Economy

Special Report

What Can 1918/1919 Teach Us About COVID-19?   “Those who cannot remember the past are condemned to repeat it” George Santayana – 1905 Chart II-1Coronavirus: As Contagious But Not As Deadly As Spanish Flu Today’s economy is very different to that of 100 years ago. Many countries then were in the middle of World War I (which ended in November 1918). The characteristics of the Spanish Flu which struck the world in 1918 and 1919 were also different to this year’s pandemic. COVID-19 is almost as contagious as the Spanish Flu, but it is much less deadly (Chart II-1). Healthcare systems and treatments today are far more advanced than those of a century ago: many people who caught Spanish flu died of complications caused by bacterial pneumonia, given the absence of antibiotics. Influenza viruses tend to mutate rapidly: the influenza virus in 1918 first mutated to become far more virulent in its second wave, and then to become much milder. Coronaviruses have a “proofreading” capacity and mutate less easily.1  Nevertheless, an analysis of the pandemic of 100 years ago provides a number of insights into the current crisis, particularly now that policymakers are easing social-distancing rules to help the economy, even at the risk of more cases and deaths. Among the lessons of 1918-1919: Non-pharmaceutical interventions (NPIs) do lower mortality rates. The speed at which NPIs are implemented and the period of implementation are as important as the number of measures taken. Removing or relaxing measures too early can lead to a renewed rise in mortality rates. It is hard to compare current fiscal and monetary policies to those taken during the 1918 pandemic, since policy in both areas was already easy before the pandemic as a result of the world war. However, a severe pandemic would certainly call for a wartime-like fiscal and monetary response. The economy was negatively impacted by the pandemic in 1918-19 but, despite the shock to industrial activity and employment, the economy subsequently rebounded quickly, in a V-shaped recovery. Introduction Predicting how the economy will react to the COVID-19 pandemic is hard. Governments and policymakers face multiple uncertainties: How effective are different containment measures? Will cases and deaths rebound quickly if lockdown measures are eased? When will the coronavirus disappear? When will a vaccine be ready? With an event unprecedented in the experience of anyone alive today, perhaps there are some lessons to be learned from history. For this Special Report, we attempt to draw some parallels between the current situation and the 1918-19 Spanish flu. We focus on the different containment efforts implemented, the role that fiscal and monetary policies played, the impact on markets and the economy, and whether history can throw any light on how the COVID-19 crisis might pan out. The 1918 Spanish Flu Chart II-2The Spanish Flu Hit The World In Three Waves The 1918 influenza pandemic was the most lethal in modern history. Soldiers returning from World War I helped spread the pandemic across the globe. The first recorded case is believed to have been in an army camp in Kansas. While there is no official count, researchers estimate that about 500 million people contracted the virus globally, with a mortality rate of between 5% and 10%. The pandemic occurred over three waves in 1918 and 1919 – the first in the spring of 1918, the second (and most deadly) in the fall of 1918, and the third in spring 1919 (Chart II-2). In the US alone, official data estimate that around 500,000 deaths (or over 25% of all deaths) in 1918 and 1919 were caused by pneumonia and influenza.2 The pandemic moved swiftly to Europe and reached Asia by mid-1918, but became more lethal only towards the end of the year (Map II-1).3 Map II-1The Spread Of Influenza Through Europe Initially, scientists were puzzled by the origin of the influenza and its biology. It was not until a decade later, in the early 1930s, that Richard Shope isolated the particular influenza virus from infected pigs, confirming that a virus caused the Spanish Flu, not a bacterium as most had thought. Many of those who caught this strain of influenza died as a result of their lungs filling with fluid in a severe form of pneumonia. In reporting death rates, then, it is considered best practice to include deaths from both influenza and pneumonia. The first wave had almost all the hallmarks of a seasonal flu, albeit of a highly contagious strain. Symptoms were similar and mortality rates were only slightly higher than a normal influenza. The first wave went largely unnoticed given that deaths from pneumonia were common then. US public health reports show that the disease received little attention until it reappeared in a more severe form in Boston in September 1918.4 Most countries did not begin investigating and reporting cases until the second wave was underway (Chart II-3). Chart II-3Most Countries Began Reporting Only When The Second Wave Hit This second wave – which was more lethal because the virus had mutated – had a unique characteristic. Unlike the typical influenza mortality curve – which is usually “U” shaped, affecting mainly the very young and elderly – the 1918 influenza strain had a “W”-shaped mortality curve – impacting young adults as well as old people (Chart II-4). This pattern was evident in all three waves, but most pronounced during the second wave. The reason for this was that the infection caused by the influenza became hyperactive, producing a “cytokine storm” – when mediators secreted from the immune system result in severe inflammation.5 Simply put, as the virus became virulent, the body’s immune system overworked to fight it. Younger people, with strong immune systems, suffered most from this phenomenon. Chart II-4A Unique Characteristic: Impacting Younger Adults By the summer of 1919, the pandemic was over, since those who had been infected had either died or recovered, therefore developing immunity. The lack of records makes it difficult to assess if “herd immunity” was achieved. However, some historical accounts and research – particularly for army groups in the US and the UK – suggest that those exposed to the disease in the first mild wave were not affected during the second more severe wave.6 The failure to define the causative pathogen at the time made development of a vaccine impossible. Nevertheless, some treatments and remedies showed modest success. These varied from using a serum – obtained from people who had recovered, who therefore had antibodies against the disease – to simple symptomatic drugs and various oils and herbs. The Effectiveness Of Non-Pharmaceutical Interventions (NPIs) Chart II-5Travel Slowed...Just Not Enough What we today call “social distancing” showed positive effects during the 1918-19 pandemic. These included measures very similar to those applied today: school closures, isolation and quarantines, bans on some sorts of public gatherings, and more. However, there were few travel bans. The number of passengers carried during the months of the pandemic did noticeably decline though (Chart II-5). Table II-1, based on research by Hatchett, Mecher and Lipsitch, breaks down NPIs by type for 17 major US cities. Most cities implemented a wide range of interventions. But it was not only the type of NPIs implemented that made a difference, but also the speed and length of implementation. Further research by Markel, Lipman and Navarro based on 43 US cities shows that the median number of days between the first reported influenza case and the first NPI implementation was over two weeks. The median period during which various NPIs were implemented was about six weeks (Table II-2). Table II-1Measures Applied Then Are Very Similar To Those Applied Today Table II-2NPIs Were Implemented Only For Short Periods Markel, Lipman and Navarro's findings show that a rapid public-health response was an important factor in reducing the mortality rate by slowing the rate of infection, what we now refer to as “flattening the curve.” There were major differences in cities’ policies: both the speed at which they implement NPIs, and the length of the implementation period. Chart II-6 shows that: Cities that acted quickly to implement NPIs slowed the rate of infections and deaths (Chart II-6, panel 1) Cities that acted quickly had lower mortality rates from influenza and pneumonia (Chart II-6, panel 2) Cities that implemented NPIs for longer periods had fewer deaths (Chart II-6, panel 3) Chart II-7 quantifies the number of NPIs taken, the time it took to implement the measures, and the length of NPIs to gauge policy strictness. Cities with stricter enforcement had lower death rates than those with laxer measures. Chart II-6Fast Response And Longer Implementation Led To Fewer Deaths... Chart II-7...So Did Policy Strictness     For example, Kansas City, less than a week after its first reported case, had implemented quarantine and isolation measures. By the second week, schools, churches, and other entertainment facilities closed. Schools reopened a month later (in early November) but quickly shut again until early January 1919. While we do not have definitive dates on when each NPI was lifted, some sort of protective measures in Kansas City were in place for almost 170 days. By contrast, Philadelphia, one of the cities hardest hit by Spanish Flu, took more than a month to implement any measures. Its tardiness meant that it reached a peak mortality rate much more quickly: in 13 days compared to 31 days for Kansas City. Even after the first reported case, the Liberty Loans Parade was still held on September 28, 1918 – with the knowledge that hundreds of thousands of spectators might be vulnerable to infection.7,8 It was not until a few days later that institutions were closed and a ban on public gatherings was imposed. Many other cities also held a Liberty Loans Parade, including Pittsburgh and Washington DC, but Philadelphia’s was the deadliest. Studies also show that relaxing interventions too early could be as damaging as implementing them too late. St. Louis, for example, was quick to lift restrictions and suffered particularly badly in the second wave as a result. It later reinstated NPIs up until end of February 1919. Other cities that eased restrictions too early (San Francisco and Minneapolis, for example) also suffered from a second swift, albeit milder, increase in weekly excess death rates from pneumonia and influenza (Chart II-8). Chart II-8Relaxing Lockdown Measures Too Early Can Lead To A Second Rise In Deaths... Chart II-9...And So Can Highly Effective Measures Of course, NPIs cannot be implemented indefinitely. A recent research paper by Bootsma and Ferguson raises the point that suppressing a pandemic may not be the best strategy because it just leaves some people susceptible to infection later. They argue that highly effective social distancing measures, which allow a susceptible pool of people to reintegrate into society when the measures are lifted, are likely to lead to a resurgence in infections and fatalities in a second peak (Chart II-9).9 They suggest an optimal level of control measures to reduce R (the infection rate) to a value that makes a significant portion of the population immune once measures are lifted.  