Geopolitics

Special Report

Highlights The US saves too much to achieve full employment but not enough to close the current account deficit. According to the “Swan diagram,” a weaker dollar would move the US economy closer to “external” and “internal” balance. Structural forces are unlikely to have much effect on the value of the dollar over the next few years: The neutral rate of interest is higher in the US than in most other developed economies; the US still earns more on its overseas assets than it pays on its liabilities; and there is no meaningful competition to the dollar’s reserve currency status. Cyclical forces, in contrast, will become more dollar-bearish over the coming months: A vaccine would buoy the global economy next year; interest rate differentials have moved sharply against the dollar; and further fiscal stimulus should lift US inflation expectations. Stocks tend to outperform bonds when the dollar is weakening. Investors should remain overweight global equities on a 12-month horizon, favoring non-US stocks and cyclical sectors. A Clash Of Views? Today marked the last day of BCA’s Annual Investment Conference, held virtually this year in light of the pandemic. As in past years, it was a star-studded cavalcade of the who’s who in financial and policymaking circles. I always find it interesting when two of our speakers seemingly disagree on a critical issue. Such was the case with Larry Summers and Stephen Roach. Larry kicked off the proceedings with an update of his secular stagnation thesis. He argued that his thesis had gone from “a hypothesis that needed to be considered” to a “presumptively accurate analysis of the status quo.” In Larry’s mind, the core problem facing the US and most other economies is a surplus of savings. Excess savings results in a chronic shortfall of spending relative to an economy’s productive capacity. Faced with the challenge of maintaining adequate employment, central banks have been forced to cut rates to extraordinarily low levels. Perpetually easy monetary policy has periodically spawned destabilizing asset bubbles. Larry recommends that governments ease fiscal policy in order to take the burden off central banks. Later that morning, we heard from Stephen Roach. Stephen expects the real US trade-weighted dollar to weaken by 35% by the end of next year. What’s behind this bearish forecast? The answer, according to Stephen, is that the US economy suffers from a shortage of savings. Unable to generate enough domestic savings to cover its investment needs, the US has ended up running persistent current account deficits. How can the US be saving too much, as Larry Summers claims, while also saving too little, as Stephen Roach insists? The two views seem utterly unreconcilable. In fact, I think there is a way to reconcile them with something called the Swan diagram. The Swan Diagram True to the reputation of economics as the dismal science, the Swan diagram – named after Australian economist Trevor Swan – depicts four “zones of economic unhappiness” (Chart 1). Each zone represents a different way in which an economy can deviate from “internal balance” (full employment and stable inflation) and “external balance” (a current account balance that is neither in deficit nor in surplus). Chart 1The Swan Diagram And The Four Zones Of Unhappiness The four zones are: 1) high unemployment and a current account deficit; 2) high unemployment and a current account surplus; 3) overheating and a current account deficit; and 4) overheating and a current account surplus. The horizontal axis of the Swan diagram depicts the budget deficit. A rightward movement along the horizontal axis corresponds to an easing of fiscal policy. The vertical axis depicts the real exchange rate. An upward movement along the vertical axis corresponds to a currency appreciation. The external balance schedule is downward sloping because an easing of fiscal policy raises aggregate demand (which boosts imports, resulting in a current account deficit). To restore the current account balance to its original level, the currency must weaken. A weaker currency will spur exports, while curbing imports. The internal balance schedule is upward sloping because an easing in fiscal policy must be offset by a stronger currency in order to keep the economy from overheating. The US presently finds itself in the top quadrant of the Swan diagram: It saves too much to achieve internal balance, but not enough to achieve external balance. From this perspective, both Larry Summers and Stephen Roach are correct. Unlike the US, the euro area, Japan, and China run current account surpluses. Rather than pursuing currency depreciation, the Swan diagram says that all three economies would be better off with more fiscal easing. What It Would Take To Eliminate The US Trade Deficit By how much would the real trade-weighted US dollar need to weaken to achieve external balance? According to the New York Fed, a 10% dollar depreciation raises export volumes by 3.5% after two years, while reducing import volumes by 1.6%.1 Given that exports and imports account for 12% and 15% of GDP, respectively, this implies that a 10% dollar depreciation would improve the trade balance by 0.12*0.035+0.15*0.016=0.7% of GDP. Considering that the trade deficit is around 3% of GDP, the dollar may need to weaken by 30%-to-50% to eliminate the trade deficit, a range which encompasses Stephen Roach’s projection for the dollar’s decline.  Don’t Hold Your Breath In practice, we doubt that the dollar will decline anywhere close to that much. Despite a net international investment position of negative 67% of GDP, the US still generates substantially more income from its overseas assets than it pays to service its liabilities (Chart 2). This reflects the fact that US foreign liabilities are skewed towards low-yielding government bonds, while its assets largely consist of higher-yielding equities and foreign direct investment (Chart 3). Chart 2The US Generates More Income From Its Overseas Assets Than It Pays On Its Liabilities Chart 3A Breakdown Of US Assets And Liabilities Given that the Fed will keep rates on hold at least until end-2023, it is unlikely that US government interest payments will rise substantially in the next few years. Faster Growth Helps Explain America’s Chronic Current Account Deficit The neutral rate of interest is higher in the US than in most other developed economies. Economic theory suggests that global capital will flow towards countries with higher interest rates, producing current account deficits (Chart 4).2 Chart 4Interest Rates And Current Account Balances The higher neutral rate in the US can be partly attributed to faster trend GDP growth. There are three reasons why faster growth will raise investment while lowering savings, thus leading to a current account deficit: Faster-growing economies require more investment spending to maintain an adequate capital stock. For example, if a country wants to maintain a capital stock-to-GDP ratio of 200% and is growing at 3% per year, it would need to invest (after depreciation) 6% of GDP. A country growing at 1% would need to invest only 2% of GDP. Governments