decade while Biden is proposing $1.3 trillion. The House Democrats have a bill worth $760 billion in new spending over five years ready to be passed. Also Trump is willing to capitulate on the Democrats’ preferred type of spending (direct deficit spending) due to his election constraint. These plans are all projecting considerable infrastructure spending on top of the Congressional Budget Office’s base line projection (Chart 17). Chart 16US Spends 0.7% Of GDP On Infra Each Year Biden And Stimulus Biden And Stimulus Chart 17Median Voter Wants More Infra Spending Biden And Stimulus Biden And Stimulus The fiscal multiplier of government spending is generally higher than tax cuts. Furthermore, the coronavirus hurts the economy by frightening households into their homes, which means that even the Democrats’ proposed cash transfers for low-income earners (those with a high marginal propensity to consume) may be impeded. Government-mandated infrastructure spending, by contrast, ensures that economic activity will pick up once the measures take effect (that is, with a 6-12 month lag … something the Democrats will become increasingly willing to agree to this spring given the election calendar). The impending US fiscal stimulus provides justification for going long infrastructure, construction, engineering, materials, mining, and environmental services sub-sectors included in the BCA Infrastructure Equity Basket (Chart 18). China’s large-scale stimulus measures reinforce this recommendation, since these firms are levered to China/EM growth. On a tactical basis, this trade is akin to catching a falling knife. Given our expectation that the world still faces challenges in overcoming the current turmoil, and the Democrats will hem and haw so as not to grant Trump his re-election wish list immediately, we await an opportune time to initiate this trade. A final reason to remain defensive on risk assets: the “lame duck” risk. If and when Trump’s re-election appears out of reach, he has an incentive to turn the tables. This could involve a radical or disruptive move in foreign or trade policy (e.g. on Iran, North Korea, Venezuela, China, or even Russia). At that point Trump could attempt to cement his legacy of cold war with China, or he could even lash out against Russian President Vladimir Putin, who has ostensibly stabbed him in the back by initiating a market share war with Saudi Arabia that may not be pieced back together in time to prevent job losses in shale oil swing states (Chart 19). Chart 18Look For Chance To Go Long Infrastructure Stocks Look For Chance To Go Long Infrastructure Stocks Look For Chance To Go Long Infrastructure Stocks Chart 19A Russo-Saudi Oil Market War Hurts Trump In Shale Swing States A Russo-Saudi Oil Market War Hurts Trump In Shale Swing States A Russo-Saudi Oil Market War Hurts Trump In Shale Swing States Presidential powers are least constrained in the international sphere. At the moment Trump is trying to save the economy and his presidency. But if it becomes a foregone conclusion that they cannot be saved, then he becomes a pure liability for risk assets. Housekeeping We are throwing in the towel on our US tech sector shorts for a loss of 36% and 11%, respectively, and also closing our long Thailand relative trade for a loss of 17%. We are also closing our tactical long Italian government bonds relative to Spanish for a loss of 2%. Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com   Footnotes 1 Coincidentally all were Republicans, like Trump – not that it matters. 2 The Democrats may seek to have Trump increase the tax rate on the highest income earners to the pre-TCJA level, or they may seek to increase the cap on the state and local tax deduction, which allows households (mostly high-income earners) in high-tax states to reduce their federal tax bill.

Highlights Joe Biden is the Democratic Party’s presumptive nominee following Super Tuesday. The onus is on Bernie Sanders to upset the race yet again. This is unlikely. Biden’s nomination is less market-negative than that of Sanders, but increases the risk of a Democratic Senate and hence tax hikes. The coronavirus threat to Trump’s reelection is two-pronged – and rising. Go long global equities ex-US on the basis that the virus fears will give way to public resilience and global stimulus. Feature A non-populist, non-protectionist candidate is emerging as the Democratic Party nominee for the US presidency – a positive development for global risk assets in 2020. Judging by preliminary results from the Democratic Party’s “Super Tuesday” primary elections, former Vice President Joe Biden has become the presumptive nominee, one of our key 2020 views. Our simple, back-of-the-envelope projection of delegates to the Democratic National Convention in Milwaukee, Wisconsin, July 13-16 shows that as long as Biden maintains his average vote share thus far, he is narrowly on track to win a majority of pledged delegates and thus clinch the nomination by June (Chart 1).  Chart 1Projection Of Democratic Delegates To National Convention, Milwaukee, July 2020 US Election: A Return To Normalcy? US Election: A Return To Normalcy? The chief risk to our view – that Vermont Senator Bernie Sanders, a left-wing populist, would run away with his momentum in February – has peaked. While Sanders won an average of 38% of the delegates on offer, he only won 28% of the popular vote, compared to Biden’s 44% of the delegates and 33% of the popular vote. The centrists as a bloc are outvoting the progressives and only two candidates are left. Ultimately Biden’s two-pronged path to victory in the Electoral College in November reinforces the Super Tuesday results, giving him greater electability and making him the likeliest victor of the Democratic Party primary. Super Tuesday Makes Biden Presumptive Nominee Biden racked up victories in key states including Texas, Massachusetts, Minnesota, and Virginia. He is now the leader in delegates to the party’s national convention (Chart 2), the popular vote, the number of states won, and the biggest states. The exception is California, one of the country’s most left-leaning states, where Sanders won, albeit with the combined progressive vote less than 50%. The voting pattern shows that Democrats still prefer centrist candidates to left-wing or “progressive” candidates by 50% to 40% on average (Chart 3). With two candidates left, this dynamic should favor Biden. Chart 2The Delegate Count Thus Far US Election: A Return To Normalcy? US Election: A Return To Normalcy? Chart 3Popular Vote: Biden/Centrists Versus Sanders/Progressives US Election: A Return To Normalcy? US Election: A Return To Normalcy? Chart 4Super Tuesday And Beyond US Election: A Return To Normalcy? US Election: A Return To Normalcy? By winning Texas and sweeping the South, Biden is heavily favored to win Florida on March 17 – always one of his strong suits vis-à-vis Sanders and a sign of electability in November. But his surprise victories over Sanders in Minnesota and Massachusetts show that he is competitive in the Midwest and Northeast, meaning that he is also likely favored to come out on top in Michigan and Ohio on March 10. The same goes for Illinois, the home state of his 2008-12 running mate Obama, on March 17 (Chart 4). True, in Minnesota and Massachusetts Biden benefited from Senator Elizabeth Warren’s clearing the 15% threshold, thus subtracting from Sanders’s vote share and delegate share. Warren may or may not drop out of the race. Sanders needs to arrest Biden’s Super Tuesday bounce and convince Democratic voters that he is more electable against Trump than Biden. This is a tall order for March 10-17, but Sanders has performed as well or better than Biden in the Northeast and Midwest as a whole, and these are the two regions that yield the most delegates in the rest of the primary (Chart 5).  Biden’s centrist rivals dropped out of the competition after his big win in South Carolina on February 29. His remaining centrist rival, Mayor Michael Bloomberg, suffered a humiliating defeat – pulling in Aspen, Colorado and Napa Valley California along with American Samoa despite spending over $400 million in advertisements (Chart 6). As we have argued, it takes votes, not just money, to win elections. Chart 5The Battle For The Northeast And Midwest US Election: A Return To Normalcy? US Election: A Return To Normalcy? Chart 6Bloomberg’s Folly US Election: A Return To Normalcy? US Election: A Return To Normalcy? It is a two-man race. If Biden can beat Sanders surrounded by competitors, then the onus is on Sanders to change the game from here. Otherwise Biden wins. Bottom Line: Biden is the likeliest winner. We will have to see another drastic change in momentum for this outcome to be overturned. Sanders’s underperformance on Super Tuesday suggests that his challenge to our base case (a centrist nomination) has peaked.    A Contested Convention? Still Unlikely Chart 7Biden’s Super Tuesday Bounce US Election: A Return To Normalcy? US Election: A Return To Normalcy? The coalescing of the centrist and progressive blocs, combined with a likely Super Tuesday bounce, will put Biden back in the lead in national polling (Chart 7). A contested Democratic convention remains unlikely, though it cannot be ruled out. Biden and Sanders are racing neck-and-neck for delegates and another twist in the race could deprive Biden of the simple majority of pledged delegates needed to clinch the nomination. The problem for Sanders is that in a close delegate matchup, a centrist candidate is favored to come out with the nomination. VIX futures suggest that this outlook is priced in, as they are falling for July (the month of the convention) relative to June (the conclusion of the primary election). Volatility induced by the primary election should gradually subside from now through July. Volatility will spike with the conventions in July mostly because of the uncertainty over the general election, and it should also pick up in September and October ahead of the November 3 vote. The spike in volatility that is always to be expected in the October ahead of a presidential election should continue increasing relative to July (Chart 8).   How can we be confident? The combination of the party establishment and the alternate or “reformist” centrist faction should be sufficient to overwhelm the combined “progressive” or anti-establishment bloc. Biden could fail to win the nomination on the first ballot, but the pro-establishment “super delegates” (party stalwarts who are not pledged to any particular candidate) would have the ability to swing subsequent ballots either in his favor or in favor of an alternate centrist (Chart 9). From a game-theoretical point of view, a sequential voting procedure is deadly to Sanders. His only hope was to rack up such a strong plurality in the primaries that he could take the convention by force. That is now unlikely. Chart 8VIX, Rightly, Not Pricing Contested Convention VIX, Rightly, Not Pricing Contested Convention VIX, Rightly, Not Pricing Contested Convention Chart 9Which Way Will The Super Delegates Swing? US Election: A Return To Normalcy? US Election: A Return To Normalcy? Even without a contested convention – and certainly with one – the Democratic Party could suffer from internal divisions that affect its challenge to the Republicans in November. The closer Sanders comes to Biden in delegate count, and especially if he should lead Biden yet still lose the nomination, the more his supporters will cry foul. In that case the party would send anywhere from 30%-40% of its voters away feeling disenfranchised. The worst-case scenario for the Democrats would be a convention troubled by open partisan rancor and social unrest, as occurred in the infamous 1968 convention in Chicago. Peace protesters against the Vietnam War and supporters of anti-war Senator Eugene McCarthy besieged the convention and were hounded and repressed by police forces under Chicago Mayor Richard Daley. Moderate Vice President Hubert Humphrey won the nomination despite the strong showing of anti-war sentiment in the primary election. The convention exposed the party’s rifts for all the nation to see. Humphrey went on to lose the election to Republican Richard Nixon. Chart 10Democrats Need To Avoid 1968 Replay Democrats Need To Avoid 1968 Replay Democrats Need To Avoid 1968 Replay Something akin to 1968 could occur this summer if Sanders’s supporters believe he has, for the second time, been deprived of the nomination unfairly in preference for a lackluster establishment candidate who will lose to Trump. But circumstances today are not (yet) so dire. The backdrop in 1968 was one of general upheaval, with opposition to the Vietnam War and the assassinations of Martin Luther King Jr and Robert F. Kennedy, the latter directly contributing to the dispute over delegates at the convention. The labor market was extremely tight (as today), but inflation was spiking (unlike today), fueling domestic unrest (Chart 10). The Democratic Party establishment is neither as disconnected from its base nor as draconian as in 1968. Biden or any other centrist nominee will seek to placate the left wing, likely through a leftward shift on some policies and a progressive vice-presidential pick. Opposition to Trump will act as a unifying force among Democrats. Bottom Line: A contested convention remains unlikely, but it cannot be ruled out. Biden is more likely to win the nomination due to his Super Tuesday bounce and the tailwind for centrists over progressives within the primary voting patterns thus far. If the convention is contested, it will likely result in a centrist candidate and the alienation of the progressive wing, and thus favor Trump’s reelection odds. Implications For The General Election Since November 2018 we have emphasized that US presidential elections are referendums on the incumbent party. Only rarely can the opposition defeat a sitting president amid an expanding economy, even if the ruling party lost the midterm election (as did the GOP in 2018). Major scandals reduce the historic reelection rate, but Trump has been acquitted so his biggest scandal is largely neutralized (Chart 11). The uptick in his approval rating after signing trade deals with China, Canada, and Mexico and getting acquitted by his fellow Republicans in the Senate confirms that he should be seen as favored for reelection. His approval is historically low but not prohibitive, as it tracks with Obama’s ahead of the 2012 election – low approval being in part a structural indicator of highly partisan times (Chart 12).  