United States

Dear client, In lieu of our regular report next Friday, we will be sending you a special report on Australia next Tuesday, co-authored with our Global Fixed Income colleagues. We hope you will find the report insightful. Kind regards, Chester   Highlights Any tactical bounce in the dollar should be limited to 2-4%. A barbell strategy is the most attractive positioning in the next one to three months: a basket of the cheapest currencies and some safe havens. Remain short the gold/silver ratio. Feature Chart I-1Dollar Downside Hits Q1 Forecasts The market narrative towards the dollar is turning more bullish. Fundamental analysts point to the recent rise in US interest rates, relative to countries like Germany or the United Kingdom, as a serious cause for concern. A rules-based technical approach certainly warned that the dollar was getting much oversold last year, and the recent bounce is reinvigorating the possibility of a more powerful countertrend move. Being in the dollar-bearish camp, the key question is: how large could a potential dollar bounce be, and for how long can it last? According to Bloomberg forecasters, the dollar has already exhausted any potential decline penciled in for the first quarter of this year. Q1 consensus forecasts for the DXY index sit at 90, exactly where the index level rests today (Chart I-1). Bloomberg has consistently lowballed the level of the dollar since 2018, making the current forecast unduly bullish. This dovetails with recent market commentary that the decline in the dollar is largely done, and powerful catalysts for a countertrend move could take hold. Risks From The Reflation Trade Chart I-2A Stock Market Rout Could Derail The Dollar An equity market correction could be one of the potential catalysts that pushes the dollar higher. We showed last week that the dollar and the S&P 500 have had a near-perfect inverse correlation (Chart I-2). When a stock market and its currency exhibit an inverse correlation, it means that foreign investors have been hedging their equity purchases by selling the currency forward. This is not usually the norm (equity relative performance and currencies tend to move together), but was especially the case last year as inflows into US equities surged, but the dollar declined. Should any profit taking ensue, this will trigger a knee-jerk rally in the dollar, as forward shorts are closed. A few equity indicators warn that we could be at the cusp of such a counter-trend move:  The put/call ratio in the US is extremely depressed. This warns that positioning is lopsided and could easily topple the equity market rally. A rising put / call ratio has been synonymous with a higher dollar over the past few years (Chart I-3). This will be consistent with foreign investors unwinding their dollar hedges (as they take profits on equities) and/or safe-haven inflows into the dollar. Chart I-3Both Puts And The Dollar Offer Protection Cyclical stocks continue to outperform defensive ones of late, but the cracks are beginning to emerge, specifically in the industrials space. Industrials share prices have been relapsing of late (Chart I-4). The dollar tends to weaken when cyclical stocks are outperforming defensive ones, and vice versa. This is because non-US equity markets have a much higher concentration of cyclical stocks in their bourses. The huge correction in the relative performance of the global tech sector also warns that the tech-heavy US bourse might benefit from any bounce in tech equities. Global earnings revisions are heading higher, but the momentum of US earnings has regained the upper hand, especially relative to the euro area. Bottom-up analysts are usually too optimistic about the level of earnings, but are generally spot on about their direction. Relative earnings revisions between the US and other markets have led the dollar by about nine to 12 months (Chart I-5). Should cyclical earnings hit a soft patch as the pandemic engulfs much of the developing world, the more defensive US market might prove resilient. Chart I-4A Red Flag From Global Industrials Chart I-5Earnings Revisions And The Dollar In a nutshell, corrections in equity markets are usually a healthy reset for the bull market to resume. In similar fashion, a washing out of stale US dollar short positions will ensure the bear market for 2021 unfolds with higher conviction. A garden-variety 5-10% cyclical correction in the S&P 500 has usually coincided with a 2-4% bounce in the DXY, as can be seen from Chart I-2. This could be the story over the next one to three months. The Signal From Currency Markets Our dollar capitulation index hit a nadir in July last year and has since been rebounding from very oversold levels. It has been very rare that a drop in this index below the 1.5 level did not trigger a rebound in the dollar (Chart I-6). Part of the reason this did not happen this time around has been concentration. Dollar short positions since 2020 have mostly been against the euro, yen and Swiss franc, with positioning in currencies such as the Australian dollar and Mexican peso more neutral. This will limit the extent to which the broad dollar index could rise from a flushing out of stale shorts. Chart I-6BCA Dollar Capitulation Index Suggests Some Upside For example, the exchange rate that best signals whether we are in a reflationary/deflationary environment is the AUD/JPY rate. Since the Great Recession, the yen has been the best performer during equity drawdowns, while the Aussie has been the worst. As a result, the AUD/JPY cross has consistently tracked the drawdown of the broad equity market (Chart I-7). As the bottom panel shows, exuberance in the AUD/JPY cross has also coincided with equity market peaks.  That exuberance hardly exists today. The AUD/JPY cross has consistently tracked the drawdown of the broad equity market. That said, speculators are very short the dollar, even if the currencies used to implement these views are very concentrated. Sentiment towards the dollar is the lowest in over a decade and our intermediate-term indicator is at bombed-out levels (Chart I-8). Chart I-7AUD/JPY As A Risk On Gauge Chart I-8The Dollar Is Oversold In a nutshell, the message from technical indicators is that a bounce in the dollar is to be expected. However, the magnitude will be smaller than prior episodes. Ever since the dollar peaked in March 2020, counter-trend moves have been in the order of 2-3%. We expect this time to be no different.  The Dollar And Commodities Commodity prices across the board have been on a tear. This has usually been an environment where the dollar is in a broad-based decline. Commodity prices hold a special place as FX market indicators, since they are both driven by final demand and financial speculation. More importantly, rising commodity demand can signal an improving FX trend between commodity producing (Australia, Canada, Mexico, Colombia, Russia) and importing (Euro area, India, Turkey, or even China) countries. We will buy the currencies of commodity producers on weakness as the bull market continues. Metals prices have exploded higher on strong demand, especially from China (Chart I-9). Not surprisingly, speculative positioning in copper options and futures is also extremely elevated. If investors have been betting on higher copper prices, based on the expectation of a lower dollar, then a relapse in the red metal will be synonymous with a higher greenback. That said, commodity bull markets have tended to last over a decade, with the recent rise in prices also driven by deficient supply. As such, we will buy the currencies of commodity producers on weakness, rather than sell on strength, as the bull market continues. This also argues for a fleeting technical bounce in the dollar. Chart I-9A Bull Market In Metals Chart I-10The Gold/Silver Ratio is Rebounding Within the commodity space, watching the gold/silver ratio (GSR) is instructive. The GSR tends to track the US dollar (Chart I-10). This is because it has usually rallied on safe-haven demand and relapsed once there is a pickup in economic (or manufacturing) activity. Gold benefits from plentiful liquidity and very low real rates, while silver benefits from rising industrial demand. It is possible the surge in global infections dampens economic activity and lifts demand for safe havens. This will be good for the dollar. However, as vaccinations take hold and the economy reopens, silver will surge. Relative Interest Rates Interest rates are moving in favor of the dollar, and there has been a long-standing relationship between relative real rates and the US currency. The question is whether the rise in US interest rates has been sufficient to compensate investors for the higher budget deficits they will need to finance. To answer this, it is always instructive to look at the relationship between gold and US Treasuries. Remarkably, the ratio of the total return in US government bonds-to-gold prices has tracked the dollar pretty well since the end of the Bretton Woods system in the early 1970s.  