The Impact Of The Spanish Flu On The Economy And Markets How did the Spanish Flu pandemic affect the economy? Many pandemic researchers ignore the official recession identified by the NBER during the months of the pandemic (between August 1918 and March 1919).10 The reason is that most of the evidence indicates that the economic effects of the 1918-19 pandemic were short-term and relatively mild.11 Disentangling drivers of the economy is, indeed, tricky given that WW1 ended in November 1918. However, it is easy to underestimate the negative impact of the pandemic since the war had such a big impact on the economy, as well as investor and public sentiment. Various research papers support the fact that, while the pandemic did indeed have an adverse effect on the economy, NPIs did not just depress mortality rates, but also sped the post-pandemic economic recovery.12 Research by Correia, Sergio, and Luck showed that the areas most severely affected by the pandemic saw a sharp and persistent decline in real economic activity, whereas cities that intervened earlier and more aggressively, experienced a relative increase in economic activity post the pandemic.13 Their findings are based on the increase in manufacturing employment after the pandemic compared to before it (1919 versus 1914). However, note that the rise of manufacturing payrolls in 1919 was high everywhere given the return of soldiers post-WWI. The researchers also note that those cities hardest hit by the pandemic also saw a negative impact on manufacturing activity, the stock of durable goods, and bank assets. Chart II-10Short-Term Price Impact Was Disinflationary Because Spanish flu disproportionately killed younger adults, many families lost their breadwinner. In economic terms, this implies both a negative supply shock and negative demand shock. If fewer employees are available to produce a certain good, supply will fall. The same reduction in employment also implies reduced income and therefore lower purchasing power. Both cases will result in a decrease in output. However, the change in prices depends on the decline of supply relative to demand. In 1918-19, the impact was disinflationary: demand declined by more than supply, and both spending and consumer prices fell during the pandemic (Chart II-10). US factory employment fell by over 8% between March 1918 and March 1919 – the period from the beginning of the first wave until the end of the second wave. It is important to note, however, that few businesses went bankrupt during the pandemic years (Chart II-11). Additionally, the November 1918 Federal Reserve Bulletin highlighted that many cities, including New York, Kansas City, and Richmond, experienced a shortage of labor due to the influenza.14 Factory employment in New York fell by over 10% during this period. The link between the labor shortages and the decline in industrial production is unclear. Industrial activity in the US peaked just before the second wave, contracting by over 20% during the second wave (Chart II-12). Various industries reported disruptions: automobile production fell by 67%, anthracite coal production and shipments fell by around 45%, and railroad freight revenues declined by over seven billion ton-miles (Chart II-12, panels 2, 3 & 4). However, some of this decline is attributed to falling defense production after the war. Chart II-11Loss Of Middle-Aged Adults = Loss Of Breadwinners Chart II-12Activity Slowed, But Rebounded Quickly   Chart II-13The War Had A Bigger Impact On The Stock Market Than The Pandemic Chart II-14Monetary Policy Was Easy...Even Before The Pandemic Started The equity market moved in a broad range in 1915-1919 and fell sharply only ahead of the 1920 recession (Chart II-13). Seemingly, stock market participants were more focused on the war than the pandemic. The lack of reporting of the pandemic could have contributed to this: newspapers were encouraged to avoid carrying bad news for reasons of patriotism and did not widely cover the pandemic until late 1918.15 The Federal Reserve played an active role in funding the government’s spending on the war, and so monetary policy was very easy during the pandemic – but for other reasons. The Fed used its position as a lender to the banking system to facilitate war bond sales.16 Interest rates were cut in 1914 and 1915 even before the US entered the war. The US economy had been in recession between January 1913 and December 1914. Policy rates remained low throughout 1916 and 1917 and slightly rose in 1918 and 1919. It was not until 1920 that Federal Reserve Bank System tightened policy rapidly to choke off inflation, which accelerated to over 20% in mid-1920 – rising inflation being a common post-war phenomenon (Chart II-14). The Lessons Of 1918-19 For The Coronavirus Pandemic Non-pharmaceutical interventions should continue to be implemented until a vaccine, effective therapeutic drugs, or mass testing is available. Relaxing measures prematurely is as damaging as a tardy reaction to the pandemic. Reacting quickly and imposing multiple measures for longer periods not only reduces mortality rates, but also improves economic outcomes post-crisis. The economy suffers in the short-term: supply and demand shocks lead to lower output. The demand shock however is larger leading to lower prices and disinflationary pressures, at least during and immediately after the pandemic.   Amr Hanafy Senior Analyst Global Asset Allocation   Footnotes 1 Please see the Q&A with immunologist and Nobel laureate Professor Peter Doherty, published by BCA Research April 1st 2020: BCA Research Special Report, “Questions On The Coronavirus: An Expert Answers,” available at bcaresearch.com 2 Please see “Leading Cause of Death, 1990-1998,” CDC Centers for Disease Control and Prevention. 3 Please see Ansart S, Pelat C, Boelle PY, Carrat F, Flahault A, Valleron AJ, “Mortality burden of the 1918-1919 influenza pandemic in Europe,” NCBI. 4 Please see Public Health Report, vol. 34, No. 38, Sept. 19, 1919. 5 Please see Qiang Liu, Yuan-hong Zhou, Zhan-qiu Yang Cell Mol Immunol. 2016 Jan; 13(1): 3–10. 6 Please see Shope, R. (1958) Public Health Rep. 73, 165–178. 7 The Liberty Loans Parade was intended to promote the sale of government bonds to pay for World War One. 8 Please see Hatchett RJ, Mecher CE, Lipsitch M (2007) "Public health interventions and epidemic intensity during the 1918 influenza pandemic,"PNAS 104: 7582–7587. 9 Please see Bootsma M, Ferguson N, “The Effect Of Public Health Measures On The 1918 Influenza Pandemic In U.S. Cities,” PNAS (2007). 10 Please see https://www.nber.org/cycles.html 11 Please see https://www.stlouisfed.org/~/media/files/pdfs/community-development/res…12 Please see https://libertystreeteconomics.newyorkfed.org/2020/03/fight-the-pandemic-save-the-economy-lessons-from-the-1918-flu.html. 12 Please see Correia, Sergio and Luck, Stephan and Verner, Emil, Pandemics Depress the Economy, Public Health Interventions Do Not: Evidence from the 1918 Flu (March 30, 2020). Available at SSRN: https://ssrn.com/abstract=3561560 or http://dx.doi.org/10.2139/ssrn.3561560. 13 Please see Board of Governors of the Federal Reserve System (U.S.), 1935- and Federal Reserve Board, 1914-1935. "November 1918," Federal Reserve Bulletin (November 1918). 14 Please see https://newrepublic.com/article/157094/americas-newspapers-covered-pandemic. 15 Please see https://www.federalreservehistory.org/essays/feds_role_during_wwi.

    Highlights Risk assets continue to ignore the dire state of the economy. “Don’t fight the Fed” will dictate investment policy for the coming months. Populism and supply-chain diversification will shape the world after COVID-19. Global stimulus will result in higher long-term inflation when the labor market returns to full employment. Asset prices are not ready for higher inflation rates. Precious metals, especially silver, will offer inflation protection. Stocks should structurally outperform bonds, even if they generate lower returns than in the past. Tech will continue to rise for now, but this sector will suffer when inflation turns higher. Feature Despite the continued collapse in economic activity, the S&P 500 remains resilient, bolstered by the largesse of the Federal Reserve and US government, and generous stimulus packages in other major economies. Stocks will likely climb even higher with this backdrop, but a violent second wave of COVID-19 infections may derail the scenario in the near term. The biggest risk, which is long-term in nature, is rising inflation. Public debt ratios will skyrocket in the G-10 and many emerging markets. Private debt loads, which are elevated in most countries, will also increase. Add rising populism and ageing populations into this mix and the incentive to push prices higher and reduce real debt loads becomes too enticing. Long-term investors must be wary. For the time being, overweight equities relative to bonds, but the specter of rising inflation suggests that growth stocks (e.g. tech) will not offer attractive long-term returns. Investors with an eye on multi-year returns should use the ongoing surge in growth stocks to strategically switch their portfolios toward small-cap equities, traditional cyclicals and precious metals. Economic Freefall Continues Most economic indicators paint a dismal picture for the US. Industrial activity is suffering tremendously. In April, industrial production collapsed by 15%, a pace matching the depth of the Great Financial Crisis (GFC). The ISM New Orders-to-Inventories ratio remains extremely weak with no glimmer of a rebound in IP in May. The numbers for trucking activity and railway freight are equally poor. Chart I-1A Worried Consumer Saves The US labor market has not been this ill since the 1930s. 20.5 million jobs vanished in April and the unemployment rate soared to 14.7%, despite a 2.5 percentage point decline in the participation rate. The number of employees involuntarily working in part-time positions has surged by 5.9 million, which has hiked up the broader U-6 unemployment rate to 22.8%. Wage growth has rebounded smartly to 7.7%, but this is an illusion. Average hourly earnings rose only because low-wage workers in the leisure and hospitality fields bore the brunt of the pain, accounting for 37% of layoffs. The worst news is that the Bureau of Labor Statistics (BLS) classifies any worker explicitly fired due to COVID-19 as temporarily laid off, but without a vaccine it is highly unlikely that employment in the leisure, hospitality or airline sectors will normalize anytime soon. Unsurprisingly, lockdowns have limited the ability of households to spend. Americans have boosted their savings rate to 13.1%, the highest level in 39 years, as they worry about catching a potentially deadly illness, losing their jobs, watching their incomes fall, or all of the above (Chart I-1). This double hit to both employment and consumer confidence sparked a 22% collapse in retail sales on an annual basis in April, the worst reading on record. Putting it all together, real GDP contracted at a 4.8% quarterly annualized rate in Q1 2020 and the Congressional Budget Office expects second-quarter annual growth to plummet to -37.7%. The New York Fed’s Weekly Economic Index suggests a more muted contraction of 11.1% (Chart I-2), which would still represent a post-war record. Investors must look beyond the gloom. The economic weakness is not limited to the US. In Europe and in emerging markets, retail sales and auto sales are disappearing at an unparalleled pace. Industrial production readings in those economies have been catastrophic and manufacturing PMIs are still in deeply contractionary territory. As a result, our Global Economic A/D line and our Global Synchronicity indicator continues to flash intense weakness (Chart I-3). Chart I-2The Worst Is Still To Come Chart I-3Dismal Growth, Everywhere   Chart I-4China Leads The Way Investors must look beyond the gloom. China’s experience with COVID-19 is instructive despite questions regarding the number of cases reported. China was the first country to witness the painful impact of COVID-19 and the quarantines needed to fight the disease. It was also the first country to control the virus’s spread and, most importantly, to escape the lockdown, along with being the first to enact economic stimulatory measures. The results are clear: industrial production, domestic new orders, and to a lesser extent, retail sales, are all experiencing V-shaped recoveries (Chart I-4). Even Chinese yields are rising, despite interest rate cuts by the People’s Bank of China. Accommodative Policy Matters Most The global policy “put option” is still in full force, which is boosting asset prices. A 41% rally in the median US stock reflects both a massive amount of funds inundating the financial system and a recovery that will take hold in the coming 12 months in response to this stimulus and the end of lockdowns. Global monetary policies have been even more aggressive than after the GFC. Interest rates have fallen as quickly and as broadly as they did around the Lehman bankruptcy. Moreover, unorthodox policy measures have become the norm (Chart I-5). Chart I-5Easy Policy, Everywhere In China, credit generation is quickly accelerating and has reached 28% of GDP, the highest in 2 years. Moreover, policymakers are emphasizing the need to create 9 million jobs in cities and keep the unemployment rate at 6%. Consequently, the recent rebound in construction activity will continue because it is a perfect medium to absorb excess workers. The ever-expanding quotas for local government special bonds to CNY3.75 trillion will also ensure that infrastructure spending energizes any recovery. Therefore, we expect Chinese imports of raw materials and machinery to accelerate into the second half of the year. The country’s orders of machine tools from Japan have already bottomed, which bodes well for overall Japanese orders (Chart I-6). Europe has also moved in the right direction. Government support continues to expand and combined public deficits will reach EUR 0.9 trillion, or 8.5% of GDP. Governmental guarantees have reached at least EUR1.4 trillion. Meanwhile, the European Central Bank’s