Economy

Highlights Chart 1Making New Lows While the number of daily new COVID-19 cases is falling in China, the virus is spreading rapidly to the rest of the world. It is now clear that the outbreak will not be contained, though much uncertainty remains about the magnitude and duration of the global economic fallout. US bond yields have dropped dramatically, with the 10-year yield threatening to break below 1% for the first time ever (Chart 1). Interest rate markets are also pricing-in a rapid Fed response, with more than 100 bps of rate cuts priced for the next year and a 50 bps rate cut discounted for March. On Friday, BCA released a Special Alert making the case that stock prices have fallen enough to buy the market, even on a tactical (3-month) horizon. It is too early to make a similar call looking for higher bond yields. While risk assets will get near-term support from a dovish monetary policy shift, bond yields will stay low (and could even fall further) until global economic recovery appears likely. On a 12-month horizon, our base case scenario is that the Fed will not have to deliver the 110 bps of cuts that are currently priced. We therefore expect bond yields to be higher one year from now. But investors with shorter time horizons should wait before calling the bottom in yields.  Feature Investment Grade: Neutral Chart 2Investment Grade Market Overview Investment grade corporate bonds underperformed the duration-equivalent Treasury index by 176 basis points in February, dragging year-to-date excess returns down to -255 bps. Coronavirus fears pushed spreads wider in February, and the average spread for the overall investment grade index moved back above our cyclical target (Chart 2).1 As for specific credit tiers, Baa spreads are 9 bps above target and Aa spreads are 3 bps cheap. A-rated spreads are sitting right on our target, and Aaa debt remains 5 bps expensive. Looking beyond the economic fallout from the coronavirus, accommodative monetary conditions remain the key support for corporate bonds. Notably, both the 2-year/10-year and 3-year/10-year Treasury slopes steepened in February, and both remain firmly above zero. This suggests that the market believes that the Fed will keep policy easy. As we discussed two weeks ago, restrictive Fed policy – as evidenced by an inverted 3-year/10-year Treasury curve and elevated TIPS breakeven inflation rates – is required before banks choke off the supply of credit, causing defaults and a bear market in corporate spreads.2 Bottom Line: Corporate spreads will keep widening until coronavirus fears abate, but COVID-19 will not cause the end of the credit cycle. Once the dust settles, a buying opportunity will emerge in investment grade corporates, with spreads back above our cyclical targets. Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Table 3BCorporate Sector Risk Vs. Reward* High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield underperformed the duration-equivalent Treasury index by 271 basis points in February, dragging year-to-date excess returns down to -379 bps. The junk index spread widened 110 bps on the month and is currently 37 bps below its early-2019 peak. Ex-energy, the average index spread widened 93 bps in February. It is 71 bps below its 2019 peak. High-yield spreads were well above our cyclical targets prior to the COVID-19 outbreak and have only cheapened further during the past month. More spread widening is likely in the near-term, but an exceptional buying opportunity will emerge once virus-related fears fade. This is especially true relative to investment grade corporate bonds. To illustrate the valuation disparity between investment grade and high-yield, we calculated the average monthly spread widening for each credit tier during this cycle’s three major “risk off” phases (2011, 2015 and 2018). We then used each credit tier’s average option-adjusted spread and duration to estimate monthly excess returns for that amount of spread widening (Chart 3, bottom panel). The results show that, in past years, Baa-rated corporates behaved much more defensively than Ba or B-rated bonds. But now, because of the greater spread cushion and lower duration in the junk space, estimated downside risk is similar. In other words, the valuation disparity between investment grade and junk means that investment grade corporates offer much less downside protection than usual compared to high-yield. MBS: Neutral Chart 4MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 7 basis points in February, dragging year-to-date excess returns down to -60 bps. The conventional 30-year zero-volatility spread widened 1 bp on the month, driven by a 7 bps widening of the option-adjusted spread that was partially offset by a 6 bps reduction in expected prepayment losses (aka option cost). The 10-year Treasury yield has made a new all-time low, and the 30-year mortgage rate – at 3.45% – is only 14 bps above its own (Chart 4). At these levels, an increase in mortgage refinancing activity is inevitable, and indeed, the MBA Refi index has bounced sharply in recent weeks. MBS spreads, however, have not yet reacted to the higher refi index (panel 3). The nominal spread on 30-year conventional MBS is only 9 bps above where it started the year, and expected prepayment losses are 5 bps lower.3 Some widening is likely during the next few months, and we recommend that investors reduce exposure to Agency MBS. Even on a 12-month horizon, MBS spreads offer good value relative to investment grade corporate bonds for now (bottom panel), but investment grade corporates will cheapen on a relative basis if the current risk-off environment continues. This is probably a good time to start paring exposure to MBS, with the intention of re-deploying into corporate credit when spreads peak. Government-Related: Underweight Chart 5Government-Related Market Overview The Government-Related index underperformed the duration-equivalent Treasury index by 86 basis points in February, dragging year-to-date excess returns down to -99 bps. Sovereign debt underperformed duration-equivalent Treasuries by 270 bps in February, dragging year-to-date excess returns down to -367 bps. Foreign Agencies underperformed the Treasury benchmark by 162 bps on the month, dragging year-to-date excess returns down to -189 bps. Local Authority debt underperformed Treasuries by 14 bps in February, dragging year-to-date excess returns down to +47 bps. Domestic Agency bonds underperformed by 5 bps in February, dragging year-to-date excess returns down to -7 bps. Supranationals outperformed by 5 bps on the month, bringing year-to-date excess returns up to +7 bps. We continue to see little value in USD-denominated Sovereign debt, outside of Mexico and Saudi Arabia where spreads look attractive compared to similarly-rated US corporate bonds (Chart 5). The Local Authority and Foreign Agency sectors, however, offer attractive combinations of risk and reward according to our Excess Return Bond Map (see Appendix C). Our Global Asset Allocation service just released a Special Report on emerging market debt that argues for favoring USD-denominated EM sovereign debt over both USD-denominated EM corporate debt and local-currency EM sovereign bonds.4 Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal bonds underperformed the duration-equivalent Treasury index by 80 basis points in February, dragging year-to-date excess returns down to -114 bps (before adjusting for the tax advantage). The average Aaa-rated Municipal / Treasury (M/T) yield ratio rose 11% on the month to 88%, remaining below its post-crisis mean (Chart 6). For some time we have been advising clients to focus municipal bond exposure at the long-end of the Aaa curve, where yield ratios were above average pre-crisis levels. But last month’s sell-off brought some value back to the front end (panel 2). Specifically, the 2-year, 5-year and 10-year M/T yield ratios are all back above their average pre-crisis levels at 85%, 83% and 86%, respectively. 