may wish to run larger budget deficits in faster-growing economies in the belief that they will be able to outgrow their debt burdens. To the extent that faster growth may reflect productivity gains, households may choose to spend more and save less in anticipation of higher real incomes in the future. While trend growth is just one of several factors influencing the balance of payments, in general, the evidence does suggest that fast-growing developed economies such as the US and Australia have tended to run current account deficits, while slower-growing economies such as the euro area and Japan have generally run current account surpluses (Chart 5). Chart 5Fast-Growing Developed Economies Tend To Run Current Account Deficits, While Slower- Growing Economies Tend To Run Surpluses The Dollar’s Reserve Currency Status Is Not In Any Jeopardy Even if many commentators do tend to overstate the importance of having a reserve currency, the dollar’s special status in the global financial system will still provide it with support. The US dollar’s share of global central bank reserves stood at 61.3% in the second quarter of 2020, only modestly lower than where it was a decade ago (Chart 6). While the euro area is not at risk of collapse, it remains an artificial political entity. China’s role in the global economy continues to increase. However, the absence of an open capital account limits the yuan’s appeal. Chart 6The US Dollar’s Share Of Global Central Bank Reserves Has Barely Fallen Then there’s the dollar’s first mover advantage. During our conference, Marc Chandler likened the greenback to the QWERTY keyboard: It may not be perfect, but like it or not, it has become the default choice for typing.  I like to equate the dollar’s role with that of the English language. When a Swede has a business meeting with another Swede, they will speak in Swedish. However, when a Swede has a business meeting with an Indonesian, chances are they will speak in English. By the same token, when a Swede wants to purchase Indonesian rupiah, the bank is unlikely to convert krona directly to rupiah since the probability is low that many people will just happen to be looking to exchange rupiah for krona at precisely the same time. Rather, the bank will first convert the krona to US dollars and then convert the dollars to rupiah. The dollar is the hub of the global financial system. Just like the pound remained the global currency long after the sun had set on the British Empire, King Dollar will endure for many years to come. Cyclical Forces Will Drive The Dollar Lower Chart 7The Dollar Is A Countercyclical Currency The discussion above suggests that structural forces are unlikely to have much effect on the value of the dollar for the foreseeable future. Cyclical forces, in contrast, will become more dollar-bearish over the coming months. The US dollar is a countercyclical currency, meaning that it tends to move in the opposite direction of the global business cycle (Chart 7). According to the Good Judgment Project, there is a 43% chance that a Covid vaccine will be available by the first quarter of 2021, and a 91% chance it will be available by the end of the third quarter (Chart 8). A vaccine would supercharge global growth, causing the dollar to weaken.   Chart 8When Will A Vaccine Become Available? Interest rate differentials have moved considerably against the dollar – more so, in fact, than one would have expected based on the fairly modest depreciation that the greenback has experienced thus far (Chart 9). Chart 9A Relatively Muted Decline In The Dollar Given The Move In Real Yield Differentials Chart 10Stocks Tend To Outperform Bonds When The Dollar Is Weakening... As Do Non-US Stocks Versus US   An open question is how additional fiscal support will affect the dollar and other financial assets. Equity investors have brushed off the dwindling prospects for a pandemic relief bill before the election on the assumption that a “blue sweep” will allow the Biden administration to enact even more stimulus than was possible under President Trump and a Republican senate. The dollar rallied in the weeks following Donald Trump’s victory. The dollar also surged in the early 1980s after Ronald Reagan lowered taxes and raised military spending. A key difference between now and then is that real interest rates rose during both of those two prior episodes. Today, the Fed is firmly on hold. This implies that real rates are unlikely to rise much, and could even fall if inflation expectations move up in response to easier fiscal policy. Stocks tend to outperform bonds when the dollar is weakening (Chart 10). In particular, stock markets outside the US often do well in a soft-dollar environment. Investors should remain overweight equities on a 12-month horizon, favoring non-US stocks and cyclical sectors.   Peter Berezin Chief Global Strategist peterb@bcaresearch.com   Footnotes 1  Mary Amiti, and Tyler Bodine-Smith, “The Effect of the Strong Dollar on U.S. Growth,” Liberty Street Economics, (July 17, 2015). 2 There are many different ways to measure the neutral rate. As depicted in Chart 4, capital flows tend to equalize the neutral rate across countries. This is another way of saying that the neutral rate would be higher in the US were it not for the fact that the US runs a current account deficit.   Global Investment Strategy View Matrix Current MacroQuant Model Scores ​​​​​​​

Special Report

Highlights The US Senate election is as important as the presidency for US politics and markets. Our quantitative Senate election model suggests Democrats will win control – as we have long argued – but there is a 49% chance that they do not, which is higher than consensus. A Republican Senate under a Biden presidency is positive for US stocks relative to global. Corporate taxes will stay put. However, fiscal reflation will have to be earned through tough budget battles, which will raise hurdles for markets. The Democratic sweep scenario is generating excessive enthusiasm in the media, as taxes will rise, but it is ultimately reflationary. It will benefit global stocks more than US stocks. Feature Chart 1Democratic Sweep Favors Global Stocks Versus US Throughout the year we have argued that, as a base case for the US election, investors should expect that the pandemic, recession, and widespread social unrest in the United States would culminate in an anti-incumbent movement among voters. President Trump and the Republicans would lose the White House and Senate in a Democratic sweep. The implication for markets was that, after election volatility, global equities would rally in expectation of less hawkish US foreign and trade policy, while US equities would underperform on the expectation of higher taxes and regulation at home. This view has now become the market consensus (Chart 1). However, our quantitative US election model – which does not rely on head-to-head opinion polling – has recently given President Trump a 49% chance of winning in the latest reading. It is flagging a Biden victory but is essentially “too close to call” (Chart 2). The rapid snapback in the economy provides a basis for Trump to make an eleventh-hour