balance sheet is swelling more quickly than during either the GFC or the euro area crisis (Chart I-7). Unsurprisingly, European shadow rates have collapsed to -7.6% and European financial conditions are the easiest they have been in 8 years. Chart I-6Will China's Rebound Matter? Chart I-7The ECB Is Aggressive   More importantly, COVID-19 has broken the taboo of common bond issuance in Europe. Last week, Chancellor Merkel, President Macron and EC President von der Leyen hatched a plan to issue common bonds that will finance a EUR 750 billion recovery fund as part of the European Commission Multiannual Financial Framework. The EC will then allocate EUR 500 billion of grants (not loans) to EU nations as long as they adhere to European principles. The unified front by the three most senior European politicians reflects elevated support for the EU among all European nations and an understanding that economic ruin in the smaller nations could capsize the core nations (Chart I-8). Hence, fiscal risk-sharing will increasingly become the norm in Europe. Unsurprisingly, Italian, Spanish, Portuguese and Greek bond spreads all narrowed significantly following the announcement. Chart I-8The Forces That Bind Chart I-9Negative Rates Are Here, Sort Of US policymakers have abandoned any semblance of orthodoxy. The Fed’s programs announced so far have lifted its balance sheet by $2.9 trillion and could generate an expansion to $11 trillion by year-end. Moreover, Fed Chair Jerome Powell has highlighted that there is “no limit” to what the Fed can do with its unconventional policy apparatus. The nature of the US funding market makes negative rates very dangerous and, therefore, highly doubtful in that country. Nonetheless, the Fed is willing to buy more paper from the public and private sectors to push the shadow rate and real interest rates further into negative territory (Chart I-9). Moreover, the Federal government has already bumped up the deficit by $3 trillion and the House has passed another $3 trillion in spending. Senate Republicans will pass some of this program to protect themselves in November. According to BCA Research’s Geopolitical Strategy service, a total escalation in the federal deficit of $5 trillion (or 23% of 2020 GDP) is extremely likely this year. Chart I-10The Fed Is Monetizing The Deficit Combined fiscal and monetary policy in the US will have a more invigorating impact on the recovery than the measures passed in 2008-09. They represent a larger share of output than during the GFC (10.5% versus 6% of GDP for the government spending and 15.2% versus 8.3% for the Fed’s balance sheet expansion). Moreover, the Fed is buying a much greater percentage of the Treasury’s issuance than during the GFC (Chart I-10). Therefore, the Fed is much closer to monetizing government debt than it was 11 years ago. The combined monetary and fiscal easing should result in a larger fiscal multiplier because the private sector is not financing as much of the government’s largesse. Thus, the increase in the private sector’s savings rate should be short-lived and the current account deficit will widen to reflect the greater fiscal outlays. Low real rates and a larger balance-of-payments disequilibrium should weaken the dollar which will ease US financial conditions further. A Trough In Inflation Maintaining incredibly easy monetary and fiscal conditions as the economy reopens will lead to higher inflation when the labor market reaches full employment. Core CPI has collapsed to 1.4% on an annual basis and to -2.4% on a three-month annualized basis, the lowest reading on record. The breakdown of the CPI report is equally dreadful (Chart I-11). However, CPI understates inflation because the basket measured by the BLS includes many areas of commerce currently not frequented by consumers. Items actually purchased by households, such as food, have experienced accelerating inflation in recent months. Fiscal risk-sharing will increasingly become the norm in Europe. Beyond this technicality, the most important factor behind the anticipated structural uptick in inflation is a large debt load burdening the global economy. Total nonfinancial debt in the US stands at 254% of GDP, 262% in the euro area, 380% in Japan, 301% in Canada, 233% in Australia, 293% in Sweden and 194% in emerging markets (Chart I-12). Historically, the easiest method for policymakers to decrease the burden of liabilities is inflation; the current political climate increases the odds of that outcome. Chart I-11Weak Core Chart I-12Record Debt, Everywhere   Households in the G-10 and emerging markets are angry. Growing inequalities, coupled with income immobility, have created dissatisfaction with the economic system (Chart I-13). Before the GFC, US households could gorge on debt to support their spending patterns, and inequalities went unnoticed. After the crisis revealed weakness in the household sector, banks tightened their credit standards and consumption slowed, constrained by a paltry expansion of the median household income. As a consequence, the American public increasingly supports left-wing economic policies (Chart I-14). Chart I-13Inequalities + Immobility = Anger Chart I-14The US Population's Shift To The Left COVID-19 is exacerbating the population’s discontent and highlighting economic disparities. The recession is hitting poor households in the US harder than the general population or highly skilled white-collar employees who can easily telecommute. Millennials, the largest demographic group in the US, are also irate. Their lifetime earnings were already lagging that of their parents because most millennials entered the job market in the aftermath of the GFC.1 Their income and balance sheet prospects were beginning to improve just as the pandemic shock struck. Finally, in response to the lockdowns and school closures caused by COVID-19, young families with children have to juggle permanent childcare and daily work demands from employers, resulting in a lack of separation between home and office.2  Economic populism will generate a negative supply shock, which will push up prices (Diagram I-1). BCA has espoused the theme of de-globalization since 20143 and COVID-19 will accelerate this trend. Firms do not want fragile supply chains that fall victim to random shocks; instead, they are looking to diversify their sources (Chart I-15). Additionally, workers and households want protection from foreign competition and perceived unfair trade practices. This sentiment is evident in a lack of trust toward China (Chart I-16). China-bashing will become a mainstay of American politics and rising tariffs will continue to increase the cost of doing business (Chart I-17). Last year’s Sino-US trade war was a precursor of events to come. Diagram I-1The Inflationary Impact Of A Stifled Supply Side Chart I-15COVID-19 Accelerates The Desire To Repatriate Production Chart I-16China As A Political Piñata Chart I-17The Cost Of Doing International Business Will Rise Chart I-18A Problem For Productivity The rate of capital stock accumulation does not bode well for the supply side of the economy. Productivity trails the path of capex, with a long time lag. The 10-year moving average of non-residential investment in the US bottomed three years ago. Its subsequent uptick should enhance average productivity. However, the growth of the real net capital stock per employee remains weak and will not strengthen because companies are curtailing spending in the recession. Moreover, the efficiency of the capital stock is well below its long-term average and probably will not mend if supply chains are made less efficient. These factors are negative for productivity and thus, the capacity to expand the supply side of the economy (Chart I-18). Finally, a significant share of capital stock is stranded and uneconomical. The airline industry is a good example. Going forward, regulations will keep the middle row seats empty. Fewer filled seats imply that the capital stock has lost significant value, which creates a negative supply shock for the industry. To break even, airlines will have to raise the price of fares. IATA estimates that fares will increase by 43%, 49% and 54% on North American, European and Asian routes, respectively (Table I-1). The same analysis can be applied to restaurants, hotels, cinemas, etc. – industries that will have to curtail their supplies and change their practices in response to COVID-19. Table I-1The Inflationary Impact Of Supply Cuts Chat I-19Pandemics Boost Wages While rising populism will hurt the supply side of the economy, it will also hike demand. Redistribution is an outcome of populism. Corporate tax hikes hurt rich households that receive more than 50% of their income from profits. High marginal tax rates on high earners will also curtail their disposable income. Shifting a bigger share of national income to the middle class will depress the savings rate and boost demand. It is estimated that the middle class’s marginal propensity to spend is 90% compared with 60% for richer households. In fact, in the past 40 years, the shift in income distribution has curtailed demand by 3% of GDP. Pandemics also increase real wages. Òscar Jordà, Sanjay Singh, and Alan Taylor demonstrated that European real wages accelerated following pandemics (Chart I-19). Fewer willing workers contributed to the climb in real wages by decreasing the supply of labor. Higher real wages are positive for consumption. China-bashing will become a mainstay of American politics and rising tariffs will continue to increase the cost of doing business. Populism will also put upward pressure on public spending. Governments globally and in the US are bailing out the private sector to an even larger extent than they did after the GFC. Discontent with expanding inequalities and the perceived lack of accountability of the corporate sector4 will push the government to be more involved in economic management than it was after 2008. Moreover, the post-2008 environment showed that austerity was negative for private sector income growth and the economic welfare of the middle class (Chart I-20). Thus, government spending and deficits as a share of GDP will be structurally higher for the coming decade. Higher deficits mechanically boost aggregate demand which is inflationary if the advance of aggregate supply is sluggish. Chat I-20Austerity Hurts Central banks will likely enable these inflationary dynamics. The Fed knows that it has missed its objective by a cumulative 4% since former Chairman Ben Bernanke set an official inflation target of 2% in 2012. Thus, it has lost credibility in its ability to generate 2% inflation, which is why the 10-year breakeven rate stands at 1.1% and not within the 2.3%-2.5% range that is consistent with its mandate. Moreover, the Fed is worried that the immediate deflationary impact of COVID-19 will further depress inflation expectations and reinforce low realized inflation. This logic partly explains why the Fed currently recommends more stimulus and the Federal Open Market Committee will be reluctant to remove accommodation anytime soon. Inflation will likely move toward 4-5% after the US economy regains full employment. Central banks may fall victim to growing populism. Both the Democrats and Republicans want control over the US Fed. If Congress changes the Fed’s mandate, there would be great consequences for inflation. Prior to the Federal Reserve Reform Act of 1977, the Fed’s mandate was to foster full employment conditions without any explicit mention of inflation. Therefore, the Fed kept the unemployment rate well below NAIRU for most of the post-war period. This tight labor market was a key ingredient behind the inflationary outbreak of the 1970s. After the reform act explicitly imposed a price stability directive on top of the Fed’s employment mandate, the unemployment rate spent a much larger share of time above NAIRU, which contributed to the structural decline in inflation after 1982 (Chart I-21). Chat I-21The Fed's Mandate Matters Finally, demographics will also feed inflationary pressures. The global support ratio peaked in 2014 as the number of workers per dependent decreased due to ageing of the population in the West and China (Chart I-22). A declining support ratio depresses the growth of the supply side of the economy because the dependents continue to consume. In today’s world, dependents are retirees, who have higher healthcare spending needs. This healthcare spending will accrue additional government spending. Moreover, it will continue to push up healthcare inflation, which will contribute to higher overall inflation (Chart I-23). Chat I-22Demographics: From Deflation To Inflation Chat I-23Aging Will Feed Healthcare Inflation   