20-year and 30-year maturities are still cheapest, at yield ratios of 93% and 94%, respectively. Investors should adopt a laddered allocation across the municipal bond curve, as opposed to focusing exposure at the long-end. Fundamentally, state and local government balance sheets remain solid. Our Municipal Health Monitor is in “improving health” territory and state & local government interest coverage has improved considerably in recent quarters (bottom panel). Both trends are consistent with muni ratings upgrades continuing to outpace downgrades going forward. Treasury Curve: Maintain A Barbell Curve Positioning Chart 7Treasury Yield Curve Overview The Treasury curve bull-steepened dramatically in February, with yields down at least 30 bps across the board. The 2/10 Treasury slope steepened 9 bps on the month, reaching 27 bps. The 5/30 slope also steepened 9 bps to reach 76 bps. February’s plunge in yields was massive, but the fact that it occurred without 2/10 or 5/30 flattening signals that the market expects the Fed to respond quickly and that any economic pain will be relatively short lived. In fact, the front-end of the curve is now priced for 110 bps of rate cuts during the next 12 months (Chart 7). That amount of easing would bring the fed funds rate back to 0.48%, less than two 25 basis point increments off the zero lower bound. Though the drop in 12-month rate expectations didn’t move the duration-matched 2/5/10 or 2/5/30 butterfly spreads very much, the 5-year note remains very expensive relative to both the 2/10 and 2/30 barbells (bottom 2 panels). The richness in the 5-year note will reverse if the Fed delivers less than the 110 bps of rate cuts that are currently priced for the next year. At present, we view less than 110 bps of easing as the most likely scenario, and therefore maintain our position long the 2/30 barbell and short the 5-year bullet. TIPS: Overweight Chart 8Inflation Compensation TIPS underperformed the duration-equivalent nominal Treasury index by 159 basis points in February, dragging year-to-date excess returns down to -232 bps. The 10-year TIPS breakeven inflation rate fell 24 bps to 1.42%. The 5-year/5-year forward TIPS breakeven inflation rate fell 21 bps to 1.50%. Both rates remain well below the 2.3%-2.5% range consistent with the Fed’s inflation target. We have been recommending that investors own TIPS breakeven curve flatteners on the view that inflationary pressures will first show up in the realized inflation data and the short-end of the breakeven curve, before infecting the long-end.5 However, recent risk-off market behavior has caused long-end inflation expectations to fall dramatically, while sticky near-term inflation prints have supported short-dated expectations. Case in point, the 2-year TIPS breakeven inflation rate declined 16 bps in February, compared to a 24 bps drop for the 10-year (Chart 8). Inflation curve flattening could continue in the near-term but will reverse when risk assets recover. As a result, we recommend taking profits on TIPS breakeven curve flatteners and waiting for a period of re-steepening before putting the trade back on. Fundamentally, we note that the 10-year TIPS breakeven inflation rate is 38 bps cheap according to our re-vamped Adaptive Expectations Model (bottom panel).6 Investors should remain overweight TIPS versus nominal Treasuries on a 12-month horizon. ABS: Underweight Chart 9ABS Market Overview Asset-Backed Securities underperformed the duration-equivalent Treasury index by 6 basis points in February, dragging year-to-date excess returns down to +26 bps. The index option-adjusted spread for Aaa-rated ABS widened 7 bps on the month. It currently sits at 33 bps, right on top of its minimum pre-crisis level (Chart 9). Our Excess Return Bond Map (see Appendix C) shows that Aaa-rated consumer ABS ranks among the most defensive US spread products. This explains why the sector has weathered the recent storm so well, and why it is actually up versus Treasuries so far this year. ABS also offer higher expected returns than other low-risk spread sectors such as Domestic Agency bonds and Supranationals. For as long as the current risk-off phase continues, consumer ABS are a more attractive place to hide than Domestic Agencies or Supranationals. However, once risk-on market behavior re-asserts itself, consumer ABS will once again lag other riskier spread products. In the long-run, we also remain concerned about deteriorating consumer credit fundamentals, as evidenced by tightening lending standards for both credit cards and auto loans, and a rising household interest expense ratio (bottom 2 panels). Non-Agency CMBS: Neutral Chart 10CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 42 basis points in February, dragging year-to-date excess returns down to +1 bp. The index option-adjusted spread for non-agency Aaa-rated CMBS widened 9 bps on the month. It currently sits at 76 bps, below its average pre-crisis level (Chart 10). In a recent Special Report, we explored how low interest rates have boosted commercial real estate (CRE) prices this cycle and concluded that a sharp drawdown in CRE prices is likely only when inflation starts to pick up steam.7 In that report we also mentioned that non-agency Aaa-rated CMBS spreads look attractive relative to US corporate bonds in risk-adjusted terms (Appendix C), and that the macro environment is close to neutral for CMBS spreads. Both CRE lending standards and loan demand were close to unchanged during the past quarter, as per the Fed’s Senior Loan Officer Survey (bottom 2 panels).  Agency CMBS: Overweight Agency CMBS performed in line with the duration-equivalent Treasury index in February, leaving year-to-date excess returns unchanged at +35 bps. The index option-adjusted spread widened 2 bps on the month to reach 56 bps. Agency CMBS offer greater expected return than Aaa-rated consumer ABS, while also carrying agency backing (Appendix C). An overweight allocation to this sector remains appropriate. Appendix A: The Golden Rule Of Bond Investing We follow a two-step process to formulate recommendations for bond portfolio duration. First, we determine the change in the federal funds rate that is priced into the yield curve for the next 12 months. Second, we decide – based on our assessments of the economy and Fed policy – whether the change in the fed funds rate will exceed or fall short of what is priced into the curve. Most of the time, a correct answer to this question leads to the appropriate duration call. We call this framework the Golden Rule Of Bond Investing, and we demonstrated its effectiveness in the US Bond Strategy Special Report, “The Golden Rule Of Bond Investing”, dated July 24, 2018, available at usbs.bcaresearch.com. Chart 11 illustrates the Golden Rule’s track record by showing that the Bloomberg Barclays Treasury Master Index tends to outperform cash when rate hikes fall short of 12-month expectations, and vice-versa. Chart 11The Golden Rule's Track Record At present, the market is priced for 110 basis points of cuts during the next 12 months. We anticipate a flat fed funds rate over that time horizon, and therefore anticipate that below-benchmark portfolio duration positions will profit. We can also use our Golden Rule framework to make 12-month total return and excess return forecasts for the Bloomberg Barclays Treasury index under different scenarios for the fed funds rate. Excess returns are relative to the Bloomberg Barclays Cash index. To forecast total returns we first calculate the 12-month fed funds rate surprise in each scenario by comparing the assumed change in the fed funds rate to the current value of our 12-month discounter. This rate hike surprise is then mapped to an expected change in the Treasury index yield using a regression based on the historical relationship between those two variables. Finally, we apply the expected change in index yield to the current characteristics (yield, duration and convexity) of the Treasury index to estimate total returns on a 12-month horizon. The below tables present those results, along with 95% confidence intervals. Excess returns are calculated by subtracting assumed cash returns in each scenario from our total return projections. Appendix B: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of February 28, 2020) Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 5Butterfly Strategy Valuation: Standardized Residuals (As Of February 28, 2020) Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of 50 bps in the 5 over 2/10 cell means that we would only expect the 5-year to outperform the 2/10 if the 2/10 slope steepens by more than 50 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) Appendix C: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Chart 12Excess Return Bond Map (As Of February 28, 2020)   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 For more information on how we calculate our spread targets please see US Bond Strategy Weekly Report, “The Value In Corporate Bonds”, dated February 19, 2019, available at usbs.bcaresearch.com 2 Please see US Bond Strategy Weekly Report, “The Credit Cycle Is Far From Over”, dated February 18, 2020, available at usbs.bcaresearch.com 3 Expected prepayment losses (or option cost) are calculated as the difference between the index’s zero-volatility spread and its option-adjusted spread. 4 Please see Global Asset Allocation Special Report, “Understanding Emerging Markets Debt”, dated February 27, 2020, available at gaa.bcaresearch.com 5 Please see US Bond Strategy Special Report, “2020 Key Views: US Fixed Income”, dated December 10, 2019, available at usbs.bcaresearch.com  6 Please see US Bond Strategy Weekly Report, “How Are Inflation Expectations Adapting?”, dated February 11, 2020, available at usbs.bcaresearch.com 7 Please see US Investment Strategy / US Bond Strategy Special Report, “Commercial Real Estate And US Financial Stability”, dated January 27, 2020, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation

Highlights Policy Responses To The Virus: Markets are now pricing in significant monetary policy easing in response to the growth shock from the COVID-19 outbreak and related financial market instability. It is not yet clear, however, that central banks will NOT ease by as much as currently discounted in the low level of bond yields – especially as risk assets will riot anew if policymakers are not dovish enough. Duration: Raise overall global duration exposure to neutral on a tactical basis (0-3 months) until there is greater clarity on the full magnitude of the hit to global growth from the virus. Spread Product: The widening of global corporate bond spreads during last week’s equity market correction was relatively modest, suggesting that the COVID-19 outbreak has not become a credit event that raises downgrade/default risks. Maintain an overall overweight allocation to global corporates versus government bonds. Downgrade US MBS to neutral, however, given the risk of higher prepayments from falling mortgage rates. Feature What a wild ride it has been for investors. Equity markets worldwide corrected sharply last week as investors were forced to downgrade global growth expectations with the COVID-19 outbreak spreading more rapidly outside of China. US equities were particularly savaged with the S&P 500 shedding -11% of its value in a mere five trading sessions, with the VIX index of implied equity volatility spiking over 40, evoking comparisons to some of the darkest days of the 2008 financial crisis. Chart of the WeekCOVID-19 Concerns Causing Market Jitters Government bond yields have collapsed alongside plunging equity values, with the benchmark 10-year US Treasury yield hitting an all-time intraday low of 1.04% yesterday. Investors are betting on aggressive rate cuts by global central bankers to offset weak growth momentum and disinflationary pressures that were already in place before the arrival of COVID-19. At the same time, corporate credit spreads widened worldwide last week, but the moves were relatively subdued and do not signal growing concern over future default losses (Chart of the Week). In this report, we discuss how to best position a global bond portfolio given these competing messages from government bond and credit markets. We conclude that maintaining selective strategic (6-12 months) overweights in global spread product versus governments, while also maintaining a neutral tactical (0-3 months) overall duration exposure - as a hedge against a more “U-shaped” recovery from the virus-driven downturn in global growth - is the best way to position for a backdrop where policymakers will need to be as easy as possible in a more uncertain world. What To Do Next On … Duration Risk assets were staging a massive rebound yesterday as we went to press, after policymakers worldwide signaled the need for stimulus measures to offset the COVID-19 growth shock. Both Fed Chairman Jerome Powell and Bank of Japan (BoJ) Governor Haruhiko Kuroda promised to ease monetary policy, if necessary, to stabilize markets. Meanwhile, looser fiscal policy may finally be on the way in Europe. The government of virus-stricken Italy announced a €3.6 billion stimulus package, while the German Finance Minister has hinted at a temporary suspension of Germany’s constitutional “debt brake” on deficit spending. A true coordinated global easing of both monetary and fiscal policy, would be very bullish for beaten-down growth-sensitive assets like equities and industrial commodities that have been focused on the shutdown of China’s economy in February to combat the spread of the virus. A true coordinated global easing of both monetary and fiscal policy, would be very bullish for beaten-down growth-sensitive assets like equities and industrial commodities that have been focused on the shutdown of China’s economy in February to combat the spread of the virus (Chart 2). It’s a different story for government bonds, however, as a rebound in yields from current depressed levels is not assured, even if monetary policy is eased further. This is because central bankers must maintain a dovish bias until the virus-driven uncertainty over global growth begins to fade, or else risk assets will riot once again. It’s all about financial conditions now, especially in the US where COVID-19 and the stock market selloff have become front-page news in a presidential election year. Chart 2How Quickly Will China Rebound? For example, the entire US Treasury curve now trades below the mid-point of the fed funds target range, with the market now pricing in a very rapid dovish move by the Fed (Chart 3). Chart 3A Big Grab For Global Duration Yield curves are now very flat in other major developed market (DM) economies, as well. This is partly due to the risk aversion bid for safe assets, which is evident in the deeply negative term premium component of bond yields. Flat curves also reflect a more long-lasting component, with markets pricing in lower equilibrium rates in the future. Investors are not only demanding immediate rate cuts to boost growth and stabilize financial markets, but also see little chance of those cuts eventually being reversed in the future. Chart 4Markets Increasingly Pricing In Global ZIRP Our simple proxy for the market expectation of the nominal terminal rate- the 5-year overnight index swap (OIS) rate, 5-years forward – is between 0-1% for all major DM countries (Chart 4). The implication is that investors are not only demanding immediate rate cuts to boost growth and stabilize financial markets, but also see little chance of those cuts eventually being reversed in the future. Chart 5Our Central Bank Monitors Say More Easing Is Needed Chart 6Global Yields Reflect Dovish Rate Expectations At the moment, our global Central Bank Monitors – a compilation of economic and financial variables that influence monetary policy decisions – are all signaling a need for rate cuts (Chart 5). This is a function of sluggish growth & weak inflation. The plunge in global government bond yields already reflects that dovish shift in market expectations for central banks. Our 12-month discounters, which measure the expected change in short-term interest rates over the next year as extracted from OIS curves, are all priced for lower policy rates in the US (-97bps as of last Friday’s close), the euro area (-15bps) the UK (-35bps), Japan (-17bps), Canada (-72bps) and Australia (-46bps) (Chart 6). In the US, the current level of the benchmark 10-year Treasury yield is consistent with the extended slump in US industrial activity – as measured by the fall in the ISM manufacturing index – and risk-off sentiment measures like the CRB Raw Industrials/Gold price ratio (Chart 7). Yet at the same time, financial conditions remain very accommodative despite last week’s selloff, suggesting that the US economy can potentially weather a bout of COVID-19 uncertainty – as long as the Fed does not disappoint by delivering fewer rate cuts than the market is demanding and creating another down leg in the equity market. Chart 7UST Yields Need To Stay Lower For Longer Outside the US, other central banks that have non-zero policy rates – like the Bank of Canada, Reserve Bank of Australia and Bank of England – can deliver on the rate cuts discounted in their OIS curves to fight a COVID-19 global growth downturn, if needed. Chart 8UST Bullishness Still Not At Historical Extremes The negative rate club of the ECB and BoJ, however, is far less likely to actually cut rates and will rely on greater asset purchases and forward guidance to try and provide more policy stimulus. We prefer to view duration exposure – on a tactical basis – as a hedge to owning risk assets like corporate bonds, where we see some value now opening up after last week’s selloff, rather than a way to express a directional view on interest rates where we have less visibility and conviction. So what should a bond investor do with duration exposure? It is a difficult call with so many uncertainties on global growth momentum, the spread of the virus outside China, the size of any monetary or fiscal policy stimulus measures, and the degree of risk aversion still evident in financial markets. We prefer to view duration exposure – on a tactical basis – as a hedge to owning risk assets like corporate bonds, where we see some value now opening up after last week’s selloff, rather than a way to express a directional view on interest rates where we have less visibility and conviction. Therefore, we are raising our recommended overall duration exposure to neutral this week on a tactical basis. At the same time, we are maintaining an underweight stance on government bonds versus an overweight on corporate debt. We think a true bottom in yields will be reached when there are more decisive signs that bond positioning has reached a bullish extreme, according to indicators like the JP Morgan duration survey and the Market Vane US Treasury bullish sentiment index (Chart 8). In our model bond portfolio, we are expressing that extension of duration by shifting exposure from shorter maturity buckets to longer duration buckets in most countries. While also increasing exposure to “higher-beta” government bond markets like the US and Canada, at the expense of lower-beta Japanese government bonds. Bottom Line: Raise overall global duration exposure to neutral on a tactical basis (0-3 months) until there is greater clarity on the full magnitude of the hit to global growth from the COVID-19 outbreak. Increase allocations to countries with higher yield betas, like the US and Canada, at the expense of low-beta markets like Japan. What To Do Next On … Spread Product Allocations Chart 9US HY Selloff Was Focused On Energy Names Last week’s equity market meltdown did spill over into corporate bond markets, with credit spreads widening for both investment grade and high-yield corporate debt in the US and Europe. In the US, however, the jump in high-yield spreads was particularly acute among Energy names, with the index option-adjusted spread (OAS) climbing over 1000bps as oil prices plunged (Chart 9). US high-yield ex-energy has been relatively more stable, with the spread climbing to 436bps, despite the surge in equity volatility. Stepping back and looking at US investment grade and high-yield corporates, more broadly, last week’s selloff has restored some value, most notably in high-yield. Stepping back and looking at US investment grade and high-yield corporates, more broadly, last week’s selloff has restored some value, most notably in high-yield.  