Chart 11Unseating An Incumbent Is Difficult US Election: A Return To Normalcy? US Election: A Return To Normalcy? Chart 12Trump’s Low Approval Not Prohibitive US Election: A Return To Normalcy? US Election: A Return To Normalcy? Yet Trump is only slightly favored. The coronavirus outbreak – and more importantly, the fear of it – threatens to damage Trump’s economy and highlight his fatal policy flaw: health care. Most of his first year in office consisted of a failed attempt to repeal and replace the Affordable Care Act (Obamacare), leaving 28 million Americans without health insurance (uninsured individuals increased by 2 million in 2018, the first increase since Obamacare was passed). The Democrats weaponized this gaping policy vulnerability in the vital Rust Belt swing states during the midterm election. Anything that shifts the focus of the election to health, as opposed to the growing economy, is positive for the Democrats on the margin (Chart 13). Granted, the narrative over Trump’s handling of the coronavirus crisis will become a non-diagnostic partisan battle. Neither Xi Jinping nor Donald Trump are responsible for the virus outbreak, but Trump is accountable for the popular perception of his handling of it whereas Xi is not. Ultimately the underlying material conditions of the economy will prove decisive. If the fear factor at home and abroad results in a sharper slowdown and higher unemployment by November, Trump is doomed. The swing states are already vulnerable because they took a heavy blow as a result of Trump’s trade war with China (Chart 14). Chart 13Is Health Care Trump’s Fatal Flaw? US Election: A Return To Normalcy? US Election: A Return To Normalcy? Chart 14Virus Fears Threaten Trump's Economy Virus Fears Threaten Trump's Economy Virus Fears Threaten Trump's Economy On the other hand, if the fear factor subsides due to the virus’s non-apocalyptic death rate, globally coordinated stimulus – starting with China but reinforced by the Federal Reserve’s surprise 50 basis point rate cut on March 3 – could generate a rebound by Q4 that redounds to Trump’s favor. Doesn’t America’s extreme political polarization create a kind of tribalism that overwhelms traditional “pocketbook” variables in forecasting an election (Chart 15)? Aren’t Democrats sufficiently fired up against President Trump to generate massive voter turnout that wipes out his thin margins of victory in the key swing states? After all, turnout in some of the primary elections is on par with the year the Great Recession began (Chart 16). Chart 15Does Reality Matter Amid Polarization? YES Does Reality Matter Amid Polarization? YES Does Reality Matter Amid Polarization? YES Chart 16Democrats Not Turning Out At 2008 Levels US Election: A Return To Normalcy? US Election: A Return To Normalcy? Most likely the economy will be decisive. Democratic fury against Trump will not translate as easily to the broader public if the economy is decent or rebounding in the second half of the year. Voter turnout tends to correlate with unemployment, including in the swing states (Chart 17). The coronavirus shock to the economy, not the blame game surrounding the virus or health care system, will be the determining factor. Chart 17Voter Turnout Responds To Economy … Including In Key Swing States US Election: A Return To Normalcy? US Election: A Return To Normalcy? This offers little consolation for Trump, since the brunt of the coronavirus impact on the economy is yet to be felt. While we still give Trump the benefit of the doubt for reelection, our quantitative election model says that the election is “too close to call,” primarily because of weak state-by-state leading economic indicators for Pennsylvania, Michigan, and Wisconsin (Chart 18). These indicators will tick down further due to the virus impact before they tick back up. Our base case is that the uptick will occur, but clearly the fear factor is the biggest risk to Trump’s reelection. Chart 18Quant Model Says US Election “Too Close To Call” US Election: A Return To Normalcy? US Election: A Return To Normalcy? The fact that Biden is a slightly more competitive candidate against Trump than Sanders will not help. Biden has a broader Electoral College pathway than Sanders. Both are competitive in the key Rust Belt swing states on which the 2016 election hinged – Michigan, Pennsylvania, Wisconsin. But Biden is also competitive in Florida, Arizona, and North Carolina, states largely closed to Sanders. Still, the difference between the Democratic challengers is marginal as neither is extremely charismatic and the election is a referendum on the ruling party and national direction as a whole. The Senate race is critical to the general election outcome (Chart 19). A Democratic president will be constrained if the Republicans maintain control – Sanders’s revolutionary agenda would be put on ice from the beginning, whereas Biden would have to focus on compromise (and would be prevented from repealing Trump’s tax cuts). Because Republicans saw a banner year in the Senate election in 2014 they must defend a larger number of competitive seats this year (10) than Democrats do (3) (Chart 20). If Democrats win the White House then they also need to win all three “toss up” races (Arizona, Colorado, Maine) – which is very doable – as well as keeping hold of their weakest seat (Alabama) or winning one additional seat (Kansas? North Carolina? Iowa?) in order to get an even balance in the Senate. This would give them the minimum necessary for majority voting since the vice president casts the decisive vote in a tie. Chart 19Democrats Lead Generic Ballot US Election: A Return To Normalcy? US Election: A Return To Normalcy? Chart 20Balance Of Power In The US Senate, 2020 US Election: A Return To Normalcy? US Election: A Return To Normalcy?   Winning this many seats seems extremely difficult, based on the voting patterns in 2016 and 2018 (Table 1, Appendix), unless one considers the type of national environment that would see the incumbent Trump removed from office: it is an environment in which either voter turnout or support rates have shifted, in which case voters who view the Republicans as discredited are less likely to retain Republican senators who carried Trump’s water in the impeachment trial. Note that Biden is an asset in every key Senate race mentioned above except Colorado, whereas Sanders is probably a liability. Chart 21Balance Of Power In the US House Of Representatives, 2020 US Election: A Return To Normalcy? US Election: A Return To Normalcy? By contrast the Democrats are defending many more seats than Republicans in the House of Representatives (Chart 21). Yet Republicans would have to retain their five toss-up seats, three vacant seats, while poaching 18 of the Democrats 19 toss-up seats, to reclaim a majority (Table 2, Appendix). This is possible if there is a strong economic rebound in the second half of the year and Trump is “winning” on other policies, but it is unlikely. Thus a second-term President Trump is much more likely to be constrained by the House than a first-term President Biden is likely to be constrained by the Senate. It follows that Trump would focus on foreign policy, where he faces the fewest constitutional constraints – and in a second term he would be unshackled from reelection concerns. He would only be constrained by the desire for a magnificent legacy that keeps Ivanka Trump electable someday. This is not a constraint worth betting money on, especially not in the first two years when he is fresh off reelection (2021-22). The implication is more trade war with China, Europe, or both. Meanwhile Biden with the Senate would focus on the Democrats’ domestic legislative agenda – and would be likely to rack up successes. Without the Senate he too would be driven toward foreign policy, and given his age he would face a limited reelection constraint, like Trump. Bottom Line: Biden’s likely nomination solidifies our view that if Democrats win, they are likely to eke out a bare one-vote majority in the Senate, though not guaranteed. Biden is a Democratic asset for key Senate races while Sanders would be more likely to be constrained by a Republican Senate. If Democrats lose, they would have to lose in the context of a big economic rebound (or some other policy windfall for Trump) in order to yield the House of Representatives. In the context of the coronavirus shock, this seems unlikely. But it is likeliest if the economy is rebounding and the Democrats run a “socialist” for the presidency. Economic Policy Implications The most important investment takeaway from Super Tuesday is that the “Bernie Sanders Panic Index” risk will now tend to subside and the key sectors of the US stock market – tech and health – plus financials and energy will no longer have as big of a threat of punitive regulation hanging over their heads (Chart 22). Chart 22Bernie Panic Index Will Subside Bernie Panic Index Will Subside Bernie Panic Index Will Subside Biden’s approach to health would be to restore and expand Obamacare, which is already the law of the land and thus not nearly as disruptive as the attempt by Sanders to create a universal single-payer program that would eliminate private insurance (a large source of uncertainty since it would have been extremely difficult to achieve yet central to his agenda). Incidentally, Big Pharma faces headwinds under Democrats or Republicans, as the populist demand for lower prices will carry the day. President Biden would certainly re-regulate, reversing the deregulatory tailwind for corporate profits and animal spirits under President Trump (Chart 23). But there is much less negative of an impact on business optimism and the job market under Biden than Sanders. Business concern over tax hikes, as outlined, will largely depend on the Senate outcome (Chart 24). The consolation for the financial markets is that, with Biden the presumptive nominee, the tax cut rollback would not be complete: Biden aims for a 28% corporate rate, which is still a net seven percentage point cut from 2016. Chart 23Trump’s De-Regulatory Shock US Election: A Return To Normalcy? US Election: A Return To Normalcy? Chart 24The Oval Office Has A Pen And A Phone The Oval Office Has A Pen And A Phone The Oval Office Has A Pen And A Phone   The financial industry has faced a long and rocky recovery since the 2008 crash, reminiscent of the tech sector in the wake of the dotcom bubble (Chart 25). A Democratic victory will be negative on the margin, as even Biden will need to sharpen his knives when it comes to the banks. Even the Wall Street candidate Bloomberg had proposed a financial transactions tax. By contrast, Trump would clearly benefit this sector – as long as the business cycle recovers and the yield curve steepens. Chart 25Regulation Returns To Financial Industry? Regulation Returns To Financial Industry? Regulation Returns To Financial Industry? The loser, in either outcome, is the tech sector – which is the most richly valued. Both Republicans and Democrats are investigating Big Tech for anti-competitive practices. Wealth inequality, and the eventual end of the bull market and business cycle, will generate public unrest and encourage the government to identify and punish scapegoats, as in the past with leading companies that had excessive market concentration (Chart 26). Yet neither Trump nor Biden will be as aggressive on this front as Sanders would be. Chart 26Anti-Trust Suits Distract From Inequality, Late-Cycle Woes Anti-Trust Suits Distract From Inequality, Late-Cycle Woes Anti-Trust Suits Distract From Inequality, Late-Cycle Woes Chart 27Infrastructure Stocks Will Reboot Infrastructure Stocks Will Reboot Infrastructure Stocks Will Reboot There is little difference between Trump and Biden (or Sanders for that matter) on the question of infrastructure. Americans want better infrastructure but an economic slowdown is required to provide the impetus. Democrats are unlikely to grant new spending to Trump prior to the election unless he is reelected or a full-blown economic collapse is occurring (in which it is his final act). The