Bottom Line: COVID-19 has highlighted inequalities in the population and will accelerate a move toward populism that started four years ago. Consequently, the supply side of the economy will grow more slowly than it did in prior decades, while greater government interventions and redistributionist policies will boost aggregate demand. Additionally, monetary policy will probably stay easy for too long and demographic factors will compound the supply/demand mismatch. Inflation will likely move toward 4-5% after the US economy regains full employment, but will not surge to 1970s levels. Investment Implications Chat I-24Breakevens Will Listen To Commodities Extremely accommodative economic policy and a shift to higher inflation will dominate asset markets for the next five years or more. Breakevens in the G-10 are pricing in permanently subdued inflation for the coming decade, which creates a large re-pricing opportunity if inflation troughs when the labor market reaches full employment. Investors cannot wait for inflation to turn the corner to bet on higher breakevens. After the GFC, core CPI bottomed in October 2010, but US breakevens hit their floor at 0.15% in December 2008. Instead, a rebound in commodity prices and a turnaround in the global economic outlook may signal when investors should buy breakevens (Chart I-24). Chat I-25Deleterious US Balance Of Payments Dynamics A repricing of inflation expectations will depress real rates. Central banks want to see inflation expectations normalize towards 2.3%-2.5% before signaling an end to accommodation. Moreover, political pressures and high debt loads will likely loosen their reaction functions to higher breakeven. As a result, real interest rates will decline because nominal ones will not rise by as much as inflation expectations. This is exactly what central banks want to achieve because it will foster a stronger recovery. Our US fixed-income strategists favor TIPS over nominal Treasurys. The dollar will probably depreciate in the post-COVID-19 environment. As we wrote last month, the US is the most aggressive reflator among major economies. The twin deficit will expand while US real rates will remain depressed. This is very negative for the USD, especially in an environment where the US money supply is outpacing global money supply (Chart I-25).5 Additionally, Chinese reflation will stimulate global industrial production, which normally hurts the dollar. EM currencies are cheap enough that long-term investors should begin to bet on them (Chart I-26), especially if global inflation structurally shifts higher. Precious metals win from the combination of higher inflation, lower real rates and a weaker dollar. However, silver is more attractive than gold. Unlike the yellow metal, it trades at a discount to the long-term inflation trend (Chart I-27). Moreover, silver has more industrial uses, especially in the solar panel and computing areas. Thus, the post-COVID-19 recovery and the need to double up supply chains will boost industrial demand for silver and lift its price relative to gold. Our FX strategists recommend selling the gold-to-silver ratio.6 Chat I-26Cheap EM FX Chat I-27Silver Is The Superior Inflation Hedge   Chat I-28Still Time To Favor Stocks Over Bonds Investors should favor stocks over bonds. This statement is more an indictment of the poor value of bonds and their lack of defense against rising inflation than a structural endorsement of stocks. The equity risk premium is elevated. To make this call, we need to account for the lack of stationarity of this variable and adjust for the expected growth rate of earnings. Nonetheless, once those factors are accounted for, our ERP indicator continues to flash a buy signal in favor of equities at the expense of bonds (Chart I-28). Moreover, bonds tend to underperform stocks when inflation trends up for a long time (Table I-2).   Table I-2Rising Inflation Flatters Stocks Over Bonds Chart I-29Bonds Are Prohibitively Expensive In absolute terms, G-7 government bonds are also vulnerable, both tactically and structurally. They are overbought and currently trade at their greatest premium to fair value since Q4 2009 and Q1 1986, two periods followed by sharp rebounds in yields (Chart I-29). Moreover, the previous experience with QE programs shows that even if real rates diminish, the reflationary impact of aggressive monetary policy on breakeven rates is enough to increase nominal interest rates (Chart I-30). Additionally, as our European Investment Strategy team indicates, bond yields are close to their practical lower bound, which creates a negative skew to their return profile.7 This asymmetric return distribution destroys their ability to hedge equity risk going forward, making this asset class less appealing to investors. This problem is particularly salient in Europe and Japan. A lower dollar, which is highly reflationary for global growth, will likely catalyze the rise in yields.   Chart I-30QE Will Lift Breakevens And Yields As long as real rates remain under downward pressure, the window to own stocks remains open, even if stocks continue to churn. Equities are expensive, but when yields are taken into consideration, their adjusted P/E is in line with the historical average (Chart I-31). Moreover, periods of weak growth associated with lower real interest rates can foster a large expansion in multiples (Chart I-32). Chart I-31Low Bond Yields Allow High Stock Multiples Chart I-32Multiples Will Rise Further As The Fed Floods The World With Low Rates Whether to have faith in stocks in absolute terms on a long-term basis is complicated by our view on inflation and populism. Strong inflation will increase nominal rates. Moreover, low productivity coupled with higher real wages, less-efficient supply chains and higher taxes will accentuate the margin compression that higher inflation typically creates. Thus, equities are expected to generate poor real returns over the long term, even if they beat bonds. Chart I-33Tech EPS Leadership Tech stocks are another structural problem for equities. Including Amazon, Google and Facebook, tech stocks account for 41% of the S&P 500’s market cap. As our US Equity Strategy service explains, wherever tech goes, so does the US market.8 Tech stocks are the current market darling. Today, the tech sector is the closest thing to a safe-haven in the mind of market participants, because a post-COVID-19 environment will favor tech spending (telecommuting, e-commerce, cloud computing, etc.). The problem for long-term investors is that this view is the most consensus view. Already, investors expect the tech sector to generate the highest EPS outperformance relative to the rest of the S&P 500 in more than 15 years (Chart I-33). Moreover, in a low-yield environment, investors are particularly willing to bid up the multiples of growth stocks such as tech equities because low interest rates result in muted discount factors for long-term cash flows. When should investors begin betting against the tech sector? Backed by a powerful narrative, tech stocks are evolving into a mania. Yet, contrarian investors understand, being too early to sell a mania can be deadly. Bond yields should not be relied on to signal an end to the bubble. During most of the 1990s, tech would outperform the market when Treasury yields declined. However, when the tech outperformance became manic, yields became irrelevant. From the fall of 1998 to the beginning of 2000, 10-year yields rose from 4.2% to 6.8%, yet the tech sector outperformed the S&P 500 by 127%. More recently, yields rose from 1.33% in the summer of 2016 to 3.25% in November 2018, but tech outperformed the broader market by 39%.   Investors should favor stocks over bonds. Instead, higher inflation will be the key factor to end the tech sector’s infallibility. Since the 1990s, higher core inflation has led periods of tech underperformance by roughly six months. This relationship also held at the apex of the tech bubble in the second half of the 1990s (Chart I-34). Relative tech forward EPS suffers when core inflation rises, as the rest of the S&P 500 is more geared to higher nominal GDP growth. In essence, if nominal growth is less scarce, then the need to bid up growth stocks diminishes. Moreover, the dollar will likely be the first early signal because it leads nominal GDP. As a result, a weak dollar leads to a contraction in tech relative multiples by approximately 9 months (Chart I-35). Chart I-34Tech Hates Inflation... Chart I-35...And A Soft Dollar   We recommend long-term investors shift their portfolios toward industrial equities when inflation turns the corner. As a corollary, the low exposure of European and Japanese stocks to the tech sector suggests these cheap bourses will finally reverse their more-than-a-decade-long underperformance at the same time. This strategy means that even if the S&P 500 generates negative real returns during the coming decade, investors could still eke out positive returns from their stock holdings. Higher inflation will be the key factor to end the tech sector’s infallibility. Chart I-36The Time For Commodities Is Coming Back Finally, commodities plays are also set to shine in the coming decade. Commodities are very cheap and oversold relative to stocks (Chart I-36). Commodities outperform equities in an environment where inflation rises, real rates decline and the dollar depreciates. Consequently, materials and energy stocks may be winners. As a corollary, Latin American and Australian equities should also reverse their decade-long underperformance when inflation and the dollar turn the corner. This month's Section II Special Report is an in depth study of the Spanish Flu pandemic, written by our colleague Amr Hanafy and also published in BCA Research’s Global Asset Allocation service. Amr thoroughly analyses the evolution of the 100-year old pandemic and which measures mattered most to contain the virus and allow a return to economic normality. Mathieu Savary Vice President The Bank Credit Analyst May 28, 2020 Next Report: June 25, 2020 II. Lessons From The Spanish Flu What Can 1918/1919 Teach Us About COVID-19?   “Those who cannot remember the past are condemned to repeat it” George Santayana – 1905 Chart II-1Coronavirus: As Contagious But Not As Deadly As Spanish Flu Today’s economy is very different to that of 100 years ago. Many countries then were in the middle of World War I (which ended in November 1918). The characteristics of the Spanish Flu which struck the world in 1918 and 1919 were also different to this year’s pandemic. COVID-19 is almost as contagious as the Spanish Flu, but it is much less deadly (Chart II-1). Healthcare systems and treatments today are far more advanced than those of a century ago: many people who caught Spanish flu died of complications caused by bacterial pneumonia, given the absence of antibiotics. Influenza viruses tend to mutate rapidly: the influenza virus in 1918 first mutated to become far more virulent in its second wave, and then to become much milder. Coronaviruses have a “proofreading” capacity and mutate less easily.9  Nevertheless, an analysis of the pandemic of 100 years ago provides a number of insights into the current crisis, particularly now that policymakers are easing social-distancing rules to help the economy, even at the risk of more cases and deaths. Among the lessons of 1918-1919: Non-pharmaceutical interventions (NPIs) do lower mortality rates. The speed at which NPIs are implemented and the period of implementation are as important as the number of measures taken. Removing or relaxing measures too early can lead to a renewed rise in mortality rates. It is hard to compare current fiscal and monetary policies to those taken during the 1918 pandemic, since policy in both areas was already easy before the pandemic as a result of the world war. However, a severe pandemic would certainly call for a wartime-like fiscal and monetary response. The economy was negatively impacted by the pandemic in 1918-19 but, despite the shock to industrial activity and employment, the economy subsequently rebounded quickly, in a V-shaped recovery. Introduction Predicting how the economy will react to the COVID-19 pandemic is hard. Governments and policymakers face multiple uncertainties: How effective are different containment measures? Will cases and deaths rebound quickly if lockdown measures are eased? When will the coronavirus disappear? When will a vaccine be ready? With an event unprecedented in the experience of anyone alive today, perhaps there are some lessons to be learned from history. For this Special Report, we attempt to draw some parallels between the current situation and the 1918-19 Spanish flu. We focus on the different