According to our framework for calculating spread targets for global credit, last week’s selloff pushed US investment grade spreads back to our spread targets from very expensive levels (Chart 10).1 Baa-rated US investment-grade moved slightly above our spread target, but we would describe investment grade spreads as now overall fairly valued. US high-yield spreads, on the other hand, have widened well in excess of our spread targets across all credit rating tiers (Chart 11). Chart 10US Investment Grade Spreads Now Fairly Valued Chart 11US High-Yield Spreads Look Very Cheap In our framework, the spread targets are determined by looking at 12-month breakeven spreads – the amount of spread widening necessary to eliminate the yield cushion of owning corporates over government bonds on a one-year horizon – relative to their long-run history. We group those spreads according to phases of the monetary policy cycle, as defined by the slope of the US Treasury yield curve. The spread target is then calculated based on the median breakeven spread for that phase of the cycle. Currently, we are in “Phase 2” of the policy cycle, which means that the Treasury yield curve (10-year minus 3-year) is positively sloped between 0 and 50bps. In Charts 10 & 11, we add a new wrinkle to our existing way to present the spread targets. We also calculate the targets using the 25th and 75th percentile observations for the breakeven spreads for that phase of the monetary policy cycle. This gives us a range for the spread target that encompasses more of the historical data. Given the improved valuations in US junk bonds, however, we think increasing allocations in our model bond portfolio makes sense. The spread widening in US high-yield has very clearly restored value to spreads, which are well above the upper level of our spread target range. The same cannot be said for US investment grade, where spreads are in the middle of the target range. Chart 12European Corporates Now Offer Better Value Based on this analysis, we remain comfortable in maintaining our neutral recommended stance on US investment grade corporates and overweight stance on US high-yield. Given the improved valuations in US junk bonds, however, we think increasing allocations in our model bond portfolio makes sense. Thus, this week, we are adding to our recommended high-yield exposure (see Page 12). That increased allocation is “funded” by reducing our US Agency MBS exposure from overweight to neutral. Our colleagues at BCA Research US Bond Strategy are concerned that MBS spreads are likely to widen in the next few months to reflect the higher prepayment risk from the recent steep fall in US mortgage rates. One final note: our spread target framework for euro area corporates also indicates that last week’s global risk-off event also restored some value to European credit (Chart 12). Thus, we are maintaining our recommended overweights for both euro area investment grade and high-yield. Bottom Line: The widening of global corporate bond spreads during last week’s equity market correction was relatively modest, suggesting that the COVID-19 outbreak has not become a credit event that raises downgrade/default risks. Maintain an overall overweight allocation to global corporates versus government bonds. Downgrade US MBS to neutral, however, given the risk of higher prepayments from falling mortgage rates.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 We presented our framework for calculating global corporate spread targets, which builds on the work from our US Bond Strategy sister service, back in January. Please see BCA Research Global Fixed Income Strategy Special Report, "How To Find Value In Global Corporate Bonds", dated January 21, 2020, available at gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index ​​​​​​​ Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Feature “Bayesian: …statistical methods that assign probabilities or distributions to events…based on experience or best guesses before experimentation and data collection and that apply Bayes' theorem to revise the probabilities and distributions after obtaining experimental data.” — Merriam-Webster Dictionary Markets have reacted pretty rationally to the outbreak of the COVID-19 virus. Equities initially rebounded a few days ahead of the peak of new cases in China (Chart 1). But then, once the number of cases in the rest of the world started to accelerate, stock markets sold off again sharply. The MSCI All Country World Index is now down 13% from its peak on February 12. Recommended Allocation Chart 1Markets Have Reacted In Line With New COVID-19 Cases No one knows whether this episode will turn into an unprecedented pandemic, which will kill millions worldwide, last for months, and trigger a global recession. So it is the sort of environment in which Bayesian analysis becomes useful. Our “prior” for the probability of a full pandemic would be around 10-20%. If it doesn’t happen, an attractive buying opportunity for risk assets should present itself soon. But there could be further downside first, especially if the number of cases in major countries such as the US, Germany, and the UK were to accelerate significantly. There are some sign that Chinese activity is beginning to recover. There are some signs that Chinese activity is beginning to recover, as new cases of COVID-19 slow, thanks to the draconian measures taken by the authorities. Big Data can help analyze this. For example, live traffic statistics from TomTom show that by February 28, weekday road congestion in Shanghai was back to 50% of its normal level, compared to 19% on February 14 (Chart 2). The Chinese authorities have relaunched fiscal and monetary stimulus, causing short-term rates to fall to their lowest level since 2010 (Chart 3). Monetary policy has been upgraded from “prudent” to “flexible and moderate.” BCA Research’s China strategists believe there is even an increasing possibility of a stimulus overshoot in the next 6-12 months, as the authorities plan for the worst-case scenario but the economy rebounds.1 Chart 2Chinese People Getting Back On The Roads Chart 3Chinese Stimulus Pushing Down Rates In the short-term, it is clear that global growth will weaken, though quantifying this is hard. A 1% quarter-on-quarter decline in Chinese GDP in Q1 would bring growth down to 3.5% year-over-year. Our colleagues in BCA’s Global Investment Strategy estimate this would cause global growth to fall 0.8% below trend in Q1, mainly from a contraction in tourism, but that this would be largely made up in Q2, assuming that the epidemic is over by then (Chart 4).2 Could even a limited epidemic tip the world into recession? We doubt it. Consumer confidence remains strong in developed economies (Chart 5) and the virus is not yet serious enough to stop most consumers going out to spend. The global economy was in the process of bottoming out before COVID-19 hit (Chart 6) and there is little reason to think that we will not return to the status quo ante. Chart 4Global Growth To Slow In Q1, But Rebound In Q2   Chart 5Consumers Remain Confident Chart 6Before COVID-19, Growth Was Bottoming Out We see the two biggest risks being: 1) a rise in defaults in China, especially among smaller companies, that the government is unable or unwilling to prevent (Chart 7); and 2) a deterioration in the jobs market in the US, as companies start to postpone hiring, or lay off staff (Chart 8). We will watch these carefully over coming weeks. Chart 7Are Chinese Companies Vulnerable? Chart 8Is The US Job Market Starting To Wobble? Chart 9Markets Believe Trump Would Beat Sanders There is one other risk that might give equity markets an excuse for a further sell-off: November’s US presidential election. The probability that Bernie Sanders wins the Democratic nomination has risen to 60% from 15% over the past two months. The consensus believes that Trump can easily defeat Sanders, which is why the President’s probability of being reelected has risen in tandem (Chart 9). But, if the economy starts to weaken and Trump’s approval rating slips, investors could become nervous about the likelihood of a market-unfriendly Sanders administration. We would not recommend long-term investors sell out of risk assets at this point. There could be an attractive buying opportunity over the next few weeks, and investors who have derisked should be looking for a reentry point. With US 10-year bonds yields at 1.2% and German yields at -60 basis points, it is hard to see much further upside for risk-free bonds. Equities should be able to outperform over the next 12 months, as growth rebounds following the COVID-19 episode. We have been recommending overweights in cash and gold, as hedges, since December, and these still make sense. However, if events over the coming weeks point to the risk of global pandemic being higher than we currently think, then investors should Bayesianally adjust and move more risk-off. Otherwise, a