performance of BCA’s Infrastructure Basket will improve after the election given that both parties are embracing expansive fiscal spending while China is launching another stimulus mini-cycle (Chart 27). The fiscal trajectory of the United States is unlikely to correct anytime soon. Trumpism has routed the fiscal hawks within the Republican Party and Biden is attempting to lead a Democratic Party that is making increasingly extravagant spending demands. The median American voter is demanding greater government provision of services and social spending. If Democrats win the White House and Senate, they will be able to claw back some revenue by repealing Trump’s tax cuts, but the pressure to spend will outweigh their ability to increase taxes (Chart 28). They will need to expand non-defense discretionary spending even as mandatory outlays rise inexorably due to the aging of the population (Chart 29). Chart 28More Fiscal Profligacy In The US Outlook US Election: A Return To Normalcy? US Election: A Return To Normalcy? Chart 29Zero Chance Of Entitlement Cuts Zero Chance Of Entitlement Cuts Zero Chance Of Entitlement Cuts Investment Conclusions The US election is eight months away and much can change between now and then. What we know is that Biden now has the clearest path to the Democratic nomination, while Sanders would require another rapid reversal in momentum in order to take the lead. Even if he does, the Democratic convention will favor a centrist as long as Sanders falls short of a commanding lead, which is likely given the 50%-versus-40% split in favor of centrists over progressives thus far. A two-man race will favor Biden as long as this dynamic persists. Biden is slightly more competitive against Trump than Sanders, and slightly more likely to take the Senate for the Democrats. Yet ultimately Trump’s presidency will live or die based on the economy. Otherwise a significant policy humiliation (or surprise right-wing third party candidate) would be required to undo his reelection bid. Chart 30Valuations Favor Non-US Stocks Valuations Favor Non-US Stocks Valuations Favor Non-US Stocks Unfortunately for Trump, the coronavirus outbreak presents precisely this two-pronged risk of worsening economy and policy failure. If this risk fully materializes then he is finished, but markets will most likely have the consolation that it is Biden, not Sanders, waiting in the wings. Our base case remains constructive over the next twelve months, particularly for global stocks ex-US, which are much more heavily discounted and will benefit from Chinese stimulus (Chart 30). The virus shock is clearly a massive risk, but as long as the death rate does not surprise to the upside the ultimate impact will be public resilience and global stimulus.   Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com   Appendix Table 1Democrats Likely To Win The Senate If They Win White House US Election: A Return To Normalcy? US Election: A Return To Normalcy? Table 2Republicans Unlikely To Reclaim House Even If They Keep White House US Election: A Return To Normalcy? US Election: A Return To Normalcy? Footnotes

Highlights The latest interest rate cuts by central banks confirms the narrative that the authorities view economic risks as asymmetrical to the downside. This all but assures that competitive devaluation will become the dominant currency landscape in the near future. If the virus proves to be just another seasonal flu, the global economy will be awash with much more stimulus, which will be fertile ground for pro-cyclical currencies. In the event that we get a much more malignant outcome, discussions around interest rate cuts will rapidly evolve into quantitative easing and debt monetization. The dollar will be the ultimate loser in both scenarios, but this path could be lined with intermediate strength. Our highest-conviction call before the dust settles is to short USD/JPY. We are also making a few portfolio adjustments in light of recent market volatility. Buy NOK/SEK and NZD/CHF and take profits soon on long SEK/NZD. Feature The DXY rally that began last December faltered below overhead psychological resistance at 100, and has since broken below key technical levels. The V-shaped reversal has been a mirror image of developments in equity markets, with the S&P 500 off 6% from its lows. The catalyst was aggressive market pricing of policy action from the Federal Reserve, to which the authorities yielded. The latest policy action confirms the narrative that most central banks continue to view deflation as a much bigger threat than inflation, since few have been able to achieve their mandate. This all but assures that competitive devaluation will become the dominant currency landscape, as each central bank prevents appreciation in their respective currency. Should the Fed continue on the path of much more aggressive stimulus, this will have powerful implications for the dollar and across both G10 and emerging market currencies.   The US 10-year Treasury yield broke below 1% around 1:40 p.m. EST on March 3rd. This was significant not because of the level but because it emblematically erased the US carry trade for a number of countries (Chart I-1). Should the Fed continue on the path of much more aggressive stimulus, this will have powerful implications for the dollar and across both G10 and emerging market currencies.  Chart I-1The Big Convergence The Big Convergence The Big Convergence To Buy Or Sell The DXY? If the virus proves to be only slightly more lethal than the seasonal flu, the global economy will be awash with much more stimulus, which will be fertile ground for pro-cyclical currencies. As a counter-cyclical currency, the dollar will buckle, lighting a fire under our favorites such as the Norwegian krone and the Swedish krona. The euro will be the most liquid beneficiary of this move. Chart I-2 shows that the global economy was already on a powerful V-shaped recovery path before the outbreak. More importantly, this recovery was on the back of easier financial conditions. Chart I-2V-Shaped Recovery At Risk V-Shaped Recovery At Risk V-Shaped Recovery At Risk Chart I-3A Second Wave Of Infections? A Second Wave Of Infections? A Second Wave Of Infections? Our roadmap is the peak in the momentum of new infections outside of China. During the SARS 2013 episode, the bottom in asset prices (and peak in the DXY) occurred when the momentum in new cases peaked. Currency markets are currently pricing a much worse outcome than SARS. The risk is that we are entering a second wave of infections outside Hubei, China, which will be more difficult to control than when it was relatively more contained within the epicenter (Chart I-3). As we aptly witnessed a fortnight ago, currency markets will make a binary switch to risk aversion on such an outcome. This warns against shorting the DXY index or buying the euro or pound in the near term. As we go to press, the virus has been identified on almost every continent except Antarctica. Even in countries such as the US, with modern and sophisticated health facilities, the costs to get tested are exorbitant for underinsured individuals.1 This all but assures that the number of underreported cases is likely non-trivial, which could trigger another market riot once they surface. Chart I-4DXY and USD/JPY Tend To Move Together DXY and USD/JPY Tend To Move Together DXY and USD/JPY Tend To Move Together Our highest-conviction call before the dust settles is therefore to short USD/JPY. As Chart I-1 highlights, the Bank of Japan is much closer to the end of their rope in terms of monetary policy tools. Long bond yields have already hit the zero bound, which means that real rates in Japan will continue to rise until the authorities are forced to act. One of the triggers to act will be a yen soaring out of control, which is not yet the case. Speculative evidence is that it will take a yen rally in the order of 12% to catalyze the BoJ. More importantly, the speed of the rally will matter. This was the trigger for negative interest rates in January 2016 as well as yield curve control in September of 2016. The first rally from USD/JPY 125 to around 112 and the subsequent rise towards 100 were both in the order of 12%. A similar rally from the recent peak near 112 will pin the USD/JPY at 100.   Bottom Line: The yen is the most attractive currency to play dollar downside at the moment. Remain short USD/JPY. If global growth does pick up and the dollar weakens, the USD/JPY and the DXY tend to be positively correlated most of the time, providing ample room for investors to rotate into more pro-cyclical pairs (Chart I-4). Competitive Devaluation? In the event that we get a much more malignant outcome, discussions around interest rate cuts will rapidly evolve into quantitative easing and debt monetization. The Reserve Bank of Australia has already stated that QE is on the table if rates touch 0.25%.2 Other central banks are likely to follow suit. As the chorus of central banks cutting rates and stepping into QE on COVID-19 rises, the rising specter of currency brinkmanship is likely to unnerve countries pursuing more orthodox monetary policies. The currency of choice will be gold and other precious metals, though the dollar, Swiss franc, and yen are likely to also outperform.  The velocity of money in both the US and the euro area was in a nascent upturn, but has started to roll over.  Whether or not countries adopt QE, what is clear is that balance sheet expansion at both the Fed and the European Central Bank is set to continue. Chart I-5 shows that the velocity of money in both nations was in a nascent upturn, but has started to roll over. This tends to lead inflation by a few quarters. On a relative basis, our bias is that the pace of expansion should be more pronounced in the US. This will eventually set the dollar up for a significant decline, albeit after a knee-jerk rally. Chart I-5ADownside Risks To US Inflation Downside Risks To US Inflation Downside Risks To US Inflation Chart I-5BDownside Risks To Euro Area Inflation Downside Risks To Euro Area Inflation Downside Risks To Euro Area Inflation In terms of quantitative easing, it is most appealing when a country has low growth, low inflation, and large amounts of public debt. If we are right that inflation is about to roll over in the US, then the public debt profile and political capital to expand the budget deficit places the nation as a prime candidate for QE (Chart I-6). Fiscal stimulus is a much more difficult discussion in Europe, Japan, or elsewhere for that matter, and likely to arrive late. Chart I-6US Government Debt Is Very High US Government Debt Is Very High US Government Debt Is Very High The backdrop for the US dollar is a 37% rise from the bottom. The New York Fed estimates that a 10 percentage point appreciation in the dollar shaves 0.5 percentage points off GDP growth over one year, and an additional 0.2 percentage points in the following year.3 With growth now hovering around 2%, a strong currency could easily nudge US growth to undershoot potential.  The Fed is one of the few G10 central banks with room to ease monetary policy. This sets the dollar up for an eventual decline. However, the path to QE will be lined by a strong dollar if the backdrop is flight to safety. This entails rolling currency depreciations among some developed and emerging markets. When looking for the next candidates for competitive devaluation, the natural choices are the countries with overvalued exchange rates that are exerting a powerful deflationary impulse into their economies. Chart I-7 shows the deviation of real effective exchange rates from their long-term mean, according to the BIS. Chart I-7Competitive Devaluation Candidates Are Competitive Devaluations Next? Are Competitive Devaluations Next? Bottom Line: The Fed is one of the few G10 central banks with room to ease monetary policy. This sets the dollar up for an eventual decline. It will first occur among the safe havens (currencies with already low interest rates), before it rotates to more procyclical currencies. Where Does US Politics Fit In? Politics should start to have a meaningful impact on the dollar once the democratic nominee is sealed. Super Tuesday revealed a powerful shift to the center, pinning former Vice President Joe Biden as the preferred candidate (Chart I-8). The dollar tends to thrive as political uncertainty rises. While not a forgone conclusion, a Sanders–Trump rivalry would have been a very polarized outcome, putting a bid under the greenback. Markets are likely to take a more conciliatory tone from a Biden victory, which will be negative for the greenback.   