Economy

Highlights Even as a net oil importer, China loses more than it gains when oil prices collapse. An oil price collapse generates a formidable deflationary force, which will further depress China’s industrial pricing power and profit growth in Q2. There are early signs that demand in some sectors is gaining traction in the first three weeks of April. A full removal of travel restrictions in late May in China should help speed up the return of domestic business activities. We maintain our view that China’s economic recovery will pick up momentum in H2, underpinning our cyclical overweight stance on Chinese risk assets. Feature The nosedive in oil futures last week was a rude awakening of the enormous and unpredictable impact the pandemic has on the global economy and financial markets. WTI futures for May 2020 delivery fell to -$40.40 per barrel on April 20, an unprecedented event.  The collapse in oil prices since March will generate substantial deflationary headwinds to China’s economy in the months ahead (Chart 1). Producer prices are already in contraction. An imported deflation from low oil prices will weaken industrial pricing power even more, pushing up real rates. China’s industrial profit growth also moves in lockstep with producer prices. A deepening in PPI contraction means industrial profit growth will remain underwater, underscoring our view that the near-term outlook for Chinese stocks is yet to turn sanguine (Chart 2). Chart 1Falling Oil Prices: A Substantial Deflationary Force Chart 2Deflation Weakens Industrial Profit Growth   Oil prices will likely rebound in Q3 when the global economy re-opens, oil supply cuts take hold and the US dollar peaks. Our Commodity and Energy strategist estimates that WTI spot prices will reach $38/barrel by end-2020.1 A modest recovery in oil prices alone will not be enough to lift Chinese producer prices back to positive. The substantial reflationary efforts from China’s policymakers since Q1 should start to have an impact on the real economy in H2. The exponential credit growth should effectively prop up investment and consumption growth, and reduce inventory overhang in the industrial sector. We expect industrial producer prices and profits to turn slightly positive in Q3/Q4, underpinning our constructive view on Chinese stocks in the next 6- to 12-months. Oil Price Collapse: A Bane, Not A Boon China, as a net oil importer, stands to lose more than gain in an oil price war. This is contrary to commonly held economic theory that net oil importing countries are winners from cheaper oil. In theory falling oil prices reduces import prices, improves net oil importers’ term of trade, and in turn contributes positively to their GDP growth. In reality oil prices rarely fall in isolation. A precipitous fall in oil prices is almost always triggered by a sharp decline in global demand, accompanied with a spike in the US dollar, and results in a turmoil in the global financial markets (Chart 3). Therefore, depending on where an economy is positioned in the global value chain, a net oil importer may lose even more than a net oil exporter when oil prices collapse. Chart 3Global Trade Remains Under Pressure Until Dollar Peaks Chart 4China Loses More From Falling Trade Than Gains From Falling Oil Prices At only 14% of world oil consumption, China’s demand for oil alone is not enough to support a price recovery. But as a global manufacturing powerhouse, the benefits China has gained from cheaper oil in the past cycles were often more than offset by the economic and financial shocks from an oil price collapse (Chart 4). The small positive contribution to China’s GDP growth via savings on oil import bills is further discounted by losses from China’s own oil and oil-product exports (Chart 4, middle panel). China’s oil and gas sector does not necessarily benefit from collapsing oil prices. The country’s domestic oil exploration becomes deeply unprofitable when international oil prices collapse. Falling domestic demand for finished oil products and rising competition in the industry when prices are low squeeze out any extra profits for oil refineries (Chart 5). Chart 5China’s Energy Sector Suffers Too In An Oil Bear Market Chart 6Energy Costs: A Small Part Of Chinese CPI Chart 7US Consumers Benefit Much More From An Oil Price Decline Than Chinese Consumers Furthermore, unlike the US, Chinese household consumption does not get a boost from cheaper oil. Food prices, rather than energy, drive the overall consumer price inflation in China (Chart 6). In addition, China’s domestic petrol market is heavily regulated and retail prices for energy are set by the Chinese government. China does not pass on the entire benefit of an energy price decline to its consumers, a rigid policy that has not been changed since 2016.2 As such, the current reduction in oil prices will not have the same “tax cut” benefit as it does for US consumers (Chart 7). Bottom Line: Low oil prices, accompanied by a strong dollar and depressed global trade, create a self-feeding deflationary feedback loop to China’s industrial sector, reducing the effects of the existing reflationary measures on its economy. Budding Signs Of Reflation A modest recovery in oil prices in Q3 will not be enough to return China's PPI to positive territory. Even when the global economy re-opens, the initial recovery in business activities and demand will likely be gradual, a situation China has experienced in the past two months (Chart 8). Thus, China’s domestic demand will bear most of the brunt to shore up inflation in produced goods, by propping up investment and consumption growth. We expect China’s substantial reflationary measures to start filtering into the real economy in H2. China’s industrial sector should get a boost from an acceleration in infrastructure investment and producer prices should turn moderately positive later in Q3 (Chart 9). Chart 8China’s Export Growth Set To Decline Further In Q2 Chart 9Huge Credit Wave Should Start Lifting Industrial Profits In H2 High-frequency data point to some early signs of a rebound in China’s domestic demand. The annual growth in the transaction volume of rebar steel rebounded from an 8% decline in March to 4% growth in the first three weeks in April.3 The contraction in passenger car sales also narrowed from -38% in March to -7.3% so far in April.4 China is ramping up its COVID-19 antibody testing to prevent a second-wave outbreak and is preparing for the National People’s Congress (NPC), which may take place in mid-May. Inter-provincial travel restrictions have limited the speed of recovery in business operations, but we expect such cautionary measures to be fully lifted in late May. The removal of logistic restrictions will help to accelerate a return to normal in both domestic production and demand. As we noted in our last week’s report,5 the April 17 Politburo meeting confirmed a policy shift to maximum reflation. President Xi’s new slogan, “The Six Stabilities and The Six Guarantees,” sets the tone that the government will increase investments to ensure that China’s post-pandemic economic growth is strong enough to stabilize employment. Bottom Line: Chinese business activities continue to inch up.  The recovery in domestic demand should pick up momentum in H2 to offset imported deflationary pressures on China’s industrial profits.  Investment Conclusions In the near term, a strong US dollar is a key risk to the recovery of China’s industrial profits.  The greenback not only generates downward pressure on oil prices and global trade, but also puts the RMB in a poor position of depreciating against the dollar but at the same time appreciating against China’s export competitors (Chart 10). All are creating headwinds to China’s economic recovery. We recommend that investors stay on the sidelines in the near term until the dollar peaks and oil prices rebound, probably in Q3.  However, on a cyclical time horizon, as the global economy re-opens and demands slowly recovers in H2, the flood of stimulus including China's own reflation efforts should help to restore investors’ risk appetite and lift the prices of risk assets. Although Chinese stocks have passively outperformed global stocks this year, the strong rebound in the SPX in recent weeks has made Chinese stocks slightly less overbought in relative terms (Chart 11). Chart 10A Tough Combination For The RMB Chart 11Chinese Stocks: Slightly Less Overbought In Past Weeks We expect China’s corporate profit growth to outpace global earnings growth this year, even as other economies re-open and start to recover. This warrants an overweight stance on Chinese stocks after near-term risks and market gyrations subside.   Jing Sima China Strategist jings@bcaresearch.com     Footnotes 1Please see Commodity & Energy Strategy Weekly Report "USD Strength Restrains Commodity Recovery," dated April 23, 2020, available at ces.bcaresearch.com 2The floor for retail fuel prices is set at $40 a barrel to limit losses at China’s state-owned oil companies, which generally have average production costs in the range of $40-$50 per barrel. http://english.www.gov.cn/news/top_news/2016/01/13/content_281475271410529.htm 3Based on daily data from MySteel. 4Based on weekly data from China Passenger Car Association. 5Please see China Investment Strategy Weekly Report "Three Questions Following The Coronacrisis," dated April 23, 2020, available at cis.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations

Highlights Real Yield Curve: Last week’s negative oil print could signal the peak in deflationary sentiment for this cycle. It’s a good time for bond investors to enter real yield curve steepeners. Buy a short-maturity real yield (1-year or 2-year) and sell a long-maturity real yield (10-year or 30-year). High-Yield: High-yield bond spreads are much too tight relative to the VIX and ratings migration. This is justified for Ba-rated issuers that can tap the Fed’s emergency programs. However, B-rated and below spreads look vulnerable. Investors should overweight Ba-rated junk bonds and underweight the B-rated and below credit tiers. Bank Bonds: US bond investors should overweight subordinate bank bonds within an allocation to investment grade corporate credit. Subordinate bank bonds are Baa-rated and thus offer reasonably high spreads. But unlike other Baa-rated bonds, banks should avoid ratings downgrades during this cycle. Feature Oil was the big mover in financial markets last week, with the WTI price dropping briefly into negative territory on the day before expiry of the May futures contract.1  Bond markets didn’t react much to the negative oil price (Chart 1), but this doesn’t mean that the energy market is unimportant for yields. On the contrary, the oil price often sends important signals about the near-term outlook for inflation, a key input for bond investors. Chart 1Negative Oil Didn't Shock The Bond Market A Bond Market Trade Inspired By Negative Oil The Fisher Equation is the formula that relates nominal yields, real yields and inflation expectations. In its simplest form the Fisher equation is: Nominal Yield = Real Yield + Inflation Expectations When applying this equation to the act of bond yield forecasting we find it helpful to note that both the nominal yield and inflation expectations have specific valuation anchors. The Federal Reserve sets the valuation anchor for nominal yields because it controls the overnight nominal interest rate. If you enter a long position in a nominal Treasury security and hold to maturity you will make money versus a position in cash if the average overnight nominal interest rate turns out to be lower than the nominal bond yield at the time of purchase. The oil price often sends important signals about the near-term outlook for inflation, a key input for bond investors. Similarly, inflation expectations are anchored by the actual inflation rate. If you enter a long position in inflation protection and hold to maturity you will make money if actual inflation turns out to be higher than the rate that was embedded in bond prices at the time of purchase.2 Turning to real yields, we see why the Fisher Equation is important. Real yields have no obvious valuation anchor. This means that the best forecasting technique is often to: (1)   Use our known valuation anchors (the fed funds rate and inflation) to forecast the nominal yield and inflation expectations. (2)  Use the Fisher Equation to back-out a fair value for real yields. With all that said, let’s apply this framework to today’s bond market in light of last week’s dramatic oil price moves. Inflation Compensation The cost of inflation protection tracks the oil price, more so at the front end of the curve than at the long end. This makes sense given that recent oil price trends tell us a fair amount about the outlook for inflation over the next year but very little about the outlook for inflation over the next 10 or 30 years. The inflation market didn’t react much to oil’s dip into negative territory last week, but this year’s broader drop in the WTI price from above $50 to below $20 had a big impact on TIPS breakeven inflation rates and CPI swap rates, particularly at short maturities (Chart 2). In fact, consistent with expectations for a very low oil price, the bond market is now pricing-in deflation over the next two years. Chart 2Bond Market Priced For Deflation Nominal Yields The Fed’s zero interest rate policy is having a profound effect on nominal bond yield volatility. Because the consensus investor expectation is that the Fed will keep rates pinned near zero for a long time, almost irrespective of economic outcomes, even a significant market event like a plunge in the oil price will do very little to move nominal bond yields. During the last zero-lower-bound period, nominal bond yield volatility fell across the entire yield curve but fell much more at the short end of the curve than at the long end (Chart 3). The same phenomenon will re-occur during the current zero-lower-bound episode. Chart 3The Zero Lower Bound Crushes Nominal Bond Yield Volatility Real Yields Using the Fisher Equation, we can deduce how real yields must move given changes in inflation expectations and nominal bond yields. With the Fed ensuring that short-maturity nominal yields remain stable, the recent decline in oil and inflation expectations caused short-dated real yields to jump (Chart 4). Long-maturity real yields remain low because (a) the shock to inflation expectations was smaller at the long-end of the curve and (b) the Fed’s forward rate guidance doesn’t suppress nominal bond yield volatility as much for long maturities. Chart 4There's Value In Short-Maturity Real Yields Investment Implications If we assume that last week’s -$37.60 WTI print will mark the cyclical trough in oil prices, US bond investors can profit by implementing real yield curve steepeners.3  Short-dated real yields will fall as oil and short-dated inflation expectations recover and nominal yields remain stable. In this scenario, real yields are more likely to rise at the long-end of the curve, given the greater volatility in long-dated nominal yields and the fact that long-maturity inflation expectations are not as depressed. Looking at the 2008 episode as a comparable, we see that the cost of inflation protection bottomed around the same time as the trough in oil, and about 7 months before the trough in 12-month headline CPI (Chart 5). After that trough, with the Fed keeping short-dated nominal rates pinned near zero, the inflation compensation curve flattened and the real yield curve steepened. Chart 5Initiate Real Yield Curve Steepeners Bottom Line: Last week’s negative oil print could signal the peak in deflationary sentiment for this cycle. It’s a good time for bond investors to enter real yield curve steepeners. Buy a short-maturity real yield (1-year or 2-year) and sell a long-maturity real yield (10-year or 30-year). Poor Junk Bond Valuations Illustrated In recent reports we have been advising investors to own spread products that offer attractive spreads and that benefit from Fed support.4 This includes investment grade corporate bonds and Ba-rated high-yield bonds, but not junk bonds rated B or below. In past reports we also showed that B-rated and below junk spreads don’t adequately compensate investors for likely default losses. But this week, we want to quickly illustrate that junk spreads are trading too tight even compared to other common coincident indicators. Specifically, we zero in on the VIX and ratings migration. In 2008, the cost of inflation protection bottomed around the same time as the trough in oil, and about 7 months before the trough in 12-month headline CPI. Charts 6A, 7A and 8A show the historical relationship between the VIX and Ba, B and Caa junk spreads. In all three cases, spreads are well below levels that have been historically consistent with the current reading from the VIX. Charts 6B, 7B and 8B show the historical relationship between the monthly Moody’s rating downgrade/upgrade ratio and Ba, B and Caa spreads. These charts tell a similar story. In fact, March saw nearly 12 times as many ratings downgrades as upgrades, the third highest monthly ratio since 1986. With more downgrades coming in the months ahead, it is apparent that junk spreads are stretched. Chart 6ABa Spreads & VIX Chart 6BBa Spreads & Ratings Chart 7AB Spreads & VIX Chart 7BB Spreads & Ratings Chart 8ACaa Spreads & VIX Chart 8BCaa Spreads & Ratings Relatively tight spreads are probably justified in the Ba space where firms will benefit from the Federal Reserve’s Main Street Lending facilities.5 However, B-rated and below securities have mostly been left out in the cold. We see high odds of spread widening for those credit tiers.  