peak in COVID-19 cases ex-China should be a strong signal to buy risk assets again. Chart 10Why Should Long-Run Inflation Expectations Fall? Fixed Income: US Treasurys have become investors’ safe haven of choice over the past few weeks. A marked drop in long-run inflation expectations (Chart 10), in particular, has pushed the 10-year yield to a record low. This seems somewhat illogical, since the Fed will announce this summer the results of its review of monetary policy, which is likely to lead to a more dovish long-term inflation target (perhaps a commitment to achieve 2% on average over the cycle). The market has also priced in at least three Fed rate cuts by year-end (Chart 11). The Fed will certainly cut rates if US growth falters as a result of COVID-19, but this is by no means a certainty. History shows that Treasury yields jumped sharply once previous viral outbreaks ended (Chart 12). We expect yields to be significantly higher in 12 months, and so are underweight duration and prefer TIPS over nominal bonds. Credit will continue to underperform in the risk-off phase, but some interesting opportunities should arise soon, especially among the lowest-rated credits and in the Energy sector. Chart 11Will The Fed Really Be This Accommodating? Chart 12After Previous Virus Outbreaks, Rates Leapt Equities: The sell-off has already put on fire sale some stocks most affected by the epidemic. For example, cruise lines are down by 40% over the past month or so, European oil stocks 25%, some luxury goods makers 30%, and airlines 30%. Opportunistic investors might want to buy a basket of the most oversold quality names. Our overweight on euro area stocks has not worked in the sell-off. But, as a cyclical, export-oriented market, we continue to expect Europe to outperform when global growth rebounds. Euro area banks, in particular, represent the best call option on a rise in bond yields, since their performance is highly correlated to the shape of the yield curve. We continue to have a somewhat cyclical tilt among our sector weightings (with overweights on, for example, Energy and Industrials), but may adjust this in our Quarterly Portfolio Outlook in early April if we decide to reduce risk. The sell-off has already put on fire sale some stocks most affected by the epidemic. Currencies: The dollar is a safe-haven currency and so, unsurprisingly, has benefitted from the rush to safety in recent weeks. However, it remains overvalued (Chart 13), and interest rate differentials would move further against it if the Fed does cut rates, since other major developed central banks have much less room to move (Chart 14). This suggests that it will probably resume the weakness it experienced from August to December last year as soon as global growth rebounds. Chart 13Dollar Is Overvalued... Chart 14...And Interest Differentials Have Moved Against It Chart 15Metals Prices Stabilized In Recent Weeks Commodities: Industrial metals fell sharply on the outbreak of COVID-19 in China, but have bottomed in line with the stabilization of the situation in that country (Chart 15). Gold has worked predictably as the best hedge in the sell-off. While it is starting to look technically overbought and would be hurt by a rise in bond yields (Chart 16), for prudent investors it remains a useful hiding place amid heightened risk and ultra-low interest rates. Oil is the commodity that has fallen the most surprisingly, with Brent close to the low it reached during the sell-off in December 2018 (Chart 17).  It is much less dependent on Chinese demand than metals are, and so is maybe pricing in a global recession – as well as questioning the commitment of OPEC to cut production further. This would suggest upside to the oil price if global growth turns out not to be so bad, oil demand continues to pick up, and supply remains constrained.   Chart 16How Much Could Gold Overshoot? Chart 17Oil Discounting A Global Recession Garry Evans, Senior Vice President Chief Global Asset Allocation Strategist garry@bcaresearch.com Footnotes 1    Please see China Investment Strategy Weekly Report, “China: Back To Its Old Economic Playbook?” dated 26 February 2020, available at cis.bcaresearch.com 2   Please see Global Investment Strategy Weekly Report, “Market Too Complacent About The Coronavirus,” dated 21 February 2020, available at cis.bcaresearch.com GAA Asset Allocation  

Highlights Portfolio Strategy It is still early to bottom fish, and trying to catch the proverbial falling knife does not interest us for cyclically oriented capital. Uncertainty surrounding the coronavirus epidemic and its effects on economic and profit growth, and uncertainty with regard to US elections both signal that it still pays to be cautious on the prospects of the broad equity market on a cyclical 9-12 month time horizon. Lofty valuations, stretched technicals, souring macro and cresting capex, underscore that the time is ripe to take profits in software stocks and move to the sidelines. Faltering operating metrics, stretched relative valuations, a firming greenback, looming fed funds rate cuts and a contracting capex backdrop, all suggest that an underweight stance is now warranted in tech stocks. Recent Changes Book gains of 51% in the S&P software index and downgrade to neutral, today. Downgrade the S&P tech sector to underweight, today. We got stopped out and booked gains of 10% in the Global Gold Mining index. It is now neutral, from previously overweight. Table 1 Feature The SPX convulsed last week, as investors grappled with the risk of the coronavirus epidemic becoming a true pandemic (Chart 1A), and with Bernie Sanders likely clinching the Democratic nomination (Chart 1B). While a technical reflex rebound is in order as indiscriminate selling took center stage and we are looking to deploy short term oriented capital from current SPX levels all the way down to 2714 (or 20% SPX correction from recent peak), the cyclical outlook for the broad equity market remains grim. Chart 1ABlame The Virus…. Chart 1B…And Bernie We have been cautioning investors all year long in our reports, warning that the stock market’s advance has been precarious on a number of fronts and have been recommending investors sell the market’s strength. First, the extreme concentration of returns in a handful of teflon-tech stocks has been disconcerting, heralding an equity market wobble.1 Likely, a mania has taken root in certain tech stocks and the inevitable bursting of the “ATLAS” mania (Apple, Tesla, Lam Research, AMD and Salesforce) would end in tears.2 As an update, as we went to press these five stocks were down 21% from their all-time highs. Second, on January 13 we highlighted that gold has been trumping the SPX and sniffing out two-to-three fed funds rate cuts, leading the fed fund futures market, similar to last spring (top & middle panels, Chart 2).3 Third, we highlighted that the recent positive correlation between the VIX and the SPX was disquieting and signaling that a pullback was nearing.4 Now the jump in the VIX along with the vol curve inversion and the collapse in the stock-to-bond ratio all warn that the path of least resistance for the market and the forward multiple remains lower (Chart 3). Chart 2Gold Sniffed Out Fed Cuts First Chart 3Financial Conditions Are … This has already tightened financial conditions according to the soaring junk spread (top panel, Chart 4), and we deem that unless the Fed relents and eases monetary policy, the stock market will remain in melt down mode. Fourth, market internals have been screaming “get out” of the broad equity market for some time now (bottom panel, Chart 4) and the epitome was when semi stocks stalled versus the NASDAQ 100 (middle panel, Chart 4).5 Fifth, the “tenuous trio” as we have coined it (stock prices, bond prices and the US dollar) cannot all rise simultaneously. Typically we cautioned, this gets resolved with an equity market pullback as a rising greenback is deflationary for US profits (bottom panel, Chart 2). Finally, in our “Sell The Rip” report, we worried about extreme investor complacency and showed that the economic backdrop was soft owing to the collapse in imports in Q4 2019, predating the coronavirus epidemic.6 Tying everything together, ultimately what matters most to equity investors is profit growth. On that front we have heavily relied on the message of our four-factor EPS growth model, which has consistently delivered. Chart 4…Tightening Rapidly   In mid-January, our SPX profit growth model continued to have no pulse, warning that the Street’s 10% profit growth estimate for calendar 2020 was unattainable. Our analysis of three EPS scenarios showed that at the time the SPX was overvalued by 8% according to the SPX 3,049 expected value for end-2020 that was actually hit last week.7 Recently, we have been inundated with client requests to update our analysis and incorporate the coronavirus epidemic to our adverse EPS scenario. Chart 5 shows that in our worst case scenario, EPS will contract by 2.41% in calendar 2020. Assuming final 2019 EPS comes in at 162.95, using I/B/E/S’ latest estimate, then the 2020 EPS level falls to 159.02. Assigning a trough multiple of 16x results in a 2,544 SPX ending value as a worst case outcome. Chart 5Our EPS Model Has Delivered Importantly, our newly weighted expected 2020 EPS falls to 164.48 versus 169.40 previously as we penciled