Chart I-8US Politics Will Be Important Are Competitive Devaluations Next? Are Competitive Devaluations Next? Our colleague Matt Gertken, chief geopolitical strategist, just published his analysis of Super Tuesday.4 While a contested convention remains unlikely, it will likely favor Trump’s reelection odds. What is common about a Biden-Sanders-Trump trio is that fiscal policy is set to expand in the US. This will ultimately be dollar bearish (Chart I-9). Chart I-9The Dollar And Budget Deficits The Dollar And Budget Deficits The Dollar And Budget Deficits Bottom Line: The election is still many months away and much can change between now and then. For now, Biden is the preferred democratic nominee. Portfolio Adjustments Chart I-10Sell CHF/NZD Sell CHF/NZD Sell CHF/NZD The sharp rally in the VIX index has opened up a trading opportunity on the short side. The historical pattern of previous spikes in the VIX is that unless the market starts to price in an actual recession, which is quite plausible, the probability of a short-term reversal is close to 100%. Given our base case that we are not headed for a recession over the next six to 12 months, we are opening a short CHF/NZD trade today. The cross tends to benefit from spikes in volatility, correcting sharply as the market unwinds overreactions. More importantly, the cross has already priced in an overshoot in the VIX in an order of magnitude akin to 2008. Place stops at 1.75 with a target of 1.45 (Chart I-10). We are also placing a limit buy on NOK/SEK at parity. The risk to this trade is a further down-leg in oil prices, but at parity, the cross makes for a compelling tactical trade. Momentum on the cross is currently bombed out. We will be closely watching whether Russia complies with OPEC production cuts and act accordingly. Remain long NOK within our petrocurrency basket against the euro. We are also looking to take profits on our long SEK/NZD trade, a nudge below our initial target. The market has fully priced in a rate cut by the Reserve Bank of New Zealand, suggesting the kiwi could have a knee-jerk rally, similar to the Aussie on the actual announcement. Finally, we were stopped out of our short gold/silver trade for a loss of 5.5%. We will be looking to re-establish this trade in the coming weeks. Stay tuned. Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Bertha Coombs and William Feuer, “The coronavirus test will be covered by Medicaid, Medicare and private insurance, Pence says,” CNBC, dated March 4, 2020. 2 Michael Heath, “RBA Says QE Is Option at 0.25%, Doesn’t Expect to Need It,” Bloomberg News, dated November 26, 2019. 3 Mary Amiti and Tyler Bodine-Smith, “The Effect of the Strong Dollar on U.S. Growth,” Federal Reserve Bank of New York, dated July 17, 2015. 4  Please see Geopolitical Strategy Special Report, titled “US Election: A Return To Normalcy?”, dated March 4, 2020, available at gps.bcaresearch.com. Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 Recent data in the US have been positive: The ISM manufacturing PMI fell slightly to 50.9, dragged down by the prices paid and new orders component, while the non-manufacturing index ticked up to 57.3. Core PCE inflation increased to 1.6% year-on-year in January. Unit labor costs came in at 0.9% quarter-on-quarter in Q4 of last year. This is a deceleration from the previous print of 2.5%. The DXY index depreciated by 1.4% this week. Following a conference call with G7 central banks, the Fed made an emergency rate cut of 50bps. Chairman Powell cited risks to the outlook from Covid-19 but acknowledged that the Fed can keep financial conditions accommodative, not fix broken supply chains or cure infections. Report Links: The Near-Term Bull Case For The Dollar - February 28, 2020 On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Building A Protector Currency Portfolio - February 7, 2020 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Recent data in the euro area have been positive: Core CPI inflation increased slightly to 1.2% year-on-year in February.  The producer price index contracted by 0.5% year-on-year in January. The unemployment rate remained flat at 7.4% in January. Retail sales grew by 1.7% year-on-year in January, remaining flat from the previous month. The euro appreciated by 3.6% against the US dollar this week. As the ECB is limited by the zero lower bound, the euro strengthened on expectations that rate differentials with the US will continue to narrow. The ECB could resort to policy alternatives such as a special facility targeting small and medium enterprises. Markets are pricing in an 81% probability of a rate cut as we go into the ECB meeting next week. Report Links: On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 On Money Velocity, EUR/USD And Silver - October 11, 2019 Japanese Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data in Japan have been negative: The Tokyo CPI excluding fresh food grew by 0.5% year-on-year in February from 0.7% the previous month. The jobs-to-applicants ratio decreased to 1.49 from 1.57 while the unemployment rate increased to 2.4% from 2.2% in January. The consumer confidence index declined to 38.4 from 39.1 in February. Housing starts contracted by 10.1% year-on-year in January from 7.9% the previous month. The Japanese yen appreciated by 2.5% against the US dollar this week. Lower US yields, combined with continued risk-on flows, have extended the rally in the Japanese yen. Weakness in the Japanese economy is broad based, but the BoJ has limited policy space and fiscal action looks unlikely anytime soon. Global central bank action will drive the yen in the near term. Report Links: The Near-Term Bull Case For The Dollar - February 28, 2020 Building A Protector Currency Portfolio - February 7, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data in the UK have been mixed: Consumer credit decreased to GBP 1.2 billion from GBP 1.4 billion while net lending to individuals fell to GBP 5.2 billion from GBP 5.8 billion in January. Mortgage approvals increased to 70.9 thousand from 67.9 thousand in January, while the Nationwide housing price index grew by 2.3% year-on-year in February from 1.9% the previous month.  The British pound appreciated by 0.2% against the US dollar this week. At a hearing this week, incoming governor Andrew Bailey stated that the BoE is still assessing evidence on the nature of the shock from Covid-19. The BoE has limited room to cut and is constrained by possible stagflation; we expect targeted supply chain finance and cooperation with fiscal authorities to take precedence.   Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 A Few Trade Ideas - Sept. 27, 2019 United Kingdom: Cyclical Slowdown Or Structural Malaise? - Sept. 20, 2019 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Recent data in Australia have been mixed: GDP grew by 2.2% year-on-year in Q4 2019, improving from 1.7% the previous quarter.  Imports and exports both contracted by 3% while the trade balance dropped to AUD 5.2 billion in January. Building permits contracted by a dramatic 15.3% month-on-month in January, compared to growth of 3.9% in December. The RBA commodity price index contracted by 6.1% year-on-year in February.  The Australian dollar appreciated by 0.8% against the US dollar this week. The Reserve Bank of Australia cut its official cash rate to 0.5%, an all-time low, citing the impact of Covid-19 on domestic spending, education, and travel. Watch to see if the signal from building permits is confirmed by other housing market indicators. The RBA might not be done easing. Report Links: On AUD And CNY - January 17, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 A Contrarian View On The Australian Dollar - May 24, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 Recent data in New Zealand have been negative: The terms of trade index grew by 2.6% quarter-on-quarter in Q4 2019, improving from 1.9% in Q3. The ANZ commodity price index contracted by 2.1% in February, deepening from 0.9% the previous month. Building permits contracted by 2% month-on-month in January, from growth of 9.8% in December.  The global dairy trade price index contracted by 1.2% in March.  The New Zealand dollar appreciated by 0.3% against the US dollar this week. There is pressure on the Reserve Bank of New Zealand (RBNZ) to ease at its next meeting on March 27, with markets pricing in 42 basis points of easing over the next 12 months. However, the RBNZ has dispelled notions of a pre-meeting cut. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Place A Limit Sell On DXY At 100 - November 15, 2019 USD/CNY And Market Turbulence - August 9, 2019 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Recent data in Canada have been negative: Annualized GDP grew by 0.3% quarter-on-quarter in Q4 2019, slowing from 1.4% the previous quarter.  The raw material price index contracted by 2.2% and industrial product price index contracted by 0.3% month-on-month in January.  Labor productivity contracted by 0.1% quarter-on-quarter in Q4 2019, compared to growth of 0.2% the previous quarter. The Canadian dollar depreciated by 0.1% against the US dollar this week. The Bank of Canada (BoC) followed the Fed and cut rates by 50bps. In addition to the confidence hit from Covid-19, the BoC cited falling terms of trade, depressed business investment, and dampened economic activity due to the CN rail strikes. The BoC stands ready to ease further, and Prime Minister Trudeau has raised the possibility of a fiscal response.   Report Links: The Loonie: Upside Versus The Dollar, But Downside At The Crosses Updating Our Balance Of Payments Monitor - November 29, 2019 Making Money With Petrocurrencies - November 8, 2019 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Recent data in Switzerland have been positive: GDP grew by 1.5% year-on-year in Q4 2019, from growth of 1.1% the previous quarter. The SVME PMI increased to 49.5 from 47.8 in February. The KOF leading indicator increased to 100.9 from 100.1 in February. CPI contracted by 0.1% year-on-year in February, from growth of 0.2% the previous month. The Swiss franc appreciated by 1.6% against the US dollar this week. A combination of strong domestic data and global risk-off flows contributed to strength in the Swiss franc. However, the Swiss government will be revising down growth forecasts and a recent UN report has estimated that Switzerland lost US$ 1 billion in exports in February due to Chinese supply disruptions. Combined with a strong franc, this puts the domestic outlook at risk.  Report Links: On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 Portfolio Tweaks Before The Chinese New Year - January 24, 2020 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Recent data in Norway have been positive: The current account decreased to NOK 19.1 billion from NOK 29.5 billion in Q4 2019. The credit indicator grew by 5% year-on-year in January. Registered unemployment decreased slightly to 2.3% from 2.4% in February.  The Norwegian krone appreciated by 1.3% against the US dollar this week. Expect the petrocurrency to trade on news from the OPEC meetings in the coming days. The committee has proposed a production cut of 1.5 million barrels per day through Q2 2020, conditional on approval from Russia, to offset the demand shock from Covid-19.  Report Links: Building A Protector Currency Portfolio - February 7, 2020 On Oil, Growth And The Dollar - January 10, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Recent data in Sweden have been positive: The Swedbank manufacturing PMI increased to 53.2 from 52 in February. Industrial production grew by 0.9% year-on-year, from a contraction of 2.6% the previous month. GDP grew by 0.8% year-on-year in Q4 2019, slowing from 1.8% the previous month. The Swedish krona appreciated by 1.5% against the US dollar this week. After hitting a 2-decade high near 10, USD/SEK has violently reversed and is now trading at the 9.45 level. What is evident from incoming data is that the cheap currency has been a perfect shock absorber, cushioning the domestic economy. We are protecting profits on long SEK/NZD today and we will be looking for other venues to trade SEK on the long side.   Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019 Balance Of Payments Across The G10 - February 15, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights Joe Biden is the Democratic Party’s presumptive nominee following Super Tuesday. The onus is on Bernie Sanders to upset the race yet again. This is unlikely. Biden’s nomination is less market-negative than that of Sanders, but increases the risk of a Democratic Senate and hence tax hikes. The coronavirus threat to Trump’s reelection is two-pronged – and rising. Go long global equities ex-US on the basis that the virus fears will give way to public resilience and global stimulus. Feature A non-populist, non-protectionist candidate is emerging as the Democratic Party nominee for the US presidency – a positive development for global risk assets in 2020. Judging by preliminary results from the Democratic Party’s “Super Tuesday” primary elections, former Vice President Joe Biden has become the presumptive nominee, one of our key 2020 views. Our simple, back-of-the-envelope projection of delegates to the Democratic National Convention in Milwaukee, Wisconsin, July 13-16 shows that as long as Biden maintains his average vote share thus far, he is narrowly on track to win a majority of pledged delegates and thus clinch the nomination by June (Chart 1).  