Financial Markets

Dear Client, There will be no US Equity Insights from July 1-3 inclusive, as the US Equity team will be on vacation for the week. Our regular publication schedule will resume on Monday July 13, 2020 with our Weekly Report. Happy Independence Day.  Kind Regards, Anastasios Highlights Portfolio Strategy Odds are high that stocks will move laterally in Q3, digesting the massive gains since the March 23 lows. Beyond that, on a cyclical 9-12 month time horizon we remain constructive on the return prospects of the broad market. On all three key profit fronts – price of credit, loan growth and credit quality – banks are starting to show signs of stress. Tack on the potential dividend cuts/suspensions and we were compelled to downgrade exposure to neutral. A dearth of M&A deals, a steep fall in margin debt and declining equity flows into mutual funds and exchange traded funds and potential dividend cuts/suspensions enticed us to trim exposure in the S&P investment banks & brokers index to neutral. Recent Changes Last Tuesday we downgraded the S&P banks and S&P investment banks & brokers indexes to neutral. These two moves also pushed the S&P financials sector weighting to neutral.1 Feature The SPX remains in churning mode, consolidating the massive gains since the March 23 lows. Easy fiscal and monetary policies are still the dominant macro themes underpinning markets, and thus any letdown in either loose policies poses a threat to the 1000 point three-month SPX run-up (bottom panel, Chart 1). Importantly, correlations have gone vertical of late with the CBOE’s implied correlation index – gauging the S&P 500 constituents’ pairwise correlations – surging to 70% (implied correlation index shown inverted, second panel, Chart 1). This is cause for concern as it has historically been a precursor to SPX pullbacks. Typically, stocks move in tandem, especially during risk off phases when everything becomes one big macro trade. Similarly, two Fridays ago we highlighted that the VIX and the S&P 500 were becoming positively correlated.2 The 20-day moving correlation between these two assets is shooting higher, approaching positive territory. Since late-2017 every time this correlation has hit the inflection point near the zero line, stocks has subsequently suffered a sizable setback (Chart 2). Chart 1Short-Term Downdraft Risks Are Rising Chart 2Watch SPX/VIX Correlation Tack on the public’s renewed interest in COVID-19 according to Google trends search results, and the odds are high that stocks will be range bound this summer (top panel, Chart 1). Beyond that, on a cyclical 9-12 month time horizon we remain constructive on the return prospects of the broad market. Turning over to profits on the eve of earnings season, our four-factor macro EPS growth model for the SPX has tentatively troughed at an extremely depressed level (Chart 3). Our SPX EPS estimate for next calendar year remains near $162/share which we consider trend EPS and was last hit both in 2018 and 2019.3 Chart 3Our EPS Growth Model Has Troughed Moreover, drilling beneath the surface, this week Table 1 updates the sector and subgroup EPS growth expectations. First we rank the GICS1 sectors and then within each sector we rank the subsectors, both times by absolute 12-month forward EPS growth using I/B/E/S/ data (see second columns, Table 1). The third columns in Table 1 show the sector growth rate relative to the SPX. Table 1Identifying S&P 500 Sector EPS Growth Leaders And Laggards The final columns highlight the trend in relative growth. In more detail, they compare the current relative growth rate to that of three months ago: a positive sign indicates an upgrade in analysts’ relative estimates and a negative sign a downgrade in analysts’ relative estimates. Tech, health care and communication services occupy the top ranks with positive EPS growth expectations, while financials, real estate and energy are forecast to contract in the coming 12 months and have fallen at the bottom of the table. Table 2Sector EPS And Market Cap Weights Given that the tech sector has the highest profit weight in the SPX roughly 23% projected for next year (Table 2) it has really helped the broad market’s profit growth recovery (Chart 4). As a reminder, we continue to employ a barbell portfolio approach and prefer defensive (software and services) to aggressive tech (hardware and equipment). On the flip side, financials have the third largest profit weight roughly 16% in the S&P 500, trailing tech and health care, and pose a big threat to overall SPX profits next year, especially if there are any hiccups with the reopening of the economy (Table 2). Worrisomely, investors are not voting with their feet and are doubting that financials profits will deliver as the market cap weight relative to the profit weight stands at negative 540bps.  Last Tuesday we downgraded the S&P financials sector to a benchmark allocation via trimming the S&P banks and S&P investment banks & brokers indexes to neutral and this week we delve into more details on these two early cyclical subgroups. Chart 4Earnings Finding Their Footing Downgrade Banks To Neutral… We were compelled to downgrade the S&P banks index to neutral last Tuesday in advance of the Fed’s stress test results. There are high odds that a number of banks will cut/suspend dividend payments in coming quarters in line with the Fed’s guidance in the latest round of stress test, especially if profits take a big hit as we expect. As a reminder, dividends are paid out below-the-line. Beyond the Fed’s stress tests and rising political risks,4 yellow flags are waving on all three key bank profit drivers, namely the price of credit, loan growth and credit quality. First, it is disconcerting that bank relative performance has really not taken the yield curve’s steepening cue and has negatively diverged as we showed last week.5 The year-to-date plummeting 10-year yield is weighing heavily on relative share prices (top panel, Chart 5). The transmission mechanism to bank profits of this lower price of credit is via the net interest margin (NIM) avenue (third panel, Chart 5). NIMs will remain under downward pressure as long at the 10-year Treasury yield stays suppressed owing to the Fed’s immense b/s expansion. The rising likelihood of yield curve control could keep interest rates on the long end of the curve depressed for a number of years similar to what happened between 1942 and 1951. Second, on the credit growth front news is equally worrisome. The widening in the junk spread signals loan growth blues in the quarters ahead (second panel, Chart 6). Despite the initial knee jerk reaction, primarily by corporations, of tapping existing C&I credit lines and causing a surge in bank credit growth, bankers are not willing to extend credit according to the latest Fed Senior Loan Officer survey (third panel, Chart 6). The same survey revealed that banks are reporting lower demand for credit across the board, warning that future loan growth will be anemic at best, especially given the collapse in our economic impulse indicator (bottom panel, Chart 6). Chart 5Bank Yellow Flags Waving Chart 6Loan Growth Will Suffer Finally, with regard to credit quality, delinquency and charge-off rates are all but certain to spike in the coming months. The third panel of Chart 7 highlights that historically all these credit quality gauges are lagging. However, the near vertical climb in the unemployment rate recently and persistently high continuing unemployment benefit claims near 20mn signal that non-performing loans (NPLs) are slated to soar in the back half of 2020 (bottom panel, Chart 7). True, the recent $2tn+ fiscal package is acting as a Band-Aid solution by putting money in unemployed consumers’ pockets, but when the money runs out on July 31, the going will get tough especially if Congress does not pass a new fiscal package. In addition, there are “extend and pretend” clauses in the existing relief package especially on the residential mortgage front that aim to help homeowners make ends meet. But, the longer workers stay out of the labor force the higher the chances that their skills atrophy making it difficult for them to return to work. As a result, foreclosure risk is on the rise. While residential real estate loans are no longer the largest category in bank loan books they still comprise a respectable 21% of total loans or $2.3tn, a souring housing market could spell trouble for banks (Chart 8). Chart 7Deteriorating Credit Quality Will Sink Profits Chart 8Housing Arrears Are A Risk Already, residential mortgage delinquencies are rising and in May surged to the highest level since November 2011 according to Bloomberg. 4.3mn residential real estate borrowers are in arrears (this delinquency count includes borrowers with forbearance agreements who missed payments) and “more than 8% of all US mortgages were past due or in foreclosure” according to Black Night Inc., a property information service. Tack on the shattering consumer confidence and the consumer loan category (credit card, auto and student debt) is also under risk of severe credit quality deterioration (fourth panel, Chart 7). The commercial real estate (CRE) side of loan books is also likely to bleed. Anecdotes where landlords are demanding past due rent payment from tenants are mushrooming, at a time when the same landlords refuse to service their loan obligations. According to TREPP, CMBS delinquencies are skyrocketing across different REIT lines of business. Importantly, CRE loans add up to $2.4tn on commercial bank balance sheets or roughly 22% of total loans. Encouragingly, in Q1 banks started to aggressively provision for steep credit losses with commercial bank loan loss reserves now climbing just shy of $180bn according to the latest FDIC Quarterly Banking Profile (second panel, Chart 7). This figure is almost twice as high as noncurrent loans and represents a healthy reserve coverage ratio. However, our fear is that if history at least rhymes NPLs will sling shot higher (bottom panel, Chart 7) rendering loan loss reserves insufficient. Putting this provisioning number in context, according to the Fed’s most adverse stress test scenarios banks’ losses could spring to $700bn: “In aggregate, loan losses for the 34 banks ranged from $560bn to $700bn”.6 As a result, banks will have to further provision for futures losses and thus take an additional hit to profitability. Our bank earnings growth model does an excellent job in capturing all these moving parts and warns of a contraction in profit in the back half of the year (bottom panel, Chart 9). Nevertheless, before getting too bearish on banks, there two key offsetting factors. Relative valuations are bombed out, signaling that most of the bad news is likely reflected in prices (bottom panel, Chart 5). Finally, technicals are also extremely oversold. The second panel of Chart 5 shows that relative momentum is as bad as it gets. Netting it all out, on all three key profit fronts – price of credit, loan growth and credit quality – banks are starting to show signs of stress and compel us to downgrade exposure to neutral. Chart 9Dividend Cuts Are Looming …And Move To The Sidelines On Investment Banks & Brokers The S&P investment banks & brokers (IBB) group has a similar investment profile to the S&P banks index. But, given its more cyclical nature it typically oscillates violently around banks’ relative performance. Thus last Tuesday, we were also compelled to move to the sidelines on this higher beta financials subgroup.7 The COVID-19 accelerated recession has not only mothballed potential M&A deals that were in the works, but also a number of previously announced deals have been canceled. In addition, the outlook for M&A is grim, at least until the dust really settles from the coronavirus pandemic (second panel, Chart 10), weighing heavily on the sector’s profit prospects. While “Robinhood” (retail investor) trading stories abound, margin debt remains moribund and continues to contract, despite the V-shaped recovery in all major US stock markets since the March 23 lows (third panel, Chart 10). This coincident indicator speaks volumes in the near term direction of the broad market and any sustained contraction in trading related debt uptake will likely dent IBB profitability. According to the American Association of Individual Investors bullish retail investors have been absent from this quarter’s massive stock market rally and equity mutual fund and exchange traded fund flows corroborate this message (fourth panel, Chart 10). With regard to cyclicality, IBB are extremely quick to prune labor in times of duress and aggressively add to headcount during expansions. Recent trimming of IBB input costs signal that this industry is retrenching as it is trying to adjust cost structures to lower revenue run rates (bottom panel, Chart 10). Chart 10Diminishing Activities Are Profit Sapping Related to the cyclical nature of the IBB industry, an accelerating stock-to-bond ratio has been synonymous with relative share outperformance and vice versa. In early June we turned cautious on the broad market’s near-term return prospects primarily on the back of rising (geo)political risks. The implication is that a lateral move in the broad market would push down the S/B ratio and weigh on relative share prices (Chart 11). However, there are some offsets that prevent us from turning outright bearish on this niche early-cyclical group. First relative valuations are extremely alluring. On a price-to-book basis IBB traded recently at 0.8x in absolute terms and at a steep 68% discount to the broad market (bottom panel, Chart 12). Chart 11Move To The Sidelines On This Highly Cyclical Industry Chart 12Some Positive Offsets Second, volatility has gone haywire since late-February and it remains elevated with a VIX reading still north of 30. This is a fertile environment for IBB trading desks and should translate into higher profits (second panel, Chart 12). Third, equity trading volumes have exploded. True, volumes spike on downdrafts, but they have remained at an historically high level recently underscoring that IBB trading desk should be minting money (third panel, Chart 12). Adding it all up, a dearth of M&A deals, a steep fall in margin debt and declining equity flows into mutual funds and exchange traded funds and potential dividend cuts/suspensions compelled us to trim exposure in the S&P investment banks & brokers index to neutral. Bottom Line: Downgrade the S&P banks index to neutral for a loss of 32.4% since inception. Trim the S&P investment banks & brokers index to neutral for a loss of 24% since inception. These moves also push the S&P financials sector to a benchmark allocation. The ticker symbols for the stocks in these indexes are: BLBG S5BANKX – JPM, BAC, C, WFC, USB, TFC, PNC, FRC, FITB, MTB, KEY, SIVB, RF, CFG, HBAN, ZION, CMA, PBCT, and BLBG S5INBK – GS, MS, SCHW, ETFC, RJF, respectively.   Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com     Footnotes 1    Please see BCA US Equity Strategy Insight Report, “Unresponsive” dated June 23, 2020, available at uses.bcaresearch.com. 2    Please see BCA US Equity Strategy Insight Report, “Tales Of The Tape” dated June 19, 2020, available at uses.bcaresearch.com. 3    Please see BCA US Equity Strategy Weekly Report, “Gauging Fair Value ” dated April 27, 2020, and BCA US Equity Strategy Special Report, “Debunking Earnings” dated May 19, 2020, both available at uses.bcaresearch.com. 4    Please see BCA US Equity Strategy Insight Report, “Unresponsive” dated June 23, 2020, available at uses.bcaresearch.com. 5    Ibid. 6    https://www.federalreserve.gov/newsevents/pressreleases/bcreg20200625c.htm 7    Please see BCA US Equity Strategy Insight Report, “Unresponsive” dated June 23, 2020, available at uses.bcaresearch.com.   Current Recommendations Current Trades Strategic (10-Year) Trade Recommendations Size And Style Views June 3, 2019 Stay neutral cyclicals over defensives (downgrade alert)  January 22, 2018 Favor value over growth 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).

