Emerging Markets

Highlights Q3/2020 Performance Breakdown: Our recommended model bond portfolio outperformed the custom benchmark by +19bps during the third quarter of the year. Winners & Losers: The government bond side of the portfolio outperformed by +10bps, led by overweights in US (+13bps), Canada (+2bps) and Italy (+4bps) that favored allocations to inflation-linked government bonds out of nominals. Spread product generated a similar-sized outperformance (+9bps), led by overweights to US investment grade corporates (+8bps). Portfolio Positioning For The Next Six Months: We continue to prefer keeping aggregate portfolio duration close to benchmark, with only a moderate overweight allocation to spread product versus government bonds, given the lingering uncertainties over the global spread of COVID-19 and near-term US election risk. Instead, we recommend focusing on relative value allocations, favoring countries and sectors that will benefit most in our base case medium-term scenario of slowly improving global growth, reflationary global monetary/fiscal policies, low bond yield volatility and a softening US dollar. Feature As we enter the final quarter of 2020, global financial markets are dealing with many near-term uncertainties related to the upcoming US presidential election, potential next moves in global policy stimulus and, perhaps most worrying, a second wave of coronavirus infections in Europe and the US. That means the “easy money” has been made in global fixed income from the unwind of the blowout in credit spreads, and collapse of government bond yields, seen following the COVID-19 related market turbulence of February and March. Investors should expect substantially lower fixed income returns in the coming months. Relative performance between countries and sectors will be the more dominant influence on bond portfolio returns in the absence of big directional moves in yields or spreads. Alternatively put, expect alpha to win out over beta. This week we are reviewing the performance of the BCA Research Global Fixed Income Strategy (GFIS) model bond portfolio during the third quarter of 2020. We also present our recommended positioning for the portfolio for the next six months. With that in mind, this week we are reviewing the performance of the BCA Research Global Fixed Income Strategy (GFIS) model bond portfolio during the third quarter of 2020. We also present our recommended positioning for the portfolio for the next six months (Table 1), as well as portfolio return expectations for our base case and alternative investment scenarios. Table 1GFIS Model Bond Portfolio Recommended Positioning For The Next Six Months GFIS Model Bond Portfolio Q3/2020 Performance Review & Current Allocations: The Power Of Reflation GFIS Model Bond Portfolio Q3/2020 Performance Review & Current Allocations: The Power Of Reflation As a reminder to existing readers (and to new clients), the model portfolio is a part of our service that complements the usual macro analysis of global fixed income markets. The portfolio is how we communicate our opinion on the relative attractiveness between government bond and spread product sectors. We do this by applying actual percentage weightings to each of our recommendations within a fully invested hypothetical bond portfolio. Q3/2020 Model Portfolio Performance Breakdown: Another Positive Quarter, Led By Linkers & Corporates Chart of the WeekQ3/2020 Performance: Gains From Both Sides Of The Portfolio Q3/2020 Performance: Gains From Both Sides Of The Portfolio Q3/2020 Performance: Gains From Both Sides Of The Portfolio The total return for the GFIS model portfolio (hedged into US dollars) in the third quarter was 3.14%, modestly outperforming the custom benchmark index by +19bps (Chart of the Week).1 This is the second consecutive positive quarter, lifting the year-to-date outperformance into positive territory (+12bps) – an impressive accomplishment given the sharp drawdown that occurred during the market volatility of February and March. In terms of the specific breakdown between the government bond and spread product allocations in our model portfolio, the former generated +10bps of outperformance versus our custom benchmark index while the latter outperformed by +9bps. That government bond return includes a substantial gain (+17bps) from inflation-linked bonds, which we added as a new asset class in our model portfolio framework back on June 23.2 In a world of very low bond yields (Table 2), our preference for the relatively higher-yielding government bond markets in the US, Canada and Italy was an important source of outperformance, delivering a combined excess return of +19bps (including inflation-linked bonds). This was only partially offset by the negative active returns from underweights in low-yielding countries such as Germany, France, and Japan (a combined drag of -9bps). Table 2GFIS Model Bond Portfolio Q3/2020 Overall Return Attribution GFIS Model Bond Portfolio Q3/2020 Performance Review & Current Allocations: The Power Of Reflation GFIS Model Bond Portfolio Q3/2020 Performance Review & Current Allocations: The Power Of Reflation In spread product, our overweights in US investment grade corporates (+8bps), UK investment grade corporates (+3bps) and US Agency CMBS (+4bps) were the main sources of outperformance, while the negative active return from underweighting Euro Area high yield (-2bps) was minimal. Our preference to favor higher-rated US high-yield relative to lower-rated US junk bonds, even as riskier credit rallied, did little damage to portfolio performance, with a combined excess return across all three US junk credit tiers of just -2bps. The moderate outperformance of the model bond portfolio versus the benchmark in Q3 is in line with our cautious recommended stance on what are always the largest drivers of the portfolio returns: overall duration exposure and the relative allocation between government debt and spread product. We have stuck close to benchmark exposures on both, eschewing big directional bets on bond yields or credit spreads while focusing more on relative opportunities between countries and sectors – particularly in sectors most strongly supported by central bank easing actions, like US investment grade corporates. The bar charts showing the total and relative returns for each individual government bond market and spread product sector are presented in Charts 2 & 3. Chart 2GFIS Model Bond Portfolio Q3/2020 Government Bond Performance Attribution GFIS Model Bond Portfolio Q3/2020 Performance Review & Current Allocations: The Power Of Reflation GFIS Model Bond Portfolio Q3/2020 Performance Review & Current Allocations: The Power Of Reflation Chart 3GFIS Model Bond Portfolio Q3/2020 Spread Product Performance Attribution By Sector GFIS Model Bond Portfolio Q3/2020 Performance Review & Current Allocations: The Power Of Reflation GFIS Model Bond Portfolio Q3/2020 Performance Review & Current Allocations: The Power Of Reflation Biggest Outperformers: Long US TIPS (+12bps) Overweight US investment grade industrials (+5bps) Overweight US Agency CMBS (+4bps) Overweight UK investment grade corporates (+3bps) Overweight US high-yield Ba-rated corporates (+3bps) Biggest Underperformers: Underweight French government bonds with maturity greater than 10 years (-4bps) Underweight US high-yield B-rated corporates (-2bps) Chart 4 presents the ranked benchmark index returns of the individual countries and spread product sectors in the GFIS model bond portfolio for Q3/2020. Returns are hedged into US dollars (we do not take active currency risk in this portfolio) and adjusted to reflect duration differences between each country/sector and the overall custom benchmark index for the model portfolio. We have also color coded the bars in each chart to reflect our recommended investment stance for each market during Q3/2020 (red for underweight, dark green for overweight, gray for neutral).3 Ideally, we would look to see more green bars on the left side of the chart where market returns are highest, and more red bars on the right side of the chart were returns are lowest. Chart 4Ranking The Winners & Losers From The GFIS Model Bond Portfolio In Q3/2020 GFIS Model Bond Portfolio Q3/2020 Performance Review & Current Allocations: The Power Of Reflation GFIS Model Bond Portfolio Q3/2020 Performance Review & Current Allocations: The Power Of Reflation The top performing sectors within our model bond portfolio universe in Q3 were well distributed among government bonds and spread products: Italian government bonds (relative index return of +3.8), New Zealand government bonds (+3.0%), EM USD-denominated sovereign (+2.6%), US high-yield corporates (2.4%), Spanish government bonds (+2.3%), and investment grade corporates in the UK (+2%) and US (1.9%). Importantly, we were overweight or neutral all of those markets during the quarter, driven by our main investment themes of “buying what the central banks are buying” and “yield chasing.”4 On the other side, we had limited exposure to the worst performing sectors during Q3, with underweights to government bonds in Germany and Japan, US Agency MBS and euro area high-yield. Cutting our long-standing overweight on UK Gilts to neutral in early August also benefitted the portfolio performance, with Gilts being the worst performer in our model bond universe by far in Q3. Bottom Line: Our model bond portfolio modestly outperformed its benchmark index in the second quarter of the year by +19bps – a positive result driven by our relative positioning that favored higher yielding government debt and spread product sectors directly supported by central bank purchases. Future Drivers Of Portfolio Returns & Scenario Analysis Looking ahead, the performance of the model bond portfolio will be driven by relative positioning across sectors and countries, rather than big directional bets on moves in government bond yields or corporate credit spreads. This is in line with the current strategic investment recommendations of the BCA Research fixed income services. Looking ahead, the performance of the model bond portfolio will be driven by relative positioning across sectors and countries, rather than big directional bets on moves in government bond yields or corporate credit spreads. The overall duration of the portfolio is in line with that of the custom benchmark index (Chart 5), consistent with our strategic investment recommendation to be neutral on exposure to changes in interest rates. With central banks actively seeking to keep policy rates as low as possible until inflation returns – i.e. aiming to push real rates even lower - we expect the negative correlation seen between global inflation breakevens and real bond yields to persist over at least the next 6-12 months. Offsetting moves in both will continue to dampen the volatility of nominal bond yields, as has been the case over the past six months (Chart 6). Chart 5Overall Portfolio Duration Exposure: At Benchmark Overall Portfolio Duration Exposure: At Benchmark Overall Portfolio Duration Exposure: At Benchmark Central banks aiming for an inflation overshoot and negative real rates will also continue to boost the relative performance of inflation-linked bonds versus nominal equivalents. Chart 6Within Governments, Continue Overweighting Linkers Vs Nominals The Strategic Case For Inflation-Linked Bond Outperformance The Strategic Case For Inflation-Linked Bond Outperformance We see this as a similar environment to the years following the 2008 financial crisis, with central banks keeping rates at 0% while rapidly expanding their balance sheets via quantitative easing and cheap liquidity provision for banks. The result was a multi-year period where linkers outperformed nominal government bonds (Chart 7). Thus, we are maintaining a large core allocation to linkers in the portfolio, focused on US TIPS and inflation-linked bonds in Italy and Canada. Chart 7The Strategic Case For Inflation-Linked Bond Outperformance Within Governments, Continue Overweighting Linkers Vs Nominals Within Governments, Continue Overweighting Linkers Vs Nominals Chart 8Overall Portfolio Allocation: Moderately Overweight Credit Vs Governments GFIS Model