The bond-to-gold ratio is an important signal for the dollar, since both US Treasuries and gold are safe-haven assets and thus, by definition, are competing assets (Chart I-11). The ratio of the US bond ETF (TLT)-to-gold (GLD) is an important proxy for investor sentiment on the dollar (Chart I-12). Ultimately, investors are driven by real rates. Positive real returns will favor Treasuries, while negative real returns will favor gold. The latter appears to have the upper hand for now. Remarkably, the ratio of the total return in US government bonds-to-gold prices has tracked the dollar pretty well since the end of the Bretton Woods system in the early 1970s. Chart I-11Gold and Treasurys Are Competing Assets Chart I-12Watch The Bond-To-Gold Ratio The implication is that the rise in US interest rates has not yet convinced investors that a significant margin of safety exists for possible runaway inflation. This augurs badly for the dollar, beyond the near term. Investment Implications Our investment strategy is simple: hold a basket of the cheapest currencies and, some safe havens that will benefit if the dollar bounces. Opportunities at the crosses also make sense. On safe-haven currencies, our preferred vehicle is the Japanese yen, which sports an attractive real rate relative to the US. Relative value is particularly attractive on short CAD/NOK, long AUD/NZD, short EUR/GBP and long EUR/CHF. Stick with them. Stay short USD/JPY and long the Scandinavian currencies as a core holding. Remain short the gold/silver ratio.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the US have been resilient: The headline 140K job loss last Friday was not as dire, looking into the details. There was a net two-month revision of +135K jobs. Core CPI came in line at 1.6% year-on-year, while average weekly earnings surged by 4.9%. MBA mortgage applications came in at a blockbuster 16.7% week-on-week, for the week ending on January 8. The DXY rose by 0.3% this week. There was some element of consolidation in markets earlier this week, with a few equity bourses softening and the dollar catching a bid. However, that has been overwhelmed by the reflation trade as we go to press. We expect any dollar bounce to be technical in nature, and in order of magnitude of around 2-4%.  Report Links: The Dollar In A Blue Wave - January 8, 2021 The Dollar Conundrum And Protection - November 6, 2020 The Dollar In A Market Reset - October 30, 2020 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data from the euro area have help up: The unemployment rate in the euro area fell from 8.4% to 8.3% in November. Sentix investor confidence remains resilient at 1.3 in January, versus -2.7 the previous month. Industrial production in the euro area is recovering, as signaled by the PMI releases. The euro fell by 0.5% against the US dollar this week. The unfolding political crisis in Italy warns that the euro might be due for a setback, as European peripheral bond spreads rise. We remain bullish the euro longer-term, but short-term trades are at risk from lopsided positioning.  Report Links: The Dollar Conundrum And Protection - November 6, 2020 Addressing Client Questions - September 4, 2020 On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 The Japanese Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data from Japan has been better than expected: The expectations component of the Eco Watchers Survey rose from 36.5 to 37.1, versus expectations of 30.5 in December. Machine tool orders continued to inflect higher in December, to the tune of 8.7% year-on-year. Bank lending remained around a robust 6% in December. The Japanese yen was flat against the US dollar this week. Japanese fixed income investors are in a quagmire, since nominal rates are better in the US, but real rates are more favorable in Japan. The yen could remain caught in a tug of war between these forces, with a slight advantage to Japanese rates. We remain long the yen as a portfolio hedge.   Report Links: The Dollar Conundrum And Protection - November 6, 2020 The Near-Term Bull Case For The Dollar - February 28, 2020 Building A Protector Currency Portfolio - February 7, 2020 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 There was scant data out of the UK this week: BRC like-for-like sales rose by 4.8% year-on-year in December. The British pound rose by 0.8% against the US dollar this week. Vaccinations continue to progress smoothly in the UK, but cracks are already starting to emerge in the post Brexit UK-EU relationship. There are mounting food shortages in Northern Ireland and a hiccup in fish exports from the UK, as the necessary paperwork adds a layer of bureaucracy. As investors digest the potential impact to the pound, it will add to volatility. Ultimately, a cheap pound should outperform both the dollar and euro. Report Links: The Dollar Conundrum And Protection - November 6, 2020 Revisiting Our High-Conviction Trades - September 11, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 There was little data out of Australia this week: The final retail sales print was 7.1% month-on-month in November. The Australian dollar appreciated by 0.4% against the US dollar this week. Base metals, especially copper and iron ore have been on a tear this year. This is boosting Australian terms of trade. More importantly, a shortage of ships has catapulted Asian LNG prices to all-time highs as a cold spell hits countries like Japan and Korea. This should be beneficial for Australian energy producers. We are currently long AUD/NZD. 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 There was scant data out of New Zealand this week: REINZ house sales rose by 36.6% year-on-year in December. Building permits rose 1.2% month-on-month in November. The New Zealand dollar fell by 0.3% against the US dollar this week. The release of the US WASDE report confirmed a looming agricultural shortage, as production forecasts were slashed on weather worries. This is NZD bullish. That said, technically, agricultural prices are stretched, and so some consolidation will deflate air off the high-flying kiwi. In a commodity basket, we prefer the Aussie that is underpinned by more structural factors. 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 disappointing: Employment fell by 62.6K jobs in December. However, this was driven by 99K part-time job losses, with full-time job gains of 36.5K. The sales outlook in the BoC survey improved from 39 to 48 in 4Q 2020. The Canadian dollar appreciated by 0.5% against the US dollar this week. Oil prices are dominating commodity gains this year, given the shift from Saudi Arabia and the prospect of higher transport demand. This bodes well for the loonie. 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 unemployment rate was flat at 3.4% in December. FX reserves increased from CHF 876 billion to CHF 891 billion. The Swiss franc fell by 0.2% against the US dollar this week. The biggest risk to Switzerland and the SNB authorities is a potential correction in the euro, which encourages safe-haven flows into the franc. This will also be a risk to our long EUR/CHF position. Our bias is that the valuation cushion on the cross provides an ample margin of safety. Report Links: The Dollar Conundrum And Protection - November 6, 2020 On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 The data out of Norway has been robust: Headline CPI came in at 1.4% year-on-year, while underlying CPI was a whopping 3%. House prices rose 2.9% quarter-on-quarter in Q4. Industrial production came in at -0.9% in November, an improvement from -2.7% the previous month. The Norwegian krone is the best performing currency this year at +1.5%. Good management of the COVID-19 situation as well as rising oil prices have been positive catalysts. We expect the krone to keep outperforming for the rest of the year. 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 has been rather disappointing: Private sector production fell by 1% year-on-year in November. We would expect this to reverse with the improvement in the December PMIs. Industrial orders rose 5.7% year-on-year in November. Household consumption fell 5% year-on-year in November. The Swedish krona has been the worst performing currency this year, falling by 0.7% against the US dollar this week. That said, it might be a case of profit taking. The Swedish krona remains cheap and should benefit from an upshot in the global manufacturing cycle. 