comeback, contrary to optics. Chart 2Quant Model Shows Trump Loss, But 49% Odds Of Winning In this report we present our quant model for the US Senate election, updated for the 2020 cycle. The Senate model is constructed with similar variables, though not exactly the same, and the result is that Democrats are favored to win control but only slightly. The implication is that Democrats are currently overrated by markets and that the election could still go either way. Uncertainty will go up for the remainder of the month. Ultimately we are sticking with our original forecast unless Trump and the Republicans regain momentum in opinion polling, but our models are flagging major risk. Investors should expect volatility to rise in the short term. We will maintain our tactical risk-off trades, since the risk of a contested election and/or a Trump re-election (and hence renewed global trade war) is rising. The Foundations Of Our Senate Model BCA Geopolitical Strategy developed a US Senate election model in September 2018 which quantified the margin of victory for the GOP among several Senate races during the 2018 mid-term election. The beta model focused on modeling individual Senate races, those deemed competitive by BCA’s Geopolitical Strategy at the time, by combining state and national level economic and political variables as well as the latest polling data applicable to each race.1 We are now re-introducing this model, but with a twist: this time we are adopting the same methodology as per our US presidential election model. The result is a state-by-state model that predicts the number of seats the incumbent party will win in the Senate election on November 3, 2020. Like our US election model, our Senate model is based off a probit model that produces a probability that each state will remain under the control of the incumbent party. The dependent variable (classified as “elected”) is stated as 1 = incumbent party wins the Senate election in each state; or 0 = incumbent party does not win the Senate election in each state. This method allows us to measure the probability that a state with certain characteristics will fall into one of these two categories. Therefore we can predict the probability of the incumbent party winning all the Senate seats in each of the 50 states (though, of course, this is only relevant to the one-third of the states that have a Senate seat up for election in 2020). Our model would have predicted the past five Senate election outcomes correctly on an in-sample basis and the past four Senate elections on an out-sample basis. Unlike our presidential election model, which sampled nine elections (1984 to 2016), our sample size for the Senate model is notably larger. That is, our sample consists of 18 Senate elections (1984 to 2018), across 50 states, amounting to 900 observations. While midterm Senate elections are different from those held during a presidential election year, we would not want to exclude the information they provide. The 2018 Senate race has a bearing on our 2020 prediction and this is appropriate. The Senate Model’s Variables Our Senate model includes six explanatory variables: 1. The Federal Reserve Bank of Philadelphia State Coincident Index. The coincident index for each state combines four of the state’s indicators to summarize current economic conditions in a single statistic. The four indicators are nonfarm payroll employment; average hours worked in manufacturing by production workers; the unemployment rate; and wage and salary disbursements plus proprietors' income deflated by the consumer price index (U.S. city average). Like in our US Presidential model, we applied several transformations to the data to obtain meaningful results in the modeling process. We found that using a three-month change of the state coincident index in our Senate model provided the most statistically significant result. Our Senate model suggests that Republican odds of winning are underrated by online betting markets, as with our presidential model. The three-month change of all the monthly state coincident indexes are given heavier weight as we approach the Senate election early in November. However, we only include the preceding year of a Senate election up until September of the election year (i.e. the last data release in October prior to the election itself). Senate elections occur every two years, and we excluded data that has been accounted for in previous elections. As we highlighted in the update of our US Election model we assume that prevailing economic conditions matter most to voters (as future expectations inevitably affect people’s assessment of their current situation), and this bolsters our rationale in using a 3-month change of the state coincident index. 2. The incumbent party’s margin of victory in previous Senate elections in each state Senate race. This is measured as the incumbent party’s share of the popular vote minus the non-incumbent party’s share. If the incumbent party failed to secure a solid win in each state in the previous Senate election, the probability of securing a solid win in the current election becomes smaller. Moreover, the larger the margin of victory in a previous Senate election race, the more likely that incumbent party will win re-election in said state. 3. Net average approval level of the incumbent president in a Senate election year. This is the difference between the incumbent president’s approval and disapproval levels in a Senate election year, from the start of the year up until the end of October of that year – taken as an average. 4. Generic congressional ballot (net support rate). The generic congressional ballot asks people which party they are likely to vote for in Congress. We take the average net support rate in a Senate election year (that being whichever party leads the other in congressional ballot polling). Democrats are usually favored in congressional generic ballot voting, so the net rate is more predictive than the gross rate 5. Dummy variable for congressional ballot. A dummy variable is assigned to variable number four. For example, dummy takes the value of 1 when Democrats have a positive net support rate in generic congressional ballot voting, and 0 when Republicans have a net positive support rate. We assign only one dummy variable to avoid a dummy variable trap.2 6. A “time for change” variable, a categorical variable indicating whether the incumbent party has controlled the Senate for three or more terms (six or more years). If the Senate has been controlled by the incumbent party for three or more terms, the model will “punish” the incumbent party, as we would expect to see a change in control of the Senate the longer one incumbent party controls it. Estimating The Model Since this is a probit model, the coefficients cannot be directly interpreted like in an ordinary regression.3 In Table 1, the sign of the coefficient corresponds to the direction of change in probability. An increase in the State Coincident Index, the incumbent’s margin of victory in previous Senate races, net approval of the incumbent president and generic congressional support ballot, all increase the