in a 60% and 50% probability that our worst case scenario materializes in EPS and multiple assumptions, respectively (Chart 6). As a result our expected end-2020 SPX value falls to 2,755 which makes the S&P 500 still 4% overvalued (please find the assumptions on the four factor model along with the updated table of expected outcomes in the Appendix below). While no one really knows how this virus outbreak will evolve, there are two predominant market narratives that can serve as positive catalysts: a.) China will massively ease both on the monetary and fiscal policy fronts (Chart 7) and b.) the Fed (and likely other CBs) will be forced to cut interest rates despite the fact that lower fed funds rates will likely not fix the supply side global problems owing to the corona virus. In other words, liquidity injections will remain upbeat. However, if these measures – especially on the Fed’s side – prove ineffective to generate GDP growth, then the risk of a recession will skyrocket for 2020, a presidential election year. Chart 6Updated Three EPS Scenarios   Chart 7How Much Will China Stimulate? As a reminder, parts of the US yield curve (YC) first inverted in December 2018 and currently the 2-year/fed funds rate slope is inverted, implying that the bond market deems the Fed will ease monetary policy. In fact, the latest CME probability of a 50bps cut on March 18 last stood at 100%. Importantly, the YC inversions did not predict the oil embargoes of the 70s, or the 9/11 attacks or the sub-prime crisis or the coronavirus outbreak. Typically, the YC inverts at the point of maximum economic strength and signals that the cycle is long in the tooth, i.e. in the current episode, 2018 registered roughly 3% real GDP growth and 25% SPX EPS growth. Put differently, the YC inversion suggests that the economy is, at the margin, vulnerable to an external shock as economic growth settles down to a lower rate trajectory. While the YC inversion does not predict recession, it forewarns recession and we continue to heed this message (Chart 8). It will not be different this time. In sum, it is still early to bottom fish, and trying to catch the proverbial falling knife does not interest us for cyclically oriented capital. Uncertainty surrounding the coronavirus epidemic and its effects on economic and profit growth, and uncertainty with regard to US elections both signal that it still pays to be cautious on the prospects of the broad equity market on a cyclical 9-12 month time horizon. This week we are making some tech sector adjustments. Chart 8The Yield Curve is ALWAYS Right! Crystalize Software Gains And Downgrade To Neutral… Market events last week compel us to take profits of 51% in the S&P software index above and beyond the S&P 500’s return since the late-2017 inception and downgrade exposure to neutral. The multiyear juggernaut in software stocks is primed for a much needed pause. Its appeal is well known as within the tech space software is considered a defensive holding owing to the productivity enhancing properties it enjoys in both good and bad times. Anecdotally, it was disquieting that the Standard & Poor’s decided to add two additional cloud stocks to the S&P 500 recently, further boosting the software group’s weight in the tech sector and in the SPX. Likely, the reason was the flurry of M&A deals that has been ongoing for years. Most recently however, this M&A frenzy hit a wall (top panel, Chart 9). Meanwhile, last Monday we wrote that AAPL’s profit warning was the tip of the iceberg and an avalanche of warnings would ensue.8 MSFT followed suit and issued their own profit warning and this negative backdrop is not yet reflected in the sell side’s S&P software profit and revenue forecasts. Tack on the message from the contracting software sector deflator and odds are high that sales will underwhelm in the coming quarters (middle panel, Chart 9). The latest GDP report also revealed that, up to recently bulletproof, software capex growth sunk to nil in Q4 (bottom panel, Chart 9). Not only in absolute, but also in relative terms software outlays have petered out and have been decreasing in intensity as measured by the decelerating contribution to GDP growth (Chart 10). Chart 9Softening… Chart 10…Software Capex Beyond investment, the recent plunge in the Markit services PMI that really ignited the recent selling in equities, warns that the time is ripe to cement software gains and move to the sidelines (Chart 11). Moreover, there is a high chance that IPOs peaked last year and will dry up in 2020, which is slightly negative for overall market sentiment in general and for market darlings software stocks in particular (Chart 11). From a technical perspective, software equities went ballistic. Relative momentum surged north of 25%/annum, a nineteen-year high (middle panel, Chart 12). Similarly, relative valuations went parabolic. The S&P software index trades at a 60% premium to the broad market on a forward P/E basis (bottom panel, Chart 12). Such overvaluation was last seen in 2003. Chart 11Do Not Overstay… Chart 12…Your Welcome Finally, we refrain from getting bearish this heavyweight tech subindex. Our long-held belief is that SaaS, the broader push to the cloud, augmented reality, AI and autonomous driving, which are all software dependent, are not fads, but are here to stay.  Netting it all out, we do not want to overstay our welcome in the S&P software index and are cementing gains and moving to the sidelines, for now. Bottom Line: Take profits of 51% since inception in the S&P software index and downgrade to neutral. The ticker symbols for the stocks in this index are: BLBG: S5SOFT – MSFT, ADBE, CRM, ORCL, INTU, NOW, ADSK, ANSS, SNPS, CDNS, FTNT, PAYC, CTXS, NLOK.   …Which Pushes Tech To Underweight Our intra-sector positioning shifts with the recent S&P tech hardware storage & peripherals downgrade to underweight9 and today’s trimming of the S&P software index to neutral, reduce the S&P tech sector to a below benchmark allocation. Tech stocks are stretched, trading near two standard deviations above the historical time trend, a level that has marked three previous peaks since 1960 (top panel, Chart 13). From a macro perspective, when the Fed cuts rates as the end of the cycle is nearing it has been a treacherous time to own tech stocks. If we are entering a recession owing to the coronavirus epidemic, underweighting tech stocks is the right portfolio strategy to generate alpha (Chart 13). Chart 13End Of Cycle Dynamics Business investment in tech has been losing market share for the better part of the last year and according to the national accounts tech capex is contracting. Excluding the software industry, capital outlays are in dire straits (top & second panels, Chart 14). Meanwhile, lofty valuations, with the tech forward P/E trading at a 20% premium to the overall market, signal that there is no cushion for this deep cyclical sector that has 60% of sales originating abroad, the largest among its GICS1 peers (third panel, Chart 14). While the Fed will likely cut interest rates soon, the stampede in the US dollar, the reserve currency of the world, is unwelcome news for the heavily export-dependent US technology sector (trade-weighted US dollar shown inverted, middle panel, Chart 15). Chart 14Red Flag: Crumbling Tech Capex Chart 15Large Foreign Sales Exposure Is Problematic Turning over to tech-heavy Korean and Taiwanese exports, they peaked in 2017, and the coronavirus epidemic guarantees that they will suffer a steep decline in the coming months, dealing a blow to the tech sector’s top line growth prospects (bottom panel, Chart 15). If supply chain breakdowns increase over the course of the next few weeks as the coronavirus related shut downs accelerate, then more tech profit warnings are looming and the resulting hit to still ultra-wide relative profit margins and EPS will likely be severe (bottom panel, Chart 14). In more detail on the operating front, the coincident San Francisco Fed Tech Pulse Index is sinking like a stone and this weakness predates the coronavirus epidemic. The implication is that highly inflated relative share prices are vulnerable to a sizable pullback (second panel, Chart 16). Worrisomely, the industry’s new orders-to-inventories ratio is contracting at the fastest pace in eight years and bodes ill for still accelerating relative forward profit growth estimates (bottom panel, Chart 16). Finally, given the severity of recent market moves, when investors typically get margin calls they tend to sell their high flying stocks that currently are mostly concentrated in the tech space. Tack on the proliferation of passive investment, and as everyone is headed for the exit doors simultaneously, tech stocks that dominate hundreds of popular and large capitalization exchange traded funds are at risk of liquidation. Adding it all up, faltering operating metrics, stretched relative valuations, a firming greenback, looming fed funds rate cuts and a contracting capex backdrop, all signal that an underweight stance is now warranted in tech stocks. Bottom Line: Trim the S&P tech sector to underweight, today. Chart 16Weakening Operating Metrics Housekeeping Our long GDX:US / short ACWI:US portfolio position got stopped out at a 10% gain. The global gold mining index is now back to neutral, from previously overweight.   Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com   Appendix Table A1 Table A2 Table A3     Footnotes 1     Please see BCA US Equity Strategy Weekly Report, “Three EPS Scenarios”, dated January 13, 2020, available at uses.bcaresearch.com. 2     Please see BCA US Equity Strategy Weekly Report, “When The Music Stops…” dated January 27, 2020, available at uses.bcaresearch.com 3    Please see BCA US Equity Strategy Weekly Report, “Three EPS Scenarios” dated January 13, 2020, available at uses.bcaresearch.com. 4    Please see BCA US Equity Strategy Weekly Report, “Will The Fed Save The Day, Again?” dated February 18, 2020, available at uses.bcaresearch.com. 5    Please see BCA US Equity Strategy Weekly Report, “Crosscurrents” dated February 3, 2020, available at uses.bcaresearch.com. 6    Please see BCA US Equity Strategy Weekly Report, “Sell The Rip” dated February 10, 2020, available at uses.bcaresearch.com. 7     Please see BCA US Equity Strategy Weekly Report, “Three EPS Scenarios”, dated January 13, 2020, available at uses.bcaresearch.com. 8    Please see BCA US Equity Strategy Weekly Report, “Vertigo” dated February 24, 2020, available at uses.bcaresearch.com. 9    Please see BCA US Equity Strategy Weekly Report, “Crosscurrents” dated February 3, 2020, available at uses.bcaresearch.com. Current Recommendations Current Trades Strategic (10-Year) Trade Recommendations Size And Style Views June 3, 2019 Stay neutral cyclicals over defensives (downgrade alert)  January 22, 2018 Favor value over growth 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 We spent last week meeting with clients in South Africa, who maintained their equanimity despite the spread of the coronavirus: Maybe it was because there were not yet any reported cases close to home, but investors discussed the global outbreak dispassionately. We repeated our view that a US recession is not imminent, ex-a significantly adverse exogenous event: Tight monetary policy is a necessary precondition of a recession, and there’s no reason to expect that the Fed will make any move to remove accommodation in 2020. Investors were open to our view that the US economy is subject to upward inflation pressures, even if the time is not yet ripe for them to manifest themselves: Excess global capacity is still thwarting goods inflation, but it appears to be on its way to being absorbed. In the meantime, the Fed is deliberately encouraging the economy to run hot. Inflation just might surprise investors who have been lulled to sleep by its post-crisis absence. The presidential election is a hot topic in South Africa, too: The Democratic nomination appears to be Bernie Sanders’ to lose, and he has more of a chance in the general election than investors might expect. Feature We spent last week meeting with clients in South Africa. They expressed considerably more optimism about financial markets and the global economy than they did on our previous visit in January 2019, though we all conceded that the coronavirus outcome was unknowable. We discussed a wide range of topics, with COVID-19, recession prospects, the inflation outlook, and November’s election coming up in nearly every meeting. A summary of our discussions, organized by topic, follows below. Coronavirus Impressions We discussed the coronavirus at the beginning of every meeting, albeit after acknowledging that no one can know for sure how it will unfold. We discussed the virus’ potential outcomes, our base-case expectation, and the news and data we’re monitoring to track its course. Everyone is familiar by now with the best- and worst-case scenarios, and the continuum of possibilities in between, so we will not rehash them here. The main variables we have been watching – infection, mortality and recovery rates – are also surely familiar. From a review of those metrics within China – the daily rate of new incidences inside and outside of Hubei province (Chart 1), mortality (Chart 2) and recovery rates (Chart 3) within and without Hubei – there is good reason to conclude that China is gaining the upper hand, having sharply limited the virus’ spread beyond Hubei, and steadily slowing its spread in the epicenter. Chart 1Stringent Quarantine Measures Seem To Have Gotten Some Traction Chart 2Mortality Rates Are Inconclusive, ... Chart 3... But Recovery Rates Are Encouraging Unfortunately, however, other countries cannot perfectly replicate China’s template for corralling the virus, as their governments have considerably less ability to limit their citizens’ movements. It is a lot easier to impose and enforce a quarantine or other emergency restrictions in China than it is in any other major country. It is important, then, to consider not just the number of countries to which the virus spreads, but the characteristics of the countries themselves. In this sense, Italy and Iran may offer some insight. The Italians reacted swiftly and decisively when the first cluster emerged in northern Italy. They drew a circle with a large radius around the cluster, restricted movement in and out of that circle, and sharply limited activities within it. Carnival celebrations in Venice were called off, and Sunday’s slate of matches in Italy’s Serie A professional soccer league were cancelled (subsequent matches are being played in empty stadiums). Although the number of reported infections in Italy has been rising, and infections have begun to pop up in western and central Europe, Italian officials appear to have both the ability and the will to contain it. The Iranian experience contrasts with Italy’s. In Iran, the mortality rate (deaths divided by confirmed cases) is roughly five times greater than it has been everywhere else the virus has erupted. That seems improbably high, and our best guess is that the infections denominator is being undercounted. A country that cannot provide a reliable count (or a reasonably accurate estimate) of infections presumably lacks the public health infrastructure to contain the virus. We conclude that it matters where the infections occur – the wealthy countries of western Europe, North America, Asia and Oceania likely have a better chance of bringing the virus to heel than developing countries. Our interactions in South Africa, among the wealthiest countries in the developing world, may further reinforce the point. In several meetings, clients asked what entering the country was like. I told them that when I arrived at the Johannesburg airport on the morning of Sunday the 23rd, all passengers from international destinations had to pass by a screener who pointed a clunky object shaped like a radar gun in the vicinity of their nose and forehead. Several planes had landed just before mine and the passport control line wound around three or four times, affording repeated opportunities to look over the radar-gun employee’s shoulder at the images on her screen. They appeared to be simple black-and-white video of the arriving passengers without any color imagery to indicate body temperature ranges. The clients uniformly laughed at that detail, exclaiming that of course the screening was ineffectual. They then soberly conceded that Africa is especially vulnerable to an outbreak. If the coronavirus or another severe adverse exogenous event doesn't do it, it will take restrictive monetary policy to induce a recession. Infections outside of China are rising with no end yet in sight (Chart 4), but the news isn’t all bad. There are some promising treatment developments that may yield effective therapies, either from the conventional drug that worked wonders on an infected patient in Washington State and is now being tested on infected groups in China, or from antibody-based therapies of the type that were successfully deployed against Ebola. Our own views are conditional upon COVID-19’s evolution, but our current base case is that it is more likely to produce a soft patch within the context of a global expansion, and a correction within the context of a continuing equity bull market, than it is to trigger a recession or a bear market. Chart 4Now It's The Rest Of The World's Turn Recession Prospects Chart 5Necessary, If Not Sufficient Nearly every client asked us about the prospects for a US recession. We discussed how the negative term premium had made the yield curve more prone to invert, thereby diluting its predictive value, and asserted our view that restrictive monetary conditions are a necessary precondition of recessions (Chart 5). We touched on the rest of the points covered in last week’s report, which argued that a strong near-term outlook for consumption, dependable government spending and a post-trade-tensions recovery in investment would keep the US out of recession over a 12-month horizon. But we spent the most time outlining what we see as the most likely route to the next recession. Expansions don’t die of old age, they die because the Fed murders them, and we told our clients that we expect that maxim will be especially apropos in this cycle. Investors should therefore focus on the factors that will prod the Fed to embark on a tightening cycle with the express intent of reining in an overheating economy. We see two main catalysts: concern that inflation may get away from the Fed on the upside (discussed in the following section), and/or concern that there are unsustainable excesses in either the economy or financial markets. Chart 6The Real Economy Isn't Close To