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 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights In the wake of COVID-19, the low-probability, high-impact “Black Swan” event is as relevant as ever. Investors should already expect US terrorist incidents, a fourth Taiwan Strait crisis, and crises involving Turkey – these are no longer black swans. What if Russia had a color revolution, Japan confronted China, or Saudi Arabia collapsed? What if the US and China brokered a North Korean deal? Or a major terrorist attack caused government change in Germany? Ultimately this exercise illustrates what the market is not prepared for – a new rally in the US dollar – though some scenarios would fuel the rise of the euro and renminbi. Feature The COVID-19 pandemic reminded us all of the power of the “Black Swan” – the random, unpredictable event with massive ramifications. As historian Niall Ferguson pointed out at the BCA Conference last fall, COVID-19 was not really a black swan, as epidemiologists had predicted that a pandemic would occur and the world was not ready. Astrophysicist Martin Rees made a bet with psychologist and linguist Steven Pinker that “bioterror or bioerror will lead to one million casualties in a single event within a six month period starting no later than 31 December 2020.”1 Tellingly, countries neighboring China were the best prepared for the outbreak, having dealt with SARS and bird flu. COVID accelerated major trends building up throughout the past decade – notably the shift toward pro-active fiscal policy, which had been gaining traction in policy circles ever since the austerity debates of the early 2010s. In that sense forecasting is still necessary. If solid trends can be identified, then random shocks may simply reinforce them (Chart 1). Chart 1US Fiscal Stimulus About To Get Even Bigger In this year’s “Five Black Swans” report, we focus on geopolitical risks that are highly unlikely, not at all being discussed, and yet would have a major impact on financial markets. Domestic terrorist events in the United States in 2021 would not qualify as a black swan by this definition. A crisis in the Taiwan Strait, which we have warned about for several years, is now widely (and rightly) expected. Black Swan #1: A Color Revolution In Russia Russia is one of the losers of the US election. Not because Trump was a Russian agent – the Trump administration ended up authorizing a fairly hawkish posture toward Russia in eastern Europe – but rather because the Democratic Party threatens Russia with a strengthening of the trans-Atlantic alliance and a recovery of liberal democratic ideology. Geopolitical risk surrounding Russia is therefore elevated, as we argued last year. Both President Vladimir Putin and his government have seen their approval rating drop, a development that has often led Russia to lash out abroad (Chart 2). But our expectation of rising political risk within Russia’s sphere has been reinforced by Russia’s alleged poisoning of opposition politician Alexei Navalny and the eruption of pro-democracy protests in Belarus. Vladimir Putin is increasingly focusing on home affairs due to domestic instability worsened by the pandemic and recession. Fiscal and monetary austerity have weighed on the public. The largest protests since 2011 occurred in mid-2019 in opposition to the fixing of the Moscow municipal elections. This could be a harbinger of larger unrest around the Russian legislative elections on September 19, 2021. Nominal wage growth has collapsed and is scraping its 2015-16 lows (Chart 3). Chart 2Black Swan #1: A Color Revolution In Russia Chart 3Russia's Fiscal Austerity Meanwhile US policy toward Russia will become more confrontational. New US presidents always start with outreach to Russia, but the Democratic Party blames Russia for betraying the good faith of the Obama administration’s “diplomatic reset” from 2009-11. Russia invaded Ukraine and took Crimea in exchange for cooperating on the 2015 Iran nuclear deal. Adding in the Snowden affair, the 2016 election interference, and now the monumental SolarWinds cyberattack, the Democratic Party will want to strike back and reestablish deterrence against Russia’s asymmetrical warfare. While Biden will seek to negotiate an extension of the New START missile treaty from February 5, 2021 until 2026, he will gear up for confrontation in other areas. The US could seek to go on offense with Russia’s wonted tools: psychological warfare and cyberattacks. The Americans are not willing or able to attempt regime change in Moscow. That would be taken as an act of war among nuclear powers. But if Russia is less stable internally than it appears, then US meddling could hit a weak spot and set off a chain reaction. Even if the US is incapable of anything of the sort, Russia is still ripe for social unrest. Should the authorities mishandle it, it could metastasize. Russia has a long tradition of peasant uprisings – a descent into anarchy is not out of the question. The regime would not be devoting so much attention to suppressing domestic dissent if the conditions for it were not ripe.2 Putin’s constitutional reforms in mid-2020, which could extend his term until 2036, also speak to concerns about regime stability. A successful Russian uprising would threaten to raise serious instability in Europe and the world. When great but decadent empires are destabilized, political struggle can intensify rapidly and spill out to affect the neighbors. Bottom Line: Russian domestic political instability could produce a black swan. The ruble would tank and the US dollar would catch a bid against European currencies. Black Swan #2: A Major Terror Attack In Germany 2020 was a banner year for European solidarity. Brexit went forward but none of the European states have followed – nor would any want to follow given the political turmoil it aroused. Brussels initiated a recovery fund to combat the global pandemic that consisted of a mutual debt scheme – in what has been hailed somewhat excessively as a “Hamiltonian moment,” a move toward federalism. Germany stood at the center of this process. After opening the doors to a flood of migrants from Syria in 2015, Chancellor Angela Merkel suffered a blow to her popularity and was eventually forced to make plans for her exit. But she stuck to her core liberal policies and her fortunes have recovered (Chart 4). She is stepping down in 2021 as the longest-serving chancellor since Helmut Kohl and an influential European stateswoman. The EU member states are more integrated than ever while Germany has taken another step toward improving its international image. The public has rewarded the ruling coalition for its relatively competent handling of the global pandemic (Chart 5). Chart 4Black Swan #2: A Major Terror Attack In Germany Chart 5German People Happy With Their Government Merkel’s approval coincides with a recovery of the liberal democratic consensus in Europe after a series of challenges from anti-establishment and populist parties. Only in Italy did populists take power, and they were forced to back down from their extravagant fiscal policy demands while modifying their policy platform with regard to membership in the monetary union. Even today, as Italy’s ruling coalition comes apart at the seams, the risk of a populist backlash is lower than it was in most of the past decade. One of the main ways the European establishment neutralized the populist challenge was by tightening control over immigration and cracking down on terrorism (Charts 6 and 7). These two forces have played a large role in generating support for right wing parties, and these parties have declined in popularity as these two forces have abated. Chart 6Terrorist Attacks Have Fallen In Europe Chart 7Europeans Softening Toward Immigrants? Still, the risk posed by terrorist groups has not disappeared – and it is always possible that disaffected individuals could evade detection. French President Emmanuel Macron faced seven terrorist attacks over the past year, which partly stemmed over the commemoration of the Charlie Hebdo massacre but also points to the persistence of underground extremist networks (Chart 8).3 Chart 8French Fear Of Terrorism Has Increased Chart 9European Breakup Risk At Testing Point What would happen if a major attack occurred in Germany in 2021? Would it upset the country’s liberal consensus and fuel another surge in popular support for far-right parties like the Alternative for Germany? Only a major attack would have a lasting impact. A systemically