Bond Portfolio Q3/2020 Performance Review & Current Allocations: The Power Of Reflation GFIS Model Bond Portfolio Q3/2020 Performance Review & Current Allocations: The Power Of Reflation In terms of country allocations on the government bond side of the portfolio, we continue to favor overweights in higher-yielding markets with overall global yield volatility likely to remain subdued. Chart 9Global QE Continues To Support Credit Markets Global QE Continues To Support Credit Markets Global QE Continues To Support Credit Markets That means overweighting the US, Canada, Australia, Italy and Spain, while underweighting Germany, France and Japan. The UK belongs in that latter list, but we are maintaining a neutral stance on the UK, for now, given the near-term uncertainty surrounding final Brexit negotiations and the surge in new UK COVID-19 cases. Turning to spread product, we are maintaining only a moderate aggregate overweight allocation versus government bonds, equal to 4% of the portfolio (Chart 8). The same aggressive easing of global monetary policy and expansion of central bank balance sheets that is good for relative inflation-linked bond performance also benefits global corporate bonds. The annual rate of growth of the combined balance sheets of the Fed, ECB, Bank of Japan and Bank of England has proven to be an excellent leading indicator of the excess returns of both global investment grade and high-yield corporates over the past decade (Chart 9). With the combined balance sheet now expanding at a 40% pace, corporate bonds are likely to continue to outperform government debt over the next 6-12 months. Thus, our allocation to inflation-linked bonds and corporate credit, both out of nominal government bonds, are both motivated by the same factor – monetary policy reflation. The rally in the lower-rated tiers of the high-yield corporate universe in the US and euro area looks particularly unsustainable, if corporate defaults follow the path of previous recessions in both regions. At the same time, we continue to maintain a cautious stance on allocations to countries and sectors within that overall overweight tilt towards spread product in the model bond portfolio. We prefer to stay relatively up-in-quality within global corporate debt, even with high-yield bonds in the US and Europe offering relatively high spreads using our 12-month breakeven spread metric (Chart 10).5 Chart 10US & European HY Offer Relatively Wide Breakeven Spreads GFIS Model Bond Portfolio Q3/2020 Performance Review & Current Allocations: The Power Of Reflation GFIS Model Bond Portfolio Q3/2020 Performance Review & Current Allocations: The Power Of Reflation Chart 11US & European HY Offer No Spread Cushion Against Rising Defaults US & European HY Offer No Spread Cushion Against Rising Defaults US & European HY Offer No Spread Cushion Against Rising Defaults The rally in the lower-rated tiers of the high-yield corporate universe in the US and euro area looks particularly unsustainable, if corporate defaults follow the path of previous recessions in both regions. Our measure of the default-adjusted spread, calculated by taking the option-adjusted spread of the Bloomberg Barclays high-yield index and subtracting default losses, shows that high-yield spreads on both sides of the Atlantic will be dwarfed by expected default losses over the next year, assuming a typical pattern of defaults after recessions (Chart 11). We continue to prefer staying up-in-quality within our recommended corporate allocations, favoring Ba-rated US high-yield over B-rated and Caa-rated credit while also underweighting euro area high-yield relative to euro area investment grade corporates. This strategy lowers the yield of the model portfolio, which is currently in line with that of the custom benchmark index (Chart 12), at the expense of stretching for yields in riskier credit that may not be sustainable over the medium-term. Chart 12Overall Portfolio Yield: At Benchmark Overall Portfolio Yield: At Benchmark Overall Portfolio Yield: At Benchmark Chart 13Overall Portfolio Risk: Moderate Overall Portfolio Risk: Moderate Overall Portfolio Risk: Moderate At the same time, our measured stance on relative corporate exposure also acts to reduce portfolio risk – a useful outcome as we are targeting a relatively moderate tracking error (relative portfolio volatility versus that of the benchmark) within the model portfolio (Chart 13). Given the near-term uncertainties over the US elections and the potential second wave of COVID-19 in the US and Europe, staying relatively cautious on the usage of the “risk budget” of the portfolio seems prudent. Scenario Analysis & Return Forecasts In past quarterly reviews of our model bond portfolio, we have presented forecasts for the performance of the overall portfolio based off scenario analysis and some simple quantitative model-based predictions of various fixed income sectors. Given the unprecedented nature of the COVID-19 shock, we chose to avoid such model driven forecasts based on historical coefficients and correlations that may not be applicable. As it turns out, we may have been too cautious in that decision. The “risk-factor” models that we have used to forecast future yield changes for global spread product sectors as a function of four major factors - the VIX, oil prices, the US dollar and the fed funds rate (Table 2A) - have actually done a reasonable job of predicting yield changes over the past year. This can be seen in the charts shown in the Appendix on pages 18-20. Only in the case of US Caa-rated high-yield and EM USD-denominated corporates – two sectors where we are underweight given our concerns about valuation - have yields fallen by a far greater amount than implied by our models. Table 2AFactor Regressions Used To Estimate Spread Product Yield Changes GFIS Model Bond Portfolio Q3/2020 Performance Review & Current Allocations: The Power Of Reflation GFIS Model Bond Portfolio Q3/2020 Performance Review & Current Allocations: The Power Of Reflation Based on how the models have performed in the COVID era, we believe we can use them again to forecast the expected relative returns of the credit side of the model bond portfolio. For the government bond side, we avoid using regression models and instead use a yield-beta driven framework, taking forecasts for changes in US Treasury yields and translating those into changes in non-US bond yields by applying a historical yield beta (Table 2B). Table 2BEstimated Government Bond Yield Betas To US Treasuries GFIS Model Bond Portfolio Q3/2020 Performance Review & Current Allocations: The Power Of Reflation GFIS Model Bond Portfolio Q3/2020 Performance Review & Current Allocations: The Power Of Reflation Chart 14Risk Factor Assumptions For The Scenario Analysis Risk Factor Assumptions For The Scenario Analysis Risk Factor Assumptions For The Scenario Analysis For our scenario analysis over the next six months, we use a base case scenario plus two alternate “tail risk” scenarios, based on the following descriptions and inputs (Chart 14): Base Case: The US election result is initially uncertain, but a clear winner is determined within a few days. COVID cases continue to increase, but with less severe economic restrictions than during the first wave. Global growth continues to show steady improvement. There will be some additional global fiscal stimulus, with central banks keeping foot on monetary accelerator. There is mild bear steepening of the US Treasury curve with moderate widening of US inflation breakevens. The VIX reaches 25, the USD dollar depreciates by -5%, oil prices climb 10% and the fed funds rate remains at 0%. Based on how the models have performed in the COVID era, we believe we can use them again to forecast the expected relative returns of the credit side of the model bond portfolio. Optimistic Scenario: The US election goes smoothly and a clear winner is declared on election night. The current uptick in global COVID cases does not turn into a full-blown second wave requiring severe economic restrictions. Global growth continues to steadily improve, with additional global fiscal stimulus and central banks staying highly dovish. The US Treasury curve bear steepens as US inflation expectations steadily increase. The VIX falls to 20, the USD dollar depreciates by -7%, oil prices climb 20%, and the fed funds rate stays at 0%. Table 3AGFIS Model Bond Portfolio Scenario Analysis For The Next Six Months GFIS Model Bond Portfolio Q3/2020 Performance Review & Current Allocations: The Power Of Reflation GFIS Model Bond Portfolio Q3/2020 Performance Review & Current Allocations: The Power Of Reflation Table 3BUS Treasury Yield Assumptions For The 6-Month Forward Scenario Analysis GFIS Model Bond Portfolio Q3/2020 Performance Review & Current Allocations: The Power Of Reflation GFIS Model Bond Portfolio Q3/2020 Performance Review & Current Allocations: The Power Of Reflation Chart 15US Treasury Yield Assumptions For The Scenario Analysis US Treasury Yield Assumptions For The Scenario Analysis US Treasury Yield Assumptions For The Scenario Analysis Pessimistic Scenario: There is a contested US election result taking weeks to resolve, leading to major US social unrest. A full-blown second COVID-19 wave hits the world and severe economic restrictions are implemented. Governments become more worried about debt/deficits and deliver underwhelming stimulus. Central banks do not provide enough additional stimulus to offset the shocks. The US Treasury curve bull-flattens as US inflation breakevens plunge. The VIX soars to 35, the USD dollar rise by 5%, oil prices fall -20%, while the fed funds rate remains at 0%. The excess return scenarios for the model bond portfolio, using the above inputs in our simple quantitative return forecast framework, are shown in Table 3A (the scenarios for the changes in US Treasury yields are shown in Table 3B and Chart 15). The model bond portfolio is expected to deliver an excess return over the next six months of +17bps in the base case and +27bps in the optimistic scenario, but is only projected to underperform by -1bp in the pessimistic scenario. Bottom Line: We continue to prefer keeping aggregate portfolio duration close to benchmark, with only a moderate overweight allocation to spread product versus government bonds, given the lingering uncertainties over the global spread of COVID-19 and near-term US election risk. Instead, we recommend focusing on relative value allocations, favoring countries and sectors that will benefit most in our base case medium-term scenario of slowly improving global growth, reflationary global monetary/fiscal policies, low bond yield volatility and a softening US dollar.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Ray Park, CFA Research Analyst ray@bcaresearch.com Footnotes 1 The GFIS model bond portfolio custom benchmark index is the Bloomberg Barclays Global Aggregate Index, but with allocations to global high-yield corporate debt replacing very high quality spread product (i.e. AA-rated). We believe this to be more indicative of the typical internal benchmark used by global multi-sector fixed income managers. 2 Please see BCA Global Fixed Income Strategy Weekly Report, "How To Play The Revival Of lobal Inflation Expectations", dated June 23 2020, available at gfis.bcaresearch.com. 3 Note that sectors where we made changes to our recommended weightings during Q3/2020 will have multiple colors in the respective bars in Chart 4. 4 Please see BCA Research Global Fixed Income Strategy Weekly Report, "We’re All Yield Chasers Now", dated August 11, 2020, available at gfis.bcaresearch.com. 5 The 12-month breakeven spread measures the amount of spread widening that must take place for a credit product to have the same return over a one-year horizon as a duration-matched position in government bonds. We compare those breakeven spreads to their own history in a percentile ranking to determine the relative attractiveness of a credit product strictly from a spread and spread volatility perspective. Appen dix Appendix Chart 1US Investment Grade Sectors US Investment Grade Sectors US Investment Grade Sectors Appendix Chart 2US High-Yield Credit Tiers US High-Yield Credit Tiers US High-Yield Credit Tiers Appendix Chart 3US MBS & CMBS US MBS & CMBS US MBS & CMBS Appendix Chart 4Euro Area And UK Credit Euro Area and UK Credit Euro Area and UK Credit Appendix Chart 5Emerging Markets USD-Denominated Debt Emerging Markets USD-Denominated Debt Emerging Markets USD-Denominated Debt Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index GFIS Model Bond Portfolio Q3/2020 Performance Review & Current Allocations: The Power Of Reflation GFIS Model Bond Portfolio Q3/2020 Performance Review & Current Allocations: The Power Of Reflation Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