probability of the incumbent winning a Senate election in a state. Table 1Senate Model Regression Coefficients Meanwhile occupying the Senate for more than three terms serves as a “punishment” and would decrease the probability of winning a Senate election in a state. The output of our model is the probability of an incumbent win in each state. As in our US Presidential election model, there are two ways of aggregating these probabilities to produce a national-level outcome: Proportional: Allocate the number of Senate seats won by the incumbent proportionally to their probability of victory in each state, and then sum them up across all states. Winner Takes All: As we do in our US Presidential election model, assume a probability threshold of 50%: any state with an incumbent win that is at least 50% likely is fully assigned to the incumbent. The latter, winner takes all, is the aggregation method we base our Senate prediction on. Senate Election Model Prediction Table 2 shows our 2020 prediction. Overall, the Republican Party is expected to win 49 Senate seats, a decrease of four seats from its current 53-seat majority. This means that the Democrats are expected to control the Senate with 51 seats (this includes Independents that caucus with Democrats). Moreover, the model suggests that Republicans have a 49% chance of retaining Senate control. Table 2Predicted 2020 Senate Balance Of Power This is substantially higher than consensus, which has put Republicans at 42% throughout the past month and currently has them at 37% (Chart 3). As with our presidential model, the rapid recovery in the state economic indicators is providing the Republicans with a last-minute boost that contradicts the gloomier picture painted by opinion polls. We do not think they will retain the Senate, but our conviction level is now lower. Chart 3Betting Market Overrates Democratic Odds Of Winning Senate In terms of Senate seats, our model expects Republicans to lose Arizona, Colorado, Maine, Montana, and North Carolina. This is enough for Democrats to obtain 51 seats, a majority, assuming that they lose Alabama. The full list of states that have Senate races in 2020 and the probabilities of a Republican win according to the model are shown in Chart 4. Chart 4Quant Model Shows Democrats Win Senate, But GOP Odds 49% Three Senate races are classified as toss-ups, which we define as having a probability between 45% and 55% according to the model. These states are Iowa (54%), Maine (48%) and North Carolina (49%). Montana is close to a toss-up, with a 44% chance of a Republican win. We expect Democrats to win control of the Senate with 51 votes. They need 50, plus the White House, to have a majority. Of these states, if Republicans retain any two, then they will retain their majority, so control of the Senate is on a knife’s edge. Chart 5 shows the odds for each of the 12 swing states in this election. Chart 5Our Senate Odds Compared With The Bookies Bear in mind that only 50 seats are needed for the party that wins the White House, since the Vice President is also the President of the Senate and casts the tiebreaking vote. Senate Races Of Interest Our results show that the consensus is underestimating the Republicans, except in Michigan and Montana. The latter could affect overall control of the Senate. The same can be said for Maine, where the Republican challenger may be underrated (Chart 6). The trend of opinion polling in Chart 6 generally shows closer races than the betting markets expect. Our model supports the betting markets on the unlikelihood that Democrats will prevail in several deep red states. Chart 6US Senate Polling And The Betting Odds The presidential race should be the decisive factor. If voters in swing states are sufficiently motivated to vote out the sitting president that they chose only four years ago, which is uncommon in modern US history, then they will likely repudiate the senators who carried that president’s water through a whirlwind of scandals and controversies. Yet with the races so precariously balanced, small or local factors could also decide the outcome. This is an important limitation on our macro method. For example, it is not at all clear that Democrats will win Maine. Our model gives Republicans a 48% chance, while online gamblers put it at 27%. Susan Collins is well-entrenched, having survived again and again since 1996. If Democrats do poach Maine, it is still not clear that they will carry Iowa and Montana, which are more conservative yet saw Democratic victories in 2018. Our model suggests Montana will go Democratic and Iowa will stay Republican. Democrats must win one of these two states (or North Carolina) or they will not take the Senate. A feather could tip the scales. A feather may already be doing that in North Carolina, the other key toss-up state. Democratic candidate Cal Cunningham’s sex scandal has roiled the race. It is not yet clear that voters will abandon Cunningham (see Chart 6, panel 1), but that is likely unless there is an unstoppable Democratic wave.4 If North Carolina stays Republican as a result, then, according to our model, the US Senate would tie at 50-50 and the winner of the White House would turn the balance. Some Democrats have argued that deeper red states may be in contention, such as Georgia, South Carolina, Alaska, Kansas, or Kentucky. Of these, Kansas is notable since no candidate has an incumbent advantage. However, our model rules these races out of play and we tend to agree. Bottom Line: Our model suggests that Democrats will narrowly win control of the Senate as things stand today. With several races extremely close, a trivial event in a single state could turn the balance of power in the US Senate and hence the policy consequences of the entire US election. However, the close contest implies that the party that wins the White House will also win the Senate. Back Testing Our Model Our Senate model performs at an acceptable level during in-sample and out-sample back testing. For in-sample testing, we test our model over our entire sample period (1984 – 2018) and find that 72% of Senate elections (control of the Senate) are correctly predicted, with the model predicting the outcome of the last five Senate elections correctly (Chart 7). Chart 7In-Sample Back Testing Results During out-sample back testing, we look at a sample period of 2000 – 2018, comprising of ten Senate elections, where our model correctly predicts 69% of actual outcomes. The previous four Senate elections are predicted correctly (Chart 8). There is still a roughly 50/50 chance of divided US government in 2021-22. Chart 8Out-Sample Back Testing Results Investment Takeaways Our US Senate model is based off a similar methodology as our US Presidential election model. There are however some minor differences. First, we use a weighted maximum likelihood estimate as opposed to a traditional maximum likelihood estimate. This is because of unbalanced binary outcomes in our dependent variable (see Appendix). Chart 9Fair Chance Of Divided Government Still Secondly, not all our explanatory variables are the same. While we maintain using the State Coincident Index as our one