Bottom Line: High-yield bond spreads are much too tight relative to the VIX and ratings migration. This is justified for Ba-rated issuers that can tap the Fed’s emergency programs. However, B-rated and below spreads look vulnerable. Investors should overweight Ba-rated junk bonds and underweight the B-rated and below credit tiers. Subordinate Bank Debt Is A Good Bet The Fed’s decision to exclude bank bonds from its primary and secondary market corporate bond purchases complicates our investment strategy. We want to focus on sectors that offer attractive spreads and that benefit from Fed support, but should we carve out an exception for bank bonds? Bank Bonds Are A Defensive Sector First, we note that banks are a defensive corporate bond sector. This is due to bank debt’s relatively high credit rating and low duration. Notice that banks outperformed the rest of the corporate index when spreads widened in March, but have lagged the index by 131 bps since spreads peaked on March 23 (Chart 9). Bank equities don’t exhibit the same behavior and have in fact steadily underperformed the S&P 500 since the start of the year (Chart 9, bottom 2 panels). Chart 9Bank Bonds Are Defensive... However, if we consider senior and subordinate bank debt separately, a different picture emerges (Chart 10). Senior bank bonds behave defensively, as described above, but the lower-rated/higher duration subordinate bank bond index is more cyclical. It has outperformed the corporate benchmark by 316 bps since March 23 (Chart 10, bottom panel). Chart 10...Except Subordinate Debt The Value In Bank Bonds Despite being a defensive sector, senior bank bonds offer attractive risk-adjusted value. The average spread of the senior bank index is 18 bps above the spread offered by the equivalently-rated (A) corporate bond benchmark. Further, the senior bank index has lower average duration than the A-rated benchmark, making the sector very attractive on a per-unit-of-duration basis (Chart 11A). Chart 11ASenior Bank Bond Valuation Chart 11BSubordinate Bank Bond Valuation ​​​​​​​Turning to subordinate bank bonds, risk-adjusted value looks only fair compared to other equivalently-rated (Baa) corporate bonds (Chart 11B). However, in absolute terms the subordinate bank index offers a spread of 246 bps, compared to a spread of 178 bps on the senior bank index. Downgrade Risk Is Minimal We think investors should overweight subordinate bank bonds for two reasons. First, we think the Fed’s aggressive policy response means that investment grade corporate bond spreads, in general, have already peaked. We would expect defensive senior bank bonds to underperform in this environment of spread tightening, even though they offer attractive risk-adjusted value. Subordinate bank bonds should outperform the index in this environment, even if other Baa-rated sectors offer better value. Second, other Baa-rated corporate bond sectors offer elevated spreads because downgrade risk remains high. The Fed’s facilities will prevent default for investment grade firms, but many Baa-rated issuers will end up taking on a lot of debt to avoid bankruptcy and will get downgraded. We think banks are insulated from this downgrade risk. Even in the Fed's "Severely Adverse Scenario", three of banks' four main capital ratios remain above pre-GFC levels. Chart 12 shows the four main capital ratios calculated for US banks, and the dashed line shows the minimum value the Fed estimates that those ratios will hit under the “Severely Adverse Scenario” from the 2019 Stress Test. Three of the four ratios would remain above pre-crisis levels, and the Tier 1 Leverage Ratio would be only a touch lower. Chart 12Banks Have Huge Capital Buffers Further, our US Investment Strategy service observes that the large banks had sufficient earnings in the first quarter to significantly ramp up loan loss provisions without taking any capital hit at all.6 Our US Investment Strategy team believes that, as long as the shutdown doesn’t last more than six months, the big banks will have sufficient earnings power to absorb loan losses this year, without having to mark down their capital ratios, which in any case are extremely high. Bottom Line: US bond investors should overweight subordinate bank bonds within an allocation to investment grade corporate credit. Subordinate bank bonds are Baa-rated and thus offer reasonably high spreads. But unlike other Baa-rated bonds, banks should avoid ratings downgrades during this cycle. In short, subordinate bank debt looks like a reasonably safe way to capture high-beta exposure to the investment grade corporate bond market.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 For a more detailed explanation of the WTI price’s shocking move please see Commodity & Energy Strategy Special Alert, “WTI In Free Fall”, dated April 20, 2020, available at ces.bcaresearch.com 2 An example of a long position in inflation protection would be buying the 5-year TIPS and shorting the equivalent-maturity nominal Treasury security. 3 Our Commodity & Energy Strategy service’s view is that the WTI oil price will average ~$60 to $65 in 2021. For further details please see Commodity & Energy Strategy Weekly Report, “US Storage Tightens, Pushing WTI Lower”, dated April 16, 2020, available at ces.bcaresearch.com 4 Please see US Bond Strategy Weekly Report, “Is The Bottom Already In?”, dated April 21, 2020, available at usbs.bcaresearch.com 5 For more details on the Fed’s different emergency 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 Please see US Investment Strategy Weekly Report, “The Big Bank Beige Book, April 2020”, dated April 20, 2020, available at usis.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Inflation-Linked Bonds: The plunging price of oil has put renewed downward pressure on global bond yields via lower inflation expectations. With oil prices set to recover over the next 6-12 months as the global economy awakens from the COVID-19 slumber, depressed market-derived inflation expectations can move higher across the developed markets – most notably in the US, the UK, Australia and Canada. Favor inflation-linked government bonds versus nominals in those countries on a strategic (6-12 months) basis. UK Corporates: The Bank of England (BoE) is supporting the UK investment grade corporate bond market with an unprecedented level and pace of purchases, with credit spreads at attractive levels. Upgrade UK investment grade corporates to overweight on a tactical (0-6 months) and strategic (6-12 months) basis. Across sectors, favor debt from sectors such as non-bank Financials and Communications that are less exposed to pandemic-related uncertainty but still benefit from BoE buying. Feature Chart of the WeekThe Link Between Oil & Bond Yields Remains Strong The shocking, albeit brief, journey of the West Texas Intermediate (WTI) oil price benchmark below zero last week was another in a long line of stunning market moves seen during the COVID-19 pandemic. Those negative oil prices were technical in nature and lasted all of one day, but the ramifications for global bond markets of the falling cost of oil in 2020 have been more enduring. Government bond yields have largely followed the ebbs and flows in energy markets for most of the past decade, and this year has been no exception (Chart of the Week). That link from oil has been through the inflation expectations component of yields, which have been (and remain) highly correlated to oil prices in virtually every developed market country. This is likely due to the persistent low global inflation backdrop since the 2008 financial crisis, which has made cyclical swings in energy prices the marginal driver of both realized and expected inflation. Chart 2BCA's Commodity Strategists Expect Oil Prices To Recover Our colleagues at BCA Research Commodity & Energy Strategy now anticipate higher oil prices over the next 12-18 months.1 Global growth is expected to recover from the COVID-19 recession sooner (and faster) than global oil production, helping to improve the demand/supply balance in energy markets and boost oil prices (Chart 2). Our energy strategists expect the benchmark Brent oil price to rise to $42/bbl by the end of 2020 and $78/bbl by the end of 2021. Those are big moves compared to the current spot price around $20/bbl, and would impart significant upward pressure on inflation expectations if the history of the past decade is any guide. That kind of move in oil prices should also help lift overall nominal government bond yields. Although the real (inflation-adjusted) component of yields is likely to remain low as major central banks like the Fed and ECB will remain highly accommodative, even when growth and inflation begin to recover, given the severity of the COVID-19 global recession. With market-based inflation expectations now at such beaten-up levels, and with the disinflationary effect of falling energy prices set to fade, we see an opportunity to play for a cyclical rebound in inflation breakevens across the developed markets by favoring inflation-linked government bonds versus nominal yielding equivalents. A Simple Framework For Finding Value In Inflation Breakevens Given the remarkably tight correlation between oil prices and market-determined inflation expectations