Chart 1Projection Of Democratic Delegates To National Convention, Milwaukee, July 2020 US Election: A Return To Normalcy? US Election: A Return To Normalcy? The chief risk to our view – that Vermont Senator Bernie Sanders, a left-wing populist, would run away with his momentum in February – has peaked. While Sanders won an average of 38% of the delegates on offer, he only won 28% of the popular vote, compared to Biden’s 44% of the delegates and 33% of the popular vote. The centrists as a bloc are outvoting the progressives and only two candidates are left. Ultimately Biden’s two-pronged path to victory in the Electoral College in November reinforces the Super Tuesday results, giving him greater electability and making him the likeliest victor of the Democratic Party primary. Super Tuesday Makes Biden Presumptive Nominee Biden racked up victories in key states including Texas, Massachusetts, Minnesota, and Virginia. He is now the leader in delegates to the party’s national convention (Chart 2), the popular vote, the number of states won, and the biggest states. The exception is California, one of the country’s most left-leaning states, where Sanders won, albeit with the combined progressive vote less than 50%. The voting pattern shows that Democrats still prefer centrist candidates to left-wing or “progressive” candidates by 50% to 40% on average (Chart 3). With two candidates left, this dynamic should favor Biden. Chart 2The Delegate Count Thus Far US Election: A Return To Normalcy? US Election: A Return To Normalcy? Chart 3Popular Vote: Biden/Centrists Versus Sanders/Progressives US Election: A Return To Normalcy? US Election: A Return To Normalcy? Chart 4Super Tuesday And Beyond US Election: A Return To Normalcy? US Election: A Return To Normalcy? By winning Texas and sweeping the South, Biden is heavily favored to win Florida on March 17 – always one of his strong suits vis-à-vis Sanders and a sign of electability in November. But his surprise victories over Sanders in Minnesota and Massachusetts show that he is competitive in the Midwest and Northeast, meaning that he is also likely favored to come out on top in Michigan and Ohio on March 10. The same goes for Illinois, the home state of his 2008-12 running mate Obama, on March 17 (Chart 4). True, in Minnesota and Massachusetts Biden benefited from Senator Elizabeth Warren’s clearing the 15% threshold, thus subtracting from Sanders’s vote share and delegate share. Warren may or may not drop out of the race. Sanders needs to arrest Biden’s Super Tuesday bounce and convince Democratic voters that he is more electable against Trump than Biden. This is a tall order for March 10-17, but Sanders has performed as well or better than Biden in the Northeast and Midwest as a whole, and these are the two regions that yield the most delegates in the rest of the primary (Chart 5).  Biden’s centrist rivals dropped out of the competition after his big win in South Carolina on February 29. His remaining centrist rival, Mayor Michael Bloomberg, suffered a humiliating defeat – pulling in Aspen, Colorado and Napa Valley California along with American Samoa despite spending over $400 million in advertisements (Chart 6). As we have argued, it takes votes, not just money, to win elections. Chart 5The Battle For The Northeast And Midwest US Election: A Return To Normalcy? US Election: A Return To Normalcy? Chart 6Bloomberg’s Folly US Election: A Return To Normalcy? US Election: A Return To Normalcy? It is a two-man race. If Biden can beat Sanders surrounded by competitors, then the onus is on Sanders to change the game from here. Otherwise Biden wins. Bottom Line: Biden is the likeliest winner. We will have to see another drastic change in momentum for this outcome to be overturned. Sanders’s underperformance on Super Tuesday suggests that his challenge to our base case (a centrist nomination) has peaked.    A Contested Convention? Still Unlikely Chart 7Biden’s Super Tuesday Bounce US Election: A Return To Normalcy? US Election: A Return To Normalcy? The coalescing of the centrist and progressive blocs, combined with a likely Super Tuesday bounce, will put Biden back in the lead in national polling (Chart 7). A contested Democratic convention remains unlikely, though it cannot be ruled out. Biden and Sanders are racing neck-and-neck for delegates and another twist in the race could deprive Biden of the simple majority of pledged delegates needed to clinch the nomination. The problem for Sanders is that in a close delegate matchup, a centrist candidate is favored to come out with the nomination. VIX futures suggest that this outlook is priced in, as they are falling for July (the month of the convention) relative to June (the conclusion of the primary election). Volatility induced by the primary election should gradually subside from now through July. Volatility will spike with the conventions in July mostly because of the uncertainty over the general election, and it should also pick up in September and October ahead of the November 3 vote. The spike in volatility that is always to be expected in the October ahead of a presidential election should continue increasing relative to July (Chart 8).   How can we be confident? The combination of the party establishment and the alternate or “reformist” centrist faction should be sufficient to overwhelm the combined “progressive” or anti-establishment bloc. Biden could fail to win the nomination on the first ballot, but the pro-establishment “super delegates” (party stalwarts who are not pledged to any particular candidate) would have the ability to swing subsequent ballots either in his favor or in favor of an alternate centrist (Chart 9). From a game-theoretical point of view, a sequential voting procedure is deadly to Sanders. His only hope was to rack up such a strong plurality in the primaries that he could take the convention by force. That is now unlikely. Chart 8VIX, Rightly, Not Pricing Contested Convention VIX, Rightly, Not Pricing Contested Convention VIX, Rightly, Not Pricing Contested Convention Chart 9Which Way Will The Super Delegates Swing? US Election: A Return To Normalcy? US Election: A Return To Normalcy? Even without a contested convention – and certainly with one – the Democratic Party could suffer from internal divisions that affect its challenge to the Republicans in November. The closer Sanders comes to Biden in delegate count, and especially if he should lead Biden yet still lose the nomination, the more his supporters will cry foul. In that case the party would send anywhere from 30%-40% of its voters away feeling disenfranchised. The worst-case scenario for the Democrats would be a convention troubled by open partisan rancor and social unrest, as occurred in the infamous 1968 convention in Chicago. Peace protesters against the Vietnam War and supporters of anti-war Senator Eugene McCarthy besieged the convention and were hounded and repressed by police forces under Chicago Mayor Richard Daley. Moderate Vice President Hubert Humphrey won the nomination despite the strong showing of anti-war sentiment in the primary election. The convention exposed the party’s rifts for all the nation to see. Humphrey went on to lose the election to Republican Richard Nixon. Chart 10Democrats Need To Avoid 1968 Replay Democrats Need To Avoid 1968 Replay Democrats Need To Avoid 1968 Replay Something akin to 1968 could occur this summer if Sanders’s supporters believe he has, for the second time, been deprived of the nomination unfairly in preference for a lackluster establishment candidate who will lose to Trump. But circumstances today are not (yet) so dire. The backdrop in 1968 was one of general upheaval, with opposition to the Vietnam War and the assassinations of Martin Luther King Jr and Robert F. Kennedy, the latter directly contributing to the dispute over delegates at the convention. The labor market was extremely tight (as today), but inflation was spiking (unlike today), fueling domestic unrest (Chart 10). The Democratic Party establishment is neither as disconnected from its base nor as draconian as in 1968. Biden or any other centrist nominee will seek to placate the left wing, likely through a leftward shift on some policies and a progressive vice-presidential pick. Opposition to Trump will act as a unifying force among Democrats. Bottom Line: A contested convention remains unlikely, but it cannot be ruled out. Biden is more likely to win the nomination due to his Super Tuesday bounce and the tailwind for centrists over progressives within the primary voting patterns thus far. If the convention is contested, it will likely result in a centrist candidate and the alienation of the progressive wing, and thus favor Trump’s reelection odds. Implications For The General Election Since November 2018 we have emphasized that US presidential elections are referendums on the incumbent party. Only rarely can the opposition defeat a sitting president amid an expanding economy, even if the ruling party lost the midterm election (as did the GOP in 2018). Major scandals reduce the historic reelection rate, but Trump has been acquitted so his biggest scandal is largely neutralized (Chart 11). The uptick in his approval rating after signing trade deals with China, Canada, and Mexico and getting acquitted by his fellow Republicans in the Senate confirms that he should be seen as favored for reelection. His approval is historically low but not prohibitive, as it tracks with Obama’s ahead of the 2012 election – low approval being in part a structural indicator of highly partisan times (Chart 12).  Chart 11Unseating An Incumbent Is Difficult US Election: A Return To Normalcy? US Election: A Return To Normalcy? Chart 12Trump’s Low Approval Not Prohibitive US Election: A Return To Normalcy? US Election: A Return To Normalcy? Yet Trump is only slightly favored. The coronavirus outbreak – and more importantly, the fear of it – threatens to damage Trump’s economy and highlight his fatal policy flaw: health care. Most of his first year in office consisted of a failed attempt to repeal and replace the Affordable Care Act (Obamacare), leaving 28 million Americans without health insurance (uninsured individuals increased by 2 million in 2018, the first increase since Obamacare was passed). The Democrats weaponized this gaping policy vulnerability in the vital Rust Belt swing states during the midterm election. Anything that shifts the focus of the election to health, as opposed to the growing economy, is positive for the Democrats on the margin (Chart 13). Granted, the narrative over Trump’s handling of the coronavirus crisis will become a non-diagnostic partisan battle. Neither Xi Jinping nor Donald Trump are responsible for the virus outbreak, but Trump is accountable for the popular perception of his handling of it whereas Xi is not. Ultimately the underlying material conditions of the economy will prove decisive. If the fear factor at home and abroad results in a sharper slowdown and higher unemployment by November, Trump is doomed. The swing states are already vulnerable because they took a heavy blow as a result of Trump’s trade war with China (Chart 14). Chart 13Is Health Care Trump’s Fatal Flaw? US Election: A Return To Normalcy? US Election: A Return To Normalcy? Chart 14Virus Fears Threaten Trump's Economy Virus Fears Threaten Trump's Economy Virus Fears Threaten Trump's Economy On the other hand, if the fear factor subsides due to the virus’s non-apocalyptic death rate, globally coordinated stimulus – starting with China but reinforced by the Federal Reserve’s surprise 50 basis point rate cut on March 3 – could generate a rebound by Q4 that redounds to Trump’s favor. Doesn’t America’s extreme political polarization create a kind of tribalism that overwhelms traditional “pocketbook” variables in forecasting an election (Chart 15)? Aren’t Democrats sufficiently fired up against President Trump to generate massive voter turnout that wipes out his thin margins of victory in the key swing states? After all, turnout in some of the primary elections is on par with the year the Great Recession began (Chart 16). Chart 15Does Reality Matter Amid Polarization? YES Does Reality Matter Amid Polarization? YES Does Reality Matter Amid Polarization? YES Chart 16Democrats Not Turning Out At 2008 Levels US Election: A Return To Normalcy? US Election: A Return To Normalcy? Most likely the economy will be decisive. Democratic fury against Trump will not translate as easily to the broader public if the economy is decent or rebounding in the second half of the year. Voter turnout tends to correlate with unemployment, including in the swing states (Chart 17). The coronavirus shock to the economy, not the blame game surrounding the virus or health care system, will be the determining factor. Chart 17Voter Turnout Responds To Economy … Including In Key Swing States US Election: A Return To Normalcy? US Election: A Return To Normalcy? This offers little consolation for Trump, since the brunt of the coronavirus impact on the economy is yet to be felt. While we still give Trump the benefit of the doubt for reelection, our quantitative election model says that the election is “too close to call,” primarily because of weak state-by-state leading economic indicators for Pennsylvania, Michigan, and Wisconsin (Chart 18). These indicators will tick down further due to the virus impact before they tick back up. Our base case is that the uptick will occur, but clearly the fear factor is the biggest risk to Trump’s reelection. Chart 18Quant Model Says US Election “Too Close To Call” US Election: A Return To Normalcy? US Election: A Return To Normalcy? The fact that Biden is a slightly more competitive candidate against Trump than Sanders will not help. Biden has a broader Electoral College pathway than Sanders. Both are competitive in the key Rust Belt swing states on which the 2016 election hinged – Michigan, Pennsylvania, Wisconsin. But Biden is also competitive in Florida, Arizona, and North Carolina, states largely closed to Sanders. Still, the difference between the Democratic challengers is marginal as neither is extremely charismatic and the election is a referendum on the ruling party and national direction as a whole. The Senate race is critical to the general election outcome (Chart 19). A Democratic president will be constrained if the Republicans maintain control – Sanders’s revolutionary agenda would be put on ice from the beginning, whereas Biden would have to focus on compromise (and would be prevented from repealing Trump’s tax cuts). Because Republicans saw a banner year in the Senate election in 2014 they must defend a larger number of competitive seats this year (10) than Democrats do (3) (Chart 20). If Democrats win the White House then they also need to win all three “toss up” races (Arizona, Colorado, Maine) – which is very doable – as well as keeping hold of their weakest seat (Alabama) or winning one additional seat (Kansas? North Carolina? Iowa?) in order to get an even balance in the Senate. This would give them the minimum necessary for majority voting since the vice president casts the decisive vote in a tie. Chart 19Democrats Lead Generic Ballot US Election: A Return To Normalcy? US Election: A Return To Normalcy? Chart 20Balance Of Power In The US Senate, 2020 US Election: A Return To Normalcy? US Election: A Return To Normalcy?   