and only economic variable, our suite of political variables has changed to be more geared towards predicting the Senate outcome. Our Senate model predicts Republicans will retain only 49 seats and lose control of the Senate. The Democrats will take control with 51 seats. And yet Republicans have a 49% chance of retaining Senate control. This is equivalent to saying that the race is “too close to call” – which is similar to our presidential model results. The reason is the rapid snapback in the economy. Subjectively, the risk is to the downside for Republicans given the President’s poor polling, particularly on his handling of the pandemic, and the high unemployment rate. The Senate outcome should be determined by the White House race, but obviously there is a fair chance that the winner of the White House still loses control of the Senate (Chart 9). Chart 10Wall Street Expects Divided Government Chart 11Trump Protectionism Good For The Dollar The stock market is behaving like it expects gridlock, rather than a Democratic sweep – the latter offering greater downside and lesser upside, at least judging by history (Chart 10). So let’s boil this all down to what we know with reasonable certainty: If Trump wins with a Republican Senate, he will still face opposition from House Democrats, so he will be driven to foreign and trade policy in his second term. Protectionism will affect not only China but also Europe and other economies. This is broadly positive for the dollar and US equities relative to global stocks and commodities (Chart 11). Government bond yields would be volatile due to the risk to the cyclical recovery from global trade war. If Biden wins in a Democratic sweep, economies other than China will benefit from lower trade risk and the US will benefit from higher odds of unfettered fiscal stimulus in 2021. But financial markets will simultaneously have to adjust for the negative shock to US corporate earnings from higher taxes and regulation. This outcome is broadly negative for the dollar and US equities relative to global equities and commodities. Government bond yields would rise on the generally reflationary agenda. If Biden wins without the Senate, the market has the most positive outcome of all: less trade war yet no new tax hikes. Both US and global equities would benefit. Bond prices and the dollar would trend downward over time, but not during the occasional fiscal battles that would ensue between the Democratic president and Republican senators.   Guy Russell Research Analyst GuyR@bcaresearch.com Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Statistical Appendix A notable property in our dependent variable data requires a brief discussion. Our dependent variable classified as “elected” takes the form of a binary outcome. This data, however, is what’s called “unbalanced,” since incumbent Senators are re-elected approximately 80% of the time. This means that most outcomes in our dependent variable are coded as “1,” with fewer “0’s” because of the strong incumbency effect in Senate races. There are many data sets that exhibit this type of property, such as events like wars, vetoes, cases of political activism, or epidemiological infections, where non-events occur rarely. To alleviate this statistical property in the data, we estimate our model using a weighted maximum likelihood estimate as opposed to the ordinary maximum likelihood estimate usually used in a probit regression.5 This method assigns more weighting to the unbalanced data, or what is known theoretically as “rare event” data, to aid the probit regression in assigning higher probabilities to “0” outcomes. Through this process, we effectively deal with our unbalanced dependent variable data. That said, in developing our quantitative US Senate Election Model, we estimated a suite of probit regressions with several other variables that were theoretically assumed to be relevant and subsequently tested empirically. In Appendix Table 1 below, we only include variables 1, 2, 3 and 6 from our listed variables (we excluded the generic congressional ballot and its corresponding dummy variable). This model suggests that Republicans will hold control of the Senate with 51 seats. Back testing this model revealed that 71% of past Senate elections were correctly predicted, while 67% were correctly predicted in out-sample testing. This is only slightly worse of a track record than our final model. If this model proves more accurate in the event, the implication is that the generic congressional ballot is an unreliable poll. Americans could be shy about stating their support for the Republican Party in the era of Trump. For this outcome, Republicans would only lose Arizona and Colorado. Critical swing states here are Montana (53%) and Arizona (45%). Appendix Table 1Alternative Senate Model Predictions A re-work of the above model, but with a variable that punishes Republicans for holding the Senate for six years or more on average, suggests that Republicans will only win 47 seats in the Senate, giving up six seats (Appendix Table 2). Forecast accuracy is slightly worse off, giving just 68% and 67% predictive accuracy during in and out-sample forecasting of previous Senate elections, respectively. Compared to our primary model, Republicans would lose Arizona, Colorado, Iowa, Maine, Montana, North Carolina and Alabama. Alabama (45%) is the only critical swing state. Appendix Table 2Alternative Senate Model Predictions Note: This report has been corrected since publication due to errors in charting. Charts 7 and 8 showed the correct majority party in historical Senate elections but mistakenly attributed to that party the minority party’s number of seats. The changes do not affect the text or the substance of the report: our quantitative model’s accuracy levels remain unchanged, as does the model’s performance relative to historical election results. Footnotes 1 The model was able to predict 14 out of 18 (77%) Senate races flagged as competitive by BCA’s Geopolitical Strategy. Florida, North Dakota, Indiana and Missouri were flagged as Democratic by our model but were won by Republican candidates. 2 A dummy variable trap is a scenario in which the independent variables are multicollinear — a scenario in which two or more variables are highly correlated; or, in simple terms, in which one variable can be predicted from the others. To avoid such a trap, we must exclude one of the categorical variables. Since there are two categorical variables that can be represented here (Republican or Democrat), we use k-1 (where k = the number of categorical variables). 3 The coefficients in a probit regression model measure the change in the Z-score associated to each independent variable for a one-unit change in that variable. 4 See Evie Fordham, "NC Democrat Cal Cunningham faces FEC complaint over California trip amid affair," Fox News, October 13, 2020, foxnews.com. 5 Weighted maximum likelihood estimation is a reasonable approach in dealing with dependent variables that show significant imbalance in their data set. See: King, G. and Zeng, L., 2001. Logistic regression in rare events data. Political analysis, 9(2), pp.137-163.