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

Highlights Near-Term Uncertainties: Investors have grown a bit more nervous in recent weeks, amid signs of a second wave of the coronavirus in Europe and with the contentious US presidential election only five weeks away. The pro-growth cyclical investment backdrop, however, remains unchanged. From a strategic perspective (6-12 months), maintain an overall neutral stance on interest rate duration, with a moderate overweight to global spread product versus government bonds while staying up in quality. EM USD-Denominated Debt: The main drivers of the emerging market hard currency debt rally since March – a weakening US dollar, improving global growth momentum, and massively accommodative global monetary policies – remain in place. Valuations, however, appear more attractive for EM USD-denominated corporates relative to USD-denominated sovereigns. Favor the former over the latter, within an overall neutral strategic allocation to EM hard currency debt. Feature Chart of the WeekMarkets Starting To Get Cautious Markets Starting To Get Cautious Markets Starting To Get Cautious As the third quarter of 2020 draws to a close, investors have developed a slight case of the jitters about the near-term outlook for global financial markets. The positives that drove risk assets higher during the spring and summer - rebounding global economic activity, fueled by aggressive policy stimulus and a slowing of the spread of COVID-19, along with a weaker US dollar – have given way to some fresh uncertainties. Economic data releases have started to disappoint versus expectations, the rapid expansion of central bank balance sheets in the major developed economies has temporarily stalled, a second wave of new COVID-19 cases appears to have started in Europe and the US, and the US dollar has strengthened by 2.7% from the 2020 lows (Chart of the Week). Risk assets have pulled back in response, with the MSCI World equity index down -6.1% from the 2020 peak and US high-yield corporate credit spreads 66bps wider from recent lows. So far, these moves appear more a correction of overbought markets, rather than a change in trend. From the perspective of our strategic (6-12 months) investment recommendations, we remain generally positive on risk assets. Within global fixed income, that means maintaining a modest overall overweight stance on spread products versus government bonds, while focusing more on relative opportunities between countries and sectors to generate alpha. A Quick Assessment Of The Cyclical Backdrop The recent in increase in market volatility has started to shake out crowded positioning in popular winning trades. For example, high-flying US tech stocks have seen deeper pullbacks than the overall US equity market, while investors yanked nearly $5 billion from US junk bond funds in the week ending last Wednesday according to the Financial Times – the highest such outflow since the apex of the COVID-19 market rout in mid-March. We prefer to judge the health of a market rally by assessing the state of macroeconomic fundamentals underpinning that particular asset class Mainstream financial pundits often dub such corrections of overheated markets as a “healthy” way to ensure the continuation of medium-term bullish trends. We prefer to judge the health of a market rally by assessing the state of macroeconomic fundamentals underpinning that particular asset class – the most important of which remain positive for risk assets, in general, and global fixed income spread products, in particular. Economic Data Chart 2Economic Data Is Mostly Optimistic Economic Data Is Mostly Optimistic Economic Data Is Mostly Optimistic While data surprise indices like the widely followed Citigroup series are topping out, this is more because of an improvement in beaten-up growth expectations, rather than a sharp decline in the actual data. The global ZEW economic expectations survey continues to point in an optimistic direction, while other reliable measures of business confidence like the German IFO and the US NFIB small business surveys have also continued to improve in recent months. Our own global leading economic indicator (LEI) is firming, with a majority of countries seeing a rising LEI (Chart 2). At the same time, the preliminary release of manufacturing PMI data for September showed continued improvements in the US and Europe. While the news is not 100% upbeat – the services PMI for the overall euro area fell -2.9 points in September, possibly due to the increase in new reported cases of COVID-19 in Europe – the tone of global economic data remains consistent with improving cyclical momentum. The US Dollar Chart 3Growth And Yield Differentials Signalling Dollar Weakness Growth And Yield Differentials Signalling Dollar Weakness Growth And Yield Differentials Signalling Dollar Weakness The most likely medium-term path of least resistance for the US dollar remains downward. Economic growth remains stronger outside the US, based on the differential between the US and non-US manufacturing PMI data – an indicator that our currency strategists follow closely given its strong correlation to US dollar momentum (Chart 3). Relative interest rate differentials also remain less positive for the US dollar, with the decline in real US bond yields seen in 2020 pointing to additional medium-term dollar depreciation (bottom panel). US Politics The US general election is now only 35 days away, with the latest polling data showing President Trump closing the lead on the Democratic Party candidate, Joe Biden. Our colleagues at BCA Research Geopolitical Strategy remain of the view that a Biden victory is the more probable outcome, given the more difficult time Trump will have in winning all the key swing states that gave him his narrow election victory in 2016. Chart 4A "Blue Sweep" Is Bearish For Markets A "Blue Sweep" Is Bearish For Markets A "Blue Sweep" Is Bearish For Markets The recent peak in US equity markets, and trough in the VIX index, coincided with improving odds of a Democratic Party sweep of the White House, House of Representatives and Senate (Chart 4). Such an outcome would give a President Biden the power, and perceived mandate, to implement many of the more progressive elements of the Democratic Party agenda – including a hike in corporate tax rates that could damage equity market sentiment. Our political strategists think that a “Blue Sweep” would only occur if the Republican Party fails to agree with the Democrats on a new fiscal stimulus bill.1 Both sides are playing hardball in the current negotiations, which is keeping investors on edge given how much of the US economy still requires fiscal support because of the pandemic. The Republicans will not want to take the blame for a failure to reach a stimulus deal, which would likely hand the Democrats the keys to the White House and Congress. Thus, a fiscal deal of sufficient size to calm jittery markets – most likely in the $2-2.5 trillion range sought by the Democrats – should be announced within the next couple of weeks before the final run up to the election. Financial/Monetary Conditions It will take more than a corrective pullback in equity and credit markets to threaten the economic recovery from the COVID-19 recession, given how highly stimulative financial conditions have become since the spring (Chart 5). In more normal times, booming equity and credit markets would eventually lead to upward pressure on government bond yields, since all would be reflecting improving economic growth and, eventually, expectations of faster inflation and tighter monetary policy. That move higher in yields would eventually act to restrain growth and depress the value of growth-sensitive risk assets. Chart 5Financial Conditions Remain Supportive For Growth Financial Conditions Remain Supportive For Growth Financial Conditions Remain Supportive For Growth As we discussed in last week’s report, government bond yields are now likely to stay very low for a period measured in years, with major central banks like the US Federal Reserve leaning dovishly to support growth during the pandemic and trigger a temporary overshoot of inflation expectations.2 Thus, loose monetary settings (including more quantitative easing) will remain a critical underpinning for keeping risk assets well supported, by eliminating the typical cyclical threat from rising bond yields. Summing it all up, the fundamental economic and political backdrop remains cyclically bullish for risk assets, despite recent investor nervousness. Of course, a major wild card could be that the latest surge in new COVID-19 cases becomes large enough to trigger renewed economic restrictions in the US or Europe. Yet any such moves would likely not be as severe as those that occurred back in the spring, given the much lower mortality rates seen during the current upturn in COVID-19 cases, which is reducing the public’s willingness to accept more economy-crushing lockdowns. Bottom Line: Investors have grown a bit more nervous in recent weeks, amid signs of a second wave of the coronavirus in Europe and with the contentious US presidential election only five weeks away. The pro-growth cyclical investment backdrop, however, remains unchanged. From a strategic perspective (6-12 months), maintain an overall neutral stance on interest rate duration, with a moderate overweight to global spread product versus government bonds while staying up in quality. EM USD-Denominated Credit: Focus On Corporates Relative To Sovereigns Chart 6An Overview of USD-Denominated EM Debt An Overview of USD-Denominated EM Debt An Overview of USD-Denominated EM Debt Back in July of this year, we turned more positive on emerging market (EM) USD-denominated spread product, upgrading our recommended allocation to both EM USD sovereign and corporate debt to neutral from underweight in our model bond portfolio.3 The change was motivated by signs of rebounding global economic growth after the COVID-19 lockdowns and a loss of upward momentum in the US dollar, coming at a time when EM spreads still looked relatively cheap (wide) compared to developed market corporate debt. An underweight stance was inconsistent with that backdrop. EM credit has done well since our upgrade (Chart 6). Using Bloomberg Barclays index data, the yield on the EM USD-denominated sovereign index has fallen from 5.2% to 4.4%, while the option-adjusted spread (OAS) on that same index tightened from 447bps to 368bps. It has been a similar story for EM USD-denominated corporates, with the index yield falling from 4.1% to 3.9% and the index OAS narrowing from 361bps to 344bps.4 Given the close correlations typically exhibited between EM USD sovereign and corporate yields and spreads, we have tended to change our recommended allocations to both asset classes at the same time and in the same direction. Yet the EM credit universe is quite diverse, incorporating many different issuers of highly varying credit quality and risk (Table 1). Treating the allocations to EM USD sovereign debt and USD corporate debt separately may reveal more profitable relative return opportunities. The fundamental economic and political backdrop remains cyclically bullish for risk assets, despite recent investor nervousness. Table 1Details Of The USD-Denominated EM Sovereign And EM Corporate & Quasi-Sovereign Indices Stay The Course Stay The Course A first step to analyzing the EM USD sovereigns versus corporates investment decision is to develop a list of macro factors that correlate to the relative performance of EM sovereign and