important attack in the pivotal year of Merkel’s retirement could create more uncertainty in domestic German politics than has been seen since the 1990s and early 2000s. It is possible that an attack could strengthen the ruling coalition and the public’s desire to continue with the leadership of the Christian Democrats after Merkel. More likely, however, it would divide the conservative and right-wing parties among themselves. Merkel’s chosen successor, Defense Minister Annagret Kramp-Karrenbauer, was forced to abandon her bid for the chancellorship last year after members of her Christian Democratic Union in the state of Thuringia voted along with the anti-establishment Alternative for Germany to remove the state’s left-wing leader. The cooperation was minimal but it set off a firestorm by suggesting that Kramp-Karrenbauer was willing to work together with the far right.4 She bowed out and now the party is about to pick a new leader. The point is that if any event strengthens the far right, it would suck away votes from the Christian Democrats. The latter could also see divisions emerge with their Bavarian sister party, the Christian Social Union, which has differed on immigration in the past. Or the conservatives could alienate the median German voter by tacking too far to the right to preempt the anti-establishment vote (e.g. overreacting to the attack). Either way, German politics would be rocked. Ironically, if the coalition was seen as mishandling the response, a left-wing coalition of the Greens and the Social Democrats could be the beneficiaries. The risk of a government change – in the wake of Merkel and the pandemic – is greatly underrated, entirely aside from black swans. Nevertheless a major shock that strengthens the far right would be a black swan by forcing the question of whether the center-right is willing to cooperate with its fringe. If that occurred, then Europe would be stunned. If it did not, then the conservatives could lose the election and plunge into intra-party turmoil. The takeaway of a rightward shift on the back of any shock would be a renewed risk of fiscal hawkishness – a partial relapse from the past two years’ fiscal expansion to the more traditionally austere German posture. The takeaway of a leftward shift would be the opposite – a doubling down on that fiscal expansion. German hawkishness would increase the European breakup risk premium, while a confirmation of the new German dovishness would further suppress it (Chart 9). Bottom Line: The fiscal dovish turn is the more likely response to such a black swan in today’s climate, but a major terrorist attack could have unpredictable consequences. Black Swan #3: A US-China Deal On North Korea Critics misunderstood President Trump’s policy on North Korea. Trump’s policy – even his belligerent rhetoric – echoed that of Bill Clinton in the 1990s. The intention of the US show of force was to create an overwhelming threat that would force Pyongyang into serious negotiations toward a nuclear deal. That in turn would pave the way to economic cooperation. Trump’s efforts failed – Kim Jong Un stonewalled him in the final year and a half. Kim’s bet paid off since he avoided making major concessions and now Biden must start from scratch. Pyongyang has ramped up its threats and Kim has elevated his sister, Kim Yo Jong, to a higher standing in the party – apparently to lob attacks at South Korea full-time. Biden will put the technocrats and Korea experts in charge. Pyongyang may test nuclear weapons or launch intercontinental ballistic missiles to attract Biden’s attention. But Kim could also go straight to negotiations. Optimistically, a few years of talks could result in a phased reduction of sanctions in exchange for nuclear inspections. Kim has the incentive and the dictatorial powers to open up the economy and engage in market reforms while managing any backlash among the army. He has already prepared the ground by elevating economic policy to the level of military policy in the national program. For years he has allowed some market activity to little effect. The North must have suffered from the pandemic, as Kim publicly confessed to the failure of economic management at the latest party meeting. His country needs a vaccine for COVID. And if he intends to go the way of Vietnam, then he needs to open up the doors while a new global business cycle is beginning (Chart 10). The black swan would emerge if the Biden administration’s attempt to reboot relations with China produced a unified effort to force a resolution onto Kim. It is undeniable that Trump broke diplomatic ice by meeting with Kim directly, giving Biden the option of doing so quickly and with minimal controversy if he should so desire. Most importantly, China has enforced sanctions, if official statistics can be trusted (Chart 11). Beijing made no secret that it saw North Korea as an area of compromise to appease US anger. After all, success on the peninsula would remove the reason for the US to keep troops there. Chart 10Black Swan #3: A US-China Deal On North Korea Chart 11An Area Of US-China Cooperation Under Biden? The last point is the material point. If the North sought to open up, it would likely have to do so through talks with the US, China, South Korea, and Japan. Success would mean that US-China engagement is still effective. Bottom Line: A breakthrough on the Korean peninsula would mean that investors could begin imagining a future in which the US and China are not “destined for war” but rather capable of reviving their old cooperative approach. This has far-reaching positive implications, but most concretely the Korean won and Chinese renminbi would rally against the US dollar and Japanese yen on the historic reduction of war risk. Black Swan #4: Saudi Arabia (And Oil Prices) Collapse Saudi Arabia is an even greater loser from the US election than Russia. The Saudis came face to face with their geopolitical nightmare of US abandonment under the Obama administration, as the US gained energy independence while reaching out to Iran. The 2015 nuclear deal gave Iran a strategic boost and enabled it to resume pumping oil (Chart 12). The Saudis, like the Israelis, lobbied hard to stop the deal but failed. They threw their full support behind President Trump, who reciprocated, and now face the restoration of the Obama policy under Joe Biden. Chart 12Black Swan #4: Saudi Arabia (And Oil Prices) Collapse Chart 13Fiscal Pressure On Saudis Global investors should expect Biden to return to the nuclear deal with Iran as quickly as possible, notwithstanding Iran’s latest nuclear provocations, since the latter are designed to increase negotiating leverage. The Joint Comprehensive Plan of Action was an executive agreement that Biden could restore with the flick of his wrist, as long as Iranian President Hassan Rouhani returned to compliance. Rouhani can do so before a new president is inaugurated in August – he could secure his legacy at the cost of taking the blame for “dealing with the devil.” This would save the regime from further economic and social instability as it prepares for the all-important succession of the supreme leader in the coming years. A black swan would occur if this diplomatic situation led to a breakdown in support for Crown Prince Mohammed bin Salman (MBS). MBS, whose nickname is “reckless,” in part because his foreign policies have backfired, could attempt to derail or sabotage the US-Iran détente. If he tried and failed, the US could effectively abandon Saudi Arabia – energy self-sufficiency, public war-weariness, and Iranian détente would pave the way for the US to downgrade its commitment. This would create an existential risk for the kingdom, which depends on the US for national security. It could also be the final straw for MBS, who already faces opposition from elites who have been shoved aside and do not wish to see him ascend the throne in a few years’ time. A different trigger for the same black swan would be a collapse of the OPEC 2.0 oil cartel. The Saudis and Russians have fought two market-share wars over the past seven years. They could relapse into conflict in the face of shifting global dynamics, such as the green energy revolution, that disfavor oil. Arthur Budaghyan and Andrija Vesic, of BCA’s Emerging Markets Strategy, have argued that financial markets will start pricing in a higher probability of Saudi currency depreciation versus the US dollar in coming years. Lower-for-longer oil prices (say $40 per barrel average over next few years) would pose a dilemma to the authorities: either (1) cut fiscal spending further and tighten liquidity or (2) resort to local banks financing (money creation “out of thin air”) to sustain economic activity. The first scenario would impose severe fiscal austerity on the population (Chart 13), which is politically difficult to endure in the long run. The second scenario will lead to depleting the country’s FX reserves, robust money growth and some inflation culminating in downward pressure on the currency. The main reason for believing the devaluation will not happen is that it would topple the regime. Currency devaluation would result in unbearable inflation in a country that lacks domestic production and domestically sourced staples. But that is precisely why it is a black swan risk. After all, prolonged fiscal austerity may not be feasible either. Bottom Line: MBS controls the security forces and has consolidated power for years but that may not save him if his foreign policies led to American abandonment or a breakdown of the peg. Black Swan #5: A Sino-Japanese Crisis For the first time since 2016, we are not including US-China tensions over Taiwan in our list of black swans. A crisis in the strait is only a matter of time and the global news media is increasingly aware of it (Chart 14). It would not necessarily have to be a war or even a show of military force, though either are possible. A mere Chinese boycott or embargo of Taiwan would violate the US’s Taiwan Relations Act and trigger a US-China crisis from the get-go of the Biden administration. What is less widely recognized is that peaceful resolution of the China-Taiwan predicament is not just a concern for the United States. It is a concern for Japan and South Korea as well – whose vital supplies must travel around the island one way or another. These two nations would face constriction if mainland China reunified Taiwan by force – and therefore Beijing’s signals of increasing willingness to contemplate armed action are already reverberating among the neighbors. Japan sounded an uncharacteristically stark warning just last month. The hawkish statement from State Minister of Defense Yasuhide Nakayama is worth quoting at length: We are concerned China will expand its aggressive stance into areas other than Hong Kong. I think one of the next targets, or what everyone is worried about, is Taiwan … There’s a red line in Asia – China and Taiwan. How will Joe Biden in the White House react in any case if China crosses this red line? The United States is the leader of the democratic countries. I have a strong feeling to say: America, be strong!5 China and Japan have improved trade relations through the RCEP agreement, as Beijing looks to diversify from the United States. But China’s rise is of enormous strategic concern for Japanese policymakers. COVID-19 and the rollback of Hong Kong’s freedoms have made matters worse. The belt of sea and land around China – the “first island chain” – is the critical area from which Beijing seeks to expel American and foreign military presence. With China already having shown a willingness to clash with India and Australia simultaneously in 2020 – as it carves a sphere of influence in the absence of American pushback – it should be no surprise to see conflicts erupt in the East or South China Sea (Chart 15). Chart 14Differences In The Taiwan Strait Chart 15Black Swan #5: A Sino-Japanese Crisis In the aftermath of the last global crisis, in 2010, China and Japan clashed mightily over maritime-territorial disputes in the East China Sea. China imposed a brief embargo on exports of rare earth elements to Japan. The two clashed again the following year and tensions escalated dramatically when China rolled out an Air Defense Identification Zone (ADIZ) in 2013. Tense periods come and go and are often attended by mass anti-Japanese protests, as in 2005 and 2012. Usually these events are of passing importance, though they have the potential to escalate. What would truly be a black swan would be if Japan took the initiative to challenge China and test the Biden administration’s commitment to Japanese security. With the US internally divided and distracted, and China ascendant, Japan could grow increasingly insecure and seek to take precautions. China could see these as offensive. A new Sino-Japanese crisis could ensue that would catch investors by surprise. It is highly unlikely that Tokyo would provoke China – hence the black swan designation – but the effective absence of the Americans is a strategic liability that Tokyo may wish to resolve sooner rather than later. In this case the market reaction would be predictable – the yen would appreciate while the renminbi and Taiwanese dollar would fall. The risk-off period could be extended if the US failed to reinforce the Japanese alliance for fear of China, with the whole world watching. Bottom Line: Global investors would be blindsided if a sudden explosion of Sino-Japanese tensions prevented any US-China thaw and confirmed their worst fears about China’s economic decoupling from the West. Investment Takeaways This exercise in identifying black swans may be useful in at least one way: it exposes the vulnerability of financial markets to a sudden reversal of the US dollar’s weakening trend (Chart 16). The dollar would surge on broad Russian instability, Sino-Japanese conflict, or another exogenous geopolitical shock. This kind of dollar surprise would be much greater than a temporary counter-trend bounce, which our Foreign Exchange Strategist Chester Ntonifor fully expects. It would upset the financial community’s dollar-bearish consensus, with far-reaching ramifications for the global economy and financial markets. A rising dollar against the backdrop of a recovering global economy represents a de facto tightening of global financial conditions. Equity markets, for example, have only started to rotate away from the US and this trend would be reversed (Chart 17). Whereas further appreciation of the euro and the renminbi is not only expected but would support global reflation. Chart 16The USD Over Trump's Four Years Chart 17Global Market Cap Over Trump's Four Years There is a much plainer and straighter way to an upset of the dollar-bearish consensus. Rather than a black swan it is a “gray rhino,” the term that Michele Wucker uses for risks that are common, expected, and staring you right in the face.6 This would be the peak of China’s stimulus, which holds out the risk of a major reversal to the pro-cyclical global financial market rally in late 2021 (Chart 18). Chart 18China Impulse Will Linger In 2021, But EM Stocks Tactically Stretched It would be a colossal error if Beijing over-tightened monetary and fiscal policy in 2021 in the context of high debt, deflation, and unemployment (Chart 19). Chart 19Three Reasons China Will Avoid Over-Tightening (If It Can) Nevertheless the government’s renewed efforts to contain asset bubbles and credit excesses clearly increase the risk. Financial policy tightening is always a risky endeavor, as global policymakers routinely discover. Chart 20Book Profits But Stay Cyclically Positive On Reflation Trades We maintain that China’s major stimulus will have a lingering positive effects for the economy for most of this year and that the authorities will relax policy and regulation as needed to secure the recovery. The Central Economic Work Conference in December suggested that the Politburo still views downside economic risks as the most important. But this is a clear and present risk that will have to be monitored closely. Clearly the global reflation trend has extended to dangerous technical extremes over the past month on the realization that US fiscal stimulus will surprise to the upside. Therefore we are doing some housekeeping. We will book 31.1% profit on long cyber security, 16.7% on long US infrastructure, and 24.3% on long US materials. We will also book 9.5% gains on our long EM-ex-China equity trade, which has gone vertical (Chart 20).     Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1 Such epidemiologists include Michael Osterholm and Lawrence Brilliant. For Pinker and Rees, see George Eaton, "Steven Pinker interview: How does a liberal optimist handle a pandemic?" The New Statesman, July 22, 2020, newstatesman.com. 2 Thomas Grove, "New Russian Security Force Will Answer To Vladimir Putin," Wall Street Journal, April 24, 2016, wsj.com. 3 Elaine Ganley, "Grisly beheading of teacher in terror attack rattles France," Associated Press, October 16, 2020, apnews.com. 4 Philip Oltermann, "German politician elected with help from far right to step down," The Guardian, February 6, 2020, theguardian.com. 5 Ju-min Park, "Japan official, calling Taiwan ‘red line,’ urges Biden to ‘be strong,’" Reuters, December 25, 2020, reuters.com. 6 See www.wucker.com.