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

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

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

Highlights Three tail risks will continue to dominate the FX market narrative in the coming weeks: The upcoming November elections, Brexit, and the new wave of COVID-19 infections. As such, markets remain vulnerable in the near term and the dollar will continue to benefit from safe-haven flows. That said, most sentiment and technical indicators suggest the dollar is undergoing a countertrend bounce rather than entering a new bull market. Stay short USD/JPY as a core holding. Look to rebuy a basket of Scandinavian currencies versus the USD and EUR at a trigger point of -2%. Overall, the DXY should continue to face significant headwinds in the 94-96 zone, as we have witnessed recently. Feature US political risk remains the key “white swan” risk for currency markets. Unfortunately for investors, this week’s US presidential debate was full of theatrics and low on content. CNN polling showed that former Vice President Joe Biden was the preferred candidate going into the debate, and emerged as the interim winner. To be sure, the CNN polls are biased, with more contribution from Democratic voters compared to Republican ones. That said, it certainly helped that despite President Donald Trump’s constant jawboning, the former Vice President appeared unfazed and managed to slip in some of the key points of his political campaign. A Debate Post-Mortem Chart I-1The Dollar And Political Uncertainty The political theater is likely to continue in the coming days. In terms of timelines, we have the Vice-Presidential debate on October 7 and the second and third Presidential debates on October 15 and October 22. But the most important dilemma for currency markets is not whether we have a Democratic or Republican victory, but if the US becomes the source of political uncertainty compared to the rest of the world. For almost two decades, the most important political driver of the dollar was whether uncertainty in the US was rising or falling relative to the rest of the world (Chart I-1). As markets begin to digest the political outcomes, the ultimate conclusion could be dollar bearish. Let’s start with what is priced in. Political uncertainty in the US has surged relative to the rest of the world as mentioned above. Part of the reason is that betting markets now expect a “blue wave” (Chart I-2).  This was reinforced by the Presidential debates where former VP Biden was the preferred candidate (Chart I-3). A blue wave implies that Bidens wins the White House while Democrats gain control of the Senate, and retain the House. Chart I-2ABetting Markets Expect A Blue Wave Chart I-2BBetting Markets Expect A Blue Wave Chart I-3AFormer Vice President Joe Biden Was A Favorite Chart I-3BFormer Vice President Joe Biden Was A Favorite Such a victory will lead to massive fiscal stimulus, since Democratic leaders have been more aggressive in their demands for a greater government role in the economy. Bigger fiscal spending will lead to a higher US debt burden, widen the twin deficits and be only modestly positive for bond yields given that the Federal Reserve will anchor short term rates at zero. If US inflation takes off from increased aggregate demand, foreign bond investors are likely to continue fleeing the US market as real rates become even more negative, driving down the dollar in the process. Admittedly, there has been a small uptick in political uncertainty in the world relative to the US. President Donald Trump’s approval rating is closely correlated to the state of the economy and the US has been in a V-shaped recovery since the second quarter of this year. But as Chart I-2 shows, the probability of a Republican victory from betting markets has fallen recently. A Trump victory will ensure that the policies that have been favorable for markets since 2016 remain in place. Vice President Joe Biden’s hawkish tax policies, which he stuck with in the debate, will also be off the table. In terms of calculus, Senate Republicans may have to give in to more stimulus before the election to grease the wheels of the economy and support asset prices, which will otherwise fall and torpedo their chances. The most favorable outcome for markets could potentially be for Biden to clinch the White House and the Republicans to maintain control of the Senate. For one, it is likely that taxes will not go up as aggressively as Biden is proposing to raise them, while the likelihood of a global trade war will also fall. The dollar’s safe-haven bid will also fade, as capital starts to gravitate from the US towards other cheaper and beaten-up markets. What, then, are the bullish scenarios for the dollar? Chart I-4Swing State Wages Turning Up First, a failure to pass a stimulus bill will boost the dollar, hijack the recovery, and cause a setback to risk assets. Second, big swings in Trump’s approval ratings will raise the prospect of a contested election. According to our Chief Geopolitical Strategist Matt Gertken, his in-house quantitative election model now pins the probability of a Trump victory at almost 50%. Remarkably, Michigan has risen to the ranks of a toss-up state, as economic indicators have drastically improved. In a nutshell, a V-shaped recovery in wages for the swing states that voted for President Trump boost his chances (Chart I-4). However, these are likely short-term hiccups that will ultimately be resolved. The base case is still for a Democratic win, according to Matt. Either way, we will know who the US President is by December (or, worst case, by January) and a new fiscal bill is likely to be passed, regardless of who sits in the White House. Forward-looking financial markets, by then, will have stopped discounting political uncertainty as they currently are. Therefore, as we argued last week, we continue to pay heed to both sentiment and technical indicators that suggest the dollar is in a counter-trend bounce, rather than a renewed bull market.  