corporate credit. From there, we can build a list of directional indicators that can help inform that sovereign versus corporates decision. Treating the allocations to EM USD sovereign debt and USD corporate debt separately may reveal more profitable relative return opportunities. Our colleagues at BCA Research Emerging Markets Strategy have long held the view that overall EM debt performance is mostly driven by just two important macro factors: industrial commodity prices and the US dollar. Specifically, they have shown that the broad cyclical swings in EM sovereign and corporate spreads correlate strongly to the price momentum of a simple blend of industrial metal and oil prices, as well as the price momentum of a basket of EM currencies versus the US dollar (Chart 7). Chart 7EM Credit Spreads: A Commodity And Currency Story EM Credit Spreads: A Commodity And Currency Story EM Credit Spreads: A Commodity And Currency Story On that basis, the recent moderate widening of EM credit spreads is justified by the corrective pullback in industrial commodity prices and a bit of US dollar strength – trends that our EM strategists believe can continue in the near-term. Although they share our view that the medium-term trend in the US dollar is still bearish, thus any near-term EM debt selloff will represent a longer-term buying opportunity.5 The demand for industrial commodities remains largely driven by economic trends in the world’s largest commodity consumer, China. Thus, our China credit impulse (the change in overall Chinese credit relative to GDP), which leads Chinese economic activity, is a good leading indicator of industrial commodity prices. We will use the China credit impulse in our list of directional indicators to forecast EM sovereign versus corporate performance. We also will include the annual rate of change of the index of EM currencies versus the US dollar (shown in Chart 7). We also believe that a global monetary policy variable should be included in our indicator list, particularly in the current environment of super-low developed market interest rates and central bank purchase of government bonds – both of which tend to drive yield-starved investors into higher-yielding EM assets and, potentially, can influence the relative performance of EM sovereigns and corporates. To capture the global monetary policy trend in our indicator list, we use the combined annual growth rate of the balance sheets of the Fed, the ECB, the Bank of Japan and the Bank of England. The message from our indicator list is that EM USD corporates should outperform EM USD sovereign debt over the next 6-12 months. In Charts 8 & 9, we show the relative total return of the Bloomberg Barclays EM USD corporate and USD sovereign indices, expressed in year-over-year percentage terms, versus our list of three potential directional indicators of the relative total return. We have broken up the overall EM universe by broad credit quality, with index data used for investment grade issuers in Chart 8 and below investment grade (high-yield) issuers in Chart 9. For all three of our directional indicators, we have pushed them forward in the charts to look for a potential leading relationship to the relative returns. Chart 8EM Investment Grade Corporates Looking Set to Outperform ... EM Investment Grade Corporates Looking Set to Outperform ... EM Investment Grade Corporates Looking Set to Outperform ... Chart 9... But The High Yield Space Tells A More Mixed Story ... But The High Yield Space Tells A More Mixed Story ... But The High Yield Space Tells A More Mixed Story The charts show that China credit impulse leads the relative total returns of EM USD corporates versus EM USD sovereigns by between 9-18 months for investment grade and high-yield EM credit. The growth of the major central bank balance sheets also leads the relative performance of EM USD corporates versus EM USD sovereigns by one full year, both for investment grade and high-yield EM credit. Finally, the annual growth of EM currencies leads the relative return of EM USD corporates versus sovereigns by around nine months, although the correlation is the weakest of the three indicators in our list. In terms of current investment strategy, the message from our indicator list is that EM USD corporates should outperform EM USD sovereign debt over the next 6-12 months, both for investment grade and high-yield, largely due to aggressive credit stimulus in China and the rapid expansion of central bank balance sheets. In terms of the attractiveness of EM USD-denominated yields in a global fixed income portfolio, however, there is a difference between higher-rated and lower-rated EM debt. In Chart 10, we present a scatter chart that plots the yields on various global fixed income sectors, all hedged into US dollars and compared to trailing yield volatility, versus the average credit rating of each sector. Investment grade EM USD corporate and sovereign issuers offer relatively more attractive yields compared to other sectors with similar credit ratings, like investment grade corporates in the US and Europe. The same cannot be said for high-yield EM USD corporates and sovereigns, which only offer a more attractive volatility-adjusted yield compared to euro area high-yield corporates among the lower-rated global credit sectors. Chart 10EM USD-Denominated High Yield Debt Not Especially Attractive On A Risk-Adjusted Basis Stay The Course Stay The Course Based on this analysis, we are making the following changes in our model bond portfolio on page 14: Upgrading EM USD corporates to overweight Downgrading EM USD sovereigns to underweight Keeping the combined EM USD credit allocation at neutral. This fits with our current overall investment theme of keeping overall spread product exposure relative close to benchmark, while taking more active risks on relative allocations between fixed income sectors. Bottom Line: The main drivers of the emerging market hard currency debt rally since March – a weakening US dollar, improving global growth momentum, and massively accommodative global monetary policies – remain in place. Valuations, however, appear more attractive for EM USD-denominated corporates relative to USD-denominated sovereigns. Favor the former over the latter, within an overall neutral strategic allocation to EM hard currency debt.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com   Footnotes 1 Please see BCA Research Geopolitical Strategy Weekly Report, "Stimulus Will Come … But May Not Save Trump", dated September 25, 2020, available at gps.bcaresearch.com. 2 Please see BCA Research Global Fixed Income Strategy Weekly Report, "What Would It Take To Get Bond Yields To Rise Again?", dated September 23, 2020, available at gfis.bcaresearch.com. 3 Please see BCA Global Fixed Income Strategy Weekly Report, "GFIS Model Bond Portfolio Q2/2020 Performance Review & Current Allocations: Selective Optimism", dated July 14, 2020, available at gfis.bcaraesearch.com. 4 Note that the index data we are using here includes both EM corporate and so-called “quasi-sovereign” debt, the latter being bonds issued by EM companies that are majority-owned by their local governments. 5 Please see BCA Emerging Markets Strategy Weekly Report, "A Reset In The Making", dated September 24, 2020, available at ems.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Stay The Course Stay The Course Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Portfolio Strategy We recommend investors participate in the equity market rotation during the ongoing correction and position portfolios for next year’s bull market resumption by preferring unloved and undervalued deep cyclical laggards. Ultra-loose Chinese fiscal policy, rising global demand and firming domestic operating conditions, all signal that the S&P machinery recovery has legs.    Vibrant emerging markets and a recuperating China, a softening US dollar rekindling the commodity complex, the nascent recovery in domestic conditions and washed out technicals, all suggest that a significant re-rating looms for severely neglected industrials equities.    Recent Changes Our trailing stop got triggered and we downgraded the S&P internet retail index to neutral for a gain of 20% since the mid-April inception. This move also pushed our S&P consumer discretionary sector weighting to a benchmark allocation for a gain of 15% since inception. Table 1 Riot Point Looms Riot Point Looms Feature The S&P 500 broke below the important 50-day moving average last week, but managed to bounce off the early-June 3233 level – also a level where the SPX started the year – that could serve as temporary support (Chart 1). We first highlighted that investors were turning a blind eye to (geo)political risks on June 8, and failure to pass a new fiscal package before the election will continue to weigh on the economy and on stocks risking a further 10% drawdown near the SPX 3000 level. Chart 1Critical Support Levels Riot Point Looms Riot Point Looms The Fed is now “out of the loop” i.e. a bystander on the sidelines, gently moving the foot off the accelerator as we illustrated last week. The FOMC’s, at the margin, less dovish monetary policy setting exerts enormous pressure on fiscal authorities to act as fiscal policy takes center stage. Our sense is that we have entered a Fiscal Policy Loop (FPL) where stalemate in Congress will cause a classic BCA riot point that in turn will force politicians’ hand to act in order to avoid a meltdown, and set in motion the next stage of the FPL (Figure 1). Keep in mind that the 2020s have ignited a paradigm shift from the Washington Consensus to the Buenos Aires Consensus1 and this is episode one of the FPL, more are sure to follow.    Figure 1The Fiscal Policy Loop Riot Point Looms Riot Point Looms It is no surprise that the Citi economic surprise index took off when the IRS started making direct payments to households in mid-April and leveled off toward the end of July when the stimulus money coffers ran dry (Chart 2). Chart 2In Dire Need Of Fiscal Stimulus In Dire Need Of Fiscal Stimulus In Dire Need Of Fiscal Stimulus If Congress fails to pass a new fiscal package by October 16, the latest now that the Ruth Bader Ginsburg SCOTUS replacement seems to have become the number one priority, we doubt a fiscal package can pass during a contested election. Thus, realistically a fresh stimulus bill is likely only after the new president’s inauguration. Under such a backdrop, the economy will suffer a relapse despite households drawing down their replenished savings (middle panel, Chart 3). This is eerily reminiscent of the October 2008 and October 2018 fiscal policy and monetary policy mistakes, respectively, that resulted in a market riot. Similar to today, markets were down 10% and on a precipice and the policy errors pushed them off the cliff leading to another 10% gap down in a heartbeat. With regard to equity market specifics during the current FPL iteration, banks are most at risk as they are levered to the economic recovery, and commercial real estate ails remain a big headache. Absent a fiscal package bank executives will have to further provision for loan losses when they kick off Q3 earnings season in late-October as CEOs will err on the side of caution. Tack on the recent news on laundering money – including by US banks – and the Fed’s new stringent stress tests, and the risk/reward tradeoff remains poor for the banking sector (bottom panel, Chart 3).  Odds are high that volatility will remain elevated heading into the election, therefore this phase represents an opportunity for investors to reshuffle portfolios and prepare for an eventual resumption of the bull market in early-2021. We continue to recommend investors avoid our “COVID-19 winners” basket and prefer our “back-to work” equity basket that we initiated on September 8. Similarly, this pullback is serving as a catalyst to shift some capital out of the fully valued tech titans and into other beaten down parts of the deep cyclical universe. Chart 3Show Me The Money Show Me The Money Show Me The Money We doubt this correction is over as positioning in the NASDAQ 100 derivative markets is still lopsided; stale bulls are caught net long as NQ futures are deflating, thus a flush out looms (Chart 4).  