There is little good news left that the market can discount to push the SPX higher through the multiple expansion pathway. This implies that earnings will have to do the heavy lifting and pull the SPX higher. The near all-time high 23x forward P/E multiple-implied SPX level will remain a bar hard to surpass and, similar to last summer when the market discounted the second wave of infections, it will face stiff resistance. We are already cautious on the near-term equity market prospects and would also recommend investors fade any overshoots above the 23 handle on the forward P/E level as the risk/reward ratio will be skewed to the downside (top & third panels). Tuesday’s Insight drew parallels with 2009-2010, and today we continue the analogy further and disaggregate the SPX return into its two components: forward P/E and “E”. Importantly the 2009-2010 episode is a close resemblance to today (third & bottom panels). The forward P/E similarity is especially striking. In fact, in order for the SPX to continue cyclically grinding higher to reach our end-2021 target of about 4,000, a repeat of 2010 is required when the forward multiple passed the baton to profits (see the second chart on the next page). Bottom Line: Lofty valuations add to our near-term cautious broad equity market view. Stay tuned.  

Highlights Structural reform is coming to the US in the wake of the riotous 2020 election cycle. Extreme levels of political polarization will subside, albeit remaining relatively elevated. This will smooth the way to a more proactive fiscal policy that secures the economic recovery. The Biden administration has enough political capital to pass large fiscal stimulus, an expansion of Obamacare, and an increase of taxes, regulations, and the minimum wage. The Republican Party will go into the political wilderness – and it may not recover from its internal struggle in time for the 2022-24 elections. Moderate Republicans will assist in passing legislation. Stay cyclically long stocks over bonds, cyclicals over defensives, and value over growth, but introduce tactical hedges. Go long VIX.  Feature Structural reform is coming to the United States in the wake of the riotous 2020 election cycle. The incoming administration of President-elect Joe Biden will usher in a stabilization of US politics by means of a substantial increase in fiscal support for the economy. This provides a backstop for the recovery that, combined with the ultra-accommodative Federal Reserve, suggests investors should keep an optimistic attitude toward risk assets over the coming 12 months, despite the inevitable ups and downs (Chart 1). Biden and the establishment politicians of both parties are beset by rising forces of populism on the right and left. They likely recognize that their political survival, as well as the country’s stability, depends on maintaining the recovery. The soon-to-be ruling Democratic Party narrowly obtained the majorities necessary to pass at least a few major laws. Chart 1Biden's First 100 Days Triggers Brief Pullback The change in political leadership will be beneficial for the middle class household but  less so for Big Business and corporate earnings. The US faces a rocky historical transition toward larger government involvement in the economy, more restrictions on private enterprise, and more redistribution of wealth. Labor is taking up a larger share of national income, as opposed to capital – a big shift away from the trend of the past 40 years (Chart 2). That period was extremely friendly to equity investors. The future will be trickier, though for the time being the market is pricing the good news. Chart 2Labor Makes A Comeback Versus Capital In this report we lay down our three key views for 2021: Peak Polarization – US political polarization is at extreme levels and though it will subside in the wake of the feverish 2020 cycle, it will remain elevated in the coming years. There will be aftershocks from the past year’s crises. Extremism and political violence will continue to flare up with the possibility of domestic terrorist incidents. The market impact of this trend is inherent in the Democratic victory in the White House and Congress, but the Biden administration’s political capital will increase upon any major shocks stemming from extreme polarization. Bipartisan Structural Reform – Investors should expect a flurry of legislation. The Democrats will be anxious to reward their base and consolidate power. Moderate Republicans will assist on some votes. New taxes and spending, a higher federal minimum wage, a larger safety net (e.g. healthcare), and administrative reforms will all ensue. Republicans In The Wilderness – The Republican Party is hereby exiled into the political wilderness to settle its internal struggle over Trumpism. The Party of Lincoln will somehow survive but it may not recover by 2024. Below we explain these views, what would undermine them, and what they mean for investors over the next 12 months and beyond. View #1: Peak Polarization US political polarization hit extreme levels over the past year according to various measures (Chart 3). Polarization will retreat as a result of Biden’s victory over Trump – Biden will have a higher approval rating, both generally and among the opposite party, than Trump did. But it will remain elevated relative to history. Structural drivers of polarization, such as wealth and racial inequality, congressional gerrymandering, and regional disparities, remain unaddressed. It will take time to reduce them. Hence, US social and political instability will continue in 2021. Most of this will be noise but some of it will not. Chart 3Polarization At Extremes Chart 4Terrorism On The Rise In The USThere will be aftershocks in the wake of the Trump rebellion on January 6 and the House Democrats’ decision to impeach him for a second time. A massive show of force will attend Biden’s inauguration, but extremism and political violence of various kinds have been flaring in recent years and will persist for some time (Chart 4). Both the FBI and the Department of Homeland Security have warned of a rise in domestic extremism and terrorism. Increased political instability creates fertile ground for malign actors of all stripes to operate, including domestic or foreign saboteurs. At a critical juncture in the nation’s politics like today, a major attack could wreak more panic and uncertainty than otherwise would be the case. The past year of unrest shows that the bar is high for markets to respond to passing political events. But a major crisis event that has systemic importance cannot be ruled out in today’s precarious environment. In the event of a major domestic terrorist incident, such as the 1995 Oklahoma City bombing, the vast majority of the public would react with utter revulsion and rally around the flag (Chart 5), while the federal counterterrorism response would be overwhelming, just as it was in the 1990s. Chart 5OKC Bombing Spurred Rally Round The Flag The market impact of such an attack would be fleeting. Other domestic incidents bear this out, such as the Waco siege (1993), the Olympic Park bombing in Atlanta (1996), the Charleston church massacre (2015), and the shooting of Republican lawmakers in 2017 (Chart 6). This point is intuitive given the extensive rioting and unrest in 2020 yet the fall of market volatility throughout the year. Yet the past year’s social and political instability does have major investment implications. It has led to full Democratic control of Congress and the White House on an agenda of fiscal expansion and wealth redistribution. Chart 6Market Largely Ignores Domestic Terrorism What About Long-Term Effects? With the government supporting the economy, it is less likely that the US will experience a drastic backslide into even greater social instability in the coming years. On the contrary, a more proactive fiscal policy, with more robust social safety nets in terms of health, unemployment, child care, and old age, means that social stability should improve (Chart 7). If the material wellbeing of the country fails to improve, or if exogenous events further destabilize the US, then the social and political environment will deteriorate further. But we would expect that 2021 will see the US secure the recovery and begin to restore order, at least temporarily. Longer term stabilization will require a succession of improvements that span administrations.  