in so many countries, it should be fairly straightforward to model the latter using the former as the main input. We have developed a series of fair value regressions for breakevens in the major developed countries which do exactly that. In this simple approach, we attempt to model the 10-year breakeven from inflation-linked bonds for eight countries – the US, the UK, Germany, Japan, France, Italy, Canada and Australia - as a function of a short-run variable (oil prices) and a long-run variable (the trend in realized inflation). Specifically, we are using the annual percentage change in the Brent oil price benchmark in local currency terms (i.e. converted from US dollars at spot exchange rates) as the short-run variable and a five-year moving average of realized headline CPI inflation as the long-run variable. The latter is included to provide an “anchor” for breakevens based on the actual performance of inflation in each country. In other words, expectations about what inflation will look like in the future are informed by what it has done in the past – what economists refer to as “adaptive” expectations. The generic regression equation used for each country is: 10-year inflation breakeven = α + β1 * (annual % change of Brent oil price in local currency terms) + β2 * (60-month moving average of headline CPI inflation) In Table 1, we present the results of the regressions of each of the eight countries, which use weekly data dating back to the start of 2012 to capture the period when oil prices have most heavily influenced inflation expectations. The coefficients, R-squareds and standard errors of the regressions are all shown, as well as the most recent model residual (i.e. the deviation of 10-year inflation expectations from model-determined fair value). All the coefficients for each model are significant. The R-squareds of the models vary, with the models for France and Australia doing the best job of explaining changes in inflation expectations in those two countries. Table 1Details Of Our New 10-Year Inflation Breakeven Models For the UK and Japan, we added an additional “dummy” variable to control for the unique situations that we believe have influenced inflation breakevens in those countries. For the UK, the period since the June 2016 Brexit vote has seen the path of inflation expectations stay nearly 50bps higher than implied by moves in GBP-denominated oil prices and the trend in actual UK inflation. For Japan, the period since the Bank of Japan initiated its Yield Curve Control policy in September 2016 has seen breakevens stay nearly 60bps below fair value as derived from JPY-denominated oil prices and the trend in actual Japanese inflation. Bond investors with longer-term investment horizons looking to play for a global growth recovery from the COVID-19 recession over the next 12-18 months should position for some widening of breakevens by favoring inflation-linked bonds over nominal paying government debt. In Charts 3 to10 over the next four pages, we show the models for each country. 10-year inflation breakevens versus the independent variables in the models are shown in the top two panels, the model fair value is presented in the 3rd panel, and the deviation from fair value is in the bottom panel. In all cases, breakevens are below fair value, suggesting that inflation-linked bonds look relatively attractive versus nominal government bonds. Chart 3Our US 10-Year TIPS Breakevens Model Chart 4Our UK 10-Year Breakeven Inflation Model Chart 5Our France 10-Year Breakeven Inflation Model Chart 6Our Italy 10-Year Breakeven Inflation Model Chart 7Our Japan 10-Year Breakeven Inflation Model Chart 8Our Germany 10-Year Breakeven Inflation Model Chart 9Our Canada 10-Year Breakeven Inflation Model Chart 10Our Australia 10-Year Breakeven Inflation Model Chart 11Real Inflation-Linked Bond Yields Will Remain Subdued For Longer The largest deviations from fair value can be found in Canada (-70bps), Australia (-48bps), the UK (-29bps), and the US (-26bps). 10-year breakevens are also below fair value in the euro zone countries and Japan, but not by more than one standard deviation as is the case for the other four countries. Bond investors with longer-term investment horizons looking to play for a global growth recovery from the COVID-19 recession over the next 12-18 months should position for some widening of breakevens by favoring inflation-linked bonds over nominal paying government debt. Focus on the four markets with breakevens furthest from fair value, although from a market liquidity perspective it is easier to implement those positions in the US and UK, which represent a combined 69% of the Bloomberg Barclays Global Inflation-Linked bond index. A rise in inflation expectations should also, eventually, put some sustained upward pressure on nominal bond yields. We would rather play that initially by positioning for higher inflation breakevens, rather than having outright below-benchmark duration exposure, as developed market central banks will stay accommodative for longer given the severity of the COVID-19 recession - that will keep real bond yields lower for longer (Chart 11). Breakevens from inflation-linked bonds are now too low across the developed markets – most notably in the US, the UK, Australia and Canada. Bottom Line: The plunging price of oil has put renewed downward pressure on global bond yields via lower inflation expectations. With oil prices set to recover over the next 6-12 months as the global economy starts to awaken from the coronavirus induced slumber, breakevens from inflation-linked bonds are now too low across the developed markets – most notably in the US, the UK, Australia and Canada. Favor linkers over nominals in those countries. Where Is The Value In UK Corporate Bonds? Chart 12Upgrade UK IG Corporates To Overweight On BoE Buying The Bank of England (BoE) initiated its Corporate Bond Purchase Scheme (CBPS) in August 2016 as part of a package of stimulus measures to cushion the economic blow from the UK’s vote to exit the European Union. As we noted in recent joint report with our sister service, BCA Research US Bond Strategy,2 the CBPS helped tighten spreads by lowering downgrade and default risk premiums and also helped spur corporate bond issuance (Chart 12). Shortly after that report was published, the BoE announced that it would be purchasing a further £10 billion in investment grade nonfinancial corporate bonds in the coming months, doubling the scheme’s aggregate holdings to £20 billion. In addition, the bank would make these purchases at a significantly faster pace than in 2016, which implies a faster transmission towards tightening of spreads. Compared to other central bank peers, however, the BoE’s program still has room to expand, which makes UK investment grade credit attractive over tactical and strategic investment horizons. Using the market value of the Bloomberg Barclays UK corporate bond index (excluding financials) as a proxy for the total value of eligible bonds, the CBPS is on track to own roughly 9% of all eligible bonds by the time the £20 billion target is reached. The neighboring European Central Bank, on the other hand, already owns 23% of the stock of eligible euro area corporate bonds in its market, and that figure is only set to increase with policymakers set to do “whatever it takes” to backstop the investment grade market. Year-to-date, UK corporate bonds appear to have recovered somewhat from the panicked selloff earlier this quarter (Table 2), with the Bloomberg Barclays UK investment grade corporate bond index down only -0.3% in total return terms. In excess return terms relative to duration-matched UK corporate bonds, however, the index is down -5.2%, indicating that weakness has persisted in the pure credit component. Table 2UK Investment Grade Corporate Bond Returns At the broad sector level, Other Industrials appear to be the outlier, having delivered positive excess returns (+0.6%) and significant total returns (+16%). These returns are not nearly as attractive, however, on a risk-adjusted basis once you consider that this sector has an index duration more than three times that of the overall index.3 Outside of that sector, the best performers, in excess return terms, are predominantly the more “defensive” sectors—Utilities (-3.4%), Technology (-3.7%), Communications (-4.2%) and Consumer Non-Cyclical (-4.6%). Meanwhile, the sectors most exposed to vanishing consumer demand and weak global growth have performed the worst—Transportation (-9.5%), Capital Goods (-7%), Energy (-6.8%), and Basic Industry (-6.2%). Credit spreads in the UK indicate that the market has already begun to stabilize in response to the BoE’s new round of corporate bond purchases. Credit spreads in the UK indicate that the market has already begun to stabilize in response to the BoE’s new round of corporate bond purchases (Chart 13). The overall index spread, although still elevated at 228bps, has already tightened by 57bps from the peak in late March. The