containment efforts implemented, the role that fiscal and monetary policies played, the impact on markets and the economy, and whether history can throw any light on how the COVID-19 crisis might pan out. The 1918 Spanish Flu Chart II-2The Spanish Flu Hit The World In Three Waves The 1918 influenza pandemic was the most lethal in modern history. Soldiers returning from World War I helped spread the pandemic across the globe. The first recorded case is believed to have been in an army camp in Kansas. While there is no official count, researchers estimate that about 500 million people contracted the virus globally, with a mortality rate of between 5% and 10%. The pandemic occurred over three waves in 1918 and 1919 – the first in the spring of 1918, the second (and most deadly) in the fall of 1918, and the third in spring 1919 (Chart II-2). In the US alone, official data estimate that around 500,000 deaths (or over 25% of all deaths) in 1918 and 1919 were caused by pneumonia and influenza.10 The pandemic moved swiftly to Europe and reached Asia by mid-1918, but became more lethal only towards the end of the year (Map II-1).11 Map II-1The Spread Of Influenza Through Europe Initially, scientists were puzzled by the origin of the influenza and its biology. It was not until a decade later, in the early 1930s, that Richard Shope isolated the particular influenza virus from infected pigs, confirming that a virus caused the Spanish Flu, not a bacterium as most had thought. Many of those who caught this strain of influenza died as a result of their lungs filling with fluid in a severe form of pneumonia. In reporting death rates, then, it is considered best practice to include deaths from both influenza and pneumonia. The first wave had almost all the hallmarks of a seasonal flu, albeit of a highly contagious strain. Symptoms were similar and mortality rates were only slightly higher than a normal influenza. The first wave went largely unnoticed given that deaths from pneumonia were common then. US public health reports show that the disease received little attention until it reappeared in a more severe form in Boston in September 1918.12 Most countries did not begin investigating and reporting cases until the second wave was underway (Chart II-3). Chart II-3Most Countries Began Reporting Only When The Second Wave Hit This second wave – which was more lethal because the virus had mutated – had a unique characteristic. Unlike the typical influenza mortality curve – which is usually “U” shaped, affecting mainly the very young and elderly – the 1918 influenza strain had a “W”-shaped mortality curve – impacting young adults as well as old people (Chart II-4). This pattern was evident in all three waves, but most pronounced during the second wave. The reason for this was that the infection caused by the influenza became hyperactive, producing a “cytokine storm” – when mediators secreted from the immune system result in severe inflammation.13 Simply put, as the virus became virulent, the body’s immune system overworked to fight it. Younger people, with strong immune systems, suffered most from this phenomenon. Chart II-4A Unique Characteristic: Impacting Younger Adults By the summer of 1919, the pandemic was over, since those who had been infected had either died or recovered, therefore developing immunity. The lack of records makes it difficult to assess if “herd immunity” was achieved. However, some historical accounts and research – particularly for army groups in the US and the UK – suggest that those exposed to the disease in the first mild wave were not affected during the second more severe wave.14 The failure to define the causative pathogen at the time made development of a vaccine impossible. Nevertheless, some treatments and remedies showed modest success. These varied from using a serum – obtained from people who had recovered, who therefore had antibodies against the disease – to simple symptomatic drugs and various oils and herbs. The Effectiveness Of Non-Pharmaceutical Interventions (NPIs) Chart II-5Travel Slowed...Just Not Enough What we today call “social distancing” showed positive effects during the 1918-19 pandemic. These included measures very similar to those applied today: school closures, isolation and quarantines, bans on some sorts of public gatherings, and more. However, there were few travel bans. The number of passengers carried during the months of the pandemic did noticeably decline though (Chart II-5). Table II-1, based on research by Hatchett, Mecher and Lipsitch, breaks down NPIs by type for 17 major US cities. Most cities implemented a wide range of interventions. But it was not only the type of NPIs implemented that made a difference, but also the speed and length of implementation. Further research by Markel, Lipman and Navarro based on 43 US cities shows that the median number of days between the first reported influenza case and the first NPI implementation was over two weeks. The median period during which various NPIs were implemented was about six weeks (Table II-2). Table II-1Measures Applied Then Are Very Similar To Those Applied Today Table II-2NPIs Were Implemented Only For Short Periods Markel, Lipman and Navarro's findings show that a rapid public-health response was an important factor in reducing the mortality rate by slowing the rate of infection, what we now refer to as “flattening the curve.” There were major differences in cities’ policies: both the speed at which they implement NPIs, and the length of the implementation period. Chart II-6 shows that: Cities that acted quickly to implement NPIs slowed the rate of infections and deaths (Chart II-6, panel 1) Cities that acted quickly had lower mortality rates from influenza and pneumonia (Chart II-6, panel 2) Cities that implemented NPIs for longer periods had fewer deaths (Chart II-6, panel 3) Chart II-7 quantifies the number of NPIs taken, the time it took to implement the measures, and the length of NPIs to gauge policy strictness. Cities with stricter enforcement had lower death rates than those with laxer measures. Chart II-6Fast Response And Longer Implementation Led To Fewer Deaths... Chart II-7...So Did Policy Strictness     For example, Kansas City, less than a week after its first reported case, had implemented quarantine and isolation measures. By the second week, schools, churches, and other entertainment facilities closed. Schools reopened a month later (in early November) but quickly shut again until early January 1919. While we do not have definitive dates on when each NPI was lifted, some sort of protective measures in Kansas City were in place for almost 170 days. By contrast, Philadelphia, one of the cities hardest hit by Spanish Flu, took more than a month to implement any measures. Its tardiness meant that it reached a peak mortality rate much more quickly: in 13 days compared to 31 days for Kansas City. Even after the first reported case, the Liberty Loans Parade was still held on September 28, 1918 – with the knowledge that hundreds of thousands of spectators might be vulnerable to infection.15,16 It was not until a few days later that institutions were closed and a ban on public gatherings was imposed. Many other cities also held a Liberty Loans Parade, including Pittsburgh and Washington DC, but Philadelphia’s was the deadliest. Studies also show that relaxing interventions too early could be as damaging as implementing them too late. St. Louis, for example, was quick to lift restrictions and suffered particularly badly in the second wave as a result. It later reinstated NPIs up until end of February 1919. Other cities that eased restrictions too early (San Francisco and Minneapolis, for example) also suffered from a second swift, albeit milder, increase in weekly excess death rates from pneumonia and influenza (Chart II-8). Chart II-8Relaxing Lockdown Measures Too Early Can Lead To A Second Rise In Deaths... Chart II-9...And So Can Highly Effective Measures Of course, NPIs cannot be implemented indefinitely. A recent research paper by Bootsma and Ferguson raises the point that suppressing a pandemic may not be the best strategy because it just leaves some people susceptible to infection later. They argue that highly effective social distancing measures, which allow a susceptible pool of people to reintegrate into society when the measures are lifted, are likely to lead to a resurgence in infections and fatalities in a second peak (Chart II-9).17 They suggest an optimal level of control measures to reduce R (the infection rate) to a value that makes a significant portion of the population immune once measures are lifted.  The Impact Of The Spanish Flu On The Economy And Markets How did the Spanish Flu pandemic affect the economy? Many pandemic researchers ignore the official recession identified by the NBER during the months of the pandemic (between August 1918 and March 1919).18 The reason is that most of the evidence indicates that the economic effects of the 1918-19 pandemic were short-term and relatively mild.19 Disentangling drivers of the economy is, indeed, tricky given that WW1 ended in November 1918. However, it is easy to underestimate the negative impact of the pandemic since the war had such a big impact on the economy, as well as investor and public sentiment. Various research papers support the fact that, while the pandemic did indeed have an adverse effect on the economy, NPIs did not just depress mortality rates, but also sped the post-pandemic economic recovery.20 Research by Correia, Sergio, and Luck showed that the areas most severely affected by the pandemic saw a sharp and persistent decline in real economic activity, whereas cities that intervened earlier and more aggressively, experienced a relative increase in economic activity post the pandemic.21 Their findings are based on the increase in manufacturing employment after the pandemic compared to before it (1919 versus 1914). However, note that the rise of manufacturing payrolls in 1919 was high everywhere given the return of soldiers post-WWI. The researchers also note that those cities hardest hit by the pandemic also saw a negative impact on manufacturing activity, the stock of durable goods, and bank assets. Chart II-10Short-Term Price Impact Was Disinflationary Because Spanish flu disproportionately killed younger adults, many families lost their breadwinner. In economic terms, this implies both a negative supply shock and negative demand shock. If fewer employees are available to produce a certain good, supply will fall. The same reduction in employment also implies reduced income and therefore lower purchasing power. Both cases will result in a decrease in output. However, the change in prices depends on the decline of supply relative to demand. In 1918-19, the impact was disinflationary: demand declined by more than supply, and both spending and consumer prices fell during the pandemic (Chart II-10). US factory employment fell by over 8% between March 1918 and March 1919 – the period from the beginning of the first wave until the end of the second wave. It is important to note, however, that few businesses went bankrupt during the pandemic years (Chart II-11). Additionally, the November 1918 Federal Reserve Bulletin highlighted that many cities, including New York, Kansas City, and Richmond, experienced a shortage of labor due to the influenza.22 Factory employment in New York fell by over 10% during this period. The link between the labor shortages and the decline in industrial production is unclear. Industrial activity in the US peaked just before the second wave, contracting by over 20% during the second wave (Chart II-12). Various industries reported disruptions: automobile production fell by 67%, anthracite coal production and shipments fell by around 45%, and railroad freight revenues declined by over seven billion ton-miles (Chart II-12, panels 2, 3 & 4). However, some of this decline is attributed to falling defense production after the war. Chart II-11Loss Of Middle-Aged Adults = Loss Of Breadwinners Chart II-12Activity Slowed, But Rebounded Quickly   Chart II-13The War Had A Bigger Impact On The Stock Market Than The Pandemic Chart II-14Monetary Policy Was Easy...Even Before The Pandemic Started The equity market moved in a broad range in 1915-1919 and fell sharply only ahead of the 1920 recession (Chart II-13). Seemingly, stock market participants were more focused on the war than the pandemic. The lack of reporting of the pandemic could have contributed to this: newspapers were encouraged to avoid carrying bad news for reasons of patriotism and did not widely cover the pandemic until late 1918.23 The Federal Reserve played an active role in funding the government’s spending on the war, and so monetary policy was very easy during the pandemic – but for other reasons. The Fed used its position as a lender to the banking system to facilitate war bond sales.16 Interest rates were cut in 1914 and 1915 even before the US entered the war. The US economy had been in recession between January 1913 and December 1914. Policy rates remained low throughout 1916 and 1917 and slightly rose in 1918 and 1919. It was not until 1920 that Federal Reserve Bank System tightened policy rapidly to choke off inflation, which accelerated to over 20% in mid-1920 – rising inflation being a common post-war phenomenon (Chart II-14). The Lessons Of 1918-19 For The Coronavirus Pandemic Non-pharmaceutical interventions should continue to be implemented until a vaccine, effective therapeutic drugs, or mass testing is available. Relaxing measures prematurely is as damaging as a tardy reaction to the pandemic. Reacting quickly and imposing multiple measures for longer periods not only reduces mortality rates, but also improves economic outcomes post-crisis. The economy suffers in the short-term: supply and demand shocks lead to lower output. The demand shock however is larger leading to lower prices and disinflationary pressures, at least during and immediately after the pandemic.   