Chart 4Flush Out Flush Out Flush Out The easy money has likely been made in the tech titans that near the peak on September 2, AAPL, MSFT and AMZN each commanded an almost $2tn market capitalization. Thus, booking some of these tech gains and redeploying capital in other unloved deep cyclical sectors would go a long way, especially if our thesis that the economic recovery will gain steam into 2021 pans out.  Using a concrete rebalancing example to illustrate such a rotation is instructive.2 The tech titans’ (top 5 stocks) market cap weight in the SPX is 22%. Were an investor to take 10% of this weight or 220bps and redeploy it to the materials sector, which commands a 2.7% market cap weight in the SPX, would effectively double the exposure on this deep cyclical sector. The same would apply to the energy sector that comprises a mere 2.2% of the SPX, while industrials with an 8.4% market cap weight would get a sizable 26% lift (Chart 5). As a reminder our portfolio has an above benchmark allocation in all three deep cyclical sectors, and this week we reiterate our overweight stance on both the industrials sector and on a key subgroup. Chart 5Rotation Rotation Rotation Rotation Rotation Rotation Rotation Rotation Rotation Buy The Machinery Breakout Were we not already overweight the S&P machinery index, would we upgrade today? The short answer is yes. Aggressive loosening in Chinese financial conditions have underpinned the economic recovery (second & third panels, Chart 6). Infrastructure projects are making a comeback and absorbing the slack in machinery demand caused by COVID-19. As a result, Chinese excavator sales have soared in the past quarter which bodes well for US machinery profit prospects (bottom panel, Chart 6). Beyond China, emerging markets demand for machinery equipment is robust as the commodity complex is recovering smartly (second panel Chart 7). The US dollar bear market is also bolstering global trade growth, despite the greenback’s recent technical bounce, and should continue to underpin machinery net export growth and therefore profit growth for US machinery manufacturers (third & bottom panels, Chart 7).   Chart 6Enticing Chinese Backdrop Enticing Chinese Backdrop Enticing Chinese Backdrop Chart 7Dollar The Great Reflator Dollar The Great Reflator Dollar The Great Reflator The domestic machinery demand backdrop is also conducive to a renormalization of top line growth to a higher run-rate. The ISM manufacturing new orders sub-component is shooting the lights out, heralding a jump in machinery orders in the coming months (second panel, Chart 8). Simultaneously, a quick inventory check is revealing: both in the manufacturing and wholesale channels cupboards are bare which means that the risk of a liquidation phase in non-existent (third panel, Chart 8). Encouragingly, an inventory buildup phase is looming in order to satisfy firming demand. The tick up in machinery industrial production growth, the V-shaped recovery in the utilization rate and newly expanding backlog orders, all suggest that domestic demand conditions are on the mend (Chart 9). Tack on still prudent payrolls management that is keeping the machinery industry’s wage bill at bay (bottom panel, Chart 8), and a profit margin expansion phase is a high probability outcome. Chart 8What’s Not… What’s Not… What’s Not… Chart 9…To Like …To Like …To Like Our resurgent S&P machinery revenue growth model and climbing profit growth model do an excellent job in encapsulating all the industry’s moving parts and suggest that the path of least resistance is higher for relative share prices in the New Year (Chart 10). Finally, relative valuations have also recovered from the depth of the recession, but are only back to the neutral zone leaving enough room for a multiple expansion phase (Chart 11). Chart 10Models Say Buy Models Say Buy Models Say Buy Chart 11Compelling Entry Point Compelling Entry Point Compelling Entry Point In sum, ultra-loose Chinese fiscal policy, rising global demand and firming domestic operating conditions, all signal that the S&P machinery recovery has legs.    Bottom Line: Stay overweight the S&P machinery index. The ticker symbols for the stocks in this index are: BLBG S5MACH– CAT, DE, PH, ITW, IR, CMI, PCAR, FTV, OTIS, SWK, DOV, XYL, WAB, IEX, SNA, PNR, FLS. Industrials Are Jumpstarting Their Engines We have been offside on the S&P industrials sector, but now is not the time to throw in the towel. In contrast we are doubling down on our overweight stance as the ongoing rotation should see some tech sector outflows find their way to under-owned capital goods producers. Industrials equities have been on the selling block and suffered a wholesale liquidation during the dark days of the COVID-19 pandemic, and have yet to regain their footing (top panel, Chart 12). The GE and Boeing sagas have dealt a big blow to this deep cyclical sector, but now this market cap weighted sector has filtered these stocks out as neither of these “fallen angels” is occupying a spot in the top 5 weight ranks. Relative valuations are washed out, and relative technicals are still deep in oversold territory (second & third panels Chart 12). Sell-side analysts are the most pessimistic they have been on record with regard to the long-term EPS growth rate that is penciled in to trail the broad market by almost 800bps (bottom panel, Chart 12)! All this bearishness is contrarily positive as a little bit of good news can go a long way. Already, relative EPS breadth is stealthily coming back, and net earnings revisions are rocketing higher (Chart 13).  Chart 12Liquidation Phase… Liquidation Phase… Liquidation Phase… Chart 13…Is Over …Is Over …Is Over One reason behind this optimism rests with the domestic recovery. Capex intentions are firming and CEO confidence is upbeat for the coming six months. The ISM manufacturing new orders-to-inventories ratio is corroborating the budding recovery in the soft data. Green shoots are also evident in hard data releases. Durable goods orders are on the verge of expanding anew (Chart 14). Emerging markets (EM) and China represent another source of industrials sector buoyancy. The EM manufacturing PMI clocking in at 52.5 hit an all-time high. China’s PMIs are also on a similar trajectory, and the Chinese Citi economic surprise index has swung a whopping 300 points from -240 to above +60 over the past six months. The upshot is that US industrials stocks should outperform when China and the EM are vibrant (Chart 15). Chart 14Domestic And … Domestic And … Domestic And … Chart 15… EM Green Shoots Are Bullish … EM Green Shoots Are Bullish … EM Green Shoots Are Bullish Peering over to the currency market, the debasing of the US dollar should also underpin industrials stocks via the export relief valve (third panel, Chart 16). A depreciating greenback also lifts the commodity complex and hence industrials equities that are levered to the extraction of commodities and other derivative activities (top panel, Chart 16). Historically, an appreciating USD has been synonymous with a multiple contraction phase and vice versa. Looking ahead, the industrials sector relative 12-month forward P/E multiple should continue to expand smartly (bottom panel, Chart 16). The US Equity Strategy’s macro based EPS growth model captures all the different earnings drivers and signals that an earnings-led recovery is in the offing (Chart 17). Chart 16The Greenback Holds The Key The Greenback Holds The Key The Greenback Holds The Key Chart 17Models Flashing Green Models Flashing Green Models Flashing Green Adding it all up, vibrant emerging markets and a recuperating China, a softening US dollar rekindling the commodity complex, the nascent recovery in domestic conditions and washed out technicals, all suggest that a significant re-rating looms for severely neglected industrials equities.   Bottom Line: We continue to recommend an above benchmark allocation in the S&P industrials sector.   Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com   Footnotes 1     The Washington Consensus – a catchall term for fiscal prudence, laissez-faire economics, free trade, and unfettered capital flows – is being replaced by economic populism, by a Buenos Aires Consensus. Buenos Aires Consensus is our catchall term for everything that is opposite of the Washington Consensus: less globalization, fiscal stimulus as far as the eyes can see, erosion of central bank independence, and a dirigiste (as opposed to laissez-faire) approach to economics that seeks to protect “state champions,” stifles innovation, and ultimately curbs productivity growth. 2     Our example assumes benchmark allocation in all sectors for illustrative purposes.   Current Recommendations Current Trades Strategic (10-Year) Trade Recommendations Drilling Deeper Into Earnings Drilling Deeper Into Earnings Size And Style Views July 27, 2020 Overweight cyclicals over defensives April 28, 2020  Stay neutral large over small caps June 11, 2018 Long the BCA Millennial basket  The ticker symbols are: (AAPL, AMZN, UBER, HD, LEN, MSFT, NFLX, SPOT, TSLA, V). January 22, 2018 Favor value over growth

Highlights Senate Republicans would be suicidal not to agree to a fiscal relief bill before the election. Democrats are still offering a $2.2 trillion package. Grassroots Republican voters will forgive Republicans for blowing out the budget deficit but they will never forgive them for throwing away control of the White House and Senate. Nevertheless financial markets face more downside until a deal is reached. We are booking gains on several of our tactical risk-off trades but will hold our strategic risk-on trades, as we are still constructive over a 12-month period. Turkey is stepping back from its foreign adventurism in the face of constraints. Our GeoRisk Indicator for Turkey has rolled over. Feature Financial markets continue to sell off in the face of a range of risks, including new threats of COVID-19 restrictions in Europe, an increase in daily new cases of the disease in the United States (Chart 1), and the US Congress’s problems passing a new round of fiscal relief. Chart 1Increase In COVID-19 Cases Among Factors Weighing On Markets Stimulus Will Come … But May Not Save Trump (GeoRisk Update) Stimulus Will Come … But May Not Save Trump (GeoRisk Update) Chart 2Congress Will Pass Stimulus ~$2-$2.5 Trillion Stimulus Will Come … But May Not Save Trump (GeoRisk Update) Stimulus Will Come … But May Not Save Trump (GeoRisk Update) Since May, when the Democrats passed the $3.4 trillion HEROES Act, we have maintained that “stimulus hiccups” would roil the market. However, we also argued that Congress would eventually pass a new package – probably in the range of $2-$2.5 trillion (Chart 2).1 The latter part of this view remains to be seen and has come under pressure from investors who fear that Congress could fail to produce a bill entirely. We are sticking with our guns. GOP senators will recognize that they face sweeping election losses; House Democrats will not be able to reverse course and deprive households of badly needed assistance. However, stock investors might sell more between now and the final deal, which must be done by around October 9 so that lawmakers can go back to their home states to campaign for the November 3 election. Moreover the fiscal deal might not come in time to save the Republicans’ re-election bid in the White House and Senate, which raises further downside risk due to the Democratic agenda of re-regulation and tax hikes. And the election’s aftershocks could also be market-negative. For example, President Trump could also escalate the conflict with China, whether as the “comeback kid” or as a lame duck. Therefore this week we are booking some gains. We will not recommend a tactical risk-on position until our fiscal view is confirmed and we can reassess. US Fiscal Stimulus Is Coming Chart 3Republicans Highly Unlikely To Win House Of Representatives Stimulus Will Come … But May Not Save Trump (GeoRisk Update) Stimulus Will Come … But May Not Save Trump (GeoRisk Update) Why would Democrats agree to a stimulus bill given that it could help President Trump and the Republicans