Overheating We contend that there are currently no signs of excesses in the real economy. Its most cyclical elements, which have driven overheating in the past, have not gotten back to their mean level, much less the red-line levels that have been associated with previous business cycle peaks (Chart 6, top panel). Proportional spending on consumer durables remains around the bottom of its 60-year range (Chart 6, second panel), investment in non-residential structures is quite low relative to history and comfortably in the middle of its post-1990-91-recession range (Chart 6, fourth panel), and residential investment is sitting at the level that previously marked business-cycle troughs (Chart 6, bottom panel). The only cyclical activity that looks a little frisky is equipment and software spending (Chart 6, third panel), which has the best chance of enhancing productivity and thereby yielding ongoing dividends. Financial market excesses are in the eye of the beholder, and reasonable people can disagree about their existence. The promiscuous application of the word “bubble” to anything and everything market related, however, has become as familiar and tiresome as rappers’ boasts of their prowess. The S&P 500’s steady climb higher doesn’t begin to approach the manic paths of prior decades’ hot assets (Chart 7). The key takeaway is that the economic or financial overheating likely to trigger the expansion’s ultimate denouement is yet to arrive. Until it does, the Fed will have no reason to intervene to stop it. Chart 7Which One Of These Is Not Like The Others? Inflation Prospects Many clients asked about inflation prospects before we could bring up the subject, a notable turnabout from our last visit thirteen months ago, when our arguments for accelerating wage gains met mostly with indifference. We were happy to oblige, as inflation occupies an essential place in our base-case cyclical scenario. Tight monetary policy is a necessary precondition for an endogenously occurring recession. Ex-a severe exogenous shock, like a global pandemic, the expansion cannot end without tight monetary conditions, and the Fed won’t knowingly impose them unless it is concerned that inflation is getting away from it on the upside. Q: Why has there been no whiff of US inflation in the last eleven years? A: Because the negative US output gap rendered it impossible until 2018. We are not daunted by inflation’s post-crisis hibernation. Meaningful price increases at the level of the entire economy cannot occur when an economy has a negative output gap (aggregate demand persistently falls short of economic capacity) unless its currency is sliding and it imports a lot of goods and services. From that perspective, inflation has only been possible in the US since 2018, because it didn’t close its output gap until 2017, according to estimates from both the IMF and the CBO. 2018 was the year that the US embarked on an unprecedented macroeconomic experiment (Chart 8), injecting fiscal stimulus amounting to one half of the economy’s long-run capacity (about 100 basis points) at a time when it was already operating at full capacity (2-2.25%). If corporations and other businesses viewed the surge in aggregate demand as a one-off event that couldn’t be replicated in the future, they would likely choose not to invest in additional capacity to meet it. The net result was demand in excess of supply in 2018 and in 2019, when an additional 50 basis points of stimulus was deployed. Inflation did not break out in either year, but negative output gaps in the rest of the developed world provided the US with the convenient out of importing other countries’ excess capacity. Chart 82018's Unprecedented Macroeconomic Experiment May Yet Produce Inflation The Bank of Canada estimated that Canada closed its output gap in 2018, and the IMF estimates that Europe’s output gap has now closed (Chart 9, top panel), and while even Japan has made a lot of progress on narrowing its output gap (Chart 9, bottom panel). Goods inflation is largely globally determined, and with excess capacity being absorbed around the world, it’s possible that the conditions that would allow for higher goods prices could soon lock into place. Services inflation, a predominantly domestic phenomenon, is poised to rise thanks to the tight-as-a-drum labor market. Just when inflation will rear its ugly head is uncertain, however, as it is a lagging indicator that often doesn’t peak, until a recession has nearly ended, or trough for nearly three years after a recession begins (Chart 10). Chart 9The Slack Is Being Absorbed Chart 10It May Take A Long Time For 2018's Seeds To Germinate We find supply and demand arguments compelling, and the excess-supply constraint on global goods inflation has quietly been easing. The bottom line is that we think the US economy harbors upward inflation pressures, though it is highly unlikely that they will manifest themselves this year. That will give the Fed free rein to allow the economy to run hot across all of 2020, in service of its primary goal of pushing inflation expectations higher, and the labor market as well, in service of its secondary goal of spreading the benefits of easy policy more evenly across the economy. The upshot is that the longer inflation remains outwardly dormant, the harder it will be to root it out once it eventually does begin to bloom. The World Is Watching American Voters As an indication of the anticipation surrounding November’s election, South African investors, who recognized Bernie Sanders’ name, asked about it in every meeting. We laid out our geopolitical strategists’ views, augmented in places by our own, on the key issues as follows: Presidential elections are referendums on the incumbent party. An incumbent president running for re-election has a sizable built-in advantage. In the postwar era, only major economic, social or international shifts have been sufficient to erode that advantage. Incumbents lose when a recession occurs near an election, but the president has to be considered a favorite if the expansion continues. The president may be an especially poor front-runner. Donald Trump personifies variability. That’s a great trait to have as an underdog, because a wide dispersion of individual outcomes broadens the range of possible competitive outcomes, but it’s a vulnerability for a favorite. It is nearly impossible for a golfer with a two-stroke lead ahead of the final par-four eighteenth hole to lose if s/he conservatively plays for par. It seems to us that the president is not wired to play conservatively, and our geopolitical strategists currently give him just a 55% chance of re-election. Bernie Sanders is not unelectable. Our geopolitical strategists note that the median voter is moving to the left, and that Sanders is many Biden supporters’ second choice. He may not be anathema to the broader public in the general election, and his leveling platform may play well in the Rust Belt states that are poised to decide the election once again. A Sanders administration would not transform America into France, but it would chip away at corporate profits. Our personal view is that a President Sanders would not mark the end of the US as a beacon of free enterprise. The Constitution was designed to obstruct dramatic changes, and his ability to pass major legislative initiatives is likely exaggerated. We think he could make his influence felt much more directly in the bureaucratic and regulatory spheres, where a president can act virtually unimpeded. A Sanders administration would be a devoted and presumably activist friend of labor, and a tenacious foe of corporate concentration. An administration that energetically champions organized labor and vigorously enforces anti-trust statutes would exert downward pressure on corporate profit margins. Bullish Or Bearish Borrowing a line from longtime Street economist and strategist Ed Yardeni, our mandate is bullish or bearish, not good or bad. We are charged with making objective decisions about what is most likely to occur in markets, not to daydream about what we would most like to happen. Our base-case scenario turns on our expectation that accommodative monetary policy will remain in place until well into 2021, and will continue to be effective in forestalling defaults and inflating asset valuations. It may not be the most comforting basis for being long risk assets, and we make no implied endorsement of its quality, but if we think it’s going to continue to work beyond the edge of the visible horizon, then we have to reiterate our recommendation that investors should remain at least equal weight equities in multi-asset portfolios, and at least equal weight credit in fixed income portfolios. Austrian adherents and self-styled monetary policy experts can howl about moral hazard and manipulation all they want, but we have to invest in the backdrop that we have, not the backdrop that we want. We do not yet see the approach of a catalyst that will prevent life insurers, pension funds, endowments and other investors who need yield from continuing to go further out the risk curve in search of it. And we don’t yet see the approach of a catalyst that will prevent equity investors from continuing to bid multiples higher. We remain constructive over the cyclical twelve-month timeframe.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com