Amr Hanafy Senior Analyst Global Asset Allocation III. Indicators And Reference Charts Last month, we maintained a positive disposition toward stocks, especially at the expense of government bonds. The global economy may be in the midst of its most severe contraction since the Great Depression, but betting against stocks is too dangerous when fiscal and monetary policy are both as easy as they are today. In essence, don’t fight the Fed. This view remains in place, even if the short-term risk/reward ratio for holding stocks is deteriorating. On a cyclical basis, the same factors that made us willing buyers of stocks remain broadly in place. Stocks are not as cheap as they were in late March, but monetary conditions have only eased further as real interest rates weakened. Additionally, our Speculation Indicator has eased, which indicates that contrary to many commentators’ perceptions, speculation is not rampant. Confirming this intuition, the equity risk premium remains elevated (even when one takes into account its lack of stationarity) and expected growth rates of earnings are still very low. Finally, our Revealed Preference Indicator is finally flashing a strong buy signal. Tactically, equities are still overbought. We have had four 5% or more corrections since March 23. More of them are in the cards. However, the most likely outcome for the S&P 500 this summer is a churning pattern, not a major downward move below 2700. The median stock is still 26% below its August 2018 low and only a fraction of equities on the NYSE trade above their 30-week moving average. These indicators do not scream that a major correction is on the horizon, especially when policy is as accommodative as it is today. We continue to recommend investors take advantage of the supportive backdrop for stocks by buying equities relative to bonds. In contrast to global bourses, government bonds are still massively overbought on a cyclical basis and trading at their largest premium to fair value since Q4 2008 and late 1985. Additionally, the vast sums of both monetary and fiscal stimulus injected in the economy should lift inflation expectations and thus, bond yields. The yield curve is therefore slated to steepen further. Since we last published, the dollar has not meaningfully depreciated, but the DXY is trying to breakdown while our composite technical indicator is making lower highs. It is too early to gauge whether the recent rebound in the IDR, the MXN, or the ZAR is anything more than an oversold bounce, but if it were to continue, it would indicate that the expensive greenback is starting to buckle under the weight of the quickly expanding twin deficit. The widening in the current account deficit that will result from extraordinarily loose fiscal policy means that the large increase in money supply by the Fed will leak out of the US economy. This process is highly bearish for the dollar. Ultimately, the timing of the dollar’s weakness will all boil down to global growth. As signs are building up that global growth is bottoming, odds are rising that the dollar will finally breakdown. Get ready for a meaningful downward move over the coming months. Finally, commodities seem to be gaining traction. The Continuous Commodity Index’s A/D line is quickly moving up and our Composite Technical Indicator is quickly rising from extremely oversold levels. Oil will hold the key for the broad complex. Oil supply has started to adjust lower and oil demand is set to improve starting June/July as the global economy re-opens, fueled with massive amounts of stimulus. As a result, inventories should start to meaningfully decline this summer, which will support the recent recovery in oil prices. If oil can rebound further, industrial commodities will follow. Finally, gold is a mixed bag in the near term. The dollar is set to weaken significantly and inflation breakevens to move higher, which will mitigate the negative impact of declining risk aversion. Silver is a superior play to gold as it will benefit from a recovery in global growth. EQUITIES: Chart III-1US Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3US Equity Sentiment Indicators   Chart III-4Revealed Preference Indicator Chart III-5US Stock Market Valuation Chart III-6US Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance   FIXED INCOME: Chart III-9US Treasurys And Valuations Chart III-10Yield Curve Slopes Chart III-11Selected US Bond Yields Chart III-1210-Year Treasury Yield ComponentsChart III-13US Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets   CURRENCIES: Chart III-16US Dollar And PPP Chart III-17US Dollar And Indicator Chart III-18US Dollar Fundamentals Chart III-19Japanese Yen Technicals Chart III-20Euro Technicals Chart III-21Euro/Yen Technicals Chart III-22Euro/Pound Technicals   COMMODITIES: Chart III-23Broad Commodity Indicators Chart III-24Commodity Prices Chart III-25Commodity Prices Chart III-26Commodity Sentiment Chart III-27Speculative Positioning   ECONOMY: Chart III-28US And Global Macro Backdrop Chart III-29US Macro Snapshot Chart III-30US Growth Outlook Chart III-31US Cyclical Spending Chart III-32US Labor Market Chart III-33US Consumption Chart III-34US Housing Chart III-35US Debt And Deleveraging   Chart III-36US Financial Conditions Chart III-37Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China   Mathieu Savary Vice President The Bank Credit Analyst Footnotes 1 Reid Cramer et al., The Emerging Millennial Wealth Gap, Divergent Trajectories, Weak Balance Sheets, and Implications for Social Policy, New America, Oct 2019. 2 https://www.wsj.com/articles/new-normal-amid-coronavirus-working-from-home-while-schooling-the-kids-11584437400 3 Please see Geopolitical Strategy Special Report "The Apex Of Globalization - All Downhill From Here," dated November 12, 2014, available at gps.bcaresearch.com 4  Please see The Bank Credit Analyst Special Report "The Productivity Puzzle: Competition Is The Missing Ingredient," dated June 27, 2019, available at bca.bcaresearch.com 5  Please see The Bank Credit Analyst Monthly Report "May 2020," dated April 30, 2020, available at bca.bcaresearch.com 6 Please see Foreign Exchange Strategy Weekly Report "A Few Trades Amidst A Pandemic," dated May 22, 2020, available at fes.bcaresearch.com 7 Please see European Investment Strategy Weekly Report "European Investors Left Defenceless," dated May 21, 2020, available at eis.bcaresearch.com 8 Please see US Equity Strategy Special Report "Debunking Earnings," dated May 19, 2020, available at uses.bcaresearch.com 9 Please see the Q&A with immunologist and Nobel laureate Professor Peter Doherty, published by BCA Research April 1st 2020: BCA Research Special Report, “Questions On The Coronavirus: An Expert Answers,” available at bcaresearch.com 10 Please see “Leading Cause of Death, 1990-1998,” CDC Centers for Disease Control and Prevention. 11 Please see Ansart S, Pelat C, Boelle PY, Carrat F, Flahault A, Valleron AJ, “Mortality burden of the 1918-1919 influenza pandemic in Europe,” NCBI. 12 Please see Public Health Report, vol. 34, No. 38, Sept. 19, 1919. 13 Please see Qiang Liu, Yuan-hong Zhou, Zhan-qiu Yang Cell Mol Immunol. 2016 Jan; 13(1): 3–10. 14 Please see Shope, R. (1958) Public Health Rep. 73, 165–178. 15 The Liberty Loans Parade was intended to promote the sale of government bonds to pay for World War One. 16 Please see Hatchett RJ, Mecher CE, Lipsitch M (2007) "Public health interventions and epidemic intensity during the 1918 influenza pandemic,"PNAS 104: 7582–7587. 17 Please see Bootsma M, Ferguson N, “The Effect Of Public Health Measures On The 1918 Influenza Pandemic In U.S. Cities,” PNAS (2007). 18 Please see https://www.nber.org/cycles.html 19 Please see https://www.stlouisfed.org/~/media/files/pdfs/community-development/res…12               Please see https://libertystreeteconomics.newyorkfed.org/2020/03/fight-the-pandemic-save-the-economy-lessons-from-the-1918-flu.html. 20 Please see Correia, Sergio and Luck, Stephan and Verner, Emil, Pandemics Depress the Economy, Public Health Interventions Do Not: Evidence from the 1918 Flu (March 30, 2020). Available at SSRN: https://ssrn.com/abstract=3561560 or http://dx.doi.org/10.2139/ssrn.3561560. 21 Please see Board of Governors of the Federal Reserve System (U.S.), 1935- and Federal Reserve Board, 1914-1935. "November 1918," Federal Reserve Bulletin (November 1918). 22 Please see https://newrepublic.com/article/157094/americas-newspapers-covered-pandemic. 23 Please see https://www.federalreservehistory.org/essays/feds_role_during_wwi.

Highlights Portfolio Strategy The Fed’s extremely easy monetary backdrop along with easy fiscal policy remain the dominant macro themes, and they will continue to underpin the equity market. We remain constructive on the equity market’s prospects on a cyclical 9-12 month time horizon. While the path of least resistance remains higher for the S&P biotech index, we do not want to overstate our welcome and are putting it on downgrade alert and instituting a 5% rolling stop in order to protect profits. Relative supply/demand dynamics, social distancing, the pendulum swinging from renting to owing and enticing relative technicals and valuations, all signal that a long S&P homebuilders/short S&P REITs pair trade is primed to generate alpha.   Recent Changes Initiate a long S&P homebuilders/short S&P real estate trade, today. Table 1 Feature The SPX had a bumper week last week, but failed to pierce through the 200-day moving average. A flare up in the US/China trade war, a barrage of positive coronavirus vaccine news and Jay Powell’s 60 minutes interview brought back some volatility in trading, however, the VIX remains in a steady downturn. Importantly, investors are nowhere near as complacent as during the 2018/19 or early 2020 SPX peaks, judging by VIX futures positioning (net speculative positions shown inverted, Chart 1). Chart 1Positioning Is Far... In other words, there is still room for equities to rise before sentiment reaches greedy levels. A number of other indicators we track confirm that recent SPX trading is associated more with panic than with euphoria. Namely, Chart 2 shows that our Complacency-Anxiety, Capitulation and Equity Sentiment Indicators, all corroborate that investor confidence is far from previous exuberant peaks, and signal that there is scope for additional equity gains on a cyclical 9-12 month time horizon.  