Highlights The highly uncertain backdrop calls for taking less near-term risk: It may be boring, but it’s only prudent for asset allocators to limit risk exposures when the distribution of economic and public health outcomes is so unusually wide. The US reported record daily COVID-19 infections last Wednesday and Thursday: Several southern and western states that led the way in easing social distancing measures are now experiencing record-high infection rates. Some states are pausing their reopening plans, and the recovery may be more drawn out than expected. Bank stocks sold off after the stress tests, but we’re still a fan of the SIFIs: The year-over-year increases in projected losses weren’t that large, and we still think the SIFIs will suffer smaller credit losses than the market expects. Feature Neutral is dull, neither hot nor cold, neither here nor there, and recommending a benchmark equity weighting in a balanced portfolio makes us restless. We see an equity equal weight as no more than a temporary pause while we wait for the balance between risk and reward to shift enough to merit an underweight or an overweight. When conditions are unusually uncertain, however, we recognize that staying within sight of the shore is prudent. Investors should only take risks when they judge that they will be adequately compensated for doing so. The IMF titled last week’s update to its World Economic Outlook, in which it lowered its 2020 global GDP growth forecast to -4.9% from April’s -3%, “A Crisis Like No Other, An Uncertain Recovery.” As the 1918-19 influenza outbreak is the only global public health threat approaching COVID-19 in terms of its seriousness and its reach, investors have to proceed without a ready basis of comparison. Six months after its emergence, there is still a great deal that we don’t know about the virus. It remains uncertain if developed economies have the hospital capacity and resource stockpiles to combat it, though many emerging economies clearly do not. Modeling the economic impact is further complicated by human vagaries. Public officials can make careful plans for the phased relaxation of activity restrictions, but there is no guarantee that the populace will abide by them. Clusters of unmasked patrons enjoying takeout service on the sidewalk outside the lower Manhattan bars that are open suggest that even likely Democratic voters are as tired of social distancing as the attendees packing the seats at the president’s recent rallies. It turns out that there is something that both sides can agree on, after all. The unpredictability of how well citizens will take direction can go the other way, as well. Just as steadily declining infection rates emboldened people to emerge from their cocoons sooner than officials wished, they may be reluctant to quit them even after officials sound the all-clear signal. As our European Investment Strategy colleagues have noted, economic activity in Sweden, which imposed barely any virus restrictions, was just as weak as it was in neighboring countries that sharply limited movement. The takeaway is that government officials may not have all that much say over how citizens change their behavior amidst a pandemic. There is a possibility, then, that even if officials become comfortable with fully reopening the economy, participants may balk at returning to some corners of it. Officials might throw a party, only to find that very few people will come. The bottom line is that economic conditions are still extremely uncertain, and we will remain in our tactically neutral limbo until we get some clarity about the virus’ path or until equity prices move significantly. Ready Or Not, Here We Come US equities stumbled last week as new COVID-19 infections staged a comeback, with the 7-day moving average rising for 13 straight days and counting (Chart 1). Increases in infections are an inevitable consequence of the expiration of temporary stay-at-home orders that stymied transmission by keeping people apart. The locus has begun to shift from a still largely limited New York City to the southern and western states that were among the first to reopen their economies. As infection rates surged beyond Gotham, the US set consecutive daily infection records last Wednesday and Thursday. Chart 1US Daily New Infections We reiterate that rising cases are no surprise. It is a certainty that more people will contract a communicable disease once large swaths of the population are released from quarantine. But the sharp increases in cases may inspire investors to ask some uncomfortable questions. The lockdowns were meant to buy time for officials to design a testing, tracing and isolation framework that other countries have successfully wielded to short-circuit the spread of the virus. Did the United States use that time to build a workable framework? If not, are conditions materially different than they were in March, when stay-at-home orders began to be issued? The testing process continues to be beset by snags. The US is now capable of administering half a million tests a day, according to health officials’ testimony before Congress last week, and they expect capacity to triple by the fall. That capacity is fragmented across several small labs and testing facilities, however, and it can take as much as a week to obtain results, hampering attempts to isolate those who test positive. The absence of a central authority to direct resources where they’re most needed as new nodes emerge undermines the aggregate national capabilities.1 Turnabout Is Fair Play New York City quickly became the global epicenter once the pandemic entered the United States on account of its density, its residents’ reliance on public transportation and its position as an international crossroads. Counties across the entire metropolitan area, stretching into New Jersey and Connecticut, suffered high per-capita infection rates. Nowhere else in the US needed lockdown measures more than New York City, and it only entered the second stage of a four-stage phased re-opening last week. Other states, observing how the virus besieged New York in March and April, imposed restrictions on New York residents traveling to their states, fearing that they could potentially spread the virus far and wide. The rise in infection rates isn't surprising, but its steepness might cause investors to revisit their virus assumptions. The shoe is now on the other foot. New York has steadily reduced its new infection rate for two months and its 7-day moving average of new infections is just one-fifteenth of its early April peak (Chart 2, top panel). It is now nervously eyeing states suffering new outbreaks, and it announced 14-day quarantine measures for visitors from nine states – Alabama, Arizona, Arkansas, Florida, North Carolina, South Carolina, Texas, Utah and Washington – last week. The visitor quarantines are a voluntary measure, and thus likely to have little practical effect, but they highlight the way that several states that have reopened are seeing sharply rising per-capita infection rates relative to the entire country. Alabama’s stay-at-home order ended on April 30th. Its relative per-capita infection rate began to rise immediately (Chart 3, bottom panel). Its 7-day moving average of new infections has since experienced three surges, with the last and most potent causing it to more than double across nine days from June 8th to June 16th (Chart 3, top panel). That span included four consecutive days of record infections. Chart 2New York Daily New Infections Chart 3Alabama Daily New Infections Arizona’s outbreak has been remarkably swift. Its stay-at-home order expired on May 15th, and both its 7-day moving average of new infections (Chart 4, top panel) and its relative per-capita infection rate (Chart 4, bottom panel) inflected sharply higher fourteen days later. The former series has risen sixfold since residents regained their ability to circulate freely outside of their homes. Arkansas did not have a statewide stay-at-home order, but several measures to slow the virus’ spread were imposed. Restaurants re-opened with capacity limits on May 11th, and by month’s end Arkansas’ 7-day moving average of new infections (Chart 5, top panel) and its relative per-capita infection rate (Chart 5, bottom panel) had begun to inflect sharply higher. Chart 4Arizona Daily New Infections Chart 5Arkansas Daily New Infections The story is similar across the rest of the states subject to New York’s quarantine. Stay-at-home orders end, stores, bars and restaurants reopen, and infection rates surge with a lag of about two weeks. Florida and Texas, the two most populous states on New York’s list, fit the general pattern, though the rate at which their infections has grown has been striking. Last Wednesday, Florida topped its previous single-day new infection record by 36%2 (Chart 6, top panel), while Texas surpassed its daily high by 30% (Chart 7, top panel). Chart 6Florida Daily New Infections Chart 7Texas Daily New Infections What’s That Have To Do With The Price Of Stocks In New York? Some of the increase in infection rates is surely a function of more widely available testing. An assessment of what increased state infection rates mean for the course of the virus in any individual state or the entire country is beyond the scope of this report, not to mention our qualifications. Our intention is simply to assess whether US equities are vulnerable to the rising state case counts. We think they could be. Combined daily new infections in Florida and Texas now exceed New York's worst levels in the first half of April. We have previously written that the political will for social distancing measures has dissipated. For many state and local leaders, a return to lockdowns is not an option, and both Missouri’s and Texas’ governors have said as much, in no uncertain terms. There must be an infection level, however, that would force their hands, no matter the depth of their personal opposition. On Thursday, Texas’ governor halted any further easing of restrictions and signed an order suspending elective procedures at hospitals in the counties encompassing Austin, Dallas, Houston and San Antonio, all the while reiterating that rolling back reopening measures was a last resort.3 A resurgence in infection rates isn’t an investment concern per se, but it could become one if it encourages state and/or municipal authorities to reinstitute strict social distancing measures or freeze steps toward reopening local economies. There is also a potential threat to consumer confidence, which could be much harder to combat. Reopening an economy too soon could produce a more persistent drag than locking it down for too long. Premature easing that leads to a widely observed surge in infections may make individuals wary of leaving their homes lest they encounter the virus. Hasty measures meant to unshackle economic activity could backfire by sapping confidence that takes a long time to restore. The bottom line is that the combination of virus risks and an elevated forward earnings multiple keeps us from changing our neutral tactical stance to overweight. We are not inclined to underweight stocks, however, unless the S&P 500 approaches its all-time high around 3,400, given the potential for a positive virus surprise and individual and institutional investors’ ample cash holdings. Over a one-year horizon, we remain overweight equities as we do not see the pandemic exerting a permanently negative impact on corporate earnings. SIFI Bank Update The Fed released the results of its annual Dodd-Frank Act Stress Tests (DFAST) after the close last Thursday. The verdict was decidedly mixed. Investors and the financial media were keenly focused on the fate of bank dividends, and while the Fed did not forbid dividend payments, it capped third-quarter distributions at the lesser of a bank’s second-quarter dividend payment or the average of its trailing four-quarter earnings. It also said it would not allow any share repurchases in the third quarter, extending the largest banks' voluntary buyback pause. Among the SIFIs, Wells Fargo (WFC) is most likely to be constrained by the dividend cap, but its stock, lagging the rest of its peers’, already discounted that possibility. Our thesis that the SIFI banks will not incur credit losses as large as the market expects is still intact, provided Congress doesn’t abandon pandemic-stricken businesses, state and local governments or the unemployed in its follow-up to the CARES Act. The Fed's stress tests highlighted the many risks the banking system still faces, but we stand behind our call to overweight the SIFIs. If Congress plays its part, reserve builds roughly equivalent to half of the credit losses projected under the severely adverse scenario should prove to be more than sufficient. Table 1 updates the table we created after first quarter earnings releases to assess the adequacy of each bank’s loan-loss reserves. It shows that the total projected stress-test losses for the SIFIs are just 8.6% larger than they were in 2019, with only JP Morgan (JPM) facing a material increase in its loan-loss rate. A modest increase in maximum projected losses suggests only a modest increase in future provisions, and we still believe that another two quarters of provisions equivalent to the first quarter’s will be enough for each bank ex-WFC, which continues to look under-provisioned alongside its peers. Table 1Loan-Loss Reserves Vs. Updated Stress Test Projections Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 Kliff, Sarah, “Arizona ‘Overwhelmed’ With Demand for Tests as U.S. System Shows Strain,” New York Times, June 25, 2020. https://www.nytimes.com/2020/06/25/upshot/virus-testing-shortfall-arizona.html 2 As we went to press Friday afternoon, Florida announced over 8,900 new cases, 60% above Wednesday's high. 3 As we went to press Friday afternoon, the governor had just issued an order closing all Texas bars.

The market gapped to fresh recovery highs in early June, but the Fed’s June meeting that lacked any additional easing measures, undermined the overshoot phase since the March 23 lows. In fact, once the Fed had to ease off the QE gas pedal, the market almost immediately paused for breath (bottom panel). In addition, the recent news flow has not helped speculators, as interest in COVID-19 is on the rise anew (google search shown inverted, top panel). While there is uncertainty with regard to how many of the rising infections will lead to actual deaths, we doubt the global economy will come to a screeching halt again. Nevertheless, these marginally negative developments as well as the increase in (geo)political risks that we have been flagging since the June 8 Weekly Report can serve as a catalyst for a consolidation phase in the broad market at least until the November Presidential election. Bottom Line: While we remain cautious on the prospects of the broad equity market in the near-term, our bullish thesis remains intact on a cyclical 9-12 month time horizon.  

Highlights Should the DXY fail to breach below 92 in the coming months, momentum will be a risk to our short dollar positions. Another risk is valuation. The trade-weighted dollar is expensive, but not overly so. It is not especially expensive versus the euro and some commodity currencies. A post-COVID-19 world in which global economies become more closed could also hurt short dollar positions. Maintain a barbell strategy, being long a basket of the cheapest currencies (SEK and NOK) together with some safe havens (JPY). This should insulate portfolios over what could become a more volatile summer. Feature Chart I-1The Dollar And Markets The breakdown in the dollar since March is still facing some skepticism, even internally at BCA. As a reserve currency, the dollar tends to do well during periods of heightened uncertainty. With a clear risk of a second COVID-19 infection wave, and with equity markets up strongly from their lows, odds are that volatility could rise in the near term. Renewed geopolitical tensions between China and the US as well as the upcoming US presidential election are also sources of risk. Historically, the dollar has tended to rise with both increasing equity and geopolitical risk premia (Chart I-1). The key question is whether any near-term bounce in the dollar is technical in nature, or represents the resumption of the bull market. While the dollar is a countercyclical currency, it has also been in a bull market since 2011, notwithstanding the growth upcycles that took place during that period. Through a series of technical, valuation, and macroeconomic charts, we will explore the key risks to our dollar-bearish view as well as potential signposts to see if we are spot on in our thinking. The Long-Term Technical Profile Is Bullish Chart I-2The Dollar And Cycles The dollar is a momentum currency, and so tends to move in long cycles. Moreover, in recent history, these cycles have tended to last around eight to 10 years, coinciding with the NBER definition of business cycles. The dollar bear market of the 1980s entered its capitulation phase with the 1990s recession. Similarly, the dollar bull market of the late ‘90s ended with the 2001 recession. The Great Recession in 2008 and subsequently cascading crises from the Eurozone to Japan in 2010-2011 ended the bear market run in the dollar from 2001. If the past is prologue, then the pandemic recession of 2020 may also be signaling an end to the dollar’s decade-long bull run. There is also an economic reason for the decade-long run in dollar cycles. This is the time it usually takes to build and subsequently unwind imbalances in the US economy. In a closed economy, savings must equal investment. However, in open economies, investors usually require a cheaper exchange rate (or higher interest rates) to fund rising deficits, just as they require a higher IRR to fund projects with risky cash flows. This has been the story for the US dollar since the 1980s (Chart I-2). Of course, dollar transition phases can be quite volatile, and the risk to this view is that the dollar bear story could be one for 2022 rather than 2020. However, it is also noteworthy that dollar tops are generally V-shaped, while bottoms are more saucer-shaped. The reason is that the Federal Reserve is usually at the center of a dollar peak, in its decisiveness to ease monetary conditions quite aggressively. At bottoms, the dollar is typically already sufficiently cheap that it does not pose headwinds to the US economy. The pandemic recession of 2020 may also be signaling an end to the dollar’s decade-long bull run. If the DXY can easily break through  the 92-94 zone, this will technically end the bull market in place since 2011, as the powerful upward-sloping channel, in place since then, will be breached (Chart I-3). On the sentiment side of things, conditions remain bullish, which is positive from a contrarian perspective. Professional forecasters often tend to be  adaptive, with a Bloomberg survey expecting the DXY to be flat by year end, but hitting 92 only in 2022 (Chart I-4). More importantly, they tend to miss important turning points in the greenback. Chart I-3A Technical Profile For DXY Chart I-4The Dollar And Forecasters The Dollar Is Not Overly Expensive The valuation picture for the dollar is more nuanced, and is our biggest source of risk. The dollar is clearly expensive versus currencies such as the Swedish krona and Norwegian krone, but on a trade-weighted basis, the dollar is only one standard deviation above our fair-value model. This still makes the dollar pricey, but not to the extent of previous peaks, that have tended to occur around two standard deviations above fair value (Chart I-5). Our long-term fair value model has two critical inputs – the productivity gap between the US and its trading partners as well as real bond yield differentials. Rising productivity ensures a country can pursue non-inflationary growth. This lifts the neutral rate of interest in the country, raising the long-term fair value of its exchange rate. The Bloomberg survey expects the DXY to be flat by year end, but hitting 92 only in 2022. Since 2010, the productivity gap between the US and its trading partners has been flat, but there is reason to believe this gap will start to roll over. For one, fiscal largesse could crowd out private investment. But more importantly, as my colleague Ellen JingYuan He of BCA’s Emerging Market Strategy reckons, productivity gains in countries like China could start to pick up as it becomes a world leader in innovation (Chart I-6). This will allow real bond yields outside the US to remain high. Chart I-5The Dollar Is Expensive Chart I-6US Relative Productivity May Decline The key point is that valuation alone is not a sufficient catalyst for dollar short positions, which is a risk to the view. This is especially the case versus commodity currencies and the euro. That said, there are still some currencies trading below or near two standard deviations from their mean relative to the US dollar. This includes the NOK, SEK, and to a certain extent the GBP (Chart I-7). We remain long these currencies in our portfolio. Chart I-7ASome G10 Currencies Are Very Cheap Chart I-7BSome G10 Currencies Are Very Cheap   Post COVID-19 Behavior Could Be Dollar Bullish A post COVID-19 world in which global economies become more closed could hurt the bearish dollar view. This is because when global growth is rebounding, more cyclical economies benefit from this growth dividend, and as such capital tends to gravitate to their respective economies. This is aptly illustrated with consumption being a much larger share of GDP in the US compared to exports (Chart I-8). A move towards more domestic production will hurt the capital flows that have tended to dictate the dollar’s countercyclical nature. A post COVID-19 world in which global economies become more closed could hurt the bearish dollar view.  Chart I-9 shows that dollar strength throughout most of March can be partly  explained by the relative resilience of the US economy, in part driven by a late start to state-wide shutdowns. With economies outside the US now reopening, PMIs abroad have recovered at a faster pace. Once the initial snapback phase has been established, differentiation among economies will then begin Chart I-8The US Economy Will Benefit From De-Globalization Chart I-9Relative Growth And ##br##The Dollar More importantly, in a post COVID-19 world, “platform” companies that can virtually leverage their technology and expertise across borders are replacing “brick and mortar” businesses that need both shipping lanes and ports to remain open. For example, will demand for autos ever recover to pre-crisis levels, when one can video conference rather than drive for two hours to the office? In general terms, if deep value stocks cannot find a way to improve their return on capital, flows into these markets (heavily represented outside the US), will dwindle. This will be a key risk to the dollar bearish view (Chart I-10).   