What About The COVID-19 Saga? Unfortunately for markets, the US presidential election is not the only source of uncertainty. As we approach the winter season in the northern hemisphere, the potential for a new wave of infections is rising. As we approach the winter season in the northern hemisphere, the potential for a new wave of infections is rising. We are already in full lockdown in Montreal, Quebec, where BCA Research's headquarters are located. Around the G10, a second wave is taking hold in the euro area, UK, and Canada. Even Norway and Switzerland, which had managed to keep the virus under wraps for most of the summer, are seeing a resurgence in cases. Infection trends remain favorable in Australia, Japan, New Zealand, and Sweden, probably due to previous localized lockdowns in most of these countries (Chart I-5). Chart I-5A New COVID-19 Wave The most direct impact for currency markets is relative economic growth. For much of the summer months, the US was under siege from a second wave while the Eurozone, and many other countries, were well into their reopening phases. This affected currency markets (Chart I-6). Specifically, the dollar declined as economic momentum was higher outside the US. More recently, improving relative economic performance between the US and other G10 countries has been a key catalyst behind the dollar’s recent strength (Chart I-7). Chart I-6Rising US Cases And A Fiscal Logjam Chart I-7The Dollar And Relative Growth Going forward, the potential impact from COVID-19 is likely to be much less than what many economies endured for the first half of 2020. There are a few reasons for this. The virus has become less deadly, as mortality rates across many countries have come down. This could be due to a higher incidence of infections among younger people, who are also healthier, or due to the widespread wearing of masks, which has helped mitigate the viral load. Governments are unlikely to introduce the kind of widespread lockdowns we saw during the onset of the outbreak. More likely are localized lockdowns, such as what we are experiencing here in Quebec, and stringent rules on sanitation and social distancing.  We are closer to a vaccine than we were at the start of the year. According to Bio, an association of biotechnology and health care companies, there are currently 739 unique active compounds in development spanning the range from vaccines and antivirals to treatments for COVID-19. Almost 20 of these are in Phase 4 trial. Overall, there are 189 vaccines under trial, a big jump up from nil at the start of the year.  Chart I-8Lots Of Fiscal Stimulus In Canada The big risk is that governments fail to provide fiscal help to bridge economies until the widespread availability of a vaccine. However, outside the US, that does not appear to be the case. For example, during his Throne Speech last week, Canadian Prime Minister Justin Trudeau vowed to do “whatever it takes” to support people and businesses throughout the crisis. The Liberal government has just followed up with a C$10 billion infrastructure spending plan. Fitch Ratings estimates that the budget deficit in Canada will still remain wide going into 2022 (Chart I-8). In Australia, the Liberal-National coalition government has also been very proactive, especially with the “Job Seeker” and “Job Keeper” scheme, which has provided a valuable cushion for domestic economic conditions. The IMF estimates the fiscal thrust in Australia will be positive in 2021. In the euro area, there is still a 750 billion euro stimulus package to be deployed, while France announced a 100 billion euro plan last month. The bottom line is that while the pandemic is likely to induce more shockwaves into markets, spending gridlock appears to be concentrated within the US. At a minimum, this will limit any upside bounce in the dollar, since it will hurt US economic growth relative to its G-10 peers.  An Update On Brexit Chart I-9EUR/GBP Bets Are Lopsided As the pandemic returns in full force again in the UK, political uncertainty is also rising. Brussels is suing the UK on the new “internal market bill” that violates the Brexit withdrawal agreement. The key issue is still Northern Ireland. Last year, the agreement was that Ireland would remain bound to the EU’s customs and trade regime. The UK is seeking an amendment to be able to intervene, if there is “inconsistency or incompatibility with international or domestic law.” As we posited two weeks ago, it provided for UK discretion in state aid and the movement of goods to and from Northern Ireland, which the EU argues is a clear breach of the last year’s treaty. From the UK point of view, if there is no trade deal, why would it allow a division to emerge within its own national borders?    It is remarkable that despite the ramp up in tensions, the GBP/USD remains well bid above 1.28. Odds of a “hard” Brexit have usually been associated with cable near 1.20. This suggests two things: Either we are in a new paradigm, where the dollar is winning the “ugly contest,” or the market is underestimating the potential for a hard Brexit. Fitch estimates that the budget deficit in Canada will still remain wide going into 2022.  We subscribe to the former view. First, because the British government has nothing to gain from failing to agree to a trade deal, since the recession would only deepen, while it has much to lose, since the Scottish independence movement would likely gain steam. Second, risk reversals between cable and the euro are close to the post-referendum lows. This means that investors have already built significant put options on the pound, and call options on the euro (Chart I-9). Our base case remains that a deal will ultimately be reached. The UK side has a more resurgent pandemic to deal with, and will need to offer some concessions to ease economic volatility. Trade links between the two are also quite large.  In terms of targets, cable will trade between 1.35-1.40 over the next six months. In an optimistic scenario, the pound could go 20%-25% higher. The pound is also cheap versus the euro — another sign that the market is not underestimating the no-deal exit risk. Ergo, shorting EUR/GBP (or being long EUR/GBP volatility) should be a good short-term bet on an eventual resolution. Investment Implications We continue to advocate for a prudent strategy when trading foreign exchange markets over the next few weeks: Hold some portfolio protection. Our preferred vehicle is the Japanese yen, which is cheap, although the pricier Swiss franc also make sense. Focus on trades at the crosses. We are short the NZD/CAD and EUR/GBP as a play on relative fundamentals, but are also looking to buy EUR/CHF on weakness and sell CAD/NOK on strength. We will discuss our CAD strategy in the coming weeks. Buy Scandinavian currencies if they drop another 2% versus an equal weighted basket of the euro and USD (Chart I-10). We initially took profits on this trade a fortnight ago, booking solid gains. Stay short the gold/silver ratio but tighten stops to 84. Chart I-10The Scandinavian Currencies Remain Cheap   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data from the US have been mostly positive: The ISM Manufacturing PMI marginally declined from 56 to 55.4 in September. The new orders component slipped but remained elevated at 60.2. The Dallas Fed Manufacturing Index increased from 8 to 13.6 in September. The Chicago Manufacturing Index surged from 51.2 to 62.4 in September.  Durable goods orders increased by 0.4% month-on-month in August. Initial jobless claims increased by 837K for the week ending on September 25. The DXY index fell by 0.6% this week. Market uncertainty continues as the election draws closer and the number of COVID cases keeps rising. The New York Fed Staff Nowcast revised Q4 GDP downward to 5.05% from 7.28% earlier this month. While risks remain tilted to the downside, any positive news on a vaccine and stimulus could revive risk sentiment, which is negative for the US dollar. Report Links: The Message From Dollar Sentiment And Technical Indicators - Sept. 25, 2020 Addressing Client Questions - Sept. 4, 2020 A Simple Framework For Currencies - July 17, 2020 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data from the euro area have been mixed: The Economic Sentiment Indicator increased from 87.5 to 91.1 in September. The Producer Price Index declined by 2.5% year-on-year in August. The unemployment rate ticked slightly up from 8 to 8.1% in August. The euro rebounded by 0.7% against the US dollar this week. The latest EU Economic Sentiment Indicator suggests that the economy continues to recover, albeit at a slower speed than expected. The resurgence of COVID cases might also lead to downward revisions to the Q4 growth outlook, which could trigger further stimulus from the ECB. Report Links: Addressing Client Questions - September 4, 2020 On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Japanese Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data from Japan have been improving: Tokyo’s headline inflation declined from 0.3% to 0.2% year-on-year in September. Core inflation remained negative at -0.2% year-on-year.   Vehicle sales contracted by 15.6% year-on-year in September. August saw a contraction of -18.5%. Industrial production rose by 1.7% month-on-month in August, while construction orders surged by 28.5% year-on-year in August. The Japanese yen has been flat against the US dollar this week. Japan’s Q3 Tankan Survey released this Thursday suggests that manufacturers’ sentiment has improved for the first time in three years, showing signs of a recovery supported by pent-up demand. The Japanese yen remains our favorite safe-haven hedge. 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 from the UK have been positive: The current account deficit narrowed from £20.8 billion to £2.8 billion in Q2. Nationwide housing prices increased by 5% year-on-year in September. Mortgage approvals surged by 84.7K in August. The British pound appreciated by 0.3% against the US dollar this week. The chief economist from the BoE, Andy Haldane, downplayed the possibility of negative interest rates in the UK in a speech on Wednesday. According to the speech, current conditions don’t warrant any further lowering of interest rates, which is positive for the British pound. Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 A Few Trade Ideas - Sept. 27, 2019 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data from Australia have been positive: Building permits fell by 1.6% month-on-month in August, following a 12.2% surge in the previous month. On a year-on-year basis, the August figure grew by 0.6% compared to the same month last year. The AiG Manufacturing PMI slipped from 49.3 to 46.7 in September. However, the final Markit Manufacturing PMI ticked up from 53.6 to 55.4. The Australian dollar increased by 1.6% against the US dollar this week. COVID-19 cases in Australia remain at low levels. As such, the Aussie has benefitted tremendously from the reflation trade. We remain positive on the Aussie both at the crosses as well as versus the USD. Report Links: An Update On The Australian Dollar - September 18, 2020 On AUD And CNY - January 17, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data from New Zealand have been positive: Building permits increased by 0.3% month-on-month in August. The ANZ Business Confidence Index declined slightly from -26 to -28.5 in September, while the ANZ Activity Outlook Index improved from -9.9 to -5.4. The New Zealand dollar appreciated by 1.4% against the US dollar this week. While the New Zealand dollar might outperform the US dollar as the growth outlook improves, it remains likely to underperform at the crosses due to a more dovish RBNZ. Moreover, our FX model downgraded the kiwi to neutral for the month of October. Tactically, we are also short NZD/CAD. Report Links: Currencies And The Value-Versus-Growth Debate - July 10, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Place A Limit Sell On DXY At 100 - November 15, 2019 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data from Canada have been positive: GDP expanded by 3% month-on-month in July. Building permits increased by 1.7% month-on-month in August. The Bloomberg Nanos confidence Index slightly ticked up from 53.1 to 53.2 for the week ending on September 25. The Canadian dollar increased by 0.7% against the US dollar this week. According to Statistics Canada, the economy expanded for a third consecutive month in July as more sectors reopened in the summer. Notably, all 20 industrial sectors posted gains in July. We continue to favor the Canadian dollar against the US dollar and will discuss the loonie more in-depth in the coming weeks. Report Links: Currencies And The Value-Versus-Growth Debate - July 10, 2020 More On Competitive Devaluations, The CAD And The SEK - May 1, 2020 A New Paradigm For Petrocurrencies - April 10, 2020 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data from Switzerland have been mixed: The KOF Leading Indicator increased from 110.2 to 113.8 in September.  Headline inflation increased from -0.9% to -0.8% year-on-year in September but remains deep in negative territory. Real retail sales increased by 2.5% year-on-year in August. Total sight deposits increased from CHF 703.9 billion to CHF 704.5 billion for the week ending on September 25. The Swiss franc appreciated by 1% against the US dollar this week. The KOF survey highlighted that Switzerland is in a V-shaped recovery. However, deflation remains pervasive, suggesting a strong franc could torpedo the recovery. We continue to expect the SNB to step up the pace of intervention, and are buyers of EUR/CHF on weakness.  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 from Norway have been positive: Real retail sales expanded by 8.2% year-on-year, following a 13.8% surge the previous month.  The Norwegian krone rose by 2.2% against the US dollar this week. The latest data from Statistics Norway showed strength in retail sales across various categories, especially in household equipment, recreational goods, food and beverages. We remain NOK bulls based on our positive energy price outlook, the resilience in domestic demand and a less dovish central bank. Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 A New Paradigm For Petrocurrencies - April 10, 2020 Building A Protector Currency Portfolio - February 7, 2020 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data from Sweden have been positive: The Swedbank Manufacturing PMI increased from 53.4 to 55.3 in September. Retail sales grew by 3% year-on-year in August. Consumer confidence increased from 85.1 to 88.3 in September. The trade balance shifted from a surplus of SEK 4 billion to a deficit of 1.6 billion in August. The Swedish krona rebounded by 1.6% against the US dollar this week. We continue to like the Swedish krona along with the Norwegian krone. We are looking to purchase the Nordic basket again at a 2% discount relative to last week’s price levels. Stay tuned. Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019   Kelly Zhong Research Analyst Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

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