Delving deeper into investor psyche, our sense is that there are three distinct camps of investors at the current juncture, two of which are fiercely battling it out in the stock market. Chart 2…From Complacent First there are the pessimists that we call “second wavers” that are more often than not also “Fed non-believers” or “Fed fighters”. They argue that stocks are extremely expensive and if a second wave of the corona virus hits, then stocks are going to plunge anew given the lack of a valuation cushion, as all the money in the world (Fed QE5) cannot cure the virus (top panel, Chart 3). Second, there are the optimists that are hopeful that a vaccine/drug cocktail discovery is looming to effectively eradicate the coronavirus. These investors also believe in the smooth reopening of the economy. But, even if there were a second wave, their thinking goes that our societies/governments/health care systems are all going to be more prepared and effective to deal with a second viral outbreak in the fall. In addition, they are in the “do not fight the Fed” camp. Finally, there are the more moderate investors that lie somewhere in between these two camps. They sat tight and held on to their stock positions during the 36% peak-to-trough SPX drawdown and have likely been on the sidelines lately (bottom panel, Chart 3) awaiting a catalyst to either deploy fresh capital or raise some cash. We are in the more optimistic camp and while a vaccine may be months away, we will have to figure out a way as a society to more effectively protect the elderly that are most at risk from the virus and continue to live on, as we first posited in the March 23rd Weekly Report when we outlined 20 reasons to buy stocks and reprint here: "20. Social-distancing measures in the West will ultimately break the Epidemic Curve first derivative and arrest the panic. Even if COVID-19 comes back in force, the fact is that most of the patients who succumb to it are elderly. In Italy, the average age of death is 80 years old. As such, the final circuit-breaker ahead of a GFC would be desensitization by the population, as selective quarantines – targeting the elderly cohorts – get implemented in order to allow other people to return to work. Furthermore, two “silver bullet” solutions remain as tail risks to the bearish narrative. First, a biotech or pharmaceutical company may make a breakthrough in the fight against COVID-19. Not necessarily a vaccine, but a treatment. Finally, upcoming warm weather in the northern hemisphere may also help the fight against the virus."1 Chart 3Cash Hoarding Is Associated With Market Troughs Chart 4Loose Monetary Policy… Moreover, we definitely refrain from fighting the Fed as we outlined in our recent “Fight Central Banks At Your Own Peril” Weekly Report2 and reiterate that view today (Chart 4). While some investors were surprised by Jay Powell’s 60 Minutes interview remarks on the way the Fed digitally creates money, Ben Bernanke in another 60 Minutes interview in March 20093 made a similar comment that we cited in our March 23 Weekly Report (please refer to reason number 6 to buy equities).4 Importantly, we felt that Jay Powell’s demeanor was more like “please test our resolve Mr. Market if you reckon the FOMC is out of ammunition”. As a reminder, the Fed is in a position of strength: devaluing a currency is easy, revaluing/defending a currency is difficult and at times impossible as FX (and gold) reserves eventually run dry. In sum, the Fed’s extremely easy monetary backdrop along with easy fiscal policy (Chart 5) remain the dominant macro themes, and they will continue to underpin the equity market. Eventually, a liquidity handoff to growth will take root, and the SPX will no longer require the immense fiscal and monetary supports. As a result we continue to believe that stocks will be higher in the coming 9-12 months. Chart 5…And Easy Fiscal Policy Are Underpinning Stocks Biotech Delivers We have been overweight the S&P biotech index and adding alpha to our portfolio in the double digits, however we do not want to overstate our welcome and are putting it on downgrade alert and instituting a 5% rolling stop in order to protect profits. While a few technology sectors and subsectors have come close to vaulting to fresh all-time highs, none other than the S&P biotech index has managed such an impressive feat. The stealthy advance in biotech stocks has been earnings driven and is not only confined to the narrow based Big-Pharma lookalike S&P biotech index (Chart 6). The broader-based NASDAQ biotech index comprising 209 stocks has also quietly sprang to uncharted territory. True, relative share prices have yet to make the all-time high leap, but have bested the market roughly by 30% year-to-date irrespective of the biotech index or ETF tracked (Chart 6). Importantly, growth stocks in general and biotech stocks in particular perform exceptionally well in a disinflationary growth environment. Therefore biotech stocks are the primary beneficiaries of the Fed’s QE5 and NIRP policies at a time when inflation is missing in action (top panel, Chart 7). Chart 6Earnings-Led Advance This goldilocks backdrop is also evident in the US bank credit impulse that has gone parabolic. When there is flushing liquidity and growth is scarce and declining, investors flock to any growth they can get their hands on (bottom panel, Chart 7). Chart 7Goldilocks Backdrop US dollar based liquidity, also underpins biotech stocks. In recent research, we have been highlighting that the Fed is indirectly targeting the debasing of the greenback. All this excess US dollar liquidity will eventually boost global growth, and reflate corporate earnings via the export relief valve. Biotech stocks will also get a fillip from a depreciating US dollar (Chart 8). Our overweight thesis in biotech was predicated – among other things – upon Big Pharma taking out biotech players and acquiring their coveted drug pipelines. We continue to side with the potential M&A targets, rather than the acquirers. The number of industry M&A deals has reached fever pitch and deal premia are still averaging over 60% (Chart 9). Chart 8Dollar Flooding Is A Boon For Biotech Equities Currently, the global race to find a coronavirus vaccine has further propelled biotech stocks. Indeed, investors are voting with their feet and are betting on a vaccine breakthrough. Thus, the allure of biotech stocks has also increased a notch as the possibility of a vaccine makes their earnings streams even more valuable and desirable to Big Pharma. A mega M&A deal in the space would not take us by surprise. Chart 9M&A Activity Will Remain Robust A few words are in order on the earnings, valuation and technical fronts. While relative share price momentum is galloping higher, it is moving in lockstep with rising earnings estimates (second panel, Chart 10). We would be extremely concerned if this were a multiple expansion driven relative share price advance. In fact, the biotech forward P/E trades both below the historical mean and at a 39% discount to the broad market hovering near an all-time low (Chart 10). Even on a dividend yield basis, biotech stocks are cheap sporting a higher (and safer) dividend yield than the SPX (bottom panel, Chart 10). Chart 10Biotech Stocks Are As Cheap As They Have Ever Been Chart 11Earnings Hurdle Remains Low Finally, relative long-term profit growth euphoria reaching astronomical levels, preceded previous S&P biotech index peaks: three times in the past two decades biotech stocks were projected to surpass SPX profit growth by roughly 10%. The current reading has plunged to negative 1.2% (Chart 11). Netting it all out, the global race for a coronavirus vaccine, robust earnings growth, ample US dollar liquidity and generationally low interest rates suggest that the path of least resistance remains higher for the S&P biotech index.   Bottom Line: Stay overweight the S&P biotech index, but put it on downgrade alert and set a 5% rolling stop in order to protect profits. The ticker symbols for the stocks in this index are: BLBG: S5BIOT – ABBV, ALXN, AMGN, BIIB, GILD, INCY, REGN, VRTX. Intra-Real Estate Trade Idea There is an exploitable trade opportunity in the real estate market, preferring residential real estate to commercial real estate (CRE). The cleanest way to play this is via a long S&P homebuilders/short S&P REITs pair trade, and we recommend initiating such a market-neutral trade today. Relative performance remains below the upward sloping time trend and at least a mini overshoot phase is in the cards in the coming quarters (Chart 12). One of the key drivers for this pair trade is the ebb and flow of owning versus renting and the current message is positive for homebuilders at the expense of REITs (Chart 13). Chart 12Looming Overshoot Phase Chart 13Own Versus Rent Upswing Is Bullish For The Pair Trade Home ownership has suffered a setback and never reclaimed its pre GFC highs. However, there is pent up demand for single family homes, especially given the recent drubbing of interest rates which should bring first time home buyers back into the market. Millennials up to now have been more of a renter generation, but as household formation increases for the largest cohort in the US, homeownership will make a comeback. One can argue that both real estate segments are interest rate sensitive and that they should benefit from lower rates. However, banks are more willing to lend to consumers in order to buy a home rather than to investors for CRE properties/projects by a factor of 2:1 according to the latest Federal Reserve Senior Loan Officer survey.5 Similarly, whereas demand for CRE loans has collapsed according to the same survey in April, demand for residential real estate loans spiked (top panel, Chart 14). In times of coronavirus-induced social distancing there is a lot more risk associated with CRE versus residential properties. Apartment REITs for example have an element of density-related risk versus the allure of a single family home in the suburbs. Likely social distancing will place a premium on single family homes in coming quarters at the expense of living in high rises in the city. This backdrop bodes well for home prices, but ill for CRE prices which according to Green Street Advisors contracted by 9% in April.6 Keep in mind that residential real estate price only very recently surpassed their 2006 zenith whereas CRE price are still hovering at one standard deviation above the previous peak (Chart 14). Debt deflation is a real threat for CRE prices and given that REITs are at the bottom of this levered asset’s capital structure it is last to collect.  Also the long-term ramifications to demand on CRE are grave compared with residential real estate. On the office REIT segment as an example, we deem that corporations will rethink their often expensive downtown office space requirements and likely downsize, as working from home has become mainstream. The unintended consequence of this realization is that demand for (larger) single family homes will also increase as workers opt to set up more comfortable working spaces at suburban homes. Chart 14Homebuilders Have The Upper Hand Shopping mall REITs are under relentless attack from the Amazonification of the economy and now have to contend with social distancing. The retail shopping experience will never be the same again sustaining the threat of extinction for shopping centers. On the construction front, single family housing starts are breaking ground at the historical mean and way below the 2006 peak run-rate, however, multi-family supply has gone parabolic (Chart 15). These diverging supply conditions are a harbinger of rising relative share prices. Finally, with regard to technicals and valuations homebuilders have the upper hand. Our Technical Indicator is in the neutral zone and relative valuations have collapsed near all-time lows offering a compelling entry point to the pair trade (Chart 16). Chart 15Supply Dynamics Favor Homebuilders Chart 16Relative Pessimism Is Contrarily Positive Netting it all out, relative supply and demand dynamics, social distancing, the pendulum swinging from renting to owing and enticing relative technicals and valuations, all signal that a long S&P homebuilders/short S&P REITs pair trade is primed to generate alpha.  Bottom Line: Initiate a long S&P homebuilders/short S&P REITs pair trade today. The ticker symbols for the stocks in the S&P homebuilding and S&P REITs indexes are: BLBG: S5HOME – LEN, PHM, NVR, DHI, and BLBG: S5REITS – AMT, PLD, CCI, EQIX, DLR, SBAC, PSA, AVB, EQR, WELL, ARE, O, SPG, ESS, WY, MAA, VTR, DRE, PEAK, BXP, EXR, UDR, HST, REG, IRM, VNO, FRT, AIV, KIM, SLG, respectively.   Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com     Footnotes 1     Please see BCA US Equity Strategy Weekly Report, “The Darkest Hour Is Just Before The Dawn” dated March 23, 2020, available at uses.bcaresearch.com 2     Please see BCA US Equity Strategy Weekly Report, “Fight Central Banks At Your Own Peril” dated April 14, 2020, available at uses.bcaresearch.com. 3    https://www.cbsnews.com/news/ben-bernankes-greatest-challenge/2/ 4    Please see BCA US Equity Strategy Weekly Report, “The Darkest Hour Is Just Before The Dawn” dated March 23, 2020, available at uses.bcaresearch.com 5    https://www.federalreserve.gov/data/sloos/sloos-202004.htm 6    https://www.greenstreetadvisors.com/insights/CPPI             Current Recommendations Current Trades Strategic (10-Year) Trade Recommendations Size And Style Views June 3, 2019 Stay neutral cyclicals over defensives (downgrade alert)  January 22, 2018 Favor value over growth May 10, 2018 Favor large over small caps (Stop 10%) June 11, 2018 Long the BCA  Millennial basket  The ticker symbols are: (AAPL, AMZN, UBER, HD, LEN, MSFT, NFLX, SPOT, TSLA, V).