gap between the index spreads of Baa-rated and Aa-rated UK debt remained relatively stable through the wave of sell-offs, peaking at +53bps, below the 2019 high of +55bps, and settling now to +36bps. Outside the purview of the CBPS, however, the situation is a bit rockier, with the overall high-yield index spread +590bps above that of the investment grade index. Broadly speaking, there is a clear disparity between those credit tiers that have the support of the monetary authorities and those that do not. Investment grade spreads will continue to tighten as the BoE rapidly increases its holdings of investment grade corporate bonds. However, high-yield bonds remain exposed to downgrade/default risk and ongoing uncertainty stemming from the COVID-19 economic shock. To drill down into which credit tier spreads offer the most value within the UK investment grade space, we use the 12-month breakeven spread percentile rankings. This is one of the tools we use to assess value in global credit spreads, as measured by historical “spread cushions”. Specifically, we calculate how much spread widening is required over a one-year horizon to eliminate the yield advantage of owning corporate bonds versus duration-matched government debt. We then show those breakeven spreads as a percentile ranking versus its own history, to allow comparisons over periods with differing underlying spread volatility. Chart 14 shows the 12-month breakeven spread percentile rankings for all the credit tiers in the UK investment grade space. Aaa-rated debt appears most unattractive, with the spreads currently ranking below the historical median. Between the other three tiers, Aa-rated debt offers the most value, although all three are at historically attractive levels. Chart 13UK IG Has Held Up Well During The COVID-19 Shock Chart 14UK IG Breakeven Spreads Look Most Attractive For Aa-Rated Bonds On the sector-level, the disparity in spreads is most clearly visible in the sectors most exposed to the pandemic. In Charts 15 & 16, we show the history of option-adjusted spreads (OAS) for the major industrial sub-groupings of the Bloomberg Barclays UK investment grade corporate index. Spreads look widest relative to history for sectors such as Energy and Transportation, while spread widening has been contained in more insulated sectors such as Financials. Chart 15A Mixed Performance For UK IG By Sector In 2020 … Chart 16… But Spreads, In General, Remain Below Previous Cyclical Peaks Another way to assess value across UK investment grade corporates is our sector relative value framework. Borrowing from the methodology used for US corporate credit by our colleagues at BCA Research US Bond Strategy, the sector relative value framework determines “fair value” spreads for each of the major and minor industry level sub-indices of the overall UK investment grade universe. The methodology takes each sector's individual OAS and regresses it in a cross-sectional regression with all other sectors. The dependent variables in the model are each sector's duration, 12-month trailing spread volatility and credit rating - the primary risk factors for any corporate bond. Using the common coefficients from that regression, a risk-adjusted "fair value" spread is calculated. The difference between the actual OAS and fair value OAS is our valuation metric used to inform our sector allocation ranking. We see this as an opportune time to upgrade our recommended allocation for UK investment grade corporates to overweight. The latest output from the UK relative value spread model can be found in Table 3. We also show the duration-times-spread (DTS) for each sector in those tables, which we use as the primary way to measure the riskiness (volatility) of each sector. The scatterplot in Chart 17 shows the tradeoff between the valuation residual from our model and each sector's DTS. Table 3UK Investment Grade Corporate Sector Valuation & Recommended Allocation Chart 17UK Investment Grade Corporate Sectors: Valuation Versus Risk We can then apply individual sector weights based on the model output and our desired level of overall spread risk to come up with a recommended credit portfolio. The weights are determined at our discretion and are not the output from any quantitative portfolio optimization process. The only constraints are that all sector weights must add to 100% (i.e. the portfolio is fully invested with no use of leverage) and the overall level of spread risk (DTS) must equal our desired target. Amid a backdrop of global uncertainty, we reiterate one of our major themes this quarter—buy what the central banks are buying. Given that UK corporate spreads are attractive on a breakeven basis, and with the BoE purchasing corporate debt at an even faster pace than during the volatile period following the shock Brexit vote in 2016, we see this as an opportune time to upgrade our recommended allocation for UK investment grade corporates to overweight. This is both on a tactical (0-6 months) and strategic basis (6-12 months). In our model bond portfolio, we have added two percentage points to our recommended UK corporate bond allocation, funded by reducing further our existing underweight on Japanese government bonds. At the sector level, given this positive backdrop for credit performance, we do not see a need to favor lower risk sectors with a DTS score below that of the overall UK investment grade index. On that basis, we are looking to go overweight sectors with higher relatively higher DTS and positive risk-adjusted spread residuals from our relative value model (and vice versa). Those overweight candidates would ideally be located in the upper right quadrant of Chart 17. Based on the latest output from the relative value model, the strongest overweight candidates are the following UK investment grade sectors: selected Financials (Insurance, Subordinated Bank Debt, and Other Financials), Media Entertainment, Cable Satellite, Tobacco, Diversified Manufacturing, and Communications. The least attractive sectors within this framework are: Packaging, Lodging, REITs, Other Industrials, Metals, Natural Gas, Restaurants, Transportation Services, Financial Institutions, and Midstream Energy. Bottom Line: The BoE is supporting the UK investment grade corporate bond market with an unprecedented level and pace of purchases. Spreads have already begun to tighten in response but are still at attractive levels. Upgrade UK investment grade corporates to overweight on a tactical (0-6 months) and strategic (6-12 months) basis. Across credit tiers, favor Aa-rated debt. Across sectors, favor debt from sectors such as non-bank Financials and Communications that are less exposed to pandemic-related uncertainty but still benefit from the CBPS.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Shakti Sharma Research Associate shaktis@bcaresearch.com Footnotes 1 Please see BCA Commodity & Energy Strategy Weekly Report, "US Storage Tightens, Pushing WTI Lower", dated April 16, 2020, available at ces.bcaresearch.com. 2 Please see BCA US Bond Strategy Special Report, "Trading The US Corporate Bond Market In A Time Of Crisis", dated March 31 2020, available at usbs.bcaresearch.com. 3 Other Industrials has an index duration of 28.6 years, compared to 8.5 years for the overall UK investment grade corporate bond index. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Portfolio Strategy We remain comfortable with a 3,000 SPX fair value estimate backed up by our DDM, forward ERP and sensitivity analyses. The path of least resistance remains higher for the SPX on a 9-12 month cyclical time horizon. The oil price collapse is eliciting a massive supply response that should help rebalance the oil markets, and coupled with glimmers of hope on reopening the economy, it should put a floor under oil prices. CB are injecting unprecedented amounts of liquidity in the markets and at some point this will lead to a growth revival which is negative for gold prices. Taken together, and given all-time lows in relative valuations and technicals, we are compelled to go long US oil & gas exploration & production stocks at the expense of global gold miners. We are putting the S&P managed health care index on downgrade alert to reflect the risk that rising unemployment poses to health care enrollment. Falling interest rates also weigh on industry profitability at a time when relative valuations are perky and technicals are overbought. Recent Changes Initiate a long S&P oil & gas exploration & production/short global gold miners pair trade, today. Table 1 Feature Equities marked time last week, despite the passage of a fresh mini fiscal 2.0 package and efforts to restart the economy in parts of the globe. In contrast, news that President Trump may delay reopening the economy along with negative crude oil prices weighed heavily on the S&P 500. Nevertheless, energy equities fared very well, defying the oil market carnage and impressively relative energy share prices have led the SPX trough (Chart 1). We remain