Chart 7Better Social Safety Net Could Reduce Deaths Of Despair Bottom Line: The Biden administration’s political support will increase if there are any major attacks and that support will be used to restore order. The market ramifications of any such response are already known: expansive, proactive fiscal policy to stabilize the economy and society and thus reduce the odds of greater division and radicalization. This kind of stabilization is positive for risk assets over a 12-month horizon. View #2: Bipartisan Structural Reform Investors should bet on a flurry of legislation from the Democrats (Table 1). They will be anxious to reward their base, consolidate power, and restore the political establishment to a position of primacy. They will be determined to act quickly, remembering how the 2010 midterms stymied their agenda after winning a blue sweep in the wake of the last major national crisis. Table 1Biden’s Priority? Stimulus … And More Stimulus Not only do Democrats control Congress but also Republicans are divided – by their loss of the Senate and by Trump’s rebellion. Over the coming year, moderate Republicans will be much more likely to vote with Democrats than the latter will be to defect from their party, especially on popular legislation such as economic stimulus (Chart 8). Chart 8Biden’s Priority? Stimulus … And More Stimulus If Republicans prove obstructionist then we would not rule out the Democrats mustering the votes to remove the Senate filibuster. But in the current climate, several moderate Republicans, such as Alaska Senator Lisa Murkowski, Pennsylvania Senator Pat Toomey, and Utah Senator Mitt Romney, are looking to distance themselves from Trump and Trumpism. Opposition to government spending has lost a lot of steam in US politics. The populist Republicans are increasingly willing to accept large spending to ease burdens on their voter base. Trump was a big spender, and the Republicans passed large spending bills during his term. Republicans have supported large household rebates as a COVID relief measure, as our Global Investment Strategy points out. These include prominent Senators like Lindsey Graham of South Carolina as well as presidential hopefuls like Marco Rubio of Florida and Josh Hawley of Missouri. Granted, desperate times call for desperate measures – Republican fiscal hawkishness will return now that the party is in the opposition. But there can be little doubt that Republican fiscal discipline has eroded given that both populists and moderates have loosened their standards. Austerity will not have as much support in the 2020s as it did after 2008. There is no chance that Democrats and Republicans will agree on a 2011-style Budget Control Act in the near future. The budget deficit will normalize albeit at a higher level than before the crisis (Chart 9). Chart 9Budget Deficit: Larger For Longer Democrats are guaranteed to drive a big spending agenda through Congress. They have the votes, the popular support, and the lingering COVID crisis as added impetus. The voting record of the Obama administration reinforces the high likelihood of Democratic unity as well as moderate GOP support (Chart 10). Chart 10Obama Era Shows Democrats Will Pass Legislation What About Tax Hikes? Congress will also raise taxes sooner or later. The party is united on the need to tackle economic inequality. There is no clear relationship between marginal tax rates and economic growth, capital spending, or productivity, according to our US Investment Strategist Doug Peta. If anything a positive correlation exists between corporate tax rates and economic growth, suggesting the right time to increase taxes is when the economy has recovered from recession or is otherwise in full stride (Chart 11). Nevertheless it is intuitive that a big tax hike could weigh on growth when it is first rolled out. Chart 11A Growing Economy Enables Tax Hikes So there is a good basis for the Biden administration to delay raising taxes until the recovery is secure. However, taxes will go up sooner or later (Chart 12). Chart 12Corporate Tax Rate Will Rise Sooner Or Later But The Economy Can Power Through It Taxes must rise to pay for new spending and, in the Democratic Party’s view, redress inequality. The use of the budget reconciliation procedure to pass laws with a simple majority in the Senate will necessarily require revenue offsets over a ten-year window to pay for new spending. The Trump tax cuts were never very popular to begin with, so the political blowback is manageable (Chart 13). Any delay would be temporary and thus its positive effects would be counteracted by the expectations of firms and investors. Passing tax hikes in 2021 enables COVID to serve as a pretext for a larger round of spending increases than would otherwise be possible to offset the new tax burden. Taxes can be passed in 2021 but not take effect until 2022. That might prevent the full impact from hitting ahead of midterm elections that year. Democrats hope to pick up two seats in the Senate, bringing their majority to 52-48 and bringing the more controversial parts of their agenda within reach. Chart 13Trump Tax Cuts Were Never Very Popular Note also that the Biden administration aims only partially to repeal the Trump tax cuts. The new corporate tax rate will rise to no more than 28%, which is still seven percentage points lower than Trump found it in 2016. Nor is Biden projecting a higher top marginal individual rate than the 39.6% that prevailed before Trump. The minimum corporate tax rate of 15% will bring a bigger negative impact for firms but it will be politically popular. There could also be a financial transactions tax, which Biden has said he supports. All of this is achievable with Senate control (Table 2). Table 2Biden’s Fiscal Agenda Investors should expect an early hit to earnings expectations. There will be an earnings hit from the simultaneous increase in taxes, regulations, and the doubling of the minimum wage to $15 per hour. Moreover investors need to price in more than Biden’s agenda. They need to price in a broader shift in US policy to redistribute wealth from capital to labor. Firms will face a new paradigm that is less corporate-friendly and laissez faire, at least until the Republican Party recovers and offers a viable alternative. And as discussed below, that could take a while. Bottom Line: The Biden administration will pass big new increases in spending and taxation as well as minimum wages and a slew of new regulations on labor and the environment. The shift to a fiscally proactive US government, at a time when the Fed is ultra-dovish, will ensure that the positive market reaction continues for the most part of the coming 12 months. But sooner or later markets will have to discount a generally more intrusive government that will reduce profit margins. View #3: Republicans In The Wilderness The Republican Party will go into the political wilderness in 2021, where it faces an internal struggle over how to deal with Trump and Trumpism. In the short run this means Republicans will not be well organized to oppose the Biden administration. In the long run, the outcome of this internal struggle will have a historic impact on the overall US policy outlook. Trump has become the first president to be impeached twice. There are eight days until Biden’s inauguration at noon on January 20. The Senate, still led by Republicans, has scheduled the trial to take place after that time, but it may still be relevant. If Trump is tried and convicted, which requires a two-thirds vote, then he could be disqualified from holding any future office on a simple majority vote. Otherwise, Congress could censure him, which would be merely symbolic. The Democrats hope to force Republicans to go