Winning this many seats seems extremely difficult, based on the voting patterns in 2016 and 2018 (Table 1, Appendix), unless one considers the type of national environment that would see the incumbent Trump removed from office: it is an environment in which either voter turnout or support rates have shifted, in which case voters who view the Republicans as discredited are less likely to retain Republican senators who carried Trump’s water in the impeachment trial. Note that Biden is an asset in every key Senate race mentioned above except Colorado, whereas Sanders is probably a liability. Chart 21Balance Of Power In the US House Of Representatives, 2020 US Election: A Return To Normalcy? US Election: A Return To Normalcy? By contrast the Democrats are defending many more seats than Republicans in the House of Representatives (Chart 21). Yet Republicans would have to retain their five toss-up seats, three vacant seats, while poaching 18 of the Democrats 19 toss-up seats, to reclaim a majority (Table 2, Appendix). This is possible if there is a strong economic rebound in the second half of the year and Trump is “winning” on other policies, but it is unlikely. Thus a second-term President Trump is much more likely to be constrained by the House than a first-term President Biden is likely to be constrained by the Senate. It follows that Trump would focus on foreign policy, where he faces the fewest constitutional constraints – and in a second term he would be unshackled from reelection concerns. He would only be constrained by the desire for a magnificent legacy that keeps Ivanka Trump electable someday. This is not a constraint worth betting money on, especially not in the first two years when he is fresh off reelection (2021-22). The implication is more trade war with China, Europe, or both. Meanwhile Biden with the Senate would focus on the Democrats’ domestic legislative agenda – and would be likely to rack up successes. Without the Senate he too would be driven toward foreign policy, and given his age he would face a limited reelection constraint, like Trump. Bottom Line: Biden’s likely nomination solidifies our view that if Democrats win, they are likely to eke out a bare one-vote majority in the Senate, though not guaranteed. Biden is a Democratic asset for key Senate races while Sanders would be more likely to be constrained by a Republican Senate. If Democrats lose, they would have to lose in the context of a big economic rebound (or some other policy windfall for Trump) in order to yield the House of Representatives. In the context of the coronavirus shock, this seems unlikely. But it is likeliest if the economy is rebounding and the Democrats run a “socialist” for the presidency. Economic Policy Implications The most important investment takeaway from Super Tuesday is that the “Bernie Sanders Panic Index” risk will now tend to subside and the key sectors of the US stock market – tech and health – plus financials and energy will no longer have as big of a threat of punitive regulation hanging over their heads (Chart 22). Chart 22Bernie Panic Index Will Subside Bernie Panic Index Will Subside Bernie Panic Index Will Subside Biden’s approach to health would be to restore and expand Obamacare, which is already the law of the land and thus not nearly as disruptive as the attempt by Sanders to create a universal single-payer program that would eliminate private insurance (a large source of uncertainty since it would have been extremely difficult to achieve yet central to his agenda). Incidentally, Big Pharma faces headwinds under Democrats or Republicans, as the populist demand for lower prices will carry the day. President Biden would certainly re-regulate, reversing the deregulatory tailwind for corporate profits and animal spirits under President Trump (Chart 23). But there is much less negative of an impact on business optimism and the job market under Biden than Sanders. Business concern over tax hikes, as outlined, will largely depend on the Senate outcome (Chart 24). The consolation for the financial markets is that, with Biden the presumptive nominee, the tax cut rollback would not be complete: Biden aims for a 28% corporate rate, which is still a net seven percentage point cut from 2016. Chart 23Trump’s De-Regulatory Shock US Election: A Return To Normalcy? US Election: A Return To Normalcy? Chart 24The Oval Office Has A Pen And A Phone The Oval Office Has A Pen And A Phone The Oval Office Has A Pen And A Phone   The financial industry has faced a long and rocky recovery since the 2008 crash, reminiscent of the tech sector in the wake of the dotcom bubble (Chart 25). A Democratic victory will be negative on the margin, as even Biden will need to sharpen his knives when it comes to the banks. Even the Wall Street candidate Bloomberg had proposed a financial transactions tax. By contrast, Trump would clearly benefit this sector – as long as the business cycle recovers and the yield curve steepens. Chart 25Regulation Returns To Financial Industry? Regulation Returns To Financial Industry? Regulation Returns To Financial Industry? The loser, in either outcome, is the tech sector – which is the most richly valued. Both Republicans and Democrats are investigating Big Tech for anti-competitive practices. Wealth inequality, and the eventual end of the bull market and business cycle, will generate public unrest and encourage the government to identify and punish scapegoats, as in the past with leading companies that had excessive market concentration (Chart 26). Yet neither Trump nor Biden will be as aggressive on this front as Sanders would be. Chart 26Anti-Trust Suits Distract From Inequality, Late-Cycle Woes Anti-Trust Suits Distract From Inequality, Late-Cycle Woes Anti-Trust Suits Distract From Inequality, Late-Cycle Woes Chart 27Infrastructure Stocks Will Reboot Infrastructure Stocks Will Reboot Infrastructure Stocks Will Reboot There is little difference between Trump and Biden (or Sanders for that matter) on the question of infrastructure. Americans want better infrastructure but an economic slowdown is required to provide the impetus. Democrats are unlikely to grant new spending to Trump prior to the election unless he is reelected or a full-blown economic collapse is occurring (in which it is his final act). The performance of BCA’s Infrastructure Basket will improve after the election given that both parties are embracing expansive fiscal spending while China is launching another stimulus mini-cycle (Chart 27). The fiscal trajectory of the United States is unlikely to correct anytime soon. Trumpism has routed the fiscal hawks within the Republican Party and Biden is attempting to lead a Democratic Party that is making increasingly extravagant spending demands. The median American voter is demanding greater government provision of services and social spending. If Democrats win the White House and Senate, they will be able to claw back some revenue by repealing Trump’s tax cuts, but the pressure to spend will outweigh their ability to increase taxes (Chart 28). They will need to expand non-defense discretionary spending even as mandatory outlays rise inexorably due to the aging of the population (Chart 29). Chart 28More Fiscal Profligacy In The US Outlook US Election: A Return To Normalcy? US Election: A Return To Normalcy? Chart 29Zero Chance Of Entitlement Cuts Zero Chance Of Entitlement Cuts Zero Chance Of Entitlement Cuts Investment Conclusions The US election is eight months away and much can change between now and then. What we know is that Biden now has the clearest path to the Democratic nomination, while Sanders would require another rapid reversal in momentum in order to take the lead. Even if he does, the Democratic convention will favor a centrist as long as Sanders falls short of a commanding lead, which is likely given the 50%-versus-40% split in favor of centrists over progressives thus far. A two-man race will favor Biden as long as this dynamic persists. Biden is slightly more competitive against Trump than Sanders, and slightly more likely to take the Senate for the Democrats. Yet ultimately Trump’s presidency will live or die based on the economy. Otherwise a significant policy humiliation (or surprise right-wing third party candidate) would be required to undo his reelection bid. Chart 30Valuations Favor Non-US Stocks Valuations Favor Non-US Stocks Valuations Favor Non-US Stocks Unfortunately for Trump, the coronavirus outbreak presents precisely this two-pronged risk of worsening economy and policy failure. If this risk fully materializes then he is finished, but markets will most likely have the consolation that it is Biden, not Sanders, waiting in the wings. Our base case remains constructive over the next twelve months, particularly for global stocks ex-US, which are much more heavily discounted and will benefit from Chinese stimulus (Chart 30). The virus shock is clearly a massive risk, but as long as the death rate does not surprise to the upside the ultimate impact will be public resilience and global stimulus.   Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com   Appendix Table 1Democrats Likely To Win The Senate If They Win White House US Election: A Return To Normalcy? US Election: A Return To Normalcy? Table 2Republicans Unlikely To Reclaim House Even If They Keep White House US Election: A Return To Normalcy? US Election: A Return To Normalcy? Footnotes

Feature “Bayesian: …statistical methods that assign probabilities or distributions to events…based on experience or best guesses before experimentation and data collection and that apply Bayes' theorem to revise the probabilities and distributions after obtaining experimental data.” — Merriam-Webster Dictionary Markets have reacted pretty rationally to the outbreak of the COVID-19 virus. Equities initially rebounded a few days ahead of the peak of new cases in China (Chart 1). But then, once the number of cases in the rest of the world started to accelerate, stock markets sold off again sharply. The MSCI All Country World Index is now down 13% from its peak on February 12. Recommended Allocation Monthly Portfolio Update: A Classic Bayesian Dynamic Monthly Portfolio Update: A Classic Bayesian Dynamic Chart 1Markets Have Reacted In Line With New COVID-19 Cases Monthly Portfolio Update: A Classic Bayesian Dynamic Monthly Portfolio Update: A Classic Bayesian Dynamic No one knows whether this episode will turn into an unprecedented pandemic, which will kill millions worldwide, last for months, and trigger a global recession. So it is the sort of environment in which Bayesian analysis becomes useful. Our “prior” for the probability of a full pandemic would be around 10-20%. If it doesn’t happen, an attractive buying opportunity for risk assets should present itself soon. But there could be further downside first, especially if the number of cases in major countries such as the US, Germany, and the UK were to accelerate significantly. There are some sign that Chinese activity is beginning to recover. There are some signs that Chinese activity is beginning to recover, as new cases of COVID-19 slow, thanks to the draconian measures taken by the authorities. Big Data can help analyze this. For example, live traffic statistics from TomTom show that by February 28, weekday road congestion in Shanghai was back to 50% of its normal level, compared to 19% on February 14 (Chart 2). The Chinese authorities have relaunched fiscal and monetary stimulus, causing short-term rates to fall to their lowest level since 2010 (Chart 3). Monetary policy has been upgraded from “prudent” to “flexible and moderate.” BCA Research’s China strategists believe there is even an increasing possibility of a stimulus overshoot in the next 6-12 months, as the authorities plan for the worst-case scenario but the economy rebounds.1 Chart 2Chinese People Getting Back On The Roads Monthly Portfolio Update: A Classic Bayesian Dynamic Monthly Portfolio Update: A Classic Bayesian Dynamic Chart 3Chinese Stimulus Pushing Down Rates Monthly Portfolio Update: A Classic Bayesian Dynamic Monthly Portfolio Update: A Classic Bayesian Dynamic In the short-term, it is clear that global growth will weaken, though quantifying this is hard. A 1% quarter-on-quarter decline in Chinese GDP in Q1 would bring growth down to 3.5% year-over-year. Our colleagues in BCA’s Global Investment Strategy estimate this would cause global growth to fall 0.8% below trend in Q1, mainly from a contraction in tourism, but that this would be largely made up in Q2, assuming that the epidemic is over by then (Chart 4).2 Could even a limited epidemic tip the world into recession? We doubt it. Consumer confidence remains strong in developed economies (Chart 5) and the virus is not yet serious enough to stop most consumers going out to spend. The global economy was in the process of bottoming out before COVID-19 hit (Chart 6) and there is little reason to think that we will not return to the status quo ante. Chart 4Global Growth To Slow In Q1, But Rebound In Q2 Monthly Portfolio Update: A Classic Bayesian Dynamic Monthly Portfolio Update: A Classic Bayesian Dynamic   Chart 5Consumers Remain Confident Monthly Portfolio Update: A Classic Bayesian Dynamic Monthly Portfolio Update: A Classic Bayesian Dynamic Chart 6Before COVID-19, Growth Was Bottoming Out Monthly Portfolio Update: A Classic Bayesian Dynamic Monthly Portfolio Update: A Classic Bayesian Dynamic We see the two biggest risks being: 1) a rise in defaults in China, especially among smaller companies, that the government is unable or unwilling to prevent (Chart 7); and 2) a deterioration in the jobs market in the US, as companies start to postpone hiring, or lay off staff (Chart 8). We will watch these carefully over coming weeks. Chart 7Are Chinese Companies Vulnerable? Monthly Portfolio Update: A Classic Bayesian Dynamic Monthly Portfolio Update: A Classic Bayesian Dynamic Chart 8Is The US Job Market Starting To Wobble? Monthly Portfolio Update: A Classic Bayesian Dynamic Monthly Portfolio Update: A Classic Bayesian Dynamic Chart 9Markets Believe Trump Would Beat Sanders Monthly Portfolio Update: A Classic Bayesian Dynamic Monthly Portfolio Update: A Classic Bayesian Dynamic There is one other risk that might give equity markets an excuse for a further sell-off: November’s US presidential election. The probability that Bernie Sanders wins the Democratic nomination has risen to 60% from 15% over the past two months. The consensus believes that Trump can easily defeat Sanders, which is why the President’s probability of being reelected has risen in tandem (Chart 9). But, if the economy starts to weaken and Trump’s approval rating slips, investors could become nervous about the likelihood of a market-unfriendly Sanders administration. We would not recommend long-term investors sell out of risk assets at this point. There could be an attractive buying opportunity over the next few weeks, and investors who have derisked should be looking for a reentry point. With US 10-year bonds yields at 1.2% and German yields at -60 basis points, it is hard to see much further upside for risk-free bonds. Equities should be able to outperform over the next 12 months, as growth rebounds following the COVID-19 episode. We have been recommending overweights in cash and gold, as hedges, since December, and these still make sense. However, if events over the coming weeks point to the risk of global pandemic being higher than we currently think, then investors should Bayesianally adjust and move more risk-off. Otherwise, a peak in COVID-19 cases ex-China should be a strong signal to buy risk assets again. Chart 10Why Should Long-Run Inflation Expectations Fall? Monthly Portfolio Update: A Classic Bayesian Dynamic Monthly Portfolio Update: A Classic Bayesian Dynamic Fixed Income: US Treasurys have become investors’ safe haven of choice over the past few weeks. A marked drop in long-run inflation expectations (Chart 10), in particular, has pushed the 10-year yield to a record low. This seems somewhat illogical, since the Fed will announce this summer the results of its review of monetary policy, which is likely to lead to a more dovish long-term inflation target (perhaps a commitment to achieve 2% on average over the cycle). The market has also priced in at least three Fed rate cuts by year-end (Chart 11). The Fed will certainly cut rates if US growth falters as a result of COVID-19, but this is by no means a certainty. History shows that Treasury yields jumped sharply once previous viral outbreaks ended (Chart 12). We expect yields to be significantly higher in 12 months, and so are underweight duration and prefer TIPS over nominal bonds. Credit will continue to underperform in the risk-off phase, but some interesting opportunities should arise soon, especially among the lowest-rated credits and in the Energy sector. Chart 11Will The Fed Really Be This Accommodating? Monthly Portfolio Update: A Classic Bayesian Dynamic Monthly Portfolio Update: A Classic Bayesian Dynamic Chart 12After Previous Virus Outbreaks, Rates Leapt Monthly Portfolio Update: A Classic Bayesian Dynamic Monthly Portfolio Update: A Classic Bayesian Dynamic Equities: The sell-off has already put on fire sale some stocks most affected by the epidemic. For example, cruise lines are down by 40% over the past month or so, European oil stocks 25%, some luxury goods makers 30%, and airlines 30%. Opportunistic investors might want to buy a basket of the most oversold quality names. Our overweight on euro area stocks has not worked in the sell-off. But, as a cyclical, export-oriented market, we continue to expect Europe to outperform when global growth rebounds. Euro area banks, in particular, represent the best call option on a rise in bond yields, since their performance is highly correlated to the shape of the yield curve. We continue to have a somewhat cyclical tilt among our sector weightings (with overweights on, for example, Energy and Industrials), but may adjust this in our Quarterly Portfolio Outlook in early April if we decide to reduce risk. The sell-off has already put on fire sale some stocks most affected by the epidemic. Currencies: The dollar is a safe-haven currency and so, unsurprisingly, has benefitted from the rush to safety in recent weeks. However, it remains overvalued (Chart 13), and interest rate differentials would move further against it if the Fed does cut rates, since other major developed central banks have much less room to move (Chart 14). This suggests that it will probably resume the weakness it experienced from August to December last year as soon as global growth rebounds. Chart 13Dollar Is Overvalued... Monthly Portfolio Update: A Classic Bayesian Dynamic Monthly Portfolio Update: A Classic Bayesian Dynamic Chart 14...And Interest Differentials Have Moved Against It Monthly Portfolio Update: A Classic Bayesian Dynamic Monthly Portfolio Update: A Classic Bayesian Dynamic Chart 15Metals Prices Stabilized In Recent Weeks Monthly Portfolio Update: A Classic Bayesian Dynamic Monthly Portfolio Update: A Classic Bayesian Dynamic Commodities: Industrial metals fell sharply on the outbreak of COVID-19 in China, but have bottomed in line with the stabilization of the situation in that country (Chart 15). Gold has worked predictably as the best hedge in the sell-off. While it is starting to look technically overbought and would be hurt by a rise in bond yields (Chart 16), for prudent investors it remains a useful hiding place amid heightened risk and ultra-low interest rates. Oil is the commodity that has fallen the most surprisingly, with Brent close to the low it reached during the sell-off in December 2018 (Chart 17).  It is much less dependent on Chinese demand than metals are, and so is maybe pricing in a global recession – as well as questioning the commitment of OPEC to cut production further. This would suggest upside to the oil price if global growth turns out not to be so bad, oil demand continues to pick up, and supply remains constrained.   Chart 16How Much Could Gold Overshoot? Monthly Portfolio Update: A Classic Bayesian Dynamic Monthly Portfolio Update: A Classic Bayesian Dynamic Chart 17Oil Discounting A Global Recession Monthly Portfolio Update: A Classic Bayesian Dynamic Monthly Portfolio Update: A Classic Bayesian Dynamic Garry Evans, Senior Vice President Chief Global Asset Allocation Strategist garry@bcaresearch.com Footnotes 1    Please see China Investment Strategy Weekly Report, “China: Back To Its Old Economic Playbook?” dated 26 February 2020, available at cis.bcaresearch.com 2   Please see Global Investment Strategy Weekly Report, “Market Too Complacent About The Coronavirus,” dated 21 February 2020, available at cis.bcaresearch.com GAA Asset Allocation  

Highlights We spent last week meeting with clients in South Africa, who maintained their equanimity despite the spread of the coronavirus: Maybe it was because there were not yet any reported cases close to home, but investors discussed the global outbreak dispassionately. We repeated our view that a US recession is not imminent, ex-a significantly adverse exogenous event: Tight monetary policy is a necessary precondition of a recession, and there’s no reason to expect that the Fed will make any move to remove accommodation in 2020. Investors were open to our view that the US economy is subject to upward inflation pressures, even if the time is not yet ripe for them to manifest themselves: Excess global capacity is still thwarting goods inflation, but it appears to be on its way to being absorbed. In the meantime, the Fed is deliberately encouraging the economy to run hot. Inflation just might surprise investors who have been lulled to sleep by its post-crisis absence. The presidential election is a hot topic in South Africa, too: The Democratic nomination appears to be Bernie Sanders’ to lose, and he has more of a chance in the general election than investors might expect. Feature We spent last week meeting with clients in South Africa. They expressed considerably more optimism about financial markets and the global economy than they did on our previous visit in January 2019, though we all conceded that the coronavirus outcome was unknowable. We discussed a wide range of topics, with COVID-19, recession prospects, the inflation outlook, and November’s election coming up in nearly every meeting. A summary of our discussions, organized by topic, follows below. Coronavirus Impressions We discussed the coronavirus at the beginning of every meeting, albeit after acknowledging that no one can know for sure how it will unfold. We discussed the virus’ potential outcomes, our base-case expectation, and the news and data we’re monitoring to track its course. Everyone is familiar by now with the best- and worst-case scenarios, and the continuum of possibilities in between, so we will not rehash them here. The main variables we have been watching – infection, mortality and recovery rates – are also surely familiar. From a review of those metrics within China – the daily rate of new incidences inside and outside of Hubei province (Chart 1), mortality (Chart 2) and recovery rates (Chart 3) within and without Hubei – there is good reason to conclude that China is gaining the upper hand, having sharply limited the virus’ spread beyond Hubei, and steadily slowing its spread in the epicenter. Chart 1Stringent Quarantine Measures Seem To Have Gotten Some Traction Road Trip Road Trip Chart 2Mortality Rates Are Inconclusive, ... Road Trip Road Trip Chart 3... But Recovery Rates Are Encouraging Road Trip Road Trip Unfortunately, however, other countries cannot perfectly replicate China’s template for corralling the virus, as their governments have considerably less ability to limit their citizens’ movements. It is a lot easier to impose and enforce a quarantine or other emergency restrictions in China than it is in any other major country. It is important, then, to consider not just the number of countries to which the virus spreads, but the characteristics of the countries themselves. In this sense, Italy and Iran may offer some insight. The Italians reacted swiftly and decisively when the first cluster emerged in northern Italy. They drew a circle with a large radius around the cluster, restricted movement in and out of that circle, and sharply limited activities within it. Carnival celebrations in Venice were called off, and Sunday’s slate of matches in Italy’s Serie A professional soccer league were cancelled (subsequent matches are being played in empty stadiums). Although the number of reported infections in Italy has been rising, and infections have begun to pop up in western and central Europe, Italian officials appear to have both the ability and the will to contain it. The Iranian experience contrasts with Italy’s. In Iran, the mortality rate (deaths divided by confirmed cases) is roughly five times greater than it has been everywhere else the virus has erupted. That seems improbably high, and our best guess is that the infections denominator is being undercounted. A country that cannot provide a reliable count (or a reasonably accurate estimate) of infections presumably lacks the public health infrastructure to contain the virus. We conclude that it matters where the infections occur – the wealthy countries of western Europe, North America, Asia and Oceania likely have a better chance of bringing the virus to heel than developing countries. Our interactions in South Africa, among the wealthiest countries in the developing world, may further reinforce the point. In several meetings, clients asked what entering the country was like. I told them that when I arrived at the Johannesburg airport on the morning of Sunday the 23rd, all passengers from international destinations had to pass by a screener who pointed a clunky object shaped like a radar gun in the vicinity of their nose and forehead. Several planes had landed just before mine and the passport control line wound around three or four times, affording repeated opportunities to look over the radar-gun employee’s shoulder at the images on her screen. They appeared to be simple black-and-white video of the arriving passengers without any color imagery to indicate body temperature ranges. The clients uniformly laughed at that detail, exclaiming that of course the screening was ineffectual. They then soberly conceded that Africa is especially vulnerable to an outbreak. If the coronavirus or another severe adverse exogenous event doesn't do it, it will take restrictive monetary policy to induce a recession. Infections outside of China are rising with no end yet in sight (Chart 4), but the news isn’t all bad. There are some promising treatment developments that may yield effective therapies, either from the conventional drug that worked wonders on an infected patient in Washington State and is now being tested on infected groups in China, or from antibody-based therapies of the type that were successfully deployed against Ebola. Our own views are conditional upon COVID-19’s evolution, but our current base case is that it is more likely to produce a soft patch within the context of a global expansion, and a correction within the context of a continuing equity bull market, than it is to trigger a recession or a bear market. Chart 4Now It's The Rest Of The World's Turn Road Trip Road Trip Recession Prospects Chart 5Necessary, If Not Sufficient Necessary, If Not Sufficient Necessary, If Not Sufficient Nearly every client asked us about the prospects for a US recession. We discussed how the negative term premium had made the yield curve more prone to invert, thereby diluting its predictive value, and asserted our view that restrictive monetary conditions are a necessary precondition of recessions (Chart 5). We touched on the rest of the points covered in last week’s report, which argued that a strong near-term outlook for consumption, dependable government spending and a post-trade-tensions recovery in investment would keep the US out of recession over a 12-month horizon. But we spent the most time outlining what we see as the most likely route to the next recession. Expansions don’t die of old age, they die because the Fed murders them, and we told our clients that we expect that maxim will be especially apropos in this cycle. Investors should therefore focus on the factors that will prod the Fed to embark on a tightening cycle with the express intent of reining in an overheating economy. We see two main catalysts: concern that inflation may get away from the Fed on the upside (discussed in the following section), and/or concern that there are unsustainable excesses in either the economy or financial markets. Chart 6The Real Economy Isn't Close To Overheating The Real Economy Isn't Close To Overheating The Real Economy Isn't Close To Overheating We contend that there are currently no signs of excesses in the real economy. Its most cyclical elements, which have driven overheating in the past, have not gotten back to their mean level, much less the red-line levels that have been associated with previous business cycle peaks (Chart 6, top panel). Proportional spending on consumer durables remains around the bottom of its 60-year range (Chart 6, second panel), investment in non-residential structures is quite low relative to history and comfortably in the middle of its post-1990-91-recession range (Chart 6, fourth panel), and residential investment is sitting at the level that previously marked business-cycle troughs (Chart 6, bottom panel). The only cyclical activity that looks a little frisky is equipment and software spending (Chart 6, third panel), which has the best chance of enhancing productivity and thereby yielding ongoing dividends. Financial market excesses are in the eye of the beholder, and reasonable people can disagree about their existence. The promiscuous application of the word “bubble” to anything and everything market related, however, has become as familiar and tiresome as rappers’ boasts of their prowess. The S&P 500’s steady climb higher doesn’t begin to approach the manic paths of prior decades’ hot assets (Chart 7). The key takeaway is that the economic or financial overheating likely to trigger the expansion’s ultimate denouement is yet to arrive. Until it does, the Fed will have no reason to intervene to stop it. Chart 7Which One Of These Is Not Like The Others? Which One Of These Is Not Like The Others? Which One Of These Is Not Like The Others? Inflation Prospects Many clients asked about inflation prospects before we could bring up the subject, a notable turnabout from our last visit thirteen months ago, when our arguments for accelerating wage gains met mostly with indifference. We were happy to oblige, as inflation occupies an essential place in our base-case cyclical scenario. Tight monetary policy is a necessary precondition for an endogenously occurring recession. Ex-a severe exogenous shock, like a global pandemic, the expansion cannot end without tight monetary conditions, and the Fed won’t knowingly impose them unless it is concerned that inflation is getting away from it on the upside. Q: Why has there been no whiff of US inflation in the last eleven years? A: Because the negative US output gap rendered it impossible until 2018. We are not daunted by inflation’s post-crisis hibernation. Meaningful price increases at the level of the entire economy cannot occur when an economy has a negative output gap (aggregate demand persistently falls short of economic capacity) unless its currency is sliding and it imports a lot of goods and services. From that perspective, inflation has only been possible in the US since 2018, because it didn’t close its output gap until 2017, according to estimates from both the IMF and the CBO. 2018 was the year that the US embarked on an unprecedented macroeconomic experiment (Chart 8), injecting fiscal stimulus amounting to one half of the economy’s long-run capacity (about 100 basis points) at a time when it was already operating at full capacity (2-2.25%). If corporations and other businesses viewed the surge in aggregate demand as a one-off event that couldn’t be replicated in the future, they would likely choose not to invest in additional capacity to meet it. The net result was demand in excess of supply in 2018 and in 2019, when an additional 50 basis points of stimulus was deployed. Inflation did not break out in either year, but negative output gaps in the rest of the developed world provided the US with the convenient out of importing other countries’ excess capacity. Chart 82018's Unprecedented Macroeconomic Experiment May Yet Produce Inflation 2018's Unprecedented Macroeconomic Experiment May Yet Produce Inflation 2018's Unprecedented Macroeconomic Experiment May Yet Produce Inflation The Bank of Canada estimated that Canada closed its output gap in 2018, and the IMF estimates that Europe’s output gap has now closed (Chart 9, top panel), and while even Japan has made a lot of progress on narrowing its output gap (Chart 9, bottom panel). Goods inflation is largely globally determined, and with excess capacity being absorbed around the world, it’s possible that the conditions that would allow for higher goods prices could soon lock into place. Services inflation, a predominantly domestic phenomenon, is poised to rise thanks to the tight-as-a-drum labor market. Just when inflation will rear its ugly head is uncertain, however, as it is a lagging indicator that often doesn’t peak, until a recession has nearly ended, or trough for nearly three years after a recession begins (Chart 10). Chart 9The Slack Is Being Absorbed The Slack Is Being Absorbed The Slack Is Being Absorbed Chart 10It May Take A Long Time For 2018's Seeds To Germinate Road Trip Road Trip We find supply and demand arguments compelling, and the excess-supply constraint on global goods inflation has quietly been easing. The bottom line is that we think the US economy harbors upward inflation pressures, though it is highly unlikely that they will manifest themselves this year. That will give the Fed free rein to allow the economy to run hot across all of 2020, in service of its primary goal of pushing inflation expectations higher, and the labor market as well, in service of its secondary goal of spreading the benefits of easy policy more evenly across the economy. The upshot is that the longer inflation remains outwardly dormant, the harder it will be to root it out once it eventually does begin to bloom. The World Is Watching American Voters As an indication of the anticipation surrounding November’s election, South African investors, who recognized Bernie Sanders’ name, asked about it in every meeting. We laid out our geopolitical strategists’ views, augmented in places by our own, on the key issues as follows: Presidential elections are referendums on the incumbent party. An incumbent president running for re-election has a sizable built-in advantage. In the postwar era, only major economic, social or international shifts have been sufficient to erode that advantage. Incumbents lose when a recession occurs near an election, but the president has to be considered a favorite if the expansion continues. The president may be an especially poor front-runner. Donald Trump personifies variability. That’s a great trait to have as an underdog, because a wide dispersion of individual outcomes broadens the range of possible competitive outcomes, but it’s a vulnerability for a favorite. It is nearly impossible for a golfer with a two-stroke lead ahead of the final par-four eighteenth hole to lose if s/he conservatively plays for par. It seems to us that the president is not wired to play conservatively, and our geopolitical strategists currently give him just a 55% chance of re-election. Bernie Sanders is not unelectable. Our geopolitical strategists note that the median voter is moving to the left, and that Sanders is many Biden supporters’ second choice. He may not be anathema to the broader public in the general election, and his leveling platform may play well in the Rust Belt states that are poised to decide the election once again. A Sanders administration would not transform America into France, but it would chip away at corporate profits. Our personal view is that a President Sanders would not mark the end of the US as a beacon of free enterprise. The Constitution was designed to obstruct dramatic changes, and his ability to pass major legislative initiatives is likely exaggerated. We think he could make his influence felt much more directly in the bureaucratic and regulatory spheres, where a president can act virtually unimpeded. A Sanders administration would be a devoted and presumably activist friend of labor, and a tenacious foe of corporate concentration. An administration that energetically champions organized labor and vigorously enforces anti-trust statutes would exert downward pressure on corporate profit margins. Bullish Or Bearish Borrowing a line from longtime Street economist and strategist Ed Yardeni, our mandate is bullish or bearish, not good or bad. We are charged with making objective decisions about what is most likely to occur in markets, not to daydream about what we would most like to happen. Our base-case scenario turns on our expectation that accommodative monetary policy will remain in place until well into 2021, and will continue to be effective in forestalling defaults and inflating asset valuations. It may not be the most comforting basis for being long risk assets, and we make no implied endorsement of its quality, but if we think it’s going to continue to work beyond the edge of the visible horizon, then we have to reiterate our recommendation that investors should remain at least equal weight equities in multi-asset portfolios, and at least equal weight credit in fixed income portfolios. Austrian adherents and self-styled monetary policy experts can howl about moral hazard and manipulation all they want, but we have to invest in the backdrop that we have, not the backdrop that we want. We do not yet see the approach of a catalyst that will prevent life insurers, pension funds, endowments and other investors who need yield from continuing to go further out the risk curve in search of it. And we don’t yet see the approach of a catalyst that will prevent equity investors from continuing to bid multiples higher. We remain constructive over the cyclical twelve-month timeframe.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com