constructive on the broad equity market on a cyclical 9-12 month time horizon. Following up from last week’s SPX dividend discount model (DDM) update, we complement our research with two additional ways of approximating the SPX fair value: EPS and multiple sensitivity analysis and a forward equity risk premium (ERP) analysis. While at the nadir the stock market priced in a collapse in EPS close to $104 for the current year (please refer to our analysis here1), in 2021 EPS can return to their long-term trend line near $162. At first sight this spike in EPS seems unrealistic. However, here are two salient points: Chart 1Energy As A Leading Indicator First, hard-hit COVID-19 subsectors are a small fraction of SPX profits and market capitalization. In other words, the S&P 500 is a market cap weighted index and has already filtered out hotels, cruises, restaurants, homebuilders, autos, auto parts, airlines, and even energy as they comprise a small part of the SPX. Second, historical precedents show an explosive year-over-year growth increase in EPS from recessionary troughs. In fact, the steeper the collapse the more violent the rebound. Hence, our recovery EPS estimate is more or less in line with empirical evidence (Chart 2). Chart 2Violently Oscillating EPS For comparison purposes, the Street is still penciling in EPS near $135 and $170 for 2020 and 2021, respectively. Table 2 shows our sensitivity analysis and an SPX ending value of just above 2,900 using $162 EPS and an 18x forward multiple as our base case. This multiple is slightly below the historical time trend using IBES data dating back to 1979, and represents our fair value PE estimate (please see page 17 of our April 6, 2020 webcast2 available here). Table 2SPX EPS & Multiple Sensitivity With regard to the forward ERP analysis, our starting point is an equilibrium ERP of 440 basis points (bps). The way we derived this number was using the last decade’s average observed forward ERP (middle panel, Chart 3). We used to think equilibrium ERP was closer to 200bps. However, if the Fed’s extraordinary – and unorthodox – measures since the onset of the GFC did not manage to bring down the ERP (middle panel, Chart 3), then in the current recession with uncertainty on the rise, it only makes sense to model a higher than previously thought equilibrium ERP (middle panel, Chart 4). Chart 3The Forward Equity Risk Premium… Chart 4…Will Recede And, just to put the forward ERP in perspective, keep in mind that it jumped from 350bps to just below 600bps year-to-date (Chart 4)! A doubling in the 10-year US treasury yield to 120bps is another assumption we are making along with using our trend EPS estimate of $162 for calendar 2021. Backing out price results in a roughly 2,900 SPX fair value estimate (Table 3). Table 3Forward Equity Risk Premium Analysis We remain comfortable with a 3,000 SPX fair value estimate backed up by our DDM, forward ERP and sensitivity analyses. Despite the much needed current consolidation phase, the path of least resistance is higher for the SPX on a 9-12 month cyclical time horizon. This week we are putting a health care subgroup on downgrade alert and initiating a high-octane intra-commodity market-neutral pair trade to benefit from the looming handoff of liquidity to growth. Time To Buy “Black Gold” At The Expense Of Gold Bullion We have been long and wrong on the S&P energy sector and its subcomponents, as neither we nor our Commodity & Energy Strategists anticipated -$40/bbl WTI crude oil futures prices. Nevertheless, as the energy sector is drifting into oblivion within the SPX – it is now the second smallest GICS1 sector with a 2.77% market cap weight slightly higher than materials – we think that WTI May contract reaching -$40/bbl marked the recessionary trough. Similar to the early-2018 “volmageddon” incident when a volatility exchanged trade product blew up and got dismantled and marked that cyclical peak in the VIX, the recent near collapse of USO and shuttering of another oil related levered exchange traded product serve as the anecdotes that likely mark the low in oil prices. True, negative WTI futures prices are no longer taboo and the CME prepared for them by reprograming its systems to handle negative futures prices, thus they can happen again. With regard to the significance of anecdotes in market tops and bottoms, another interesting one that comes to mind is from our early days at BCA in May of 2008 where we worked for the Global Investment Strategy team as a senior analyst. Back then, we vividly remember a Goldman Sachs analyst slapping a $150/bbl target on crude oil,3 and only days later in unprecedented hubris Gazprom’s CEO upped the ante with an apocalyptic $250/bbl prediction.4 This prompted us to create our first mania chart at BCA with crude oil prices on June 20, 2008 (please see chart 16 from that report available here5), which proved timely as oil prices peaked less than a month later at $147/bbl. Today, we are compelled to perform the opposite exercise and run a regression of previous equity sector market crashes on the S&P oil & gas exploration & production index (E&P, that most closely resembles WTI crude oil prices) in order to gauge a recovery profile. Chart 5 suggests that if the anecdotes are accurate in calling the trough in oil prices, then E&P stocks should enjoy a steep price appreciation trajectory in the coming two years. Beyond the overweights we continue to hold in the S&P energy sector and all the subgroups we cover, we believe that there is an exploitable trading opportunity to go long S&P E&P/short global gold miners (Chart 6). Chart 5Heed The US Equity Strategy’s Crash Index Message This high-octane trade is extremely volatile, but the recent carnage in the oil markets offers a great entry point for investors that can stomach heightened volatility, with an enticing risk/reward tradeoff. The gold/oil ratio (GOR) is trading at 112 as we went to press and we think that it will have to settle down. The Fed is doing its utmost to dampen volatility, and historically, suppressed volatility has been synonymous with a falling GOR (Chart 7). As a result, our pair trade will have to at least climb back to its recent breakdown point, representing a near 34% return (top panel, Chart 6). Chart 6Buy E&P Stocks At The Expense Of Gold Miners From a macro perspective the time to buy oil equities at the expense of gold miners is when there is a handoff from liquidity to growth (bottom panel, Chart 6). While we are still in the liquidity injection phase we deem the Fed and other Central Banks (CB) are committed to do “whatever it takes” to sustain the proper functioning of the markets. Therefore, at some point likely in the back half of the year when the economy slowly reopens, all these CB programs will bear fruit and growth will recover violently (middle panel, Chart 6), especially given our long-held view that the US will avoid a Great Depression. Chart 7VIX Says Sell The GOR With regard to balancing the oil market, nothing like price to change behavior. In more detail, the recent collapse in oil prices will work like magic to bring some semblance of normality back to the crude oil market, as it will naturally cause a shut in of production; there is no doubt about it. Not only has the supply response commenced, but it is also accelerating to the downside as the plunging rig count depicts (Chart 8). This will lead to some longer-term bullish oil price ramifications. As a reminder, while demand drives prices in the short-term, supply dictates the oil price direction in the long-term. Chart 8Oil Price Collapse Induced Supply Response Turning over to gold and gold miners, all this liquidity is forcing investors to chase bullion and related equities higher. Tack on that every CB the world over is trying to debase their currency, and factors are falling into place for sustainable flows into gold and gold mining equities. However, there are high odds that all this money sloshing around will eventually generate growth especially in the western hemisphere that is slowly contemplating of restarting its economic engines. As a result, real yields will rise which in turn is negative for gold and gold miners (Chart 9). Finally, relative valuations and technicals could not be more depressed, which is contrarily positive (Chart 10). Chart 9Liquidity To Growth Handoff Beneficiary Netting it all out, the oil price collapse is eliciting a massive supply response that should help rebalance the oil markets, and coupled with glimmers of hope on reopening the economy, it should put a floor under oil prices. CB are injecting unprecedented amounts of liquidity in the markets and at some point this will lead to a growth revival which is negative for gold prices. Taken together, and given all-time lows in relative valuations and technicals, we are compelled to go long US oil & gas exploration & production equities at the expense of global gold miners. Chart 10As Bad As It Gets Bottom Line: Initiate a long US oil & gas exploration & production/short global gold miners pair trade today. The ticker symbols for the stocks in these indexes are: BLBG: BLBG: S5OILP – COP, EOG, HES, COG, MRO, NBL, CXO, APA, PXD, DVN, FANG, (or XOP:US exchange traded fund) and GDX:US exchange traded fund, respectively. Put HMOs On Downgrade Alert We upgraded the S&P managed health care index last April, the Monday after Bernie Sanders re-introduced his “Medicare For All” bill.6 Our thesis was that the drubbing in this sector was a massive overreaction and we, along with our Geopolitical Strategists, thought that he would have low chances of clinching the Democratic Presidential candidacy and threatening to render HMOs obsolete. A year later, this thesis has panned out and the S&P managed care index is up 30% versus the S&P 500. Nevertheless we do not want to overstay our welcome and are putting it on our downgrade watch list and instituting a 5% rolling stop in order to protect gains in our portfolio (top panel, Chart 11). Relative share prices have broken out to fresh all-time highs, not only courtesy of a more moderate Democratic Presidential candidate, but also because a significant boost to margins and profits is looming. The delayed effect of fewer elective procedures (i.e. hip and knee replacements and even non-life threatening bypass surgeries) owing to the coronavirus pandemic will result in a sizable, yet temporary, margin expansion phase (second panel, Chart 11). Tack on, still roughly 20% health care insurance CPI and the outlook for HMO margins and profits further improves (bottom panel, Chart 11). Nevertheless, there are some negative offsets. Over the past 5 weeks unemployment insurance claims have soared to 26.5mn, erasing all the employment gains of the past decade, thus private insurance enrollment will take a sizable hit (top panel, Chart 12). Chart 11The Good… Chart 12…And The Bad Moreover on the income side, the premia that HMOs take in are typically invested in the risk free asset and given the two month fall from 1.5% to around 0.6% in the 10-year Treasury yield, managed health care earnings will also, at the margin, suffer a setback (bottom panel, Chart 12). True, the HMOs earnings juggernaut has been one of a kind over the past decade underpinning relative share prices (top panel, Chart 13). However, we reckon a lot of the good news and very little if any of the bad news is priced in extremely optimistic relative profit expectation going out five years (middle panel, Chart 13). Keep in mind that the bulk of the M&A activity is behind this industry as the dust has now settled from the previous two year frenzied pace of inter and intra industry combinations (top panel, Chart 14). Chart 13Lots Of Good News Is Already Priced In Chart 14Preparing Not To Overstay Our Welcome Finally, relative technicals are in overbought territory close to one standard deviation above the historical mean and relative valuations are also becoming a tad too lofty for our liking (middle & bottom panel, Chart 14). Adding it all up, we are putting the S&P managed health care index on downgrade alert to reflect the risk that rising unemployment poses to health care enrollment. Falling interest rates also weigh on industry profitability at a time when relative valuations are perky and technicals are overbought. Bottom Line: Stay overweight the S&P managed health care index, but it is now on our downgrade watch list. We are also instituting a rolling 5% stop as a portfolio management tool in order to protect profits. Stay tuned. The ticker symbols for the stocks in this index are: BLBG: S5MANH-UNH, ANTM, HUM, CNC.   Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com     Footnotes 1     Please see BCA US Equity Strategy Weekly Report, “What Is Priced In?” dated March 30, 2020, available at uses.bcaresearch.com. 2     https://www.icastpro.ca/events/bca/2020/04/06/us-equity-market-what-the-future-holds/play/16925 3    https://www.nytimes.com/2008/05/21/business/21oil.html 4    https://www.reuters.com/article/gazprom-ceo/russias-gazprom-sees-higher-gas-prices-ceo-idUSL1148506420080611 5    Please see BCA Global Investment Strategy Weekly Report, “Strategy Outlook - PART 1 - Third Quarter 2008” dated June 20, 2008, available at gis.bcaresearch.com. 6    Please see BCA US Equity Strategy Weekly Report, “Show Me The Profits” dated April 15, 2019, available at uses.bcaresearch.com.   Current Recommendations Current Trades Strategic (10-Year) Trade Recommendations Size And Style Views June 3, 2019 Stay neutral cyclicals over defensives (downgrade alert)  January 22, 2018 Favor value over growth 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 Why is the gap between the stock market and the economy so wide?: It is well established that stocks can diverge considerably from fundamentals in the near term, but lately it is as if the stock tables and the front-page headlines are from entirely different newspapers. It may be because the virus poses much less of a threat to the owners of equities than the general populace: More affluent households are more readily able to work from home and to practice social distancing. They also have access to better medical care. With the S&P 500 having hit technical resistance, however, the gap may be nearing its upper limit: Large-caps have run in place since retracing half of their peak-to-trough losses, and the next Fibonacci resistance level is only another 5% higher. Where are the shoddy loans?: During the expansion, corporations were able to borrow on prodigally easy terms. If banks aren't holding the loans, who is? Feature That’s New York’s future, not mine – “Hold On” (Reed) For someone who entered the business as a sell-side trader, it is a matter of course that prices can diverge from fundamentals. The trading desk had a one-day horizon, and the traders necessarily made their way on price signals while barely considering fundamentals. Though the junior traders had been exposed to dividend discount models at their fancy colleges, the ones who lasted recognized they weren’t relevant to the desk’s mission. Trading the daily flow required accepting that new news can have a dramatically larger effect on stocks in the here and now than it would on the lifetime stream of earnings available to common shareholders. Long-run fair value might solely turn on the fundamentals, but animal spirits hold sway over any given tick. The sudden stop imposed by stay-at-home orders has made backward-looking economic data nearly irrelevant, but the sizable upward surprises in unemployment claims should not be ignored. Our Global Investment Strategy colleagues showed last week just how difficult it is for even severe near-term shocks to materially alter the present value of aggregate future earnings.1 Furthermore, the market effects of negative earnings shocks are inherently self-limiting at the margin because they tend to be accompanied by lower interest rates, driving up the equity risk premium and making stocks more attractive relative to “safe” fixed income alternatives. Bear markets coincide with recessions, though, as near-term earnings expectations are revised lower and animal spirits droop (Chart 1). Given that the recession just begun is expected to be the worst since the Great Depression, one would expect that equities would be stumbling in search of a bottom as investors remained fearful of taking on risk. Chart 1Joined At The Hip They have instead been acting like the S&P 500 found that bottom on March 23rd, when the index completed a 35% peak-to-trough decline in just 23 sessions. It then proceeded to gain 28.5% over the next eighteen sessions. Some retracement is to be expected after a sudden, sharp move, and the S&P 500 has only recovered half of the ground that it lost. It certainly priced in a great deal of bad news on the way down, but the data have been worsening, and investors have been forced to give up on the notion of a swift economic recovery. Why are stocks rising when economic projections are being downwardly revised and good virus news has been few and far between? We ourselves have been barely glancing at backward-looking economic data releases that merely confirm the well-understood fact that draconian social distancing measures have wrung much of the life out of the economy. The degree to which job losses have outrun consensus forecasts stands out nonetheless. Aggregate initial unemployment claims over the last five weeks have exceeded consensus expectations by 5.5 million (Table 1). Even though the forecasts have caught up to the situation on the ground, the claims data suggest that unemployment is now pushing 20%, a worst-case-scenario level that is far above the first forecasts that incorporated the effects of stay-at-home orders. Claims may well have peaked, but they’re still an order of magnitude higher than normal, and they are not finished exerting upward pressure on the unemployment rate. Table 1Job Losses Have Been Worse Than Expected Meanwhile, COVID-19 data have yet to provoke much optimism. The rate of US infections has yet to come down to Italy’s level (Chart 2), and hopes that remdesivir might prove to be a wonder drug were dashed late last week. Clients are increasingly asking us why the stock market is traveling such a dramatically different path than the economy and the virus. How could stocks have plunged at a record rate as the coronavirus drew a bead on the United States, but surged after crippling social distancing measures were put in place? Chart 2The US Has Fallen Behind Italy's Pace A Tale Of Two Boroughs The simplest answer is that the Fed’s response was swifter and more far-reaching than expected. Ditto Congressional actions, and we expect that DC will continue to deploy its fiscal firepower to try to shield households and businesses from the worst of the effects of the anti-virus measures. We believe the monetary and fiscal efforts will make a difference, and do not think it’s a coincidence that equities turned around the week of March 23rd, which began with the Fed’s rollout of a formidable new arsenal and ended with the passage of the CARES Act. But the market action has not accounted for the shift from expectations of a V-bottom to talk of Us, Ls and Ws. Two articles published a week apart in The New Yorker vividly illustrated a demographic virus gap. The first looked at COVID-19 from the perspective of financial professionals at hedge funds and other sophisticated investment aeries.2 Although the views of the investors in the profile shifted with the tide of the incoming data, they were generally of the mind that the health threat was being dramatically overhyped. One retired hedge fund manager boasted about his and his family’s non-stop early March air travel between New York, London and a Wyoming ski resort. The second article followed an emergency room resident at Elmhurst, a publicly funded hospital in a working-class Queens neighborhood, which has been described as the epicenter of the outbreak in several local media reports.3 “‘It’s become very clear to me what a socioeconomic disease this is,’” he said. “‘Short-order cooks, doormen, cleaners, deli workers – that is the patient population here. Other people were at home, but my patients were still working. A few weeks ago, when they were told to socially isolate, they still had to go back to an apartment with ten other people. Now they are in our cardiac room dying.’” Stock ownership is largely reserved to the affluent, with the top percentile of households owning 53% of equities as of the end of 2019, and the rest of the top decile owning another 35% (Chart 3). For households in the top decile, maintaining a healthy distance from the virus isn’t that difficult. Knowledge workers equipped with a laptop and a reliable internet connection can work from anywhere, unlike the Elmhurst patients in low-skilled service positions who have to work onsite. The tonier precincts of Manhattan feel nearly deserted, with their residents having decamped for second homes in lower-density areas. Perhaps it's because the Fed's attempts to shore up the economy have far more personal relevance for investors than the spread of the virus. There are no comprehensive data series on virus infections and outcomes by zip code, which would facilitate analysis of the link between household wealth and COVID-19, but New York state reports age-adjusted fatality rates in four racial/ethnic categories. In New York state ex-New York city, which has lesser extremes of wealth than the city itself, the cross-category disparities are striking (Chart 4). Race/ethnicity is far from an ideal proxy for inequality, but it is fair to conclude that financial market participants have a sound basis for being more sanguine about the virus than the overall population. Assuming that more affluent households will be able to remain out of the virus’ reach, the dichotomy can persist for as long as the economic impacts do not become so bad that investors cannot reasonably look through them. Chart 3Demographics Drive Stock Ownership ... Chart 4... And COVID-19 Fatalities Technical Resistance Back on the trading desk, technical analysis was the go-to tool for traders pricing large blocks of stock in real time. Following sizable moves, the Fibonacci sequence provided a popular method for assessing how far a stock might retrace its steps before resuming its course. The most widely used Fibonacci retracement levels are 38% and 62%, and 50%, a round number exactly between the two, has also become an anticipated stopping point. From the February 19 closing high of 3,386.15 to the March 23 closing low of 2,237.40, the S&P 500 lost 1,148.75 points. The 38%, 50% and 62% retracement levels are 2,673.93, 2,811.78 and 2,949.63, respectively. The S&P paused at the 38% level for just two days before breaking through it decisively, but it’s had more trouble making its way through 2,812, failing to hold above it for more than a day or two at a time (Chart 5). Should it escape 2,812, the 2,950 level waits just 5% higher. Chart 5Fibonacci Retracement Levels For The S&P 500 We are fundamental investors who do not get hung up on technical levels, though they can become self-fulfilling prophecies if enough participants are following them. Given the popularity of Fibonacci retracement, it is possible that a critical mass of short-term investors may view 2,812 and 2,950 as preferred levels for exiting long positions in the S&P. Our bigger near-term concern is that it is hard to see US equities making much more headway while the virus and ongoing distancing measures have the potential to cause investors to revise their fundamental expectations lower and/or lose a little bit of their policy-fueled nerve. Who's Left Holding The Bag? Multiple commentators have expressed alarm at the post-2008 increase in corporate debt, especially given anecdotal reports that lending covenants had been loosened dramatically. If the banks don’t hold the debt, as we’ve argued, who does, and could a wave of virus-inspired defaults cause larger problems in the financial system? The Fed’s fourth quarter Flow of Funds report, published last month, provides some clues, but does not answer the question definitively. As we saw in higher frequency data on aggregate banking system exposures, bank loans to nonfinancial corporations grew modestly (3.2% annualized) since December 31, 2008. Nonfinancial corporations borrowed in the bond market at double that rate (6.2% annualized). Foreign loans, powered by near doubling in 2017 and 2018, grew at an annualized 13.4% pace, and are four times as large as they were at the end of 2008. Finance company loans have shrunk, and trade payables grew at a modest 2% rate. (Chart 6). Chart 6Debt Risks Are Pretty Well Diffused Publicly available data from Preqin on the capital raised by direct lending funds suggests that their impact has been modest, accounting for only about a quarter of outstanding bank loans if every dollar they’ve raised is currently deployed. Demand for leveraged loans, senior floating-rate debt issued to high-yield borrowers, was occasionally intense as investors sought protection from rising rates. The desire for duration protection has faded as rates have plunged to new lows, but ETFs and CLOs were eager buyers at points during the last expansion. In a Special Report published last summer, our US Bond Strategy and Global Fixed Income Strategy services concluded that the ownership of leveraged loans is diffuse enough that credit strains are unlikely to pose a systemic threat. They were also encouraged that leveraged loans and high yield corporate bonds act as substitutes, keeping one another in check as investor preferences for fixed and floating instruments wax and wane. They also noted that leveraged loan lending standards had tightened last year, with a reduced share of covenant-lite loans being issued, though standards have eased again since they published their report (Chart 7). Chart 7Covenant Protections Have Eroded Chart 8Diverse Corporate Bond Ownership Will Help Mitigate The Effect Of Defaults There is no way around the fact that high yield corporate bondholders (Chart 8), owners of CLO tranches rated below AAA and leveraged loan holders face elevated credit losses as the broad economic shutdown provokes a wave of defaults in instruments without Fed support. We expect that the default losses will be spread out across enough constituents that they will not become worryingly concentrated, but they may contribute to a further erosion of risk appetites.       Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 Please see the April 23, 2020 Global Investment Strategy Weekly Report, "Could The Pandemic Actually Raise Stock Prices?" available at gis.bcaresearch.com. 2 Paumgarten, Nick. "The Price of a Pandemic." The New Yorker, April 20, 2020, pp. 20-24. The article, relaying traders’ conversations, contains some profanity. 3 Galchen, Rivka. "The Longest Shift." The New Yorker, April 27, 2020, pp. 20-26. The article, relaying ER conversations, contains some profanity.