Chart I-10Deep Value And The Dollar That said, manufacturing renaissances do happen. Asia, for example, remains at the core of both robotic and semiconductor manufacturing, which are redefining the production landscape. And over the long term, valuations do matter – and the starting point for US equities is unfavorable. Strategy And Housekeeping We continue to recommend a barbell strategy. Hold a basket of the cheapest currencies such as the NOK, SEK, and the GBP, along with some safe havens. Our list of trades is printed on page 9. We were stopped out of our short gold/silver position and are reinstating that trade today. While gold does better than silver during market riots, the ratio is 100:1, which is the most overvalued it has been in over a century. Once retail participation gains hold of cheap silver prices, which usually occurs during latter parts of precious metal bull markets, the move could be explosive. We remain long the pound, but are respecting our stop on our short EUR/GBP position that was triggered last week. Valuation supports the pound but politics will increase near-term volatility. We are raising our limit sell to 0.92, which has provided tremendous resistance since the referendum in 2016. Finally, the correction in energy prices is providing an interesting entry point for both the NOK/SEK cross and petrocurrencies. We remain oil bulls on the back of a pickup in global demand. This should lead to the outperformance of energy stocks, benefiting inflows into the CAD, NOK, RUB, MXN, and COP.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the US have been mostly positive: The Markit manufacturing PMI rebounded to 49.6 from 39.8 in June. The services PMI and composite PMI both increased to 46.7 and 46.8, respectively. The Chicago Fed National Activity index increased from -17.89 to 2.61 in May. Existing home sales fell by 9.7% month-on-month in May. However, new home sales surged by 16.6% month-on-month. Initial jobless claims increased by 1480K for the week ended June 19th, higher than the expected 1300K. The DXY index increased by 0.34% this week. Recent data have shown some improvement in the economy, supported by the reopening and Fed’s unprecedented relief measures. We remain cautiously bearish on the US dollar. Please refer to our front section this week for a checklist of risks to the bearish dollar view. Report Links: DXY: False Breakdown Or Cyclical Bear Market? - June 5, 2020 Cycles And The US Dollar - May 15, 2020 Capitulation? - April 3, 2020 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area have been mostly positive: The Markit manufacturing PMI increased from 39.4 to 46.9 in June. The services PMI increased to 47.3 from 30.5 and the composite PMI ticked up from 31.9 to 47.5. The current account surplus shrank from €27.4 billion to €14.4 billion in April. Consumer confidence slightly improved from -18.8 to -14.7 in June. The euro fell by 0.5% against the US dollar this week. The ECB decided to offer euro loans against collateral to central banks outside the euro area during the pandemic. Besides, the Eurosystem repo facility for central banks (EUREP) will remain available until the end of June 2021. Report Links: On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 On Money Velocity, EUR/USD And Silver - October 11, 2019 Japanese Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan have been negative: The manufacturing PMI fell from 38.4 to 37.8 in June. The coincident index fell from 81.5 to 80.1 in April, while the leading economic index ticked up from 76.2 to 77.7. The All Industry Activity Index fell by 6.4% month-on-month in April. The Japanese yen depreciated by 0.5% against the US dollar this week. The BoJ Summary of Opinions released this week pointed out that Japan’s economy has been in an extremely severe downturn and the recovery is likely to be longer and slower. Moreover, the BoJ has expressed concerns that Japan might slip back into deflation. We are long the yen as portfolio insurance. Report Links: The Near-Term Bull Case For The Dollar - February 28, 2020 Building A Protector Currency Portfolio - February 7, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the UK have been positive: The Markit manufacturing PMI increased from 40.7 to 50.1 in June. The services PMI also soared from 29 to 47. Retail sales fell by 13.1% year-on-year in May. However, it increased by 12% compared to the previous month.  The British pound fell by 0.7% this week. Last week, the MPC voted unanimously to keep the current rate unchanged at 0.1%. The Committee also voted by a majority of 8-1 for the Bank to increase government bond purchases by another £100 billion, bringing the total purchases to £745 billion. However, governor Andrew Bailey also indicated in a Bloomberg Opinion article on Monday that the Bank might take measures to reduce the BoE’s swollen balance sheet, indicating the £100 billion might be the last should conditions improve. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 A Few Trade Ideas - Sept. 27, 2019 United Kingdom: Cyclical Slowdown Or Structural Malaise? - Sept. 20, 2019 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia have been positive: The manufacturing PMI increased from 44 to 49.8 in June. The services PMI soared from 26.9 to 53.2, bringing the composite PMI up to 52.6 in June. The Australian dollar initially rose against the US dollar, then fell, returning flat this week. During an online panel discussion this week, the RBA Governor Lowe warned about the long-lasting impact of the COVID-19. More importantly, he said that at the current level close to 0.7, the Australian dollar is not overvalued against the US dollar, even though a lower currency would support exports and push the inflation back to target. Report Links: On AUD And CNY - January 17, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 A Contrarian View On The Australian Dollar - May 24, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand have been negative: Exports declined by 6.1% year-on-year to NZ$5.4 billion in May, mainly due to lower sales in logs, fish, machinery and equipment. In contrast, exports of dairy products increased by 4.5% year-on-year. Imports slumped by 25.6% year-on-year, led by lower purchases of vehicles and petroleum products. The trade surplus fell to NZ$ 1.25 billion in May from NZ$ 1.34 billion in April. However, this compares favorably with a trade deficit of NZ$ 175 million in the same month last year. The New Zealand dollar fell by 0.6% against the US dollar this week. On Wednesday, the RBNZ held its interest rate unchanged at 0.25% as widely expected and maintained its current pace of QE. However, the Bank sounded quite dovish and indicted that it is ready to further ease policy whenever needed. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Place A Limit Sell On DXY At 100 - November 15, 2019 USD/CNY And Market Turbulence - August 9, 2019 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada have been positive: Preliminary data shows that retail sales rebounded by 19.1% month-on-month in May, following a 26.4% decrease the previous month. The Canadian dollar depreciated by 0.7% against the US dollar this week. In his first speech as Bank of Canada Governor this week, Tiff Macklem warned that the recovery might be longer than expected, and indicated that the Bank needs a quick response and targeted containment to fight possible future waves of COVID-19 and another round of a broad-based shutdown. Report Links: More On Competitive Devaluations, The CAD And The SEK - May 1, 2020 A New Paradigm For Petrocurrencies - April 10, 2020 The Loonie: Upside Versus The Dollar, But Downside At The Crosses Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland have been positive: The ZEW expectations index rose from 31.3 to 48.7 in June. Money supply (M3) surged by 2.5% year-on-year in May. Total sight deposits increased to CHF 680.1 billion from CHF 679.5 billion for the week ended June 19th. The Swiss franc appreciated by 0.2% against the US dollar this week. The SNB Quarterly Bulletin in Q2 was released this week and it showed that while government loans have been helpful to support the economy, the declines in profit margins were exceptionally severe. Moreover, a further appreciation of the Swiss franc remains a downside risk for a small open economy like Switzerland. Report Links: On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 Portfolio Tweaks Before The Chinese New Year - January 24, 2020 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway have been negative: The unemployment rate increased to 4.2% in April from 3.6% the previous month. The Norwegian krone fell by 1% against the US dollar this week, along with lower oil prices. Last week, the Norges Bank left its interest rate unchanged at 0% and signaled that the rates are set to remain at current levels over the next few years. Report Links: A New Paradigm For Petrocurrencies - April 10, 2020 Building A Protector Currency Portfolio - February 7, 2020 On Oil, Growth And The Dollar - January 10, 2020 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden have been positive: Consumer confidence increased from 77.7 to 84 in June. The Swedish krona appreciated by 1.2% against the US dollar this week. As one of the few countries without strict lockdown measures, Sweden’s business sectors are showing budding signs of recovery in May and June, according to a company survey by the central bank. However, most companies believe that the recovery would take at least 9 months or longer. On another note, the Riksbank has been testing its digital currency e-krona and might be the first central bank to implement the wide use of digital currency. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019 Balance Of Payments Across The G10 - February 15, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

  Highlights In the short run, extreme policy uncertainty is problematic for risk assets. In the long run, gargantuan fiscal and monetary stimulus continues to support cyclical trades. Equity volatility always increases in the lead-up to US presidential elections. Trump has a 35% chance of reelection. The US-China trade deal is intact for now but the risk of a strategic crisis or tariffs is about 40%. Our Turkish GeoRisk Indicator is lower than it should be based on Turkey’s regional escapades. Feature US equities fell back by 2.6% on June 24 as investors took notice of rising near-term risks to the rally. With gargantuan global monetary and fiscal stimulus, we expect the global stock-to-bond ratio to rise over the long run (Chart 1). However, we still see downside risks prevailing in the near term related to the pandemic, US politics, geopolitics, and the rollout of additional stimulus this summer. Chart 1Risk-On Phase Continues - But Risks Mounting Chart 2Policy Uncertainty Hitting Extremes Global economic policy uncertainty is skyrocketing – particularly due to the epic the November 3 US election showdown. Yet Chinese policy uncertainty remains elevated and will rise higher given that the pandemic epicenter now faces an unprecedented challenge to its economic and political order. China’s economic instability will increase emerging market policy uncertainty (Chart 2). Only Europe is seeing political risk fall, yet Trump’s threats of tariffs against Europe this week highlight that he will resort to protectionism if his approval rating does not benefit from stock market gains, which is currently the case. The COVID-19 outbreak is accelerating in the US in the wake of economic reopening and insufficient public adherence to health precautions and distancing measures. The divergence with Europe is stark (Chart 3). Authorities will struggle to institute sweeping lockdowns again, but some states are tightening restrictions on the margin and this will grow. Chart 3US COVID-19 Outbreak The divergence between daily new infection cases and new deaths in the US, as well as countries as disparate as Sweden and Iran, is not entirely reassuring. The US is effectively following Sweden’s “light touch” model. Ultimately COVID is not much of a risk if deaths are minimized – but tighter social restrictions will frighten the markets regardless (Chart 4). President Trump’s election chances have fallen under the weight of the pandemic – followed by social unrest and controversy over race relations. But net approval on handling the economy is holding up well enough (Chart 5). Chart 4Divergence In New Cases Versus New Deaths Chart 5Trump’s Lifeline Is The Economy Our subjective 35% odds of reelection still seem appropriate for now – but we will upgrade Trump if the financial and economic rebound is sustained while his polling improves. His approval should pick up in the face of a collapse of law and order, not to mention left-wing anarchists removing or vandalizing historical monuments to America’s Founding Fathers and some great public figures who had nothing to do with the Confederacy in the Civil War. Equity volatility will increase ahead of the US election. Chart 6Volatility Always Rises Before US Elections Equity volatility always increases in the lead up to modern American elections (Chart 6) and this year’s extreme polarization, high unemployment, and precarious geopolitical environment suggest that negative surprises could be worse than usual, notwithstanding the tsunami of stimulus. So far this year the S&P 500 is tracing along the lower end of its historical performance during presidential election years. This is consistent with a change of government in November, unless it continues to power upward over the next four months – typically a change of ruling party requires a technical correction on the year. Our US Equity Strategist, Anastasios Avgeriou, also expects the market to begin reacting to political risk – and he precisely timed the market’s peak and trough over the past year (Chart 7). We suspect that the positive correlation between the S&P and the Democratic Party’s odds of a full sweep of government is spurious. The reason the S&P has recovered is because of the economic snapback from the lockdowns and the global stimulus. The reason the odds of a Blue Wave election have surged is because the pandemic and recession decimated Trump and the Republicans. Going forward, the market needs to do more to discount a Democratic sweep. At 35%, this scenario is underrated in Chart 8, which considers all possible presidential and congressional combinations. Standalone bets put the odds of a Blue Wave at slightly above 50%. We have always argued that the party that wins the White House in 2020 is highly likely to take the Senate. Chart 7Market At Risk Of Election Cycle Chart 8Market Will Soon Worry About 'Blue Wave' True, the US is monetizing debt and this will push risk assets higher regardless over the long run. But if former Vice President Joe Biden wins the presidency, he will create a negative regulatory shock for American businesses, and if his party takes the Senate, then corporate taxes, capital gains taxes, federal minimum wages, liability insurance, and the cost of carbon (implicitly or explicitly) will all rise. The market must also reckon with the possibility that Trump is reelected or that he becomes firmly established as a “lame duck” and thus takes desperate measures prior to the election. His threat to impose tariffs on Europe this week underscores our point that if Trump’s approval rating stays low, despite a rising stock market, then the temptation to spend financial capital in pursuit of political capital will rise. This will involve a hard line on immigration and trade. Bottom Line: Tactically, there is more downside. Strategically, we remain pro-cyclical. Stimulus Hiccups This Summer One reason we have urged investors to buy insurance against downside risks this month is because of hurdles in rolling out the next round of fiscal stimulus. The four key drivers of the global growth rebound are liquidity, fiscal easing (Chart 9), an enthusiastic private sector response, and the large cushion of household wealth prior to the crisis. This is according to Mathieu Savary – author of our flagship Bank Credit Analyst report. Mathieu argues that it will be harder for investors to overlook policy uncertainty after the stimulus slows, i.e. the second derivative of liquidity turns negative. Chart 9Gargantuan Fiscal Stimulus The massive increase in budget deficits and the quick recovery in activity amid reopening have reduced politicians’ sense of urgency. We fear that the stock market will have to put more pressure on lawmakers to force them to provide more largesse. Ultimately they will do so – but if they delay, and if delay looks like it is turning into botching the job, then markets will temporarily panic. Why are we confident stimulus will prevail? In the United States, fiscal bills have flown through Congress despite record polarization. Democrats cannot afford to obstruct the stimulus just to hurt the economy and the president’s reelection chances. Instead they have gone hog wild – promoting massive spending across the board to demonstrate their fundamental proposition that government can play a larger and more positive role in Americans’ lives. Their latest proposal is worth $3 trillion, plus an infrastructure bill that nominally amounts to $500 billion over five years. President Trump, for his part, was always fiscally profligate and now wants $2 trillion in stimulus to fuel the economic recovery, thus increasing his chances of reelection as voters grow more optimistic in the second half of the year. He also wants $1 trillion in new infrastructure spending over five years. Yet Republican Senators are dragging their feet and offering only a $1 trillion package. In the end they will adopt Trump’s position because if they do not hang together, they will all hang separately in November. The debate will center on whether the extra $600 in monthly unemployment benefits will be continued (at a cost of $276bn in the previous Coronavirus Aid, Relief, and Economic Security Act). Republicans want to tie benefits to returning to work, since this generous subsidy created perverse incentives and made it more economical for many to stay on the dole. There will also be a debate over whether to issue another round of direct cash checks to citizens ($290bn in the CARES Act). Republicans want to prioritize payroll tax cuts, again focusing on reducing unemployment (Chart 10). Chart 10US Fiscal Stimulus Breakdown Our US bond strategist, Ryan Swift, has shown that the cash handouts present a substantial fiscal “cliff.” Without the original one-time stimulus checks, real personal income would have fallen 5% since February, instead of rising 9% (Chart 11). If Republicans refuse to issue a new round of checks, yet the extra unemployment benefits stay, then over $1 trillion in income will be needed to fill the gap so that overall personal income will end up flat since February. In other words, an ~8% increase in income less transfers from current levels is necessary to prevent overall personal income from falling below its February level. China and the EU will eventually provide more largesse. Republican Senators will capitulate, but the process could be rocky and the market should see volatility this summer. China may also be forced to provide more stimulus in late July at its mid-year Politburo meeting – any lack of dovishness at that meeting will disappoint investors. European talks on the Next Generation recovery fund could also see delays (though they are progressing well so far). Brexit trade deal negotiations pose a near-term risk. There is also a non-negligible chance that the German Constitutional Court will raise further obstructions with the European Central Bank’s quantitative easing programs on August 5. European risks are manageable on the whole, but the market is not discounting much (Chart 12). Chart 11Will Congress Takeaway The Money Tree? Bottom Line: We expect the S&P 500 to trade in a range between 2800 and 3200 points during this period of limbo in which risks over pandemic response and political risks will come to the fore while the market awaits new stimulus measures, which may not be perfectly timely. Chart 12European Risks Are Getting Priced Has The Phase One China Deal Failed Yet? President Trump’s threat this week to slap Europe with tariffs, if it imposes travel restrictions on the US over the coronavirus, points to the dynamic we have highlighted on the more consequential issue of whether Trump hikes broad-based tariffs on China, and/or nullifies the “Phase One” trade deal. Our sense is that if Trump is doing extremely poorly, or extremely well, in terms of opinion polls and the stock market, then the roughly 40% odds of sweeping punitive measures of some kind will go up (Diagram 1). Cumulatively we see the chance of a major tariff hike at 40%. Diagram 1Decision Tree: Risk Of Significant Trump Punitive Measures On China In 2020 White House trade czar Peter Navarro’s comments earlier this week, suggesting that the Phase One trade deal was already over, prompted Trump to tweet that he still fully supports the deal. Negotiations between Secretary of State Mike Pompeo and Chinese Politburo member Yang Jiechi also nominally kept the lid on tensions. However, China may need to depreciate the renminbi to ease deflationary pressures on its economy – and this would provoke Trump to retaliate (Chart 13). Chart 13Chinese Depreciation Would Provoke Trump We have always argued against the durability of the Phase One trade deal. Investors should plan for it to fall apart. Judging by our China GeoRisk Indicator, investors are putting in a higher risk premium into Chinese equities (Chart 14). They are also doing so with Korean equities, which are ultimately connected with US-China tensions. Only Taiwan is pricing zero political risk, which is undeserved and explains why we are short Taiwanese equities. After China’s imposition of a controversial national security law in Hong Kong and America’s decision to prepare retaliatory sanctions, reports emerged that Chinese authorities ordered state-owned agricultural traders to halt imports of soybean and pork – and potentially corn and cotton. These reports were swiftly followed by others that highlighted that state-owned Chinese firms purchased at least three cargoes of US soybeans on June 1, in spite of China’s decision to stop imports.1 Thus this aspect of the deal has not yet collapsed. But we would emphasize that the constraints against a failure of the deal are not prohibitive this year. The $200 billion worth of additional Chinese imports over 2020-2021 promised in the deal included $32 billion worth of additional US farm purchases – with at least $12.5 billion in 2020 and $19.5 billion in 2021 over 2017 imports of $24 billion. However, to date, US agricultural exports to China suggest that China may not even meet 2017 levels (Chart 15). Chart 14GeoRisk Indicators Show Rising Risk Chart 15Trade Deal Durability Still Shaky Soybeans account for roughly 60% of US agricultural exports to China. While Chinese imports are up so far this year relative to 2019, they remain well below pre-trade war levels. Although lower hog herds on the back of the African Swine Flu and disruptions caused by COVID-19 may be blamed, they are not the only cause of subdued purchases. The share of Chinese soybean imports coming from the US is also still below pre-trade war levels (Chart 16). Chart 16China Still Substituting Away From US New Chinese regulation requiring documents assuring food shipments to China are COVID-19 free adds another hurdle – China already banned poultry imports from Tyson Foods Inc. plants. Although the US’s share of China’s pork imports has picked up significantly, it will not go far toward meeting the trade deal requirements. China’s pork purchases from the US were valued at $0.3 billion in 2017, while soybean imports came in at $14 billion. Bottom Line: Trump’s only lifeline at the moment is the economy which pushes against canceling the US-China deal. But if he becomes a lame duck – or if exogenous factors humiliate him – then all bets are off. The passage of massive stimulus in the US and China removes economic constraints to conflict. Will Erdogan Overstep In Libya? We have long been bearish on Turkey relative to other emerging markets due to President Tayyip Erdogan’s populist policies, which erode monetary and fiscal responsibility and governance. Turkey’s intervention in Libya has marked a turning point in the Libyan civil war. The offensive to seize Tripoli on the part of General Khalifa Haftar of the Tobruk-based Libyan National Army (LNA) has been met with defeat (Map 1). Map 1Libya’s Battlefront Is Closing In On The Oil Crescent Foreign backing has enabled the conflict. Egypt, the UAE, Saudi Arabia, and Russia are the Libyan National Army’s main supporters, while Turkey and Qatar support Prime Minister Fayez al-Sarraj of the UN recognized Government of National Accord (GNA). The GNA’s successes this year can be credited to Turkey, which ramped up its intervention in Libya, even as oil prices collapsed, hurting Haftar and his supporters. Now the battlefront has shifted to Sirte and the al-Jufra airbase – the largest in Libya – and is closing in on the eastern oil-producing crescent, which contains over 60% of Libya’s oil. The victor in Sirte will also have control over the oil ports of Sidra, Ras Lanuf, Marsa al-Brega, and Zuwetina. With all parties eying the prize, the conflict is intensifying. Tripoli faces greater resistance as its forces move east. Egyptian President Abdel Fattah al-Sisi’s June 6 ceasefire proposal, dubbed the Cairo Initiative, was rejected by al-Sarraj and Turkey. Instead, the Tripoli-based government wants to capture Sirte and al-Jufra before coming to the table. The recapturing of oil infrastructure would bring back some of Libya's lost output (Chart 17). Nevertheless, OPEC 2.0 is committed to keeping oil markets on track to rebalance, reducing the net effect of a Libyan production increase on global supplies. However, the GNA’s swift successes in the West may not be replicable as it moves further East, where support for Haftar is deeper and where the stakes are higher for both sides. This is demonstrated by the GNA’s failed attempt to capture Sirte on June 6. The battlefront is now at Egypt’s red line – GNA control of al-Jufra would pose a direct threat to Egypt and is thus considered a border in Egypt’s national security strategy. A push eastward risks escalating the conflict further by drawing in Egypt militarily. In a televised speech on June 20, al-Sisi threatened to deploy Egypt’s military if the red line is crossed. The statement was interpreted by Ankara as a declaration of war, raising the possibility that Egypt will go to war with Turkey in Libya. On paper, Egypt’s military is up to the task. Its recent upgrades have pulled up its ranking to ninth globally according to the Global Fire Power Index, surpassing Turkey’s strength in land and naval forces (Chart 18). However, while Turkey’s military has been active in other foreign conflicts such as in Syria, Egypt’s army is untested on foreign soil. Its most recent military encounter was the 1973 Yom Kippur War. Even after years of fighting, it has yet to declare victory against terrorist cells in the Sinai Peninsula. Thus Egypt’s rusty forces could face a protracted conflict in Libya rather than a swift victory. Chart 17GNA/Turkish Success Would Revive Libyan Oil Production Chart 18Egypt Is Militarily Capable … On Paper Other constraints may also deter al-Sisi from following through on his threat: Other Arab backers of the Libyan National Army – the UAE and Saudi Arabia – are unlikely to provide much support as their economies have been hammered by low oil prices. Egypt’s own economy is in poor shape to withstand a protracted war, with public debt on an unsustainable path. Not coincidentally, Egypt faces another potential military escalation to its south where it has been clashing with Ethiopia over the construction of the Grand Ethiopian Renaissance Dam on the Blue Nile. The dam will control Egypt’s water supply. The latest round of negotiations failed last week. While Cairo is hoping to obtain a bilateral agreement over the schedule for filling the dam, Addis Ababa has indicated that it will begin filling the dam in July regardless of whether an agreement is reached. Al-Sisi’s response to the deadlocked situation has been to request an intervention by the UN Security Council. However, as the July filling date nears, the Egypt-Ethiopia standoff risks escalating into war. For Egypt, there is an urgency to secure its future water supplies now before Ethiopia begins filling the dam. And while resolving the Libyan conflict is also a matter of national security – Egypt sees the Libyan National Army as a buffer between its porous western border and the extremist elements of the GNA – the risks are not as pressing. Thus a military intervention in Libya would distract Egypt from the Ethiopian conflict and risk drawing it into a war on two fronts. Moreover, Egypt generally, and al-Sisi in particular, risk losing credibility in case of a defeat. That said, Egypt has high stakes in Libya. A GNA defeat could annul the recent Libya-Turkey maritime demarcation agreement – a positive for Egypt’s gas ambitions – and eliminate the presence of unfriendly militias on its Western border. Thus, if the GNA or GNA-allied forces kill Egyptian citizens, or look as if they are capable of utterly defeating Haftar on his own turf, then it would be a prompt for intervention. Meanwhile Turkey’s regional influence and foreign policy assertiveness is growing – and at risk of over-extension. Erdogan’s interests in Libya stem from both economic and strategic objectives. In addition to benefitting from oil and gas rights and rebuilding contracts, Ankara’s strategy is in line with its pursuit of greater regional influence as set out in the Mavi Vatan, its current strategic doctrine.2 There are already rumors of Turkish plans to establish bases in the recently captured al-Watiya air base and Misrata naval base. This would be in addition to Ankara’s bases in Somalia and in norther Iraq. Erdogan is partly driven into these foreign policy adventures to distract from his domestic challenges and keep his support level elevated ahead of the 2023 general election (Chart 19). However, his growing assertiveness threatens to alienate European neighbors and NATO allies, which have so far played a minimal role in the Libyan conflict yet have important interests there. For now, the western powers seem focused on countering Russian intervention in Libya and the broader Mediterranean. Prime Minister al-Sarraj and General Stephen Townsend, head of US Africa Command (AFRICOM), met earlier this week and reiterated the need to return to the negotiating table and respect Libyan sovereignty and the UN arms embargo, with a focus on stemming Russian interference. However, Turkish relations with the West may take a turn for the worse if Erdogan oversteps. Turkey continues to threaten Europe with floods of refugees and immigrants if its demands are not met. This pressure will grow due to the COVID-19 crisis, which will ripple across the Middle East, Africa, and South Asia. Ankara also continues to press territorial claims in the Mediterranean Sea, ostensibly for energy development.3 Turkey has recently clashed with Greece and France on the seas. In sum, the Libyan conflict is intensifying as it moves into the oil crescent. The Turkey-backed GNA will face greater resistance in Sirte and al-Jufra, even assuming that Egypt does not follow through on its threat of intervening militarily. Erdogan’s foreign adventurism will provoke greater opposition in Libya and elsewhere among key western powers, Russia, and the Gulf Arab states. Bottom Line: The implication is that a deterioration in Turkey’s relationship with the West, military overextension, and continued domestic economic mismanagement will push up our Turkey GeoRisk Indicator, which is a way of saying that it will weigh on the currency (Chart 20). Chart 19Erdogan’s Fear Of Opposition Drives Bold Policy Chart 20Foreign And Domestic Factors Will Push Up Turkish Risk Stay short our “Strongman Basket” of emerging market currencies, including the Turkish lira. Investment Takeaways We entered the year by going strategically long EUR-USD, but closed the trade upon the COVID-19 lockdowns. We have resisted reinitiating it despite the 5% rally over the past three months due to extreme political risks this year, namely the US election and trade risks. Trump’s threat of tariffs on Europe this week highlights our concern. We will wait until the election outcome before reinstituting this trade, which should benefit over time as global and Chinese growth recover and the US dollar drops on yawning twin deficits. Throughout this year’s crisis we have periodically added cyclical and value plays to our strategic portfolio. We favor stocks over bonds and recommend going long global equities relative to the US 30-year treasuries. We are particularly interested in commodities that will benefit from ultra-reflationary policy and supply constraints due to insufficient capital spending. This month we recommend investors go long our BCA Rare Earth Basket, which features producers of rare earth elements and metals that can substitute for Chinese production (Chart 21). This trade reflects our macro outlook as well as our sense that the secular US-China strategic conflict will heat up before it cools down. Chart 21Position For An Escalation In The US-China Conflict   Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com   Roukaya Ibrahim Editor/Strategist Geopolitical Strategy RoukayaI@bcaresearch.com Footnotes 1 Please see Karl Plume et al, "China buys U.S. soybeans after halt to U.S. purchases ordered: sources," Reuters, June 1, 2020. 2 The Mavi Vatan or “Blue Homeland Doctrine” was announced by Turkish Admiral Cem Gurdeniz in 2006 and sets targets to Turkish control in two main regions. The first region is the three seas surrounding it – the Mediterranean Sea, Aegean Sea, and Black Sea with the goal of securing energy supplies and supporting Turkey’s economic growth. The second region encompasses the Red Sea, Caspian Sea and Arabian Sea where Ankara has strategic objectives. 3 Ankara’s gas drilling activities off Cyprus have been a form of frequent provocation for Greece and Cyprus. Ankara has also stated that it may begin oil exploration under a controversial maritime deal with Libya as early as August. Section II: Appendix : GeoRisk Indicator China Russia UK Germany France Italy Canada Spain Taiwan Korea Turkey Brazil Section III: Geopolitical Calendar

In this Monday’s Special Report, we examined which S&P 500 GICS1 sectors have historically benefited from a falling greenback. Currently, piling evidence suggests that the path of least resistance will be lower for the US dollar. Looking at structural (five years+) dynamics, swelling twin deficits emit a bearish USD signal. In more detail, prior to COVID-19 outbreak, the US twin deficits were estimated to gradually rise towards the 7.5% mark (top panel), but now the US Congressional Budget Office (CBO) estimates that the US fiscal deficit alone will be approximately 11% of nominal GDP for 2020 if not higher. In other words, the recent pandemic has exacerbated already structurally bearish dynamics for the US dollar. Switching gears from a structural to a medium term horizon (2-3 years), BCA’s four-factor macro model, is sending an unambiguous bearish message regarding the greenback’s fate (middle panel). Finally, on a short-term time horizon, the USD is lagging the money multiplier by approximately 3 months. The COVID-19 catalyzed recession and resulting money printing will likely exert extreme downward pressure on the US dollar (bottom panel).  

Please note that yesterday we published Special Report titled Do Not Overlook China’s Innovation Drive. Please click on it to access it. Today, we publish analysis on Brazil and Ukraine.   Chart I-1Brazilian Share Prices And Commodity Prices Move In Tandem A FOMO (fear-of-missing-out) mania has pushed equity prices higher around the world. Brazilian stocks, currency and credit markets, likewise, have been staging a rebound. There is evidence that in Brazil equity purchases by local investors have been driving up share prices.1 The absolute performance of Brazilian share prices and the exchange rate trend will likely depend on commodities prices and a global rally in risk assets (Chart I-1). In relative terms, Brazilian financial markets will underperform their EM counterparts because of the following: Brazil is on track for its worst economic contraction in the past century following the deep recession of 2014-2016 (Chart I-2). This is the first nominal GDP contraction in Brazil. Growth was feeble even before the pandemic struck, but the COVID-19 lockdowns were the last nail in the coffin for the economy. Given that Brazil has not been able to control the spread of the virus – having hit another high in daily new infections last Friday – major cities will be forced to maintain social distancing measures for longer, delaying a recovery in consumer and business confidence. Chart I-2The Level Of Economic Activity In Real And Nominal Terms Table I-1Brazil's Fiscal Package Is The Largest In The Region   While Brazil has deployed the largest COVID-19 fiscal package in the region (Table I-1), its economic recovery will lag behind the majority of EM and DM countries. State-sponsored loans have not been reaching small and micro businesses, which employ over half of the working force. Moreover, informal workers amount to about 20% of the country’s total population, and they also have not been receiving any economic benefits other than a $120 US dollar monthly stipend. Household income growth was subdued during the 2017-2019 recovery. To support their living standards, families were aggressively borrowing before the pandemic (Chart I-3, top panel). Now, with their income contracting and household debt servicing costs above 20% of disposable income, consumer loan defaults will mushroom (Chart I-3, bottom panel). Chart I-4 shows that non-performing loans (NPL) for households are rising as a share of total consumer loans. Chart I-3Household Income, Credit And Debt Service Chart I-4Mushrooming Consumer Delinquencies   The private banks’ NPL provisions are set to surge due to rising defaults. Consumer loans make up 53% of private banks’ non-earmarked (non state-directed) lending. Chart I-5 shows that bank share prices are highly correlated with the annual change in provisions (shown inverted). Hence, the further rise in provisions will continue undermining bank share prices. We published a Special Report on Brazilian banks on March 31 and their outlook remains dismal. Besides, facing high credit risks, private banks have tightened credit standards and loan origination is plummeting, further hurting the economy. The sheer size of the fiscal stimulus and the historic nominal GDP contraction will push the gross public debt-to-GDP ratio well above 100% by end-2020. As discussed in our previous reports,2 and provided local currency interest rates remain above nominal GDP growth, public debt is on an unsustainable trajectory (Chart I-6). Chart I-5Do Not Chase Brazilian Bank Stocks Chart I-6Government Bond Yields Are Well Above Nominal GDP Growth   Chart I-7The Social Security Deficit Is Widening The only way to stabilize the public debt-to-GDP ratio in Brazil is via the central bank conducting substantial quantitative easing, i.e. monetary authorities purchasing local government bonds. This will push local bond yields much lower and over time boost nominal GDP growth. With interest rate on government debt below nominal GDP growth over several years, the condition of public debt sustainability will be achieved. However, this amounts to monetization of public debt and, if carried on a large scale, it will suffocate the exchange rate – the currency would depreciate a lot. Furthermore, the projected BRL 800 billion (11% of GDP) in savings from the infamous pension reform will be impossible to achieve. Chart I-7 shows that the social security deficit has widened since March due to the shortfall in revenues. Given social security revenues are derived from taxes on workers and businesses, this deficit will continue to increase as employment and wages collapse while pension payouts remain fixed. Finally, the political situation is in disarray and a presidential impeachment might be inevitable. President Bolsonaro has become even more radical and is in conflict with various branches of power. Meanwhile, corruption and electoral fraud investigations against him and his allies continue to develop. The key risk to our negative view is as follows: One could argue that investors have lost faith in the Bolsonaro administration and are actually looking forward to his removal from office. Hence, the escalating political crisis culminating in Bolsonaro’s impeachment would be bullish for financial markets. This is a valid perspective given Vice-president Mourão – who has the backing of the army and adheres to a more centrist view on a wide range of issues - would assume the presidency in the case of impeachment. He would maintain orthodox economic policies and cooperate with Congress. This kind of thinking from investors might be taking its cues from the political dynamics and market actions in early 2016, when Brazilian markets bottomed seven months before then President Dilma Rousseff was impeached. Brazil is on track for its worst economic contraction in the past century following the deep recession of 2014-2016. In addition, the long-term political outlook for Brazil might be turning positive. The quite popular ex-Justice Minister Sergio Moro hinted last week that he could run in the 2022 presidential race. While he did not explicitly announce his candidacy, he stated that he wants to “participate” in the public debate by presenting a pro-market and anti-corruption alternative to Bolsonaro. If Moro runs, he will likely win given his enormous popularity. His victory will be accordingly cheered by international and domestic investors as he would run on a platform of structural reforms. Chart I-8The Brazilian Real Is Only Modestly Cheap Nevertheless, in the near term Bolsonaro will try to maintain his grip on power as long as he can. Foreseeing the risk of impeachment, he has strengthened his ties with the big coalition of small centrist parties in Congress. For now, it is not clear if Congress will vote for his removal. Importantly, the more radical and autocratic Bolsonaro becomes in a bid to save his presidency, the higher the odds of Economy Minister Paulo Guedes resigning. This was the case with the Ministers of Health and Justice and the Secretary of the Treasury. The latter was a key figure in drafting economic reforms. If Guedes resigns, it will send shockwaves throughout the nation’s financial markets. Bottom Line: Continue underweighting Brazilian equities and fixed income within their respective EM universes. We took profits on our short BRL/long USD position on June 4th due to tactical considerations. Investors should consider shorting the BRL again. The BRL is somewhat but not very cheap (Chart I-8). Juan Egaña Research Associate juane@bcaresearch.com Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Ukraine: An Opportunity In Bonds Is Still Present Investors should stay long local currency government bonds and continue overweighting the nation’s sovereign credit within the EM sovereign credit universe. Ukraine is pursuing prudent fiscal policy under the auspices of the IMF. With the government refraining from announcing a large-scale fiscal spending package amid the COVID-19 outbreak, its fiscal overall and primary deficits will widen to 8% and 4% of GDP, respectively. In particular, the increase in healthcare and social spending will be partially offset by both a reduction in discretionary spending and a cap on public wages. Such a conservative policy approach is negative for growth but will result in lower inflation and a stable exchange rate. Critically, a prudent fiscal policy will allow the central bank to cut interest rates. Both headline and core consumer price inflation are well below the lower end of the central bank’s target band (Chart II-1). Nominal wage growth is heading toward zero and will probably deflate by the end of this year (Chart II-2). Falling domestic demand will ensure that any rise in inflation due to currency depreciation will be modest. Chart II-1Inflation Is Undershooting Chart II-2Wage Growth Is Subdued!   As a result of considerable disinflation, real interest rates are still very high. Elevated real rates warrant large interest rate cuts by the central bank. Deflated by core consumer inflation, the real policy rate is 8% and the real lending rate is 12% for companies and over 30% for consumer credit (Chart II-3). A conservative policy approach is negative for growth but will result in lower inflation and a stable exchange rate. High real rates will entice foreign portfolio capital. Chart II-4 demonstrates that foreign investors have reduced their holdings of local bonds from $5.2 billion at the end of 2019 to $3.75 billion currently. Given the very low real rates worldwide, Ukraine is one of few markets offering high real rates with decent macro policies, at least in the medium term. Chart II-3Elevated Real Rates Warrant More Rate Cuts By CB Chart II-4Foreign Inflows Could Resume   With regard to the balance of payments, the recently announced $5 billion IMF loan should help ease short-term funding for the country. The 18-month arrangement will provide the immediate disbursement of $2.1 billion with a second disbursement of $0.7 billion expected by the end of September after the IMF program review. Importantly, plummeting imports and relatively resilient exports will narrow the current account deficit (Chart II-5). Exports should remain supported by food exports, which represents close to 40% of overall exports. Besides, the central bank also carries $25 billion in foreign exchange reserves, which compares with $18 billion in foreign funding requirements for 2020 (Chart II-6). So far, the central bank has refrained from selling foreign exchange reserves but might do so if the currency depreciates significantly. Chart II-5Current Account Will Balance Soon Chart II-6Foreign Funding Requirements Are Covered By FX Reserves   Bottom Line: We continue to recommend holding 5-year local currency government bonds currently yielding 11%. Even though moderate currency depreciation cannot be ruled out, on a total return basis domestic bonds will deliver decent returns to foreign investors in the next 6-12 months.  EM fixed income investors should continue overweighting domestic bonds and sovereign US dollar credit within respective EM portfolios. Andrija Vesic Associate Editor andrijav@bcaresearch.com     Footnotes 1     Investors ignore triple crisis and bet on equities 2     Please see Emerging Markets Strategy Countries In-Depth "Brazil: Deflationary Pressures Warrant A Weaker BRL," dated November 28, 2019 available at ems.bcaresearch.com Please see Emerging Markets Strategy Countries In-Depth "Brazil: Just Above "Stall Speed"," dated September 27, 2019 available at ems.bcaresearch.com   Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights The economic performance of Sweden, which did not have a lockdown, has been almost as bad as Denmark, which did have a lockdown. This proves that the current recession is not ‘man-made’, it is ‘pandemic-made’. While the pandemic remains in play, investors should maintain a defensive bias to their portfolios: favouring US T-bonds in bond portfolios, and technology and healthcare in equity portfolios. The technology sector has become defensive, largely because it has flipped from hardware dominance to software dominance. A new recommendation is to overweight technology-heavy Netherlands. Fractal trade: short AUD/CHF. Feature Chart I-IASweden: Avoiding A Lockdown Did Not Prevent A Slump In Consumption... Chart I-1B...But Led To Many More ##br##Infections Sweden and Denmark are neighbours. They speak near-identical languages and share a broadly similar culture and demographic. Yet the two countries have followed completely different strategies to halt the coronavirus pandemic. Sweden chose not to impose a lockdown. Instead, it opted for a ‘trust based’ approach, relying on its citizens to act sensibly and appropriately. Whereas Denmark imposed one of Europe’s earliest and most draconian lockdowns. The contrasting approaches of Sweden and neighbouring Denmark provide us with the closest thing to a controlled experiment on pandemic strategies. The Recession Is Not ‘Man-Made’, It Is ‘Pandemic-Made’ The surprising thing is that the economic performance of Sweden, which did not have a lockdown, has been almost as bad as Denmark, which did. This year, the unemployment rates in both economies have surged by 2 percentage points (albeit the latest data is for May in Sweden and April in Denmark). Furthermore, high-frequency measures of consumption show that Sweden suffered almost as severe a contraction as Denmark (Chart of the Week and Chart I-2). Chart I-2Unemployment Has Surged In Both No-Lockdown Sweden And Lockdown Denmark This surprising result challenges the popular view that this global recession is man-made. This view argues that without the government-imposed lockdowns, the global economy would not have entered a tailspin. But if this view is right, then why did consumption crash in Sweden? The simple answer is that in a pandemic, most people will change their behaviour to avoid catching the virus. The cautious behaviour is voluntary, irrespective of whether there is no lockdown, as in Sweden, or there is a lockdown, as in Denmark. People will shun public transport, shopping, and other crowded places, and even think twice about letting their children go to school. In a pandemic, the majority of people will change their behaviour even without a lockdown. But if the cautious behaviour is voluntary, then why impose a lockdown? The answer is that without a lockdown, the majority will behave sensibly to avoid catching the virus, but a minority will take a ‘devil may care’ attitude. In the pandemic, this is critical because less than 10 percent of infected people are responsible for creating 90 percent of all coronavirus infections. If this tiny minority of so-called ‘super-spreaders’ is left unchecked, then the pandemic will let rip. All of which brings us back to Sweden versus Denmark.  As a result of not imposing a mandatory lockdown to rein in its super-spreaders, Sweden now has one of the world’s worst coronavirus infection and mortality rates, four times higher than Denmark (Chart I-3, Chart I-4, Chart I-5). Chart I-3No-Lockdown Sweden Has Suffered Many More Deaths Than Lockdown Denmark Chart I-4Avoiding A Lockdown Meant More Infections… Chart I-5…And More ##br##Deaths Put simply, containing the pandemic depends on reining in a minority of super-spreaders. Which explains why no-lockdown Sweden suffered a much worse outbreak of the disease than lockdown Denmark. In contrast, the economy depends on the behaviour of the majority. In a pandemic the majority will voluntarily exercise caution. Which explains why no-lockdown Sweden and lockdown Denmark suffered similar contractions in consumption. Looking ahead, will the widespread adoption of face masks and plexiglass screens change the public’s cautious behaviour? To a certain extent, yes – it will permit essential activities and let people take calculated risks. That said, if you are forced to wear a mask on public transport and in the shops, and you have to spread out in restaurants while being served by a masked waiter, then – rightly or wrongly – you are getting a strong signal: the danger is still out there. Meaning that many people will continue to shun discretionary activities and spending. The upshot is that while the pandemic remains in play, investors should maintain a defensive bias to their portfolios. Explaining Why Technology Is Now Defensive A defensive bias to your portfolio now requires an exposure to technology – because in 2020 the tech sector is behaving like a classic defensive. Its relative performance is correlating positively with the bond price, like other classic defensive sectors such as healthcare (Chart I-6 and Chart I-7). Chart I-6In 2020, Tech Is Behaving Like A Defensive... Chart I-7...Like Healthcare The behaviour of the technology sector in the current recession contrasts with its performance in the global financial crisis of 2008. Back then, it behaved like a classic cyclical – its relative performance correlated negatively with the bond price (Chart I-8). Begging the question: why has the tech sector’s behaviour flipped from cyclical to defensive? Chart I-8In 2008, Tech Behaved Like A Cyclical The main reason is that the tech sector’s composition has flipped from hardware dominance to software dominance. In 2008, the sector market cap had a 65:35 tilt to technology hardware. But today, it is the mirror-image: a 65:35 tilt to computer and software services (Chart I-9). Chart I-9Tech Is More Defensive Now Because It Is Dominated By Software Computer and software services have many defensive characteristics suited to the current environment: For many companies, enterprise software is now business critical. It is a must-have rather than a like-to-have. Computer and software services use a subscription-based revenue model, minimising the dependency on discretionary spending. Computer and software services are helping firms to cut costs through automation and back-office efficiencies as well as facilitating the boom in ‘working from home’. The sector is cash rich. Despite these defensive characteristics, there remains a lingering worry: is the tech sector overvalued? The Rally In Growth Defensives Is Not A Mania  Some people fear that the recent run-up in stock markets does not make sense, other than as a ‘Robin Hood’ day-trader fuelled mania. After all, the pandemic is still very much in play, and so are other geopolitical risks, so how can some stock prices be near all-time highs? Yet the recent run-up in growth defensives such as tech and healthcare does make sense. Their valuations have moved in near-perfect lockstep with the bond yield, implying that the rally is based on fundamentals (Chart I-10). Chart I-10Tech And Healthcare Valuations Are Tracking The Bond Yield Simply put, if the 10-year T-bond is going to deliver a pitiful 0.7 percent a year over the next decade, then the prospective return from growth defensives must also compress. It would be absurd to expect these stocks to be priced for high single digit returns. Since late 2018, the decline in growth defensives’ forward earnings yield has broadly tracked the 250bps decline in the 10-year T-bond yield. Given that the forward earnings yield correlates well with the 10-year prospective return, the depressed bond yield is depressing the prospective return from growth defensives – as it should. Tech and healthcare valuations have moved in near-perfect lockstep with the bond yield. But with the pandemic and geopolitical risks menacing in the background, shouldn’t the gap between the prospective return on stocks and bonds – the equity risk premium – be larger? This is open to debate. When bond yields approach the lower bound, the appeal of owning bonds also diminishes because bond prices have limited upside. Nevertheless, the gap between the tech and healthcare forward earnings yield and the bond yield has gone up this year and is much larger than in 2018 (Chart I-11). This suggests that valuations are taking some account of the pandemic and other risks. Moreover, in a longer-term perspective the current gap between the tech and healthcare forward earnings yield and the bond yield, at +4 percent, hardly indicates a mania. In the true mania of 2000, the gap stood at -4 percent! (Chart I-12) Chart I-11The Equity Risk Premium Has Risen In 2020 Chart I-12Tech And Health Care Valuations Are Not In A Mania In summary, until the pandemic is conquered, investors should maintain a defensive bias to their portfolios. Bond investors should overweight US T-bonds versus core European bonds. Equity investors should overweight the growth defensives, technology and healthcare, which implies overweighting the technology-heavy US versus Europe. A new recommendation is to overweight technology-heavy Netherlands. Stay overweight healthcare-heavy Switzerland, and bank-light France and Germany (albeit expect a technical 5 percent underperformance of Germany versus the UK in the coming weeks). And stay underweight bank-heavy Austria. Fractal Trading System* The AUD is technically overbought and vulnerable to a tactical reversal. Accordingly, this week’s recommended trade is short AUD/CHF, with a profit target and symmetrical stop-loss set at 4.2 percent. The rolling 1-year win ratio now stands at 63 percent. Chart I-13AUD/CHF When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated  December 11, 2014, available at eis.bcaresearch.com.   Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading System   Cyclical Recommendations Structural Recommendations Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields   Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations  

Highlights The cyclical rally in stocks is not over, but the S&P 500 will churn between 2800 and 3200 this summer. Supportive policy, robust household balance sheets and budding economic growth have put a floor under global bourses. Political risk, demanding valuations and COVID-related headlines are creating potent headwinds in the near term that must be resolved. During the ongoing flat but volatile performance of equities, investors should build short positions against government bonds and the dollar. Deep cyclicals, banks and Japanese equities offer opportunities to generate alpha. In the long term, structurally rising inflation will ensure that stocks outperform bonds, but commodities will beat them both. Feature Institutional investors still despise the equity market rebound that began on March 23. Relative to history, professional investors are heavily overweight cash, bonds and defensive sectors but they are underweight equities as an asset class and cyclical sectors specifically. Furthermore, the beta of global macro hedge funds to the stock market is in the bottom of its distribution, which indicates the funds’ low net exposure to equities. The attitude of market participants is understandable given that the economy is in tatters. According to the New York Fed Weekly Economic Index, Q2 GDP in the US will contract by 8.4% compared with last year. Industrial production is still 15.9% below its pre-pandemic high and the US unemployment rate stands at either 13.3% or 16.4%, depending how the BLS accounts for furloughed employees. Moreover, deflationary forces are building, which hurts profits. Despite these discouraging economic reports, the S&P 500 is trading only 7.9% below its February 19 all-time high and is displaying a demanding forward P/E ratio of 21.4. Stocks will continue to churn over the summer with little direction. Financial markets are forward looking and the collapse of risk asset prices in March forewarned of an economic calamity. Stimulus, liquidity conditions and an eventual recovery are creating strong tailwinds for stocks. However, demanding valuations, rising political risks and overbought short-term technicals argue for a correction. These forces will probably balance out each other in the coming months. Investors must be nimble. Buying beta is not enough; finding cheap assets levered to the nascent recovery will be a source of excess returns. Bonds are vulnerable to the recovery and purchasing deep cyclicals at the expense of defensives makes increasing sense. Japanese stocks offer another attractive opportunity. Five Pillars Behind Stocks… Our BCA Equity Scorecard remains in bullish territory despite the conflict between the sorry state of the global economy and the violence of the equity rally since late March (Chart I-1). Five forces support share prices. Chart I-1The Rally Is Underpinned The first pillar is extraordinarily accommodative liquidity conditions created by global central banks, which have aggressively slashed policy rates and allowed real interest rates to collapse. Additionally, forward guidance indicates that policy will remain easy for the foreseeable future. For example, the Federal Reserve does not anticipate tightening policy through 2022 and the Bank of Japan expects to stand pat until at least 2023. In response, the yield curve in advanced economies has started to steepen, which indicates that the policy easing is having a positive impact on the world’s economic outlook (Chart I-2). Various liquidity measures demonstrate the gush of high-powered money in the financial and economic system in the wake of monetary policy easing. Our US Financial Liquidity Index and dollar-based liquidity measure have skyrocketed. Historically, these two indicators forecast the direction of growth and the stock market (Chart I-3). Chart I-2The Yield Curve Likes What It Sees Chart I-3Exploding Liquidity Conditions   The second pillar is the greatest fiscal easing since World War II. The US government has increased spending by $2.9 trillion since March. House Democrats have passed an additional $3 trillion plan. Senate Republicans will not ratify the entire proposal, but our Geopolitical Strategy service expects them to concede to $2 trillion.1 Meanwhile, the White House is offering a further $1 trillion infrastructure program over five years. Details of the infrastructure plan are murky, but its existence confirms that fiscal profligacy is the new mantra in Washington and the federal deficit could reach 23% of GDP this year. Chart I-4Loosest Fiscal Policy Since WWII The list of new fiscal measures worldwide is long; the key point is that governments are injecting funds to lessen the COVID-19 recession pain on their respective populations and small businesses (Chart I-4). Excluding loans guarantees, even tight-fisted Germany has rolled out EUR 0.44 trillion in relief programs, amounting to 12.9% of GDP. Japan has announced JPY 63.5 trillion of “fresh water” stimulus so far, representing 11.4% of GDP. Loan guarantees administered by various governments along with the Fed’s Primary and Secondary Market Credit Facilities also limit how high business bankruptcies will climb. As we discussed last month, it is unlikely that countries will return to the level of spending and budget deficits that prevailed prior to COVID-19, even if the intensity of fiscal support declines from its current extreme.2 Voters in the West and emerging markets are fed up with the Washington Consensus of limited state intervention. Consequently, the median voter has pivoted to the left on economic matters, especially in Anglo-Saxon nations (Chart I-5).3 The fiscal laxity consistent with economic populism and dirigisme will boost aggregate demand for many years. The third supporting pillar is the private sector’s response to monetary and fiscal easing unleashed by global policymakers. Unlike in 2008, the amount of loans and commercial papers issued by US businesses is climbing, which indicates stronger market access than during the Great Financial Crisis (GFC). A consequence of the large uptick in credit growth has been an explosion in banking deposits. Given the surge in private-sector liquidity – not just base money – broad money creation has eclipsed that of the GFC (Chart I-6). Part of this money will seek higher returns than the -0.97% real short rate available to investors in the US (or -0.9% in Europe), a process that will bid up risk assets. Chart I-5The US Population's Shift To The Left Chart I-6The Private Sector's Liquidity Is Improving   The financial health of the US household sector is the fourth pillar buttressing stocks. Households entered the recession with debt equal to 99.4% of disposable income, the lowest share in 19 years. Moreover, debt servicing only represents 9.7% of disposable income, the lowest percentage of the past four decades. Along with generous support from the US government, the resilience created by strong balance sheets explains why delinquency rates remain muted despite a surge in unemployment (Table I-1).4 Moreover, the decline in household net worth pales in comparison with the GFC (Chart I-7). Hence, the wealth effect will not have the same deleterious impact on consumption as it did after 2008. In the wake of large fiscal transfers, the savings rate explosion to an all-time high of 32.9% is a blessing. The surge in savings is applying a powerful brake on 67.7% of the US economy, but its eventual decline will fuel a quick consumption recovery, a positive trend absent after the GFC. Table I-1Consumer Borrowers Are Hanging In There Chart I-7Smaller Hit To Net Worth Than The GFC     The final pillar is the path of the global business cycle. Important predictors of the US economy have improved. The June Philly Fed and Empire State surveys are gaining ground, thanks to their rebounding new orders and employment components. The Conference Board’s LEI is also climbing, even when its financial constituents are excluded.  Residential activity, which also leads the US business cycle, is sending positive signals. According to the June NAHB Housing market index, homebuilder confidence is quickly recouping lost ground and building permits are bottoming. These two series suggest that the contribution of housing to GDP growth will only expand. Household spending is showing promising growth as the economy re-opens. In May, US auto sales jumped 44.1% higher and retail sales (excluding autos) soared by 12.4%. Additionally, the retail sales control group5 has already recovered to its pre-pandemic levels. The healing labor market and the bounce in consumer confidence have fueled this record performance because they will prompt a normalization in the savings rate. Progress is also evident outside the US. The expectations component of the German IFO survey is rebounding vigorously, a good omen for European industrial production (Chart I-8). Similarly, the continued climb in China’s credit and fiscal impulse suggests that global industrial production will move higher. Finally, EM carry trades are recovering, which indicates that liquidity is seeping into corners of the global economy that contribute the most to capex (Chart I-9). Chart I-8European Hopes Chart I-9Positive Signals For Global Manufacturers     Against this backdrop, there is an increasing probability that analysts will upgrade their 2020 EPS estimates. The odds of upward revisions to 2021 and 2022 estimates (especially outside of the tech and healthcare sectors) are much more significant, especially because the historical pattern of deep recessions followed by sharp rebounds should repeat itself (Chart I-10). A strong recovery will ultimately foster risk-taking. Mechanically, higher expected cash flows and lower risk premia will remain tailwinds behind stocks. Chart I-10The Deeper The Fall, The Faster The Rebound … And Three Reasons To Worry The five pillars shoring up stocks face three powerful factors working at cross purposes against share prices. The first hurdle against stocks is that in aggregate, the S&P 500 is already discounting the coming economic recovery. In the US, the 12-month forward P/E ratio bounced from a low of 13.4 on March 23 to the current 21.4. Bidding up multiples to such heights in a short timeframe opens up the potential for investor disappointments with economic activity or earnings. Equally concerning, the global expectations component of the German ZEW survey has returned to near-record highs. The ZEW is a survey of financial professionals largely influenced by the performance of equities. In order for stocks to continue to rise, they will need an even greater global economic rebound than implied by the ZEW (Chart I-11). Chart I-11Stocks Already Know That IP Will Jump Back Political risk poses a second hurdle against stocks. As intense as it is today, policy uncertainty will not likely abate this summer, which will put upward pressure on the equity risk premium. According to BCA Research’s Geopolitical strategy service, the combination of elevated share prices and President Trump’s low approval rating will increase the prospect of erratic moves by the White House. A pitfall particularly under-appreciated by risk assets is a new round of tariffs in the Sino-US trade war.6 Another hazard is an escalation of tensions with the European Union. US domestic politics are also problematic. Fiscal stimulus has been a pillar for the market. However, as the economy recovers, politicians could let down their guard and resist passing new measures on the docket. This danger is self-limiting. If legislators delay voting on proposed laws, then the resulting drop in the market will put greater pressure on policymakers to continue to support the economy. Either way, this tug-of-war could easily cause some painful bouts of market volatility. Chart I-12How Long Will Stocks Ignore Politics? In recent months, the equity risk premium could ignore rising political risk as long as financial liquidity was expanding at an accelerating pace (Chart I-12). However, the bulk of monetary easing is over because the Fed, the ECB and the global central banks have already expended most of their ammunition. Moreover, the ECB, the Bank of England, the Bank of Japan and the Swiss National Bank have agreed to slow the pace at which they tap the Fed’s dollar swap line from daily to three times a week. This indicates that the private sector’s extreme appetite for liquidity has been satiated by the increase in base money since March 19. Thus, the expansion of liquidity will decelerate, even if its level remains plentiful. Overlooking political uncertainty will become harder after the second derivative of liquidity turns negative. The third hurdle against the stock market is the evolution of COVID-19. A second wave of infection has started in many countries and it will only continue to escalate as economies re-open, loosen social distancing rules and test more potential cases. Investors will be rattled by headlines such as the resumption of lockdowns in Beijing and mounting new cases in the southern US.  Chart I-13A Different Wave BCA’s base case is that a second wave of infections will not result in large-scale lockdowns that paralyzed the global economy in Q1 and Q2. Importantly, the number of new deaths is lagging the spread of recorded new infections (Chart 1-13). This dichotomy highlights better testing, our improved understanding of the disease and our greater capacity to protect vulnerable individuals. A Summer Of Discontent The S&P 500 and global equities will face a summer of directionless gyrations with elevated volatility. Before we can escape this pattern, the technical froth that has engulfed the market must dissipate. Our Tactical Strength Indicator is massively overbought and is consistent with a period of consolidation. (Chart I-14). The same is true of short-term breadth. The proportion of NYSE stocks trading above their 10-week moving average is close to its highest level in the past 20 years, which indicates that meaningful equity gains are doubtful in the coming months. (Chart I-14, bottom panel). A correction should not morph into a renewed bear market because the pillars behind stocks are too strong. Nonetheless, the S&P 500 may retest the 2800-2900 zone during the summer. On the upside, it will be capped near 3200 during that same period. A resolution of the political risks surrounding the market is needed to settle the churning pattern. Another factor will be the progressive normalization of our tactical indicators after an extended period of sideways trading. Finally, continued progress on the treatment of COVID-19 (not necessarily a vaccine) and the formulation of a coherent health policy for the fall will create the impetus for higher share prices later this year. How To Profit When Stocks Churn A strategy most likely to generate the highest reward-to-risk ratio will be to focus on assets and sectors that have not yet fully priced in the upcoming global economic recovery, unlike the broad stock market. The bond market fits within this strategy. G-7 and US yields remain extremely expensive (Chart I-15). Additionally, according to our Composite Technical Indicator, Treasuries are losing momentum (see Section III, page 41). This valuation and technical backdrop renders government bonds vulnerable to both a strong economy and an upward reassessment of the outlook for inflation. Chart I-14A Needed Digestive Break Chart I-15Bonds Are Pricey...   Cyclical dynamics also paint a poor outlook for bonds. Globally, the supply of government securities is swelling by approximately $6 trillion, which will slowly lift depressed term premia. Moreover, there has been a sharp incline in excess liquidity as approximated by the gap between our US Financial Liquidity Index and the rate of change of the US LEI. Such a development has led yields higher since the GFC (Chart I-16). Finally, the diffusion index of fifteen Swedish economic variables has started to recover, an indicator that often signals higher yields (Chart I-17). Sweden is an excellent bellwether for the global business cycle because it is a small, open economy where shipments of industrial and intermediate goods account for 55% of exports. Chart I-16...And Vulnerable To Excess Liquidity Chart I-17Sweden's Message   The FX market also offers reasonably priced vehicles to bet on the burgeoning global cyclical upswing. Balance-of-payments dynamics are increasingly bearish for the US dollar. A fall in the household savings rate will widen the current account deficit because the fiscal balance remains deeply negative. Meanwhile, US real interest rate differentials are narrowing, thus the capital account surplus will likely recede. The resulting balance-of-payment deficit will accentuate selling pressures on the USD created by a pick-up in global industrial activity (Chart I-18). AUD/CHF offers another attractive opportunity. The AUD trades near a record low relative to the CHF, yet this cross will benefit from a rebound in global nominal GDP growth (Chart I-19). Moreover, Australia managed the COVID-19 crisis very well and it can proceed quickly with its re-opening. Meanwhile, the expensiveness of the CHF versus the EUR will continue to foster deflationary pressures in Switzerland. This contrast ensures that the Swiss National Bank remains more dovish than the Reserve Bank of Australia. Chart I-18Bearish Dollar Backdrop Chart I-19AUD/CHF As A Bet On The Recovery   Within equities, deep cyclical stocks remain attractive relative to defensive ones. The same acceleration in our excess liquidity proxy that warned of a fall in bond prices indicates that the cyclicals-to-defensives ratio should appreciate. This ratio also benefits meaningfully when the dollar depreciates. A weaker dollar is synonymous with stronger global industrial production. It also eases deflationary pressures and boosts the price of commodities, which increases pricing power for industrial, material and energy stocks. Finally, the cyclical-to-defensives ratio rises when the silver-to-gold ratio turns up. An outperformance of silver has been an important signal that reflation is starting to improve the global economic outlook (Chart I-20).7 Chart I-20Cyclicals Have Not Priced In The Recovery Banks also offer attractive opportunities. Investors have clobbered banks because they expect prodigious non-performing loans (NPL) due to the threats to private-sector balance sheets from the deepest recession in nine decades. However, NPLs are not expanding by as much as anticipated thanks to the ample support by global monetary and fiscal authorities. Moreover, banks were conservative and built loss reserves ahead of the crisis. In this context, the extreme valuation discount embedded in banks relative to the S&P 500 seems exaggerated (Chart I-21). Additionally, the gap between the expected growth rate of banks’ long-term earnings and that of the broad market is wider than at any other point in the past 15 years. Investors have also bid up the price of protection against bank shares (Chart I-22). Therefore, despite near-term risks induced by the Fed’s Stress Test, banks are a cheap contrarian bet on a global recovery. Chart I-21Banks Are Cheap Chart I-22Banks As A Contrarian Bet     Investors should continue to favor foreign versus US equities, which is consistent with our positive outlook on banks and deep cyclical stocks, as well as our negative disposition toward the dollar. Foreign stocks outperform US ones when the dollar depreciates because the former overweight cyclical equities and financials (Chart I-23). Moreover, foreign stocks trade at discounts to US equities and embed significantly lower expected cash flow growth, which suggests that they would offer investors upside from the impending global economic recovery. Chart I-23Favor Foreign Stocks EM stocks fit within this context. Both EM FX and equities trade at a valuation discount consistent with an upcoming rally (Chart I-24). Moreover, cheap valuations increase the likelihood that a depreciating US dollar will boost EM currencies by easing global financial conditions. Moreover, the momentum of EM equities relative to global ones is forming a positive divergence with the price ratio, which is consistent with liquidity making its way into these markets (Chart I-25). Our Emerging Markets Strategy team is more worried about EM stocks than we are because EM bourses would be unlikely to participate as much as US ones in a mania driven by retail investors.8 Chart I-24Attractive EM Valuations Chart I-25EM: A Coiled-Spring Bet On A Weaker Dollar?   Chart I-26Japanese Stocks As A Trade Finally, an opportunity to overweight Japanese equities has emerged. The Nikkei has collapsed in conjunction with a meltdown in Japanese industrial production. However, Japanese earnings should recover faster than in the rest of the world. Japan has efficiently handled its COVID-19 outbreak with fewer lockdowns. Moreover, Japan’s earnings per share (EPS) are highly levered to both the global business cycle and China’s economic fluctuations. Consequently, if we expect global activity to recover and China’s credit and fiscal impulse to continue to improve, then we also anticipate that Japan’s EPS will outperform the MSCI All-Country World Index (Chart I-26). Additionally, on a price-to-cash flow basis, Japanese equities trade at a deep-enough discount to global stocks to foreshadow an upcoming period of outperformance. Bottom Line: Equities will be tossed about for the coming quarter or two, buffeted between five tailwinds and three headwinds. While the S&P is expected to gyrate between 2800 and 3200 this summer, investors can seek alpha by selling bonds, selling the dollar and buying AUD/CHF, and favoring deep cyclical stocks as well as banks at the expense of defensives. As a corollary, foreign equities, especially Japanese ones, have a window to outperform the US. EM stocks could also generate excess returns, but they are a more uncertain bet. Exploring Long-Term Risks We explore some investment implications linked to our theme of structurally rising inflation, which will cause lower real long-term portfolio returns than in the previous four decades. Populism and the ossification of the supply-side of the economy will push inflation up this cycle toward an average of 3% to 5%.9  Chart I-27S&P 500 Long-Term Perspective Adjusted for inflation, the 10-year cumulative average return for stocks stands at 12.4%, which is an elevated reading. The strength of the past performance increases the probability that a period of mean reversion is near (Chart I-27). The end of the debt supercycle raises the likelihood that an era of low real returns will materialize. Non-financial debt accounts for 258.7% of GDP, a level only topped at the depth of the Great Depression when nominal GDP collapsed by 46% from its 1929 peak. Meanwhile, yields are at record lows (Chart I-28). Such a combination suggests that there is little way forward to boost debt by enough to enhance growth, especially when each additional dollar of debt generates a diminishing amount of output. Chart I-28The End Of The Debt Super Cycle Chart I-29Little Room To Cut Taxes Populist governments will remain profligate and play an expanding role in the economy instead of accepting the necessary increase in savings required to reduce debt and create a more robust economy. However, effective personal and corporate tax rates are already very low in the US (Chart I-29). Therefore, the only way to offer fiscal support would be to increase government spending. Growth will become less vigorous as the government’s share of GDP increases (Chart I-30). Moreover, monetary policy will likely remain lax, which boosts the chance of stagflation developing.   Chart I-30The Bigger The Government, The Lower The Growth Elevated stock multiples are a problem for long-term investors. The S&P 500’s Shiller P/E ratio stands at 29.1, and its price-to-sales ratio is at 2.2. If bond yields remain minimal, then low discount rates can rationalize those extreme multiples. However, if inflation moves above 4%, especially when real output is not expanding robustly, then multiples will mean-revert and equities will generate subpar real returns. Chart I-31Profit Margins: From Tailwind To Headwind? Profit margins pose an additional problem for stocks. The decline in unit labor costs relative to selling prices has allowed abnormally wide domestic EBITDA margins to persist (Chart I-31). However, inflation, populism, greater government involvement in the economy and lower efficiency of supply chains will conspire to undo this extraordinary level of profitability. In other words, while the share of national income taken up by wages will expand, profits will account for a progressively smaller slice of output. (Chart I-31, bottom panel). Lower profit margins will push down RoE and accentuate the decline in multiples while also hurting projected long-term cash flows. Chart I-32Elevated Household Exposure To Stocks Finally, from a structural perspective, households are already aggressively overweighting equities. Stocks comprise 54% of US households’ discretionary portfolios. US households held more shares only in 1968 and 2000, two years that marked the beginning of painful drops in real stock prices (Chart I-32). US stocks are most vulnerable to the increase of inflation. Not only are they much more expensive than their global counterparts, but as the Section II special report written by Matt Gertken highlights, the growing nationalism spreading around the world hurts the global order built by and around the US during the past 70 years. With this system of influence diminished, US firms will not be able to command their current valuation premium. Despite low expected real rates of return, equities will still outperform bonds in the coming decade (Table I-2). Even though stocks are more volatile than bonds, stocks have not significantly outperformed bonds during the past 35 years. This was possible because inflation fell from its peak in the early 1980s. However, bonds are unlikely to once again generate higher risk-adjusted returns than equities if inflation bottoms. Moreover, bonds are more expensive than stocks (Chart I-33). A structural bear market in bonds would hurt risk-parity strategies and end the incredible strength in growth stocks. Table I-2Rising Inflation Flatters Stocks Over Bonds The outperformance of stocks over bonds will be of little solace to investors if equities generate poor real returns. Instead, investors should explore commodities, an asset class that benefits from rising inflation, especially given the combination of strong government spending and too-accommodative monetary policy. Moreover, after a decade of weak capex in natural resource extraction, the supply of commodities will expand slowly. Hence, our base case this cycle is for a weakening in the stock-to-gold ratio (Chart I-34). The stock-to-industrial commodities ratio will also fall from its heady levels. As a result, the energy, materials and industrial sectors are attractive on a long-term basis beyond the next six to 12 months. Chart I-33Bonds Look Worse Than Stocks... Chart I-34...But Gold Looks The Best   Mathieu Savary Vice President The Bank Credit Analyst June 25, 2020 Next Report: July 30, 2020   II. Nationalism And Globalization After COVID-19 Economic shocks in recent decades have led to surges in nationalism and the COVID-19 crisis is unlikely to be different. Nationalism adds to the structural challenges facing globalization, which is already in retreat. Investors face at least a 35% chance that President Trump will be reelected and energize a nationalist and protectionist agenda that is globally disruptive. China is also indulging in nationalism as trend growth slows, raising the probability of a clash with the US even if Trump does not win. US-China economic decoupling will present opportunities as well as risks – primarily for India and Southeast Asia. Since the Great Recession, investors have watched the US dollar and US equities outperform their peers in the face of a destabilizing world order (Chart II-1). Chart II-1US Outperformance Amid Global Disorder Global and American economic policy uncertainty has surged to the highest levels on record. Investors face political and geopolitical power struggles, trade wars, a global pandemic and recession, and social unrest.  How will these risks shape up in the wake of COVID-19? First, massive monetary and fiscal stimulus ensure a global recovery but they also remove some of the economic limitations on countries that are witnessing a surge in nationalism.  Second, nationalism creates a precarious environment for globalization – namely the wave of “hyper-globalization” since 2000. Nationalism and de-globalization do not depend on the United States alone but rather have shifted to the East, which means that geopolitical risks will remain elevated even if the US presidential election sees a restoration of the more dovish Democratic Party.  Economic Shocks Fuel Nationalism’s Revival Nationalism is the idea that the political state should be made up of a single ethnic or cultural community. While many disasters have resulted from this idea, it is responsible for the modern nation-state and it has enabled democracies to take shape across Europe, the Americas, and beyond. Industrialization is also more feasible under nationalism because cultural conformity helps labor competitiveness.10  At the end of the Cold War, transnational communist ideology collapsed and democratic liberalism grew complacent. Each successive economic shock or major crisis has led to a surge in nationalism to fill the ideological gaps that were exposed. Chart II-2The Resurgence Of Russian Nationalism Chart II-3USA: From Nationalism To Anti-Nationalism   For instance, various nationalists and populists emerged from the financial crises of the late 1990s. Russian President Vladimir Putin sought to restore Russia to greatness in its own and other peoples’ eyes (Chart II-2). Not every Russian adventure has mattered for investors, but taken together they have undermined the stability of the global system and raised barriers to exchange. The invasion of Crimea in 2014 and the interference in the US election in 2016 helped to fuel the rise in policy uncertainty, risk premiums in Russian assets, and safe havens over the past decade. The September 11, 2001 terrorist attacks in the United States created a surge in American nationalism (Chart II-3). This surge has since collapsed, but while it lasted the US destabilized the Middle East and provided Russia and China with the opportunity to pursue a nationalist path of their own. Investors who went long oil and short the US dollar at this time could have done worse. The 2008 crisis spawned new waves of nationalist feeling in countries such as China, Japan, the UK, and India (Chart II-4). Conservatives of the majority cultural group rose to power, including in China, where provincial grassroots members of the elite reasserted the Communist Party’s centrality. Japan and India became excellent equity investment opportunities in their respective spheres, while the UK and China saw their currencies weaken.  The rising number of wars and conflicts across the world since 2008 reflects the shift toward nationalism, whether among minority groups seeking autonomy or nation-states seeking living space (Chart II-5). Chart II-4Nationalist Trends Since The Great Recession Chart II-5World Conflicts Rise After Major Crises   COVID-19 is the latest economic shock that will feed a new round of nationalism. At least 750 million people are extremely vulnerable across the world, mostly concentrated in the shatter belt from Libya to Turkey, Iran, Pakistan, and India.11 Instability will generate emigration and conflict. Once again the global oil supply will be at risk from Middle Eastern instability and the dollar will eventually fall due to gargantuan budget and trade deficits. Today’s shock will differ, however, in the way it knocks against globalization, a process that has already begun to slow. Specifically, this crisis threatens to generate instability in East Asia – the workshop of the world – due to the strategic conflict between the US and China. This conflict will play out in the form of “proxy battles” in Greater China and the East Asian periphery. The dollar’s recent weakness is a telling sign of the future to come. In the short run, however, political and geopolitical risks are acute and will support safe havens. Globalization In Retreat Nationalism is not necessarily at odds with globalization. Historically there are many cases in which nationalism undergirds a foreign policy that favors trade and eschews military intervention. This is the default setting of maritime powers such as the British and Dutch. Prior to WWII it was the American setting, and after WWII it was the Japanese. Over the past thirty years, however, the rise of nationalism has generally worked against global trade, peace, and order. That’s because after WWII most of the world accepted internationalist ideals and institutions promoted by the United States that encouraged free markets and free trade. Serious challenges to that US-led system are necessarily challenges to global trade. This is true even if they originate in the United States. Globalization has occurred in waves continuously since the sixteenth century. It is not a light matter to suggest that it is experiencing a reversal. Yet the best historical evidence suggests that global imports, as a share of global output, have hit a major top (Chart II-6).12 The line in this chart will fall further in 2020. American household deleveraging, China’s secular slowdown, and the 2014 drop in oil and commodities have had a pervasive impact on the export contribution to global growth.   Chart II-6Globalization Hits A Major Top Chart II-7Both Goods And Services Face Headwinds The next upswing of the business cycle will prompt an increase in trade in 2021. Global fiscal stimulus this year amounts to 8% of GDP and counting. But will the import-to-GDP ratio surpass previous highs? Probably not anytime soon. It is impossible to recreate America’s consumption boom and China’s production boom of the 1980s-2000s with public debt alone. Global trend growth is slowing. Isn’t globalization proceeding in services, if not goods? The world is more interconnected than ever, with nearly half of the population using the Internet – almost 30% in Sub-Saharan Africa. One in every two people uses a smartphone. Eventually the pandemic will be mitigated and global travel will resume. Nevertheless, the global services trade is also facing headwinds. And it requires even more political will to break down barriers for services than it does for goods (Chart II-7). The desire of nations to control and patrol cyberspace has resulted in separate Internets for authoritarian states like Russia and China. Even democracies are turning to censorship and content controls to protect their ideologies.  Political demands to protect workers and industries are gaining ground. Policymakers in China and Russia have already shifted back toward import substitution; now the US and EU are joining them, at least when it comes to strategic sectors (health, defense). Nationalists and populists across the emerging world will follow their lead. Regional and wealth inequalities are driving populations to be more skeptical of globalization. GDP per capita has not grown as fast as GDP itself, a simple indication of how globalization does not benefit everyone equally even though it increases growth overall (Chart II-8). Inequality is a factor not only because of relatively well-off workers in the developed world who resent losing their job or earning less than their neighbors. Inequality is also rife in the developing world where opportunities to work, earn higher wages, borrow, enter markets, and innovate are lacking. Over the past decade, emerging countries like Brazil, Indonesia, Mexico, and South Africa have seen growing skepticism about whether foreign openness creates jobs or lifts wages.13  Immigration is probably the clearest indication of the break from globalization. The United States and especially the European Union have faced an influx of refugees and immigrants across their southern borders and have resorted to hard-nosed tactics to put a stop to it (Chart II-9). Chart II-8Global Inequality Fuels Protectionism Chart II-9US And EU Crack Down On Immigration   There is zero chance that these tough tactics will come to an end anytime soon in Europe, where the political establishment has discovered a winning combination with voters by promoting European integration yet tightening control of borders. This combination has kept populists at bay in France, Italy, the Netherlands, Spain, and Germany. A degree of nationalism has been co-opted by the transnational European project. In the US, extreme polarization could cause a major change in immigration policy, depending on the election later this year. But note that the Obama administration was relatively hawkish on the border and the next president will face sky-high unemployment, which discourages flinging open the gates.  Reduced immigration will weigh on potential GDP growth and drive up the wage bill for domestic corporations. If nationalism continues to rise and to hinder the movement of people, goods, capital, and ideas, then it will reduce the market’s expectations of future earnings. American Nationalism Still A Risk  The United States is experiencing a “Civil War Lite” that may take anywhere from one-to-five years to resolve. The November 3 presidential election will have a major impact on the direction of nationalism and globalization over the coming presidential term. If President Trump is reelected – which we peg at 35% odds – then American nationalism and protectionism will gain a new lease on life. Other nations will follow the US’s lead. If Trump fails, then nationalism will likely be driven by external forces, but protectionism will persist in some form. Chart II-10Trump Is Not Yet Down For The Count Investors should not write Trump off. If the election were held today, Trump would lose, but the election is still four months away. His national approval rating has troughed at a higher level than previous troughs. His disapproval rating has spiked but has not yet cleared its early 2019 peak (Chart II-10).14 This is despite an unprecedented deluge of bad news: universal condemnation from Democrats and the media, high-profile defections from fellow Republicans and cabinet members, stunning defeats at the Supreme Court, and scathing rebukes from top US army officers. If Trump’s odds are 35% then this translates to a 35% chance that the United States will continue pursuing globally disruptive “America First” foreign and trade policies in the 2020-24 period.    First Trump will attempt to pass a Reciprocal Trade Act to equalize tariffs with all trading partners. Assuming Democrats block it in the House of Representatives, he will still have sweeping executive authority to levy tariffs. He will launch the next round in the trade war with China to secure a “Phase Two” trade deal, which will be tougher because it will be focused on structural reforms. He could also open new fronts against the European Union, Mexico, and other trade surplus countries. By contrast, these risks will melt away if Biden is elected. Biden would restore the Obama administration’s approach of trade favoritism toward strategic allies and partners, such as Europe and the members of the Trans-Pacific Partnership, but only occasional use of tariffs. Biden would work with international organizations like the World Trade Organization. His foreign policy would also open up trade with pariah states like Iran, reducing the tail-risk of a war to almost zero.  Biden would be tougher on China than Presidents Obama or Bill Clinton, as the consensus in Washington is now hawkish and Biden would need to keep the blue-collar voters he won back from Trump. He may keep Trump’s tariffs in place as negotiating leverage. But he is less likely to expand these tariffs – and there is zero chance he will use them against Europe. At the same time, it will take a year or more to court the allies and put together a “coalition of the willing” to pressure China on structural reforms and liberalization. China would get a reprieve – and so would financial markets. Thus investors have a roughly 65% chance of seeing US policy “normalize” into an internationalist (not nationalist) approach that reduces the US contribution to trade policy uncertainty and geopolitical risk over the next few years at minimum. But there are still four months to go before the election; these odds can change, and equity market volatility will come first. Moreover a mellower US would still need to react to nationalism in Asia. European Nationalism Not A Risk (Yet) Chart II-11English Versus Scottish Nationalism European nationalism has reemerged in recent years but has greatly disappointed the prophets of doom who expected it to lead to the breakup of the European Union. The southern European states suffered the most from COVID-19 but many of them have made their decision regarding nationalism and the supra-national EU. Greece underwent a depression yet remained in the union. Italians could easily elect the right-wing anti-establishment League to head a government in the not-too-distant future. But there is no appetite for an Italian exit. Brexit is the grand exception. If Trump wins, then the UK and British Prime Minister Boris Johnson will be seen as the vanguard of the revival of nationalism in the West. If Trump loses, English nationalism will appear an isolated case that is constrained by its own logic given the response of Scottish nationalism (Chart II-11). The trend in the British Isles would become increasingly remote from the trends in continental Europe and the United States. The majority of Europeans identify both as Europeans and as their home nationality, including majorities in countries like Greece, Italy, France, and Austria where visions of life outside the union are the most robust (Chart II-12). Even the Catalonians are focused on options other than independence, which has fallen to 36% support. Eastern European nationalists play a careful balancing game of posturing against Brussels yet never drifting so far as to let Russia devour them. Chart II-12European Nationalism Is Limited (For Now) Europeans have embraced the EU as a multi-ethnic confederation that requires dual allegiances and prioritizes the European project. COVID-19 has so far reinforced this trend, showing solidarity as the predominant force, and much more promptly than during the 2011 crisis. It will take a different kind of crisis to reverse this trend of deeper integration. European nationalists would benefit from another economic crash, a new refugee wave from the Middle East, or conflict with Turkish nationalism. The latter is already burning brightly and will eventually flame out, but not before causing a regional crisis of some kind. European policymakers are containing nationalism by co-opting some of its demands. The EU is taking steps to guard against globalization, particularly on immigration and Chinese mercantilism. The lack of nationalist uprisings in Europe do not overthrow the contention that globalization is slowing down. Europe can become more integrated at home while maintaining the higher barriers against globalization that it has always maintained relative to the UK and United States. Chinese Nationalism The Biggest Risk The nationalist risk to globalization is most significant in East Asia and the Pacific, where Chinese nationalism continues the ascent that began with the Great Recession. China’s slowdown in growth rates has weakened the Communist Party’s confidence in the long-term viability of single-party rule. The result has been a shift in the party line to promote ideology and quality of life improvements to compensate for slower income gains. Xi Jinping’s governing philosophy consists of nationalist territorial gains, promoting “the China Dream” for the middle class, and projecting ambitious goals of global influence by 2035 and 2049. The result has been a clash between mainland Chinese and peripheral Chinese territories – especially Hong Kong and Taiwan (Chart II-13). The turn away from Chinese identity in these areas runs up against their economic interest. It is largely a reaction to the surge in mainland nationalist sentiment, which cannot be observed directly due to the absence of reliable opinion polling. Chart II-13AChinese Nationalism On The Mainland, Anti-Nationalism In Periphery Chart II-13BChinese Nationalism On The Mainland, Anti-Nationalism In Periphery   The conflict over identity in Greater China is perhaps the world’s greatest geopolitical risk. While Hong Kong has no conceivable alternative to Beijing’s supremacy, Taiwan does. The US is interested in reviving its technological and defense relationship with Taiwan now that it seeks to counterbalance China. Chart II-14Taiwan: Epicenter Of US-China Cold War Beijing may be faced with a technology cordon imposed by the United States, and yet have the option of circumventing this cordon via Taiwan’s advanced semiconductor manufacturing. Taiwan’s “Silicon Shield” used to be its security guarantee. Now that the US is tightening export controls and sanctions on China, Beijing has a greater need to confiscate that shield. This makes Taiwan the epicenter of the US-China struggle, as we have highlighted since 2016. The risk of a fourth Taiwan Strait crisis is as pertinent in the short run as it is over the long run, given that the US and China have already intensified their saber-rattling in the Strait (Chart II-14), including in the wake of COVID-19 specifically. China’s secular slowdown is prompting it to encroach on the borders of all of its neighbors simultaneously, creating a nascent balance-of-power alliance ranging from India to Australia to Japan. If China fails to curb its nationalism, then eventually US political polarization will decline as the country unites in the face of a peer competitor. If American divisions persist, they could drive the US to instigate conflict with China. Thus a failure of either side to restrain itself is a major geopolitical risk. The US and China ultimately face mutually assured destruction in the event of conflict, but they can have a clash in the near term before they learn their limits. The Cold War provides many occasions of such a learning process – from the Berlin airlift to the Cuban missile crisis. Such crises typically present buying opportunities for financial markets, but the consequences could be more far reaching if the Asian manufacturing supply chain is permanently damaged or if the shifting of supply chains out of China is too rapid. Globalization will also suffer as a result of currency wars. The US has not been successful in driving the dollar down, a key demand of the US-China trade war. It is much harder to force China to reform its labor and wage policies than it is to force it to appreciate its currency. But unlike Japan in 1985, China will not commit to unilateral appreciation for fear of American economic sabotage.   Punitive measures will remain an American tool. Contrary to popular belief, the US is not attempting to eliminate its trade deficit. It is attempting to reduce overreliance on China. Status quo globalization is intolerable for US strategy. But autarky is intolerable for US corporations. The compromise is globalization-ex-China, i.e., economic decoupling. Investment Implications Chart II-15Favor International Stocks As Growth Revives US stock market’s capitalization now makes up 58% of global capitalization (Chart II-15), reflecting the strength and innovation of American companies as well as a worldwide flight to safety during a decade of rising policy uncertainty and geopolitical risk. The revival of global growth amid this year’s gargantuan stimulus will prompt a major rotation out of US equities and into international and emerging market equities over the long run. As mentioned, the US greenback would also trend downward. However, there will be little clarity on the pace of nationalism and the fate of globalization until the US election is decided. Moreover the fate of globalization does not depend entirely on the United States. It mostly depends on countries in the east – Russia, China, and India, all of which are increasingly nationalistic.  A miscalculation over Taiwan, North Korea, the East China Sea, the South China Sea, trade, or technology could ignite into tariffs, sanctions, boycotts, embargoes, saber-rattling, proxy battles, and potentially even direct conflict. These risks are elevated in the short run but will persist in the long run. As the US decouples from China it will have to deepen relations with other trading partners. The trade deficit will not go away but will be redistributed to Asian allies. Southeast Asian nations and India – whose own nationalism has created a shift in favor of economic development – will be the long-run beneficiaries. Matt Gertken  Vice President Geopolitical Strategist   III. Indicators And Reference Charts We continue to favor stocks at the expense of bonds, a view held since our April issue. Global fiscal and monetary conditions remain highly accommodative. Now that the global economy is starting to recover as lockdowns ease, another tailwind for stocks has emerged. Nonetheless, last month we warned that the S&P 500 was entering a consolidation phase and that a pattern of volatile ups and downs would ensue. The combination of tactically overbought markets, elevated geopolitical risk, and a looming second wave of infections continues to sustain this short-term view. Hence, the S&P 500 is likely to churn between 2088 and 3200 over the coming months. On a cyclical basis, the same factors that made us willing buyers of stocks since late March remain broadly in place. Stocks are becoming increasingly expensive, but monetary conditions are extremely accommodative. Our Speculation Indicator continues to send a benign signal, which indicates that from a cyclical perspective, the market is not especially vulnerable. Finally, our Revealed Preference Indicator is flashing a strong buy signal. Tactically, equities must still digest the heady gains made since March 23. We have had five 5% or more corrections since March 23. More of them are in the cards. Both our Tactical Strength Indicator and the share of NYSE stocks trading above their 10-week moving averages point to a pullback of 5% to 10%. Moreover, while it remains extremely stimulative, our Monetary Indicator is not rising anymore, which increases the probability that traders start to pay more attention to geopolitical risks. According to our Bond Valuation Index, Treasurys are significantly more overvalued than equities. Additionally, our Composite Technical Indicator is losing momentum. This backdrop is dangerous for bonds, especially when sentiment towards this asset class is as high as it is today and economic growth is turning the corner. Finally, we expect the yield curve to steepen, especially for very long maturities where the Fed is less active. In a similar vein, inflation breakeven rates are a clean vehicle to bet on higher yields. Since we last published, the dollar has broken down. The greenback is expensive and its counter-cyclicality is a major handicap during a global economic recovery. Additionally, the US twin deficits are increasingly problematic. The fiscal deficit remains exceptionally wide and the re-opening of the US economy will pull down the household savings rate. The current account deficit is therefore bound to widen. The continued low level of real interest rates will complicate financing this deficit and to equilibrate the funding of US liabilities, the dollar will depreciate. The widening in the current account deficit also means that the large increase in money supply by the Fed will leak out of the US economy. This process will accentuate the dollar’s negative impulse. Technically, the accelerating downward momentum in our Dollar Composite Technical Indicator also warns of additional downside for the USD. Commodities continue to gain traction. The rapid move up in the Baltic Dry index suggests that more gains are in store for natural resource prices, especially as our momentum indicator is gaining strength. Moreover, the commodity advance/decline line remains in an uptrend. A global economic recovery, a weakening dollar, and falling real interest rates (driven by easy policy) indicate that fundamental factors – not just technical ones – are also increasingly commodity bullish. Tactically, if stocks churn, as we expect, commodities will likely do so as well. However, this move should also be seen as a consolidation of previous gains. Finally, gold remains strong, lifted by accommodative monetary conditions and a weak dollar. However, the yellow metal is now trading at a significant premium to its short-term fundamentals. Gold too is likely to trade in a volatile sideways pattern, especially if bond yields rise. EQUITIES: Chart III-1US Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3US Equity Sentiment Indicators   Chart III-4Revealed Preference Indicator Chart III-5US Stock Market Valuation Chart III-6US Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance   FIXED INCOME:   Chart III-9US Treasurys And Valuations Chart III-10Yield Curve Slopes Chart III-11Selected US Bond Yields Chart III-1210-Year Treasury Yield ComponentsChart III-13US Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets   CURRENCIES: Chart III-16US Dollar And PPP Chart III-17US Dollar And Indicator Chart III-18US Dollar Fundamentals Chart III-19Japanese Yen Technicals Chart III-20Euro Technicals Chart III-21Euro/Yen Technicals Chart III-22Euro/Pound Technicals   COMMODITIES: Chart III-23Broad Commodity Indicators Chart III-24Commodity Prices Chart III-25Commodity Prices Chart III-26Commodity Sentiment Chart III-27Speculative Positioning   ECONOMY: Chart III-28US And Global Macro Backdrop Chart III-29US Macro Snapshot Chart III-30US Growth Outlook Chart III-31US Cyclical Spending Chart III-32US Labor Market Chart III-33US Consumption Chart III-34US Housing Chart III-35US Debt And Deleveraging   Chart III-36US Financial Conditions Chart III-37Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China   Mathieu Savary Vice President The Bank Credit Analyst Footnotes 1  Please see Geopolitical Strategy "Social Unrest Can Still Cause Volatility," dated June 5, 2020, available at gps.bcaresearch.com 2  Please see The Bank Credit Analyst "June 2020," dated May 28, 2020, available at bca.bcaresearch.com 3  Please see Geopolitical Strategy "Introducing: The Median Voter Theory," dated June 8, 2016, available at gps.bcaresearch.com 4  Please see US Investment Strategy "So Far, So Good (How Markets Learned To Stop Worrying And Love Washington, DC)," dated June 8, 2020, available at usis.bcaresearch.com 5  The control group excludes auto and gas stations, and building materials. 6  Please see Geopolitical Strategy "Geopolitics Is The Next Shoe To Drop," dated April 10, 2020, available at gps.bcaresearch.com 7  Gold and silver are precious metals that benefit from lower interest rates and a weak dollar. However, a much larger proportion of the demand for silver comes from industrial processes. Thus, silver outperforms gold when an economic recovery is imminent. 8  Please see Emerging Markets Strategy "A FOMO-Driven Mania?," dated June 4, 2020, and Emerging Markets Strategy "EM: Follow The Momentum," dated June 18, 2020, available at ems.bcaresearch.com 9  Please see The Bank Credit Analyst "June 2020," dated May 28, 2020, available at bca.bcaresearch.com 10  Ernest Gellner, Nations and Nationalism (Ithaca, NY: Cornell University Press, 1983). 11  Neli Esipova, Julie Ray, and Ying Han, “750 Million Struggling To Meet Basic Needs With No Safety Net,” Gallup News, June 16, 2020.  12  Christopher Chase-Dunn et al, “The Development of World-Systems,” Sociology of Development 1 (2015), pp. 149-172; and Chase-Dunn, Yukio Kawano, Benjamin Brewer, “Trade globalization since 1795: waves of integration in the world-system,” American Sociological Review 65 (2000), pp. 77-95.  13  Bruce Stokes, “Americans, Like Many In Other Advanced Economies, Not Convinced Of Trade’s Benefits,” September 26, 2018. 14  In other words, the mishandling of COVID-19 and the historic George Floyd protests of June 2020 have not taken as great of a toll on Trump’s national approval, thus far, as the Ukraine scandal last October, the government shutdown in January-February 2019, the near-failure to pass tax cuts in December 2017, or the Charlottesville incident in August 2017. This is surprising and points once more to Trump’s very solid political base, which could serve as a springboard for a comeback over the next four months.

Special Report

Highlights We test the out-of-sample performance of Mean-Variance Optimization (MVO) portfolios. We find that MVO portfolios based on historical estimates have historically underperformed static-weight portfolios. However, MVO portfolios using momentum-based return estimates and a “shrunk” correlation matrix dramatically improved performance, allowing them to outperform our benchmarks. Additionally, MVO portfolios where the asset weights could not deviate more than 10% from the benchmark still added value, making them a more attractive option for benchmarked investors. Feature “Let every man divide his money into three parts, and invest a third in land, a third in business, and a third let him keep in reserve” – Rabbi Isaac bar Aha, Babylonian Talmud, 200 C.E.   Diversification is the main pillar of asset allocation. Its advantages are clear: By spreading out funds to different assets, a portfolio can remain resilient to the failings of individual investments, provided they do not occur at the same time. But, while it is universally accepted that “you should not put all your eggs in one basket”,1 putting this concept into practice remains challenging: After all, how exactly do you diversify? The first attempt to answer this question dates back to the Babylonian Talmud, which suggested that an equally weighted portfolio between a growth asset, a real asset, and a safe asset was the best way to allocate one’s funds. After that, it took almost 2000 years for the first formal theory on portfolio construction to emerge, with the derivation of the mean-variance solution by Harry Markowitz in the 1950s. Today, while other methods such as risk parity, factor-based diversification, and the Kelly criterion have also emerged, mean-variance optimization remains the standard theoretical framework for portfolio construction. However, mean-variance optimization (MVO) has not proven to be the final solution to the asset allocation puzzle. Far from it. With time, investors have realized that, while MVO might provide the optimal allocation in theory, it has several drawbacks when used to construct real world portfolios. Specifically, MVO portfolios have become notorious due to their inability to deal with estimation error, as well as for their large concentrated positions on a single asset. In this report we examine the strengths and weaknesses of MVO portfolios from an empirical standpoint, and we suggest three practical solutions to solve some of the problems described above. The report is structured as follows: We first describe our data and methodology in our Methodology section. We then provide a summary of our main findings in the Summary Of Results section. For readers who wish to read a more detailed description of our analysis, please refer the Results In Full section. Methodology Data In order to build optimized portfolios, we use monthly returns for seven assets from the perspective of a US-based investor: US equities, international equities (developed markets ex-US), US Treasurys, US investment-grade corporate bonds, commodity futures, US REITs, and US cash. We use a sample starting in 1973 and ending in April 2020.2 Optimization We build three types of mean-variance optimized portfolios: A conservative portfolio, with a target volatility of 6%, a moderate portfolio, with a target volatility of 9%, and an aggressive portfolio, with a target volatility of 12%.3 In the optimization procedure, each portfolio seeks to maximize returns subject to the risk constraint. In addition to this risk constraint, we also do not allow for leverage or short positions. The optimization and rebalancing are done on a monthly basis. Benchmarking As a benchmark we build three portfolios (an aggressive benchmark, a moderate benchmark, and a conservative benchmark) with constant weights. The portfolios are rebalanced on a monthly basis. Be advised that this is not a completely fair comparison, as these benchmarks are constructed ex-post, which means that in contrast to the MVO portfolios, these benchmark portfolios have the benefit of hindsight to achieve their target volatility. However, they will prove useful to evaluate whether MVO portfolios are doing a good job at maximizing returns. Table 1 describes the benchmark portfolios. Table 1Benchmark Portfolio Weights Turnover limits In order to get a better picture of how MVO performs under realistic conditions, we assess the performance of MVO portfolios with turnover limits. These turnover limits are put in place to take into account that changing portfolio weights by large amounts from month to month is not feasible for most asset managers. We limit the month-to-month change in the weight of each asset to 5%. As an example, if the current weight in US Treasurys is 20%, and the MVO finds that the optimal weight for the following month is 40%, the new weight will only be 25%. In a few months this results in buying and selling not being equal. In those cases, turnover for certain assets might be limited further to ensure that all of the weights add up to 100%. Transaction costs Table 2One-Way Transaction Costs To calculate transaction costs, we multiply the absolute value of the month-on-month change in the weight of each asset by the transaction costs shown in Table 2. Note that this approach does not take into account drift. However, this will not be important when comparing portfolios, given that drift will also not be considered for the benchmarks (since weights stay static from month to month, transaction costs for the benchmarks are zero in our analysis).   Summary Of Results After conducting our analysis, our main findings were the following (please see full details below in the following sections): Historical performance MVO portfolios using historical estimates as inputs have historically underperformed static-weight benchmarks in both raw return and risk-adjusted terms (Table 3). The realized volatility of MVO portfolios was relatively close to their target risk over the sample. However, this was not true when looking at shorter periods. Table 3Summary Of Results Solution #1: Momentum-based return estimates Expected return estimates can be improved by taking into account that prices usually trend (price momentum). These momentum-based return estimates improve both the return and the Sharpe ratio. Additionally, the volatility of MVO portfolios using momentum-based return estimates remains below the target risk more consistently. Solution #2: Shrinking correlation matrix  Historical correlation estimates are often too noisy and lead to estimation error.  “Shrinking” cross-asset correlations to a pre-specified value often results in improvements in both raw returns and risk-adjusted returns.   Very high shrink factors had the best performance. Solution #3: Constraining weights MVO portfolios result in large concentrations in one or two assets. Such an allocation is not practical for most asset managers, particularly if they are benchmarked. However, MVO can improve performance even when asset weights are constrained. Specifically, the information ratio can be improved when using the two solutions described above. We remind clients that MVO should be used prudently. Specifically, even though many of the measurements we have suggested here concentrate in making MVO more robust to noisy estimates, MVO is always vulnerable to the risk of estimation error. Other inputs should be considered when making final asset allocation decisions. Results In Full Historical performance The theory underpinning mean-variance optimizations assumes perfect knowledge of expected returns, volatility, and correlation. In practice, however, this is never the case. Instead, these inputs need to be estimated – a process which unavoidably carries error with it. This error in the estimated inputs can lead to significant deviations from the optimal weights, resulting in lower performance. But to what extent does performance suffer when using imperfect inputs? To answer this question, we construct MVO portfolios as they are often built in practice: using historical estimates. The portfolios are built as follows: Each month we use the historical mean return, historical volatility, and historical correlation matrix up to that point in time, as inputs for every asset with the exception of cash.4 To ensure that the historical inputs are robust enough, we start building the portfolios when we have at least 10 years of historical data (since our data begins in 1973, we start building the portfolios in 1983). Table 4 shows several key metrics for these MVO portfolios with the different risk targets as well as for their benchmarks. Overall, MVO portfolios underperformed their respective benchmarks in every single category regardless of the risk level. This result is in line with previous research, which has shown that MVO usually underperforms equally weighted or static-weight portfolios.5 Table 4MVO Versus Benchmarks The one positive trait of the MVO portfolios was that the volatility of returns over the entire sample stayed relatively close to the risk target. This happened because, over the very long term, volatility remains fairly stable within assets, in stark contrast to returns or correlations, which can undergo dramatic changes even over very long horizons. (Chart 1). However, it is important to point out that, while the volatility of the MVO portfolios stayed relatively close to the risk target throughout the almost 40-year sample, the same was not true if we look at subperiods. Volatility of MVO portfolios was often significantly higher than the risk constraint in the medium term (Chart 2). This is a problem, given that asset managers are usually evaluated in these shorter time frames. Chart 1Volatility Is Relatively Stable Over The Long-Term Chart 2MVO Volatility Can Stray Well Above Target   Solution #1: Momentum-based return estimates Expected returns are the most important input for mean-variance optimization. In general, there are many ways to improve on the dismal track record of historical estimates. However, in this report we will focus on a simple way to improve them. Specifically, we take into account the fact that prices usually trend. As we discussed in our July 2019 report, momentum in asset prices has been one of the most persistent forces in the history of financial markets.6 The propensity of returns to trend, was first discussed by the academic literature in the 1990s but has possibly been known amongst practitioners since the primitive financial markets of the 17th century. We use this simple stylized fact about returns for a couple of reasons: First, there is extensive literature arguing that there are structural forces which causes prices to trend. This gives us some assurance that this tendency is not a random trait of the data, but rather a result of an internal mechanism in the market. Second, the existence of price momentum has been known for a very long time, which means that any sophisticated investor could have realistically used this fact during our sample to improve his or her estimate of expected returns. To take price momentum into account, we estimate expected returns as follows for each asset except for cash: Each month we compute the average return of the asset up to that point, following periods when price was above the 12-month moving average (uptrend average). We also compute the average return of the asset up to that point, following periods when price was below the 12-month moving average (downtrend average). If the asset’s price is above its 12-month moving average, we use the uptrend average as our expected return estimate. If the asset’s price is below its 12-month moving average, we use the downtrend average as our expected return estimate. Much like with our historical estimates, we wait until we have 10 years of data to begin constructing the portfolios. Table 5 shows the result of the MVO portfolios using these momentum-based expected return inputs, as well as the MVO portfolios using historical estimates and the benchmarks. Overall, using momentum-based expected returns significantly improved the performance of all of the MVO portfolios. Additionally, the volatility of the enhanced MVO portfolios was much better behaved, staying much closer to the risk target than the volatility of the MVO that used historical return estimates (Chart 3). Table 5Momentum-Based Return Estimates Enhance Performance Chart 3Momentum-Based Return Estimates Lead To Better Behaved Volatility Solution #2: Shrinking correlation matrix What about improving correlation estimates? Correlations are notoriously noisy and difficult to forecast since they often change depending on the regime. Moreover, while the number of estimates necessary for expected returns and volatility increases linearly with the number of assets in consideration, the number of estimates necessary for the correlation matrix increases at a much higher rate.7 One alternative solution proposed by practitioners to deal with this noise and limit the amount of estimation error is to anchor correlations to some pre-specified value (also known as “shrinking” the correlation matrix). This reduces the noise of the correlation estimate, making for a much more robust input. Shrinking the correlation matrix can be done as follows: Choose shrinkage target: The anchor value or the shrinkage target, is the number to which cross-asset correlations are anchored. Often the average cross-asset correlation between all assets is chosen as the shrinkage target.8 Choose a shrinkage factor: The shrinkage factor is the weight we put on the anchor versus our estimate. The weighting is done with the formula below: Shrunk correlation = (Shrinkage factor) * (Shrinkage target) + (1-Shrinkage factor)* (Correlation estimate) But what exactly should the shrinkage factor be? To answer this question, we test the performance of MVO portfolios that use historical estimates for expected returns and variance, but where the correlation matrix is shrunk. Additionally, we examine how varying the shrinkage factor affected historical performance for different types of investors. Our results indicate that correlation matrices with high levels of shrinkage (70%+ shrink factor) have invariably improved Sharpe ratios and reduced volatility, while also improving returns in almost all cases (Table 6). Table 6High Shrinkage Factors Lead To Better Risk-Adjusted Returns This result was also robust to using other types of expected return estimates. Table 7 shows that shrinking the correlation continued to either maintain or improve performance when using the momentum-based expected return inputs from the section above. Importantly, MVO portfolios using momentum-based returns and shrunk correlation with high shrinkage factors were able to beat the benchmarks at various metrics regardless of the type of portfolio. Table 7Momentum-Based Return Estimates Enhance Performance Solution #3: Constraining weights MVO often results in portfolios that have highly concentrated positions in one or two assets (Chart 4). Additionally, asset weights can experience dramatic changes, even when turnover limits are imposed. For several reasons this is not a desirable trait for most asset managers. Benchmarked managers in particular are often constrained in how much they can deviate from their benchmarks. Moreover, even if they do not have explicit deviation limits, benchmarked managers are often limited implicitly since they are evaluated on their tracking error. Chart 4MVO Weights Are Highly Concentrated One solution to the extreme weights problem is to limit the amount by which the weights can deviate from the benchmark. To test this hypothesis, we perform the optimization as described previously, using momentum-based return estimates and a shrunk correlation matrix, but we limit the amount by which weights can deviate from the benchmark weights by 10%. Table 8A shows the result of MVO portfolios with weight limits, as well the benchmark. Overall, constraining the amount of deviation from the benchmark weights resulted in significant performance improvements across every metric we tested on. Additionally, while the limited MVO portfolios did not always outperform the unconstrained MVO portfolios in terms of return, they were able to have much lower tracking risk and better information ratios, making them a better option for benchmarked investors (Table 8B). Finally, the constrained portfolios had much better-behaved asset weights than the unconstrained ones9 (Chart 5). Table 8APortfolios With Shrunk Correlation (80% Shrinkage Factor) & Momentum-Based Return Estimates Table 8BPortfolios With Shrunk Correlation (80% Shrinkage Factor) & Momentum-Based Return Estimates Chart 5Limited MVO Leads To More Realistic Assets Weights For Benchmarked Investors   Juan Correa Ossa, CFA  Associate Editor juanc@bcaresearch.com Footnotes 1  The origin of this phrase is often attributed to Don Quijote, the main character of the famous 17th century Spanish novel of the same name by Miguel de Cervantes. 2 Our sources are MSCI Inc (Please see copyright declaration), Bloomberg /Barclays Indices, National Association Of Real Estate Investment Trusts and Goldman Sachs via Datastream. 3 Our approach is loosely based on the work from Bessler, Opfer and Wolff. For more details, please see Wolfgang Bessler, Heiko Opfer, and Dominik Woff, “Multi-Asset Portfolio Optimization and Out-of-Sample Performance: An Evaluation of Black-Litterman, Mean-Variance, and Naïve Diversification Approaches”, European Journal of Finance, Vol. 23, no.1, 2017. 4 For the expected return of cash we just use the current cash yield, since this will be the return of cash with certainty. Volatility and correlation are calculated using historical estimates. 5 Please see De Miguel, Garlappi, Uppal, “Optimal Versus Naïve Diversification: How Inefficient is the 1/N Portfolio Strategy?”, The Review of Financial Studies, Vol. 22, no. 5, May 2009. 6 Please see Global Asset Allocation Report “Swimming With The Tide: Momentum Strategies In Financial Markets,” dated July 23 2019, available at gaa.bcaresearch.com 7 Specifically, if you need to build a portfolio of n assets, you need n estimates of expected returns, n estimates of variances but (n*(n-1))/2 estimates of asset correlations. 8 We use this method to compute the shrinkage target in our analysis since we have a balanced variety of assets (two risk assets, two fixed income assets, two real assets and cash). However, be advised that this shrinkage target might not always be appropriate. In general, judgement should be used to choose an appropriate shrinkage target. 9 In general, there might be other benefits to constraining asset weights. A recent paper by Pedersen et al showed that MVO tends to suffer due to taking large exposure in problematic portfolios that arise due to noise. Constraining MVO weights is a solution to control for this noise and keep the optimization from overweighting this problem portfolios. For more details please see Pedersen, Lasse Heje and Babu, Abhilash and Levine, Ari, “Enhanced Portfolio Optimization”, NYU Stern School of Business, 2020.