get re-elected? Democrats are afraid to deprive households of relief amid a crisis merely to spite the president and score election points. Around 28-43 of Democrats in the House of Representatives face re-election in districts that are competitive or could become competitive. Republicans need a net gain of 20 seats to retake the House (Chart 3). If Democrats offer to cooperate yet Republican senators balk, then the latter will take the blame for any failed deal and ensuing financial turmoil. The experience of other fiscal cliffs bears this out. The debt ceiling crises of 2011 and 2013 and the government shutdowns of 2013 and 2018-19 all suggest that net presidential and congressional approval ratings suffer when partisanship prevents compromise on major fiscal issues (Charts 4A and 4B). This is a risk for the ruling GOP. All Democrats have to do is remain open to compromise. Net presidential and congressional approval ratings suffer when partisanship prevents compromise on major fiscal issues – a risk for the ruling GOP. Chart 4AFiscal Failures Pose A Risk To Ruling GOP Stimulus Will Come … But May Not Save Trump (GeoRisk Update) Stimulus Will Come … But May Not Save Trump (GeoRisk Update) Chart 4BFiscal Failures Pose A Risk To Ruling GOP Stimulus Will Come … But May Not Save Trump (GeoRisk Update) Stimulus Will Come … But May Not Save Trump (GeoRisk Update) Confirming this reasoning, Democrats joined with Republicans this week to pass a continuing resolution to maintain government spending levels through December 11, thus avoiding a government shutdown. Clearly the two parties can still cooperate despite record levels of partisanship. House Speaker Nancy Pelosi ruled out using government shutdown as a weapon to hurt the Republicans, fearing it would backfire. And just last week vulnerable House members pressured Pelosi into stating that the House will remain in session in October until a fiscal relief bill is passed. Democrats remain committed to their current plan – solidifying their grip on the House and demonstrating that they can govern, and that government can do more for households, by passing bills. This is still the strategy even if the risk is that these bills give Trump a marginal benefit. The Democratic demand is for a very large fiscal package – House Speaker Nancy Pelosi is today offering $2.2 trillion, a compromise from the initial $3.4 trillion bill (Table 1). A smaller bill is harder to negotiate because it would cut the House Democrats’ spending priorities for their constituents, including around $1 trillion in state and local government aid, while still giving Trump a bounce in opinion polls for boosting pandemic relief. This is unacceptable – and this is how a policy mistake could happen. Table 1What A Fiscal Compromise Will Look Like Stimulus Will Come … But May Not Save Trump (GeoRisk Update) Stimulus Will Come … But May Not Save Trump (GeoRisk Update) Chart 5Senate Republicans Face A Hotly Contested Election Stimulus Will Come … But May Not Save Trump (GeoRisk Update) Stimulus Will Come … But May Not Save Trump (GeoRisk Update) Chart 6Republican Senators' Hung Up On Future Deficit Concerns Republican Senators' Hung Up On Future Deficit Concerns Republican Senators' Hung Up On Future Deficit Concerns Senate Republicans face a hotly contested election – with 23 of them up for re-election versus only 12 Democrats. However, 30 of them are not up for re-election this year (Chart 5). These senators fear the eventual return of deficit concerns among the Republican base so they are bargaining to limit emergency spending (Chart 6). Until they can be cajoled by their fellow senators and the White House, they pose a risk to the passage of new stimulus. But this risk is overrated. Ultimately Senate Majority Leader Mitch McConnell and the Senate Republicans will capitulate. It is political suicide if they do not. The GOP will lose control of the Senate and the White House if premature fiscal tightening sparks a bloody September-October selloff just ahead of the election (Charts 7Aand 7B). Chart 7AStocks Sell, Bonds Rally … When Congress Goes Off Fiscal Cliff Stocks Sell, Bonds Rally... When Congress Goes Off Fiscal Cliff Stocks Sell, Bonds Rally... When Congress Goes Off Fiscal Cliff Chart 7BStocks Sell, Bonds Rally … When Congress Goes Off Fiscal Cliff Stocks Sell, Bonds Rally... When Congress Goes Off Fiscal Cliff Stocks Sell, Bonds Rally... When Congress Goes Off Fiscal Cliff Chart 8Trump Compares Poorly To Other Presidents Re-Elected Amid Recession Trump Compares Poorly To Other Presidents Re-Elected Amid Recession Trump Compares Poorly To Other Presidents Re-Elected Amid Recession Only three out of six presidents in modern times have been re-elected when a recession struck during the election year yet ended prior to the fall campaign. These were William McKinley in 1900, Teddy Roosevelt in 1904, and Calvin Coolidge in 1924.2 Trump faces the same scenario, but financial markets are signaling that Trump is not faring as well as these three predecessors (Chart 8). The Senate races are all on a knife’s edge (Chart 9). American politics are highly nationalized – partisan identification overrides regional concerns. President Trump has also personalized his political party, making the election a referendum on himself (Chart 10). These trends suggest the Senate will fall to the party that wins the White House. Chart 9The Senate Races Are All On A Knife’s Edge Stimulus Will Come … But May Not Save Trump (GeoRisk Update) Stimulus Will Come … But May Not Save Trump (GeoRisk Update) Consumer confidence is weak and bodes ill for the incumbent president and party (Chart 11). Chart 10Trump Has Personalized Partisan Politics Stimulus Will Come … But May Not Save Trump (GeoRisk Update) Stimulus Will Come … But May Not Save Trump (GeoRisk Update) Chart 11Consumer Confidence Bodes Ill For Trump And GOP Consumer Confidence Bodes Ill For Trump And GOP Consumer Confidence Bodes Ill For Trump And GOP A failure to provide stimulus will ensure that sentiment worsens for the rest of the campaign and overshadows some underlying material improvements that are the Republicans’ only saving grace. Wage growth is recovering in line with the V-shape recovery in blue and purple states, including purple states that voted for Trump (Chart 12). The manufacturing rebound – and a surge in loans – is creating the conditions for the “Blue Wall” of Pennsylvania, Michigan, and Wisconsin to re-elect President Trump (Chart 13). A fiscal failure will blot out this positive news. Chart 12Fiscal Failure Would Blot Out Economic Improvements Fiscal Failure Would Blot Out Economic Improvements Fiscal Failure Would Blot Out Economic Improvements Chart 13Blue Wall' Could Re-Elect Trump On Economic Improvement Blue Wall' Could Re-Elect Trump On Economic Improvement Blue Wall' Could Re-Elect Trump On Economic Improvement Republicans’ standing offer is for a $1.3 trillion bill. The bipartisan “Problem Solver’s Caucus” has separately proposed a $1.5 trillion package that could be converted. McConnell has shown he can muster his troops by producing 52 Republican votes on a skinny relief bill on September 10. The Senate will go on recess on Friday, October 9 and the House is committed to staying until a bill is done. Negotiations cannot drag on much longer than that, however, because lawmakers need to go back to their home states and districts to campaign for the election. The equity selloff suggests policymakers will need to respond sooner anyway. Is there a way for Trump to bypass Congress and provide stimulus unilaterally? Chart 14Gridlock In 2020-22 Is Possible Under Trump Or Biden Stimulus Will Come … But May Not Save Trump (GeoRisk Update) Stimulus Will Come … But May Not Save Trump (GeoRisk Update) Trump is only too happy to run against a “do-nothing Congress,” which is how Harry Truman pulled off his surprise victory in 1948. He could use executive orders to redirect federal funds that have already been appropriated. However, he has already provided stimulus by decree – delaying payroll tax collections and calling on states to provide unemployment insurance – and yet the market has sold off anyway. That is because these measures are half-baked – they lack the size and the force of an act of Congress. They require coordination with states and firms, which face uncertainty over the legality of the measures and have little incentive to make sacrifices for an administration that may not last more than a few months. In short, if Trump tries to stimulate by decree, it is an election gimmick that will not satisfy market participants who need to look beyond the next 39 days to the critical question of whether US fiscal authorities understand the needs of the economy and can coordinate effectively. Congressional failure will cast a pall over the outlook given that there is still a fair chance the election could produce gridlock for the 2020-22 period, under Trump or Biden (Chart 14). Bottom Line: Financial markets face more downside until Senate Republicans capitulate to Pelosi’s demand of a bill around $2-$2.5 trillion. We think they will, but that is not an argument for getting long now – Republicans could capitulate too late to save the market from a deeper selloff. Investors should book profits now and buy when the deal is clinched. What About The Supreme Court? The Supreme Court battle over the death of Justice Ruth Bader Ginsburg may increase the risk of miscalculation in the stimulus negotiations, but not by much. Subjectively we would upgrade that risk from 25% to 33%. Republicans will fill the vacant seat before the election. So far they have the votes – even if Senator Mitt Romney changes his mind, there is still a one-seat buffer. However, a win on the high court has a mixed impact on financial markets. It may increase the odds of a Democratic Party sweep, which is initially a net negative for equities. But House Democrats will become less inclined to compromise on the size of the fiscal bill that we expect. They will say “take it or leave it” on the $2.2 trillion offer. The lowest we can see Democrats passing is $1.9 trillion. If the GOP fails to budge, the equity selloff will be aggravated by the implication that Democrats will win a clean sweep and thus gain the power to raise corporate and capital gains taxes next year. We have put 55%-60% odds on a clean sweep, but the market stands at 49%, so there is room for the market to adjust (Chart 15). As for the Supreme Court itself, a Republican nomination is legitimate regardless of the election timing, though the decision to go forward this close to the election reveals extreme levels of polarization. The Republican pick could energize the Democrats in the election, as occurred with the nomination of Justice Brett Kavanaugh just ahead of the 2018 midterms. A Democratic overreaction could mobilize conservatives, but this will be moot if the stock market collapses. If the presidential election is contested or disputed, Trump’s court nominee pick could cast the decisive vote, although, once nominated, a justice may not rule in accordance with his or her nominator’s wishes. The Supreme Court battle raises the risk of stimulus miscalculation to 33%. In a period of “peak polarization,” one should expect the Supreme Court battle to escalate further from here (Chart 16). Democrats are likely to remove the filibuster if they win the Senate. This would theoretically enable them to create four new seats on the court, which they could then fill with liberal judges. Franklin Roosevelt attempted to pack the court in 1937 when it got in the way of the New Deal and his plan only narrowly failed due to the unexpected death of a key ally in the Senate. Chart 15A Democratic Sweep Would Aggravate The Equity Selloff A Democratic Sweep Would Aggravate The Equity Selloff A Democratic Sweep Would Aggravate The Equity Selloff Chart 16Supreme Court Battle Will Escalate Amid Extreme Polarization Supreme Court Battle Will Escalate Amid Extreme Polarization Supreme Court Battle Will Escalate Amid Extreme Polarization Not only might the court decide the election outcome, but future controversial legislation could live or die by the court’s vote, as occurred with Obamacare in 2012 (Chart 17). In the event that Democrats achieve a clean sweep, the conservative court will be their only obstacle and they will possess the means to remove it. Chart 17Supreme Court Battle Will Prove Market Relevant In Event Of Democratic Sweep Supreme Court Battle Will Prove Market Relevant In Event Of Democratic Sweep Supreme Court Battle Will Prove Market Relevant In Event Of Democratic Sweep Bottom Line: Earlier we saw a 25% chance that stimulus would fail – now we give it a 33% chance. However, the size of the stimulus is now even more likely to fall within the $2-$2.5 trillion range we have signaled in previous reports. The Supreme Court will become a major factor in domestic economic policy uncertainty if Democrats win a clean sweep of government. Turkey Hits Constraints In East Med – For Now … Turkish President Recep Tayyip Erdogan’s foreign policy assertiveness has once again put Turkey in conflict with NATO allies. Tensions escalated last month after Greece signed a maritime boundary deal with Egypt that Athens said nullified last November’s Libya-Turkey agreement (Map 1). Map 1Turkey Testing Maritime Borders In the East Med Stimulus Will Come … But May Not Save Trump (GeoRisk Update) Stimulus Will Come … But May Not Save Trump (GeoRisk Update) In response, Turkey issued a navigational warning (which was renewed thrice) and dispatched its seismic research vessel, the Oruc Reis, to explore for hydrocarbons in disputed areas of the Eastern Mediterranean between Greece and Cyprus. In shows of force, Turkey and Greece both deployed their navies to the area last month, raising the risk of an armed confrontation.3 The motivation for Erdogan’s hard power tactics is multi-pronged. Chart 18Erdogan’s Foreign Adventurism Reflects Domestic Weakness Stimulus Will Come … But May Not Save Trump (GeoRisk Update) Stimulus Will Come … But May Not Save Trump (GeoRisk Update) On a domestic level, Erdogan’s East Med excursions are an attempt to rally domestic support, where he and his party have lost ground (Chart 18). Given that popular opinion in Turkey indicates that the majority see the self-declared Turkish Republic of Northern Cyprus as a “kin country” and that they do not expect Turkey to be accepted into the EU, Ankara’s East Med strategy is likely to find support. On an international level, Turkey is flexing its muscles against the West. Erdogan has inserted Turkish forces into conflicts in Syria and Libya, confronting NATO allies there, and authorized the provocative purchase of the Russian S400 missile defense system at the expense of membership in the US F-35 program. The East Med gambit is another challenge to the West by testing EU unity. Specifically Erdogan is demonstrating that Turkey is willing to use military force to reject any unilateral attempts by foreign powers to impose maritime borders on Turkey – for instance through the EU’s Seville map.4 By demonstrating maritime strength, Turkey hopes to twist the EU’s arm into agreeing to a more favorable maritime partition plan in the East Med. As such the conflict is part of Turkey’s “Blue Homeland” strategy to expand its sphere of influence and secure energy supplies.5 Turkey is extremely vulnerable as a geopolitical actor because it depends on imports for three-quarters of its energy needs.6 With energy accounting for 20% of its import bill, these imports are weighing on the current account balance (Chart 19). Turkey’s exclusion from regional gas agreements has thus been a blow to its self-sufficiency goals. Meanwhile Greece, Italy, Egypt, Israel, Cyprus, and Jordan have recently formalized their cooperation through the Cairo-based East Mediterranean Gas Organization. Turkish agitation in the East Mediterranean is an attempt to prevent others from exploiting gas resources there so long as its demands remain unmet. Erdogan’s retreat demonstrates Turkey’s constraints in its challenge to the EU. While the EU has yet to impose sanctions or penalties, Erdogan has now backtracked. Oruc Reis returned to Antalya on September 13, despite official statements that it would continue its mission. Turkish and Greek military officials have been meeting at NATO headquarters. And following talks with French President Emmanuel Macron, German Chancellor Angela Merkel, and EU President Charles Michel, Erdogan’s office announced on September 22 that Turkey and Greece were prepared to resume talks. The postponement of the European Council’s special meeting to discuss Turkish sanctions to October 1-2 plays to Turkey’s favor by giving more time for talks. Chart 19Turkey's Energy Dependence A Geopolitical Vulnerability Turkey's Energy Dependence A Geopolitical Vulnerability Turkey's Energy Dependence A Geopolitical Vulnerability Erdogan’s retreat demonstrates Turkey’s constraints in its challenge to the EU. The possibility of damaging sanctions was too much at a time of economic vulnerability. Given Turkey’s dependence on the EU for export earnings and FDI inflows, the impact of sanctions on Turkey’s economy cannot be overstated (Chart 20). Chart 20EU Sanctions Could Destroy Turkey's Economy EU Sanctions Could Destroy Turkey's Economy EU Sanctions Could Destroy Turkey's Economy Turkey is also facing constraints diplomatically as two of its regional rivals – the United Arab Emirates (UAE) and Israel – have agreed to normalize relations and strengthen ties under the US-mediated Abraham Accords (Table 2). The UAE already dispatched F-16s to Crete to participate in joint training exercises in a show of support to Greece. Table 2The Abraham Accords Unify Turkey’s Regional Rivals Stimulus Will Come … But May Not Save Trump (GeoRisk Update) Stimulus Will Come … But May Not Save Trump (GeoRisk Update) Details about the potential sanctions have not been released. However, EU Minister of Foreign Affairs Josep Borrell has indicated that penalties could be levied not only on individuals, but also on assets, ships, and Turkish access to European ports and supplies. This could include banks financing energy exploration or even entire business sectors, such as the energy industry. Moreover, the EU could play other damaging cards such as halting EU accession talks, or limiting its customs union with Turkey, which Ankara hopes to modernize. Chart 21EU Needs Turkey’s Cooperation To Stem Flow Of Migrants Stimulus Will Come … But May Not Save Trump (GeoRisk Update) Stimulus Will Come … But May Not Save Trump (GeoRisk Update) It is also in Europe’s interest to de-escalate the conflict. Sanctions on Turkey could accelerate Ankara’s re-orientation towards Russia and possibly China, expediting its transition to a hostile regional actor. In addition, Turkey has not shied away from using the 2016 migration deal, whereby Turkey has become the gatekeeper of Middle Eastern migrants fleeing to Europe, as a bargaining chip (Chart 21). Foreign Minister Mevlut Cavusoglu outright stated that Turkey will respond to EU sanctions by reneging on the deal, which could result in an influx of refugees into the EU and new challenges for Europe’s political establishment. Erdogan’s retreat is also likely a response to pressure from Washington. Secretary of State Mike Pompeo lent some support to Greece and Cyprus during his September 12 visit to Cyprus. While the US has distanced itself from recent developments in the East Med, leaving German Chancellor Angela Merkel to play the role of mediator, a deterioration in Ankara’s relations with NATO allies could accelerate Turkey’s de-coupling from the West. Some within Washington are already calling for a relocation of the US strategic Incirlik air base to Greek islands. Erdogan’s retreat from a hawkish stance is in line with similar behavior elsewhere. For instance, despite having taken delivery of all parts and completed all necessary tests, Turkey has yet to activate its Russian S-400 missile defense system. It is wary of US sanctions. Similarly, Ankara has paused its Libyan offensive toward the eastern oil crescent in face of the risk of an outright military confrontation with Egypt. In each case, Erdogan appears to be at least temporarily recognizing the limits to his foreign adventurism. Nevertheless, the recent de-escalation does not mark the end of the conflict. Rather it demonstrates that both sides have hit constraints and are pausing for a breather. Chart 22Erdogan's Tactical Retreat Will Pull Down Turkish Risk Erdogan's Tactical Retreat Will Pull Down Turkish Risk Erdogan's Tactical Retreat Will Pull Down Turkish Risk The tactical retreat will provide some relief for the lira, which hit all-time lows against the dollar and euro, and thus pull down our Turkey GeoRisk indicator (Chart 22). But it does not guarantee that the Turkish risk premium will stay low. Talks between Greece and Turkey are unlikely to result in substantial breakthroughs. Instead the conflict will resurface – perhaps when Turkey is in a stronger economic position at home and the EU is distracted elsewhere, whether with internal political issues or conflicts with Russia, the UK, or any second-term Trump administration. Bottom Line: The recent de-escalation of East Med tensions does not mark the end of a bull market in Turkey-EU tensions. These tensions arise from geopolitical multipolarity – Turkey’s ability to act independently in foreign policy without facing an overwhelming, unified US-EU response. However, Turkey’s vulnerability to European economic sanctions shows that it faces real constraints. A major attempt to flout these constraints is a sell signal for the lira, as European sanctions could then become a reality. We remain negative on the lira, but will book gains on our short trade. Investment Takeaways We are booking gains on some of our tactical risk-off trades, given that we ultimately expect the US Congress to approve a new fiscal package. We are closing our long VIX December 2020 / short VIX January 2021 trade, which captured concerns about a contested election in the United States, for a gain of 4%. Volatility will still rise and a contested election is still possible, but the fiscal risk has gone up, COVID-19 cases have gone up, and Trump’s polling comeback has softened. The 4% gain does not include leverage or contract size. We were paid to put on the trade and now will be paid to exit it, so we are booking gains (Chart 23). Chart 23Book Gains On Bet On Near Term Volatility Book Gains On Bet On Near Term Volatility Book Gains On Bet On Near Term Volatility We are closing our short “EM Strongman Basket” of Turkish, Brazilian, and Philippine currencies for a gain of 4.5%. The trade has performed well but Turkey is not only recognizing its constraints abroad but also recognizing constraints at home by raising interest rates to defend the lira. In Brazil, Jair Bolsonaro’s approval rating has surged and our GeoRisk indicator has topped out. The latest readings on our GeoRisk Indicators provide confirmation of our major themes, views, and trades. The charts of each country’s indicator can be found in the Appendix. Short China, Long China Plays: Geopolitical risk continues on the uptrend that began with Xi Jinping’s consolidation of power and has not abated with the Phase One trade deal. Policymakers will remain entirely accommodative on fiscal and quasi-fiscal (credit) policy in the wake of this year’s recession. New financial regulations do not herald a return of the deleveraging campaign in any way comparable to 2017-18. The October Politburo meeting on the economy could conceivably sound a hawkish note, which could conveniently undermine sentiment ahead of the US election, but if this occurs then we would not expect follow-through. China plays and commodity plays should benefit, such as the Australian dollar, iron ore prices, and Brazilian and Swedish equities. Yet we remain short the renminbi, which has recently flagged after a fierce rally. Trump is negative for the RMB and Biden will ultimately be tough on China, contrary to the market consensus. Short Taiwan: US-China strategic relations have collapsed over the course of the year but financial markets have ignored it due to COVID-19 and stimulus. The only thing keeping US-China relations on an even keel is the Trump-Xi gentleman’s agreement, which expires on November 3 regardless of the election outcome. While outright military conflict over Taiwan cannot be ruled out, Beijing is much more likely to impose economic sanctions prior to any attempt to take the island by force. This has been our base case since 2016. Our GeoRisk indicator is just starting to price this risk so it remains highly underrated from the perspective of the Taiwanese dollar and equities. We are short and there is still time to put on shorts. Long South Korea: The rise in Korean geopolitical risk since the faltering of US-North Korean diplomacy in 2019 has peaked and fallen back, as expected. Pyongyang has not substantively tested President Trump during the election year and we still do not think he will – though a showdown would mark an October surprise that could boost Trump’s approval rating. South Korean political risk should continue falling and we are long Korean equities. Short Russia: Russian geopolitical risk has exploded upward, as we expected. We have been bearish on the Russian ruble and local currency bonds, though we should note that this differs from our Emerging Markets Strategy view based on macro fundamentals. Our reasoning predates the escalation of tensions with the EU over Belarus, but Belarus highlights the negative dynamic: Vladimir Putin in his fourth term is concerned about domestic social and political stability, and this concern is especially heightened after the global pandemic and recession. Therefore he has little ability to tolerate unrest in the former Soviet sphere. Moreover, he has a window of opportunity when the US administration is distracted, and not unfriendly, whereas that will change if the Democrats take over. If Democrats win, they will not try another diplomatic “reset” with Russia; they believe engagement has failed and want revenge for Putin’s undermining the Obama administration and 2016 election interference. The Nordstream 2 pipeline and Russian local currency bonds are at risk of new sanctions. The Democrats will also increase their efforts at cyber warfare and psychological warfare to counter Russia’s use of such measures. If Trump wins, the upside for Russia is limited as Trump’s personal preferences have repeatedly lost to the US political and military establishment when it comes to Russia. The US has remained vigilant against Russian threats and has increased support for countering Russia in eastern Europe and Ukraine. Chart 24Russia Is At Risk of US Sanctions Russia Is At Risk of US Sanctions Russia Is At Risk of US Sanctions In Belarus, President Lukashenko has been sworn in as president again, and he will not step down unless Russia and its allies orchestrate a replacement who is friendly toward Russian interests. Russia will not allow a pro-EU, pro-NATO government by any stretch of the imagination. The likeliest outcome is that Russia demonstrates its security and military superiority in a limited way, while the US and Europe respond with sanctions but not with military force. There is no appetite for the US or EU to engage in hot war with Russia over Belarus, which they have little hope of re-engineering in the Western image. We are short Russian currency and local bonds on the risk of sanctions stemming from either the US election cycle or the Belarus confrontation or both. We note that local currency bonds are not pricing in the risks that our geopolitical risk indicators are pricing (Chart 24). Long Europe: Our European geopolitical risk indicators show that the EU remains a haven of political stability in an unstable time. European integration is accelerating in the context of security threats from Russia, the potential for sustained economic conflict with the US (if Trump is re-elected), and economic competition with an increasingly authoritarian and mercantilist China. Europe’s latent strengths, when acting in unison, are brought out by the report on Turkey above. However, the 35% chance that the UK fails to reach a trade deal at the end of this year will still push our European risk indicators up in the near term.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Roukaya Ibrahim Editor/Strategist Geopolitical Strategy RoukayaI@bcaresearch.com   We Read (And Liked) … Geopolitical Alpha: An Investment Framework For Predicting The Future What better way to revive the hallowed tradition of BCA Geopolitical Strategy book reviews than to give clients a sneak preview of our founder Marko Papic’s literary debut, Geopolitical Alpha: An Investment Framework for Predicting the Future?7 Long-time readers will know much of this book – it is the distillation of a decade of Marko’s work at BCA Research and, more recently, Clocktower Group. Here is the story of European integration – perhaps Marko’s greatest call, from back in 2011. Here is the story of multipolarity and investing. Here is the apex of globalization. Here is the decline of laissez-faire and the rise of dirigisme. Here is the end of Chimerica. Attendees of the BCA Research Academy will also recognize much in Marko’s formal exposition of his method. The categories of material constraints that bind policymakers. The practical application of the median voter theorem. The psychological lessons from Richards Heuer and Lee Ross. The occasional dash of game theory – and the workingman’s critique of it. The core teaching is the same: “Preferences are optional and subject to constraints, whereas constraints are neither optional nor subject to preferences.” There is also much that is new, notably Marko’s analysis of the COVID-19 pandemic, which is bound to generate controversy for classifying the whole episode as an example of mass hysteria comparable to the Salem witch trials, but which is as well-researched and well-argued as any section in the book. I was fortunate to learn the geopolitical method with Marko under the guidance of George Friedman, Peter Zeihan, Roger Baker, Fred Burton, Scott Stewart, and other colleagues at Stratfor (Strategic Forecasting, Inc.) in Austin, Texas from the era of the Iraq troop surge, the Russian invasion of Georgia, and the Lehman Brothers collapse. We both owe a lot to these teachers: the history of geopolitics, intelligence analysis, open source monitoring, net assessments, and, of course, forecasting. What Marko did was to take this armory of geopolitical analysis – which we both can testify is best taught in practice, not universities – and to put it to use in the financial context, where political analysis was long treated as optional and anecdotal despite the manifest and growing need for a rigorous framework. A hard-nosed analyst will never cease to be amazed by the gaps that emerge between the consensus view on Wall Street and a careful, disciplined net assessment of a nation or political movement. By the same token, the investor, trader, or economist will never cease to be amazed by the political analyst’s inability to grasp the concept of “already priced in” or “the second derivative.” What needed to be done was to master the art of macro investing and geopolitics. Marko took this upon himself. It was audacious and it provoked a lot of skepticism from the dismal scientists and the political scientists alike. But Geopolitical Alpha, the concept and the book, is the consequence – and we are now all the better for it. Marko is fundamentally a post-modern thinker. His methodological hero is Karl Marx for the development of materialist dialectic, the back-and-forth debate between economic forces that humans internalize in the form of competing ideologies. His foil is the humanist and republican, Niccolo Machiavelli – not for his amoral approach, but for prizing the virtue of the prince in the face of outrageous fortune. Human agency is Marko’s favorite punching bag – he excels at identifying the ways in which individuals will be frustrated despite their best efforts by the cold, insensitive walls of reality around them. If there is a critique of Marko’s book, then, it is that he gives short shrift to the classical liberal tradition – or as I like to think of it, the balance-of-power tradition. The idea that hegemony, or unipolarity, leads to a stable social and political environment conducive to peace and prosperity has a lot going for it. But it also partakes of an older tradition of thought that envisions a single, central political order as necessarily the most stable and predictable – a tradition that can be ascribed to Plato as well as Marx. You can see the positive implication for financial markets. But what if this tradition is only occasionally right – what if it too is subject to historical cycles? If that is the case, then the Beijing consensus is a mirage – and the US’s reversion to a blue-water strategy (not only under President Trump, but also under a future President Biden, according to his campaign agenda) does not necessarily herald the “end [of] American dominance on the world stage.” The classical tradition behind the Greco-Roman, British, and American constitutional systems, including their naval strategies, envisioned a multipolar order that was somewhat less stable but more durable, and this tradition has proven immensely beneficial for the creation of technology and wealth. Of course, Marko is very much alive to this tradition and, despite his critique of the ancients, shows himself to be highly sensitive to the interplay of virtue and fortune. Throughout the work, the analytical style can be characterized as restless energy in the service of cool, chess-playing logic. Marko is generous with his knowledge, merciless in drawing conclusions, and outrageously funny in delivery. He attacks the questions that matter most to investors and that experts too often leave shrouded in finely wrought uncertainty. He also shows himself to be a superb writer as well as strategist, interspersing his methodological training sessions with vivid anecdotes of a lifelong intellectual journey from a shattered Yugoslavia to the heights of finance. The bits of memoir are often the best, such as the intro to Chapter Six on geopolitics. To paraphrase a great author, Marko writes because he has a story to tell, not because he has to tell a story. The tale of the mysterious consulting firm Papic and Parsley will do a great public service by teaching readers precisely how skeptical of mainstream news journalism they should be. It isn’t enough to say that we read Geopolitical Alpha and liked it – the sole criterion for a review in this column. Rather, the book and its author are the reason this column exists. And Geopolitical Alpha is now the locus classicus of market-relevant geopolitical analysis.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1 We favored the upper side of the range, first $2.5 trillion, and subsequently something closer to House Speaker Nancy Pelosi’s demand of $2.2 trillion. We have speculated that Republicans may get her to settle at $1.9 trillion. 2 Two of these cases were unique in that a vice president took over from a president who died and then won re-election – unlike Trump’s scenario. 3 On August 12 a Greek Navy frigate collided with a Turkish vessel guiding the Oruc Reis. Athens called the incident an accident while Ankara referred to it as a provocation. 4 The so-called Seville Map was prepared at the request of the European Union by researchers at the University of Seville, attempts to clarify the exclusive economic zones of Turkey and Greece in the Aegean Sea. The US announced on September 21 that it does not consider the Seville map to have any legal significance. 5 The Blue Homeland or Mavi Vatan doctrine announced in 2006 intends to secure Turkish control of maritime areas surrounding its coast (Mediterranean Sea, Aegean Sea, and Black Sea) in order to secure energy supplies and support Turkey’s economic growth. 6 Erdogan’s claim that gas from the recently discovered Sakarya gas field would reach consumers by 2023 is likely overly optimistic and unrealistic. The drilling costs and commercial viability of the field are yet to be determined. Thus, the find does not impact dynamics in the East Med. 7 New Jersey: Wiley, 2021. 286 pages. Section II: GeoRisk Indicators 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 Section III: Geopolitical Calendar