on the record after Trump’s interference with the peaceful transfer of power to force them either to break with their party or wear the Trump albatross forevermore. Republican senators are not as reliable for Trump in any new impeachment as in the first one. A vote to remove, disqualify, or censure him would enable them to wash their hands of his actions. This could be useful for swing state moderates. The problem for the GOP is that it is still beholden to Trump, who generated large voter turnout and won 47% of the national vote, despite a pandemic and recession. Trump has left the party in better condition, in terms of seats, than his predecessor George Bush did (Chart 14). If he leaves the GOP and starts his own party, he could bring anywhere from one-third to half of Republican voters with him and thus hobble the party semi-permanently (Chart 15). It has happened before in US history.1 Chart 14GOP Still Fairly Strong In Congress, State Capitol Chart 15If Trump Leaves, He Could Take One-Third To Half Of GOP Voters A high-stakes negotiation will have to be held in a smoke-filled back room. Trump wants the 2024 nomination; the GOP wants his base. A solution would involve the GOP exculpating Trump yet again while he shepherds his base over to a successor within the party. But there is deep distrust. Trump was never a normal Republican and now he is even at odds with Vice President Mike Pence, Senate Leader Mitch McConnell, and his former chief of staff Mick Mulvaney. The party is losing donors over Trump’s actions, as companies withdraw support in the name of democracy. Moderate lawmakers and high-profile Republicans are trying to sever ties with Trump and considering leaving the party. If Republicans convince Trump to put away his 2024 aspirations and support the party, they may recuperate fairly quickly, on a populist basis. If they cannot, then the party may split, whether formally or informally, and hand the Democrats a decade-long ascendancy in US politics. Trump has shown that his base is too small to win against a fully mobilized Democratic-led political establishment. But without his base the Republicans definitely cannot win. The Republican Party will thus experience varying degrees of fracture in 2021. So far, Trump says he will run in 2024 and there is no reason to doubt him. But this is moot if the Senate agrees to impeach. This means the party is almost guaranteed to suffer a lasting split that will undermine its prospects in 2022, which would normally be fairly strong, and set up a bloody primary election in 2024. If this is the path the party embarks on in 2021, then investors should expect the Biden administration to be more effective than its narrow majorities suggest in passing legislation. Bottom Line: The Republican Party will suffer a deep fissure, or split entirely apart, depending on President Trump’s actions in the coming years. The implication is that the GOP opposition will be mostly ineffective in Washington in 2021. Moderate senators will be liable to vote with the Democratic majority on major bills. This is especially true of bills relating to COVID relief, economic stimulus, health care, or administrative reform to prevent 2020 election debacles from happening again. Investment Takeaways US equity markets and risk assets will eventually suffer a correction when the market comes to grips with the Biden administration’s capabilities and the looming rise in taxes, regulations, and wages. A stock market drop around Biden’s inauguration and first 100 days would fit the pattern of new “sweep” governments with single-party control. Timing is always tricky especially because the market is exuberant about the combination of larger fiscal and monetary stimulus. Stock prices are technically extended, expensive, and vulnerable to a negative growth surprise, but we would be buyers amid an equity pullback as the policy and macro fundamentals remain supportive. We are bullish over the 12-month horizon, especially in the first half. We are long stocks, the stock-to-bond ratio, value over growth, infrastructure plays, and reflation plays. Fiscal spending will go up quickly with new legislation, whereas tax hikes could be delayed. The implication is that the deficit will get larger and the yield curve will steepen, which is beneficial for cyclical and value plays. When tax hikes come into focus – which we expect to be soon – the tech sector will be the first casualty. We are long materials relative to Big Tech and would also be constructive toward energy relative to tech. The sectors that face the greatest policy risks under the Biden administration – health care, energy, financials – are also the ones best positioned to capitalize on the fresh burst of policy reflation, especially the latter two.   Big Pharma and the health insurers clearly face higher policy and regulatory risks. We recommend going tactically short S&P managed health care relative to the broad market. Consumers stand to benefit from stimulus measures that add to their already formidable pile of savings and provide more robust safety nets. Consumer discretionary stocks will also benefit from the normalization of the economy. Thus we view consumer plays favorably in general and recommend going long consumer staples as a tactical hedge.     As another tactical hedge we recommend going long volatility (VIX).   Several clients have asked about the drop in Twitter’s share prices upon its announcement that President Trump would be permanently removed from the platform. In general, we expect a drop in polarization to coincide with a drop in tech outperformance (Chart 16). The reason is that a slight increase in bipartisanship will result in fewer fiscal cliffs and policy-induced shocks, thus helping inflation expectations recover. This will benefit value stocks more so than growth. The Biden administration is allied with Big Tech but the threats to this sector are sprouting up in both political parties and from every direction – from anti-trust authorities, state-level governments, privacy advocates, free speech advocates, foreign tax authorities and regulators, and unions. We will discuss the latest controversies regarding Big Tech and free speech/press in future reports but for now suffice it to say that the macro and policy landscape is shifting against Big Tech. The big five tech firms may still see their stock prices rise but they will underperform the other 495 companies on the S&P. Chart 16Polarization And Tech Go Hand-In-Hand   Matt Gertken Vice President US Political Strategy mattg@bcaresearch.com     Appendix Table A1Biden’s Cabinet Position Appointments   Footnotes 1     Namely in the 1912 election when Theodore Roosevelt left the Republican Party and started the progressive “Bull Moose” party, costing incumbent President William Howard Taft the election versus Democratic challenger Woodrow Wilson. One could loosely interpret Texan Ross Perot’s presidential runs in 1992 and 1996 in a similar vein, and perhaps that would be more applicable to any future independent run by President Trump.  

Overconcentration of returns in a handful of stocks has been an overarching theme in a number of our 2020 publications. For instance, we separated the SPX in the S&P 5 vs. the S&P 495 in late-July, and showed how a handful of tech titan stocks dominated S&P 500 returns, especially since 2015. Roughly a month later these tech stocks peaked, and the normalization process began (top panel). It is remarkable that the S&P 5 are down in absolute terms since their September 2 crest, whereas the S&P 495 are up over 15%. The recent surge in the 10-year Treasury yield exacerbated the nosedive in relative share prices as it deals a blow to the bubbly valuation of the longest duration sector in the SPX: the tech sector. Crudely put, the steeper the selloff in the bond market the greater the fall in relative market capitalization (10-year Treasury yield shown inverted, middle & bottom panels). Bottom Line: Stick with a barbell tech sub-group positioning, preferring software and services to hardware and equipment, but stay tuned.