Highlights Duration: The easing of shelter-in-place restrictions and resultant improvement in economic growth will cause US bond yields to rise somewhat during the next couple of months. However, the magnitude of economic improvement will be modest, and the Fed’s dovish rate guidance will temper the severity of any yield back-up. Municipal Bonds: The less-than-generous pricing offered through the Fed’s Municipal Liquidity Facility will not help push muni yields lower from current levels. However, very attractive valuations and the expectation of federal government relief justify an overweight allocation to the sector. Inflation & TIPS: We are not worried about significant inflation pressures any time soon. But equally, we don’t see 12-month headline CPI falling much below zero this year. This means that TIPS are cheap relative to nominal Treasuries. Treasury Yield Outlook Chart 1Taking A Breather Bond yields have been relatively stable since early April, and the Treasury index has performed roughly in-line with cash for most of the second quarter. This of course follows on the heels of massive outperformance in Q1 (Chart 1). Nonetheless, the recent stabilization in yields raises the question of whether bond returns are approaching a cyclical peak, or merely experiencing a temporary lull. Yields Are Biased Higher In The Near-Term … Our view is that a modest bond sell-off is likely during the next couple of months for four reasons. First, high-frequency global growth indicators are finally starting to hook up (Chart 2). Specifically, we like to track the CRB Raw Industrials commodity price index, emerging market currencies and the relative performance of cyclical versus defensive US equities. All three indicators track bond yields closely, and all three are showing signs of bottoming. Chart 2High-Frequency Global Growth Indicators Second, FLASH PMI estimates for May showed broad-based improvement compared to the April lows. Specifically, FLASH Manufacturing PMIs for the United States, Euro Area and United Kingdom all increased compared to April (Chart 3A). Of countries that have FLASH PMI estimates, only Japan saw a continued decline in May. If these numbers are to be believed, they suggest that April might indeed represent the global economic trough. We are still waiting for May data from China and the rest of the emerging world, important economic blocs that together account for 47% of the Global Manufacturing PMI. But China’s PMI, at least, has already rebounded off its February low (Chart 3B). China’s number will likely pressure the global index higher when it is released next week. Chart 3APMI Estimates For May Chart 3BChina's PMI Is Close To Neutral Third, high-frequency US economic data are consistent with an economy that is close to, or perhaps already passed, its economic trough. Initial jobless claims are still very high but have printed successively lower since peaking seven weeks ago. Similarly, the New York Fed’s Weekly Economic Index remains at its all-time low but is no longer in free fall (Chart 4).1   Chart 4US Economic Indicators Finally, but also most importantly, the slightly better data noted above are the result of economies that are slowly starting to re-open as daily new COVID cases roll over. This is particularly the case in Europe and North America (Chart 5). Restrictions will probably continue to ease during the next couple of months, meaning that both the economic data and bond yields are biased higher. Chart 5Global COVID-19 Cases … But Don’t Expect Anything More Than A Modest Sell-Off Chart 6Fed's Forward Guidance Quickly Dampened Vol However, there are also a few reasons to not get too bearish on US bonds. First, it is entirely possible – and even likely – that COVID cases will start to increase as shelter-in-place restrictions are lifted. If these second waves of the infection aren’t adequately suppressed via testing and contact tracing then restrictions could be re-instated by the fall, putting renewed downward pressure on bond yields. Also, while new COVID cases are declining in many parts of Europe and North America, several large emerging markets are still seeing cases accelerate. Brazil and India, for example, have yet to see a peak in new cases, while Russia’s new cases have just started to roll over (Chart 5, bottom 2 panels). Together, Brazil, Russia and India account for 8% of the Global Manufacturing PMI. Slow growth in those nations will significantly dampen any global economic recovery. On top of uncertainty surrounding the speed of any nascent global economic recovery, bond yields will also be held down by the Fed’s highly credible zero-lower-bound interest rate guidance. As we discussed in last week’s report, large bond sell-offs are almost always associated with a significant hawkish shift in monetary policy.2 This will not occur any time soon. In fact, the New York Fed’s latest Survey of Market Participants, taken just prior to the April 28-29 FOMC meeting, reveals that the median market participant expects the fed funds rate to stay at its current level at least until the end of 2022!3 On the one hand, such depressed expectations suggest scope for a massive re-pricing at some point in the future, but this will not occur until inflation forces the Fed to act. We agree with the survey respondents that this is a long way off. While new COVID cases are declining in many parts of Europe and North America, several large emerging markets are still seeing cases accelerate. It’s also interesting to note the speed at which the market has bought into the Fed’s zero-lower-bound rate guidance during the past two months. Chart 6 shows that after the Fed first cut rates to zero in December 2008, it still took several years for implied interest rate volatility to reach historically low levels. That is, the market was not initially convinced that rates would stay at zero for the long haul. In contrast, interest rate volatility has plunged dramatically since the Fed cut rates to zero on March 15. This time around, the market has been quick to buy into the Fed’s dovish message. Bottom Line: The easing of shelter-in-place restrictions and resultant improvement in economic growth will cause US bond yields to rise somewhat during the next couple of months. However, the magnitude of economic improvement will be modest, and the Fed’s dovish rate guidance will temper the severity of any yield back-up. Additionally, we can’t rule out the resumption of lockdown restrictions in the fall, should COVID cases rise during the summer. In terms of strategy, nimble investors may want to position for higher yields in the near-term. However, given the risks involved, we prefer to keep portfolio duration close to benchmark while implementing duration-neutral curve steepeners that will profit from rising yields. Specifically, we recommend going long the 5-year note and short a duration-matched barbell consisting of the 2-year and 10-year notes.4 Munis Carry Some Risk, But Offer A Lot Of Value Chart 7Munis Cheap Versus Treasuries Our spread product investment strategy during the recession has been to favor those sectors that: a)  Offer attractive yields/spreads b)  Benefit from one or more of the Fed’s emergency lending facilities Municipal bonds check both of those boxes. In terms of value, Aaa-rated municipal bond yields are consistently above Treasury yields across the entire maturity spectrum (Chart 7), a yield advantage that becomes especially pronounced when you factor in munis’ tax-exempt status. There is even a strong case for tax-exempt municipal bonds relative to corporate bonds. Table 1A shows the yield differential between tax-exempt municipal bonds and corporate bonds that carry the same credit rating and maturity. Not surprisingly, municipal bond yields are below corporate yields in most cases, with A-rated yields and longer-maturity Baa-rated yields being glaring exceptions. To put those yield differentials in context, Table 1B shows the breakeven effective tax rate for each muni/corporate combination. For example, the breakeven effective tax rate between Aaa-rated 5-year municipal and corporate bonds is 23%. This means that an investor will earn more after-tax yield in the municipal bond if his effective tax rate is above 23%, and less if it is below. It is apparent that breakeven effective tax rates are quite low, especially at the bottom-end of the credit spectrum. Table 1ASpread Between Municipal Bonds & Credit Index Yields* (BPs) Table IBMuni/Credit Breakeven Effective Tax Rate* (%) As for our second criterion, the municipal sector clearly benefits from the Fed’s Municipal Liquidity Facility (MLF). Through this facility, the Fed lends directly to eligible state & local governments for up to three years.5 However, there is a problem with the MLF: The cost. The Fed recently revealed that it will charge a rate of OIS + 150 bps for new loans taken out by Aaa-rated issuers through the MLF. That fixed spread rises as the issuer’s credit rating declines. Aa2 issuers are charged OIS + 175 bps, A2 issuers are charged OIS + 250 bps, etc…6 Chart 8MLF Pricing Doesn't Help Muni Investors For each credit rating, the rate available through the MLF is significantly higher than the actual market yield (Chart 8). This means that the MLF currently places a cap on how high municipal yields can rise, but it doesn’t actively pressure them lower. This stands in stark contrast to the rates offered through the Term Asset-Backed Securities Loan Facility (TALF) that are considerably below market yields on Aaa-rated CMBS and similar to market yields on Aaa-rated consumer ABS. Uncharitable MLF pricing structure aside, we think there are several reasons to remain overweight municipal bonds within US fixed income portfolios. First, the Fed is already facing criticism about the MLF rates and it could lower them in the near future. It has already shown a willingness to alter its facilities in response to market pressure. The MLF initially only made loans with maturities of 2 years or less, now it offers loans of up to 3 years. Second, direct federal aid to state & local governments was the centerpiece of the relief bill that recently passed through the House of Representatives. That bill will not get through the Senate in its current form, but another federal government relief package is forthcoming and it will almost certainly include money for state & local governments. There is even a strong case for tax-exempt municipal bonds relative to corporate bonds. Third, despite the massive challenges ahead, state governments entered the present crisis with relatively strong budget positions and well stocked rainy day funds (Chart 9). State & local governments will obviously be forced to make some tough budget decisions in the coming months, but there is no doubt that they are in a better position to do so than they were prior to the last two recessions. Chart 9State Rainy Day Funds Bottom Line: The less-than-generous pricing offered through the Fed’s Municipal Liquidity Facility will not help push muni yields lower from current levels. However, very attractive valuations and the expectation of federal government relief justify an overweight allocation to the sector. Deflation A Bigger Risk Than Inflation, But TIPS Still Make Sense Chart 10Energy Inflation May Have Troughed April’s CPI report saw year-over-year headline inflation fall to 0.4%, the lowest level since 2015. Deflation is clearly a bigger risk than inflation this year, but we would argue that TIPS prices are so beaten down that the sector still offers value. This is true over investment horizons as short as one year. We calculate that headline CPI inflation would have to come in below -0.85% over the next 12 months for a hold-to-maturity position in TIPS to underperform a similar position in nominal Treasuries (Chart 10). Could we actually see that much deflation during the next 12 months? It is possible, but we’d bet against it. First, the collapse in oil prices and energy inflation has been an important driver of falling inflation during the past couple of months (Chart 10, panel 2). But with oil prices having already dipped into negative territory and massive production cuts about to come on board, energy inflation may have already troughed for the year.7 At the very least, with oil prices already so low there is much less room for them to decline and thus less scope for further energy CPI deceleration. Second, the Great Financial Crisis (GFC) was the last time that headline CPI inflation went significantly below zero. Year-over-year core inflation had to get to 0.6% for that to happen. This year, 12-month core CPI dropped to 1.4% in April from 2.1%, but the trimmed mean measure only fell from 2.4% to 2.2% (Chart 10, bottom panel). During the GFC, both core and trimmed mean inflation fell in tandem. This gives us some reason to doubt the persistence of core CPI’s recent drop. Headline CPI inflation would have to come in below -0.85% over the next 12 months for a hold-to-maturity position in TIPS to underperform a similar position in nominal Treasuries. Finally, shelter accounts for roughly one third of headline inflation. Year-over-year shelter CPI troughed at -0.6% during the GFC. It also dropped sharply in April – from 3.0% to 2.6% – but it still has a long way to go to get back to GFC levels (Chart 11). We don’t think that shelter inflation will move back into negative territory, and without that drag it is hard to see 12-month headline CPI falling much below zero. Chart 11Shelter Is One Third Of CPI Rental vacancies are the number one driver of shelter CPI. The rental vacancy rate has only been updated through the end of March, and April’s data will definitely show a spike. However, the vacancy rate is starting from below 7%. The vacancy rate needed to spend several years hovering around 10% or higher before shelter CPI saw its big drop in 2008/09 (Chart 11, panel 2). The National Multifamily Housing Council (NMHC)’s Apartment Market Diffusion Index also does a good job predicting shelter inflation. Shelter inflation tends to fall when the index is below 50 and rise when it is above 50 (Chart 11, bottom panel). The Diffusion Index experienced a massive drop in April, back to GFC levels. However, it remains to be seen whether it will recover rapidly or remain below 50 for ten consecutive quarters like it did between 2007 and 2010. In fact, there is some reason to believe that the recovery might be fairly quick. Other data released by the NMHC show that as of May 20 2020, 90.8% of renters had made their monthly payments for May. In April 2020, 89.2% of renters had made their monthly payments by the 20th of the month. Unsurprisingly, both of these figures are below what was seen last year: In 2019, about 93% of renters had made their April and May monthly payments by the 20th of the month. But the fact that May 2020 data show a small increase compared to April indicates that the situation is not worsening, and it may in fact be getting better. Bottom Line: We are not worried about significant inflation pressures any time soon. But equally, we don’t see 12-month headline CPI falling much below zero this year. This means that TIPS are cheap relative to nominal Treasuries. We recommend overweighting TIPS versus nominal Treasuries across the entire maturity spectrum. We also recommend implementing TIPS curve steepeners.8 Appendix - Buy What The Fed Is Buying 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 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. Right now, that means we are overweight corporate bonds rated Ba and higher, Aaa-rated Agency and non-agency CMBS, Aaa-rated consumer ABS and municipal bonds. We are underweight residential mortgage-backed securities and corporate bonds rated B and lower. The below Table tracks the performance of these different bond sectors since the Fed’s March 23 announcement. We will use this Table to monitor bond market correlations and evaluate our strategy's success. Table 2Performance Since March 23 Announcement Of Emergency Fed FacilitiesRyan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 The Weekly Economic Index is a composite of 10 daily and weekly indicators of real economic activity. For more details on its construction please see https://www.newyorkfed.org/research/policy/weekly-economic-index 2 Please see US  Bond Strategy Weekly Report, “The Treasury Market Amid Surging Supply”, dated May 12, 2020, available at usbs.bcaresearch.com 3  https://www.newyorkfed.org/medialibrary/media/markets/survey/2020/apr-2020-smp-results.pdf 4 For more details on our recommended yield curve positioning please see US Bond Strategy Weekly Report, “Life At The Zero Bound”, dated March 24, 2020, available at usbs.bcaresearch.com 5 For more details on the MLF and the Fed’s other emergency lending facilities please see US Investment Strategy/US Bond Strategy Special Report, “Alphabet Soup: A Summary Of The Fed’s Anti-Virus Measures”, dated April 14, 2020, available at usbs.bcaresearch.com 6 For full pricing details please see https://www.federalreserve.gov/newsevents/pressreleases/files/monetary20200511a1.pdf  7 For more details on BCA’s outlook for oil prices please see Commodity & Energy Strategy Weekly Report, “US Politics Will Drive 2H20 Oil Prices”, dated May 21, 2020, available at ces.bcaresearch.com 8 For more details on our recommendation for TIPS curve steepeners please see US Bond Strategy Weekly Report, “Negative Oil, The Zero Lower Bound And The Fisher Equation”, dated April 28, 2020, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification