Asset Allocation

Highlights US Corporates: The Fed continues to expand the reach of its extraordinary monetary policies designed to combat the COVID-19 recession, now giving itself the ability to hold BB-rated US high-yield bonds within its corporate bond buying programs. Raise allocations to US BB-rated corporates to overweight, within a neutral overall strategic (6-12 months) allocation to US high-yield. Euro Area Corporates: European investment grade corporate debt has seen significant spread widening over the past month, but spreads have stabilized with the ECB introducing a new asset purchase program with fewer restrictions. Upgrade euro area investment grade corporates to neutral from underweight on both a tactical (0-6 months) and strategic (6-12 months) basis. Favor debt from beaten-up sectors that are already priced for severe economic weakness like Energy, Transportation and non-bank Financials. Central Banks Are A Corporate Bond Investor’s Best Friend Right Now Chart of the WeekThe Fed & ECB Are Supporting Bond Markets The Fed & ECB Are Supporting Bond Markets The Fed & ECB Are Supporting Bond Markets The actions of policymakers worldwide to help mitigate the severe economic shock from the COVID-19 recession have helped boost global risk assets over the past couple of weeks. This is particularly notable in US corporate bond markets, where credit spreads have tightened for both shorter-maturity investment grade bonds and Ba-rated high-yield (Chart of the Week). It is not a coincidence that those are the parts of the US corporate bond market that the Fed is now explicitly backstopping through its off-balance-sheet investment programs. Last week, the Fed unveiled yet another “bazooka” to help ease US financial conditions, broadening the scope of its previously investment grade-only corporate bond purchase programs to include Ba-rated high-yield corporate bonds and high-yield ETFs. In Europe, meanwhile, the European Central Bank (ECB) is also providing additional monetary support through increased asset purchases of both government and corporate debt. Those purchases are focused more on the weakest links in the euro area financial and economic chain like Italian sovereign bonds. This has helped to stabilize credit spreads for both Italian government bonds and euro area investment grade corporate debt. This support from policymakers is critical to prevent a further tightening of financial conditions during a severe global recession (Chart 2). The excess return (over government bonds) for the Bloomberg Barclays global high-yield bond index is now down 15% on a year-over-year basis. High-yield corporate bond spreads are well above the lows seen earlier this year on both sides of the Atlantic, across all credit quality tiers. In the US, spreads between credit quality tiers had widened to levels not seen in several years. Within the US investment grade universe, the gap between Baa-rated and Aa-rated spreads had widened from 20bps to 60bps (Chart 3), a level last seen in September 2011, but now sits at 39bps. Chart 2Junk Bonds Already Discount A Big Recession Junk Bonds Already Discount A Big Recession Junk Bonds Already Discount A Big Recession Chart 3The Fed Wants These Spreads To Tighten The Fed Wants These Spreads To Tighten The Fed Wants These Spreads To Tighten Looking in the other direction of the credit quality spectrum, the spread between Baa-rated and Ba-rated corporates – the line of demarcation between investment grade and high-yield bonds – had blown out from 132bps in February to 556bps, but is now at 360bps. This is the market pricing in the growing risk of fallen angels being downgraded from investment grade to junk. In our view, the Ba-Baa spread is the best indicator to follow to see if the Fed’s extension of its bond purchase program to high-yield is working to reduce borrowing costs for lower-rated US companies. Both in the US and Europe, we continue to recommend a credit investment strategy that favors the parts of the markets that the Fed and ECB are most directly involved in now. That means staying overweight US investment grade corporate bonds with maturities of less than five years (the Fed’s maturity limit for its bond buying program). It also means staying overweight Italian government debt versus core European equivalents. The Fed’s new extension into high-yield corporates within its buying programs means we need to upgrade our recommendation on US BB-rated high-yield to overweight within our recommended neutral strategic (6-12 months) allocation to US junk bonds. We are making that change on a tactical basis in our model bond portfolio, as well, as can be seen on pages 14-15. As the title of this Weekly Report suggests, buy what the central banks are buying. The Fed’s new extension into high-yield corporates within its buying programs means we need to upgrade our recommendation on US BB-rated high-yield to overweight within our recommended neutral strategic (6-12 months) allocation to US junk bonds. In Europe, there is now scope to also raise allocations to euro area corporate bonds, as well, as we discuss over the remainder of this report. Bottom Line: The Fed continues to expand the reach of its extraordinary monetary policies designed to combat the COVID-19 recession, now giving itself the ability to hold BB-rated US high-yield bonds within its corporate bond buying programs. Raise allocations to US BB-rated corporates to overweight within a neutral overall strategic (6-12 months) allocation to US high-yield. Looking For Value In Euro Area Investment Grade Bonds The outlook for euro area spread product does not have as clean-cut a story as is the case for US credit. The ECB is not explicitly supporting European corporate credit markets to the same degree as the Fed is with its open-ended off-balance sheet investment vehicles. While the ECB has introduced a new large €750bn asset purchase program, the Pandemic Emergency Purchase Program (PEPP), to help ease financial conditions in the euro area, no specific details have yet been provided specifying how much of the PEPP will go towards corporate debt versus sovereign bonds. The ECB has already loosened the country and issuer limit restrictions it has imposed on its existing Asset Purchase Program (APP), however, which means that the central bank will be very flexible with the PEPP purchases. That means helping reduce sovereign risk premiums in Peripheral Europe by buying greater amounts of Italian, Spanish and even Greek government debt. That also likely means buying more corporate debt in the most stressed sectors of the euro area economy, as needed. Greater ECB bond purchases would make euro area investment grade credit – which has seen some value restored after the recent bout of spread widening - more attractive over both tactical and strategic investment horizons. This is true even with much of the euro area now in a deep recession because of COVID-19 lockdowns, which has already been discounted in the poor investment performance of euro area corporates. Greater ECB bond purchases would make euro area investment grade credit – which has seen some value restored after the recent bout of spread widening - more attractive over both tactical and strategic investment horizons. Year-to-date, euro area corporate credit markets have been hit hard by the global credit selloff (Table 1). In total return terms denominated in euros, the Bloomberg Barclays euro area investment grade corporate bond index is down -5.0% so far in 2020. The numbers are slightly better relative to duration-matched euro area government bonds (the pure credit component), with the index excess return down -5.5% year-to-date. At the broad sector level, the laggards so far in 2020 have been the sectors most exposed to the sharp downturn in European (and global) economic growth. In excess return terms, the worst performing sectors year-to-date within the eleven major groupings shown in Table 1 have been Consumer Cyclicals (-8.5%), Transportation (-8.1%), Energy (-7.2%). The best performing sectors are those that would be categorized as less cyclical and more “defensive”, like Utilities (-4.3%), Technology (-4.3%) and Financials (-4.7%). In many ways, this is a mirror image of 2019, when Consumer Cyclicals and Transportation were among the top performers while Technology was the worst performer. Table 1Euro Area Investment Grade Corporate Bond Returns Buy What The Central Banks Are Buying Buy What The Central Banks Are Buying Chart 4Euro Area Corporate Spreads Are Relatively Subdued Vs. Past Credit Cycles Euro Area Corporate Spreads Are Relatively Subdued Vs. Past Credit Cycles Euro Area Corporate Spreads Are Relatively Subdued Vs. Past Credit Cycles When looking at the differences in spreads between credit tiers in the euro area, the gaps are not as wide as in the US (Chart 4). The index spread on Baa-rated euro area corporates is only 44bps above that of Aa-rated credit, far below the 100bps gap seen at the peak of the 2001 and 2011 spread widening episodes and well below the 200bps witnessed in 2008. Looking at the difference between Ba-rated and Baa-rated euro area spreads paints a similar picture, with the gap between the highest high-yield credit tier and lowest investment grade credit tier now sitting at 297bps after getting as wide as 431bps in late March – close to the 500bps peak seen in 2011 but far below the 1000bps levels seen in 2001 and 2007 The broad conclusion looking strictly at credit tiers is that euro area corporates have cheapened up a bit during the COVID-19 selloff, but on a more modest scale compared to previous euro area credit cycles. A similar conclusion is reached when looking at industry-level credit spreads. The broad conclusion looking strictly at credit tiers is that euro area corporates have cheapened up a bit during the COVID-19 selloff, but on a more modest scale compared to previous euro area credit cycles. A similar conclusion is reached when looking at industry-level credit spreads. In Charts 5 & 6, we show the history of option-adjusted spreads (OAS) for the major industrial sub-groupings of the Bloomberg Barclays euro area investment grade corporate indices. Unsurprisingly, spreads look relatively wide for the biggest underperforming sectors like Energy, Consumer Cyclicals and Transportation. The spread widening has been more contained in the better performing sectors like Technology. Chart 5A Mixed Performance For Euro Area Investment Grade Spreads By Industry … A Mixed Performance For Euro Area Investment Grade Spreads By Industry ... A Mixed Performance For Euro Area Investment Grade Spreads By Industry ... Chart 6…. With Spreads Well Below 2001 And 2008 Credit Cycle Peaks ... With Spreads Well Below 2001 And 2008 Credit Cycle Peaks ... With Spreads Well Below 2001 And 2008 Credit Cycle Peaks When looking at the individual country corporate bond indices within the euro area, the current levels of spreads do not look particularly wide in an historical context. In Chart 7, we show a bar chart of the range of index OAS for the six largest euro area countries (Germany, France, Italy, Spain, the Netherlands, Belgium and Austria). The current OAS is shown within that historical range. The chart shows that current spreads are in the middle of that range for most countries, suggesting some better value has been restored by the COVID-19 selloff but with spreads remaining relatively subdued compared to past euro area credit cycles.1 Chart 7Euro Area Investment Grade Corporate Spreads By Country Buy What The Central Banks Are Buying Buy What The Central Banks Are Buying On a relative basis, investment grade spreads are tightest in France (203bps), the Netherlands (202bps) and Belgium (226bps), and widest in Germany (255bps), Italy (255bps), Austria (251bps) and Spain (234bps). With the ECB already promising greater flexibility in the country allocations of its sovereign bond purchases within the PEPP, Italian corporates may offer the best value within the major euro area countries. With the ECB already promising greater flexibility in the country allocations of its sovereign bond purchases within the PEPP, Italian corporates may offer the best value within the major euro area countries. We can get a better sense of relative corporate bond spread valuation at the country level by looking at the 12-month breakeven spread percentile rankings of those spreads. 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. In Charts 8 & 9, we show the 12-month breakeven spread percentile rankings for Germany, France, Italy, Spain, Belgium and Austria. On this basis, the current level of spreads looks most historically attractive in Germany, Italy and France, with the breakeven spread in the upper quartile versus its history dating back to the year 2000. Spreads in Spain, Belgium and Austria also look relatively wide versus their own history, but to a lesser extent than in Germany, France and Italy. Chart 8German, Italian & French Investment Grade Corporates Offer Better Value On A Breakeven Spread Basis …. German, Italian & French Investment Grade Corporates Offer Better Value On A Breakeven Spread Basis ... German, Italian & French Investment Grade Corporates Offer Better Value On A Breakeven Spread Basis ... Chart 9… Than Spanish, Belgian & Austrian Investment Grade Corporates Buy What The Central Banks Are Buying Buy What The Central Banks Are Buying Chart 10Euro Area Investment Grade Corporate Spreads Are Relatively Wide Across All Credit Tiers Euro Area Investment Grade Corporate Spreads Are Relatively Wide Across All Credit Tiers Euro Area Investment Grade Corporate Spreads Are Relatively Wide Across All Credit Tiers So while there are some modest differences in value to exploit within the euro area investment grade corporate bond universe at the country level, there is less to choose from across credit tiers. The 12-month breakeven spreads for Aaa-rated, Aa-rated, A-rated and Baa-rated euro area corporates are all within the upper quartiles of their own history (Chart 10). One other tool we can use to assess value across euro area investment grade corporates is our sector relative value framework. Borrowing from the methodology used by our colleagues at BCA Research US Bond Strategy to assess US investment grade corporates, the sector relative value framework determines “fair value” spreads for each of the major and minor industry level sub-indices of the overall euro area investment grade universe. The methodology takes each sector's individual OAS and regresses it in a cross-sectional regression with all other sectors. The independent variables in the model are each sector's duration, trailing 12-month 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. The latest output from the euro area relative value spread model can be found in Table 2. 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 11 shows the tradeoff between the valuation residual from our model and each sector's DTS. Table 2Euro Area Investment Grade Corporate Sector Valuation & Recommended Allocation Buy What The Central Banks Are Buying Buy What The Central Banks Are Buying 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. The strongest overweight candidates (a DTS score equal to or greater than that of the overall index with the highest positive valuation residual) are the following euro area investment grade sectors: Packaging, Tobacco, Other Industrials, Media Entertainment, Supermarkets, Integrated Energy, Consumer Cyclical Services and all non-bank Financials (Insurance, REITs, Brokerages and Finance Companies). Against the current backdrop of euro area corporate spreads offering relatively wide spreads on a breakeven spread basis, and with the ECB providing a highly accommodative monetary backdrop that includes more purchases of both government and corporate debt, we think targeting an overall portfolio DTS greater than that of the euro area investment grade corporate bond index is reasonable. On that basis, we are looking to go overweight sectors with 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 11. Chart 11Euro Area Investment Grade Corporate Sectors: Valuation Versus Risk Buy What The Central Banks Are Buying Buy What The Central Banks Are Buying Based on the latest output from the relative value model, the strongest overweight candidates (a DTS score equal to or greater than that of the overall index with the highest positive valuation residual) are the following euro area investment grade sectors: Packaging, Tobacco, Other Industrials, Media Entertainment, Supermarkets, Integrated Energy, Consumer Cyclical Services and all non-bank Financials (Insurance, REITs, Brokerages and Finance Companies). The least attractive sectors within this framework (negative risk-adjusted valuations) are: Senior Bank Debt, Natural Gas, Other Utilities, Metals and Mining, Chemicals, Construction Machinery, Lodging, Cable and Satellite, Restaurants, Food/Beverage, Health Care, Oil Field Services, Building Materials and Aerospace/Defense. Bottom Line: European investment grade corporate debt has seen significant spread widening over the past month, but spreads should stabilize with the ECB introducing a new asset purchase program with fewer restrictions. Upgrade euro area investment grade corporates to neutral from underweight on both a tactical (0-6 months) and strategic (6-12 months) basis. Favor debt from beaten-up sectors that are already priced for severe economic weakness like Energy, Transportation and non-bank Financials.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 For the Netherlands, there is a much shorter history of corporate bond index data available from Bloomberg Barclays than the other euro area countries shown in Chart 7. The OAS range only encompasses about seven years of data, while the other countries go back as far as the early 2000s. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Buy What The Central Banks Are Buying Buy What The Central Banks Are Buying Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Oil prices are up strongly from their lows, but conditions for a durable bottom may not yet be in place. The main hiccup is that an air pocket will likely remain under global oil demand until most social-distancing measures are lifted. That said, most petrocurrencies offer a significant valuation cushion, making them attractive for longer-term investors. We will look to buy a basket of petrocurrencies on further weakness. The Asian economies that were closer to the epicenter of the epidemic are likely to recover faster than the West. Transport and electricity energy demand should pick up in these economies faster. AUD/CAD and AUD/EUR should benefit from this dynamic. CAD/USD is likely to weaken in the short term as Canadian crude remains trapped in Alberta, but then strengthen as the global economy recovers. Feature Chart I-1Massive Liquidation In Crude Oil Massive Liquidation In Crude Oil Massive Liquidation In Crude Oil Just over a decade ago, the price of crude oil was firmly above $100 per barrel. Fast forward to today and many blends are trading south of $20 (Chart I-1). The extraordinary drop has sent many petrocurrencies, including the Norwegian krone, Mexican peso, and Canadian dollar, into freefall. The oil industry has been hit by multiple tectonic shocks, including a sudden stop in economic activity, a fallout from the OPEC cartel, divestment from ESG funds, and falling oil intensity in many economies. Meanwhile, the trading of petrocurrencies is also complicated by a shifting production landscape among many oil producers. For investors, three key questions will determine whether petrocurrencies are a buy: Have we approached capitulation lows in oil prices? If so, what will be the velocity and magnitude of the demand recovery? Will the correlation between oil and petrocurrencies still hold once the dust settles? Have We Approached Capitulation Lows? In terms of magnitude and duration, yes. Over the last two decades, oil price drawdowns have tended to last between 8 and 20 months before a durable rally ensues. The oil price collapse from July 2008 to February 2009 lasted around 8 months. The decline from June 2014 to February 2016 was much longer, around 20 months. Given the October 2018 peak in oil prices, we should be very close to the bottom in terms of duration. Remarkably, in all episodes, the peak-to-trough decline in the West Texas Intermediate (WTI) blend has been around 75% (Chart I-2).   However, since the 1970s, oil has moved in a well-defined pattern of a 10-year bull market, followed by a 20-year bear market (Chart I-3). Assuming the bear market in oil began just after the global financial crisis, it does suggest that even if prices do recover, it will most likely be a bear-market rally. That said, history also suggests that these bear market rallies in oil can be quite powerful, with prices often doubling or trebling. As we go to press, oil prices are up a remarkable 18% from their lows Chart I-2Similar In Magnitude To Prior Oil Crashes Similar In Magnitude To Prior Oil Crashes Similar In Magnitude To Prior Oil Crashes Chart I-3Oil Prices Are Close To Capitulation Lows Oil Prices Are Close To Capitulation Lows Oil Prices Are Close To Capitulation Lows What is different this time? Aside from a breakdown in OPEC+, a few other factors are in play. This alters the timing and duration of an intermediate-term bottom: Any coordinated supply response will need to involve the US to be viable.1 The OPEC+ cartel, specifically the alliance between Russia and Saudi Arabia, is broken. Chart I-4 illustrates why. While being the stewards of global oil production discipline, there has been one sole benefactor – the US. In 2010, only about 6% of global crude output came from the US. Collectively, Canada, Norway and Mexico shared about 10% of the oil market. Meanwhile, OPEC’s market share sat just north of 40%. Fast forward to today and the US produces around 15% of global crude, having grabbed market share from many other countries. Chart I-4US Is The Big Winner From OPEC Cuts US Is The Big Winner From OPEC Cuts US Is The Big Winner From OPEC Cuts As we go to press, there are reports that Saudi Arabia and Russia have come to an agreement. However, the history of OPEC alliances suggests that it is fraught with broken promises.  Oil still trades above cash costs for many producing countries, meaning the incentive to boost production in times of a demand shock is quite strong (Chart I-5). Ditto if oil prices are recovering. Oil futures are in a massive contango, with WTI trading close to $40 per barrel two years out. This incentivizes players with strong balance sheets to keep the taps open. The oil curve needs to shift significantly lower, probably pushing some blends into negative spot territory, in order to force production discipline on some players.   Chart I-5Oil Still Trading Above Cost Of Production A New Paradigm For Petrocurrencies A New Paradigm For Petrocurrencies The dollar has been strong, meaning the local-currency revenues of oil producers have been cushioning part of the downdraft in oil prices. This could sustain production longer than would otherwise be the case, especially in a liquidation phase. The New York Fed’s model suggests that most of the downdraft in oil prices since 2010 has been due to rising supply (Chart I-6). Chart I-6Oil Downdraft Driven By Supply A New Paradigm For Petrocurrencies A New Paradigm For Petrocurrencies Both Saudi Arabia and Russia have low public debt and ample foreign exchange reserves. This buys them time in terms of dealing with a prolonged period of low prices. We know there will be massive economic pain from the oil price collapse (Chart I-7). The good news is that with the economic slowdown already in place, it may well be the catalyst needed to enforce any agreement put into effect. Chart I-7The Coming Economic Pain For Oil Producers The Coming Economic Pain For Oil Producers The Coming Economic Pain For Oil Producers While the positive correlation between oil prices and petrocurrencies has weakened in recent years, it has been re-established during the current downturn. More importantly, should production cuts be led by US shale producers, this will redistribute market share to OPEC and other non-OPEC members, allowing their currencies to benefit. Should production cuts be led by US shale producers, this will redistribute market share to OPEC and other non-OPEC members, allowing their currencies to benefit.  In statistical terms, petrocurrencies had a near-perfect positive correlation with oil around the time US production was about to take off (Chart I-8). Since then, that correlation has fallen from around 0.9 to about 0.3. Chart I-8Falling Correlation Between Petrocurrencies And The US Dollar Falling Correlation Between Petrocurrencies And The US Dollar Falling Correlation Between Petrocurrencies And The US Dollar Take the Mexican peso as an example. Since 2013, Mexico has become a net importer of oil, as the US moves towards becoming a net exporter (Chart I-9). This explains why the positive correlation between the peso and oil prices has weakened significantly in recent years. Put another way, rising oil prices benefit the US industrial base much more than in the past, while the benefits for countries like Canada and Mexico are slowly fading. Chart I-9A Shifting Export Landscape A Shifting Export Landscape A Shifting Export Landscape That said, in the case of Canada and Norway, petroleum still represents over 20% and 50% of total exports. For Russia, Saudi Arabia, Iran or Venezuela, the number is much higher. Therefore, it is easy to see why a big fluctuation in the price of oil can have deep repercussions for their external balances. Historically, getting the price of oil right was usually the most important step in any petrocurrency forecast. Bottom Line: Both the CAD and NOK remain positively correlated with oil. So do the Russian ruble and the Colombian peso. This correlation should remain in place if oil prices put in a definitive bottom, and it should strengthen if production cuts are led by the US. When Will Oil Demand Recover? Oil demand tends to follow the ebb and flow of the business cycle, with demand having slowed sharply on the back of a sudden stop in economic activity. Transport constitutes the largest share of global petroleum demand. Ergo the economic lockdowns have brought a lot of freighters, bulk ships, large crude carriers and heavy trucks to a halt. Encouragingly, passenger traffic in China has started to pick up as the number of new Covid-19 cases flattens, and the country is gradually reopening for business. There has also been an improvement in the manufacturing data. All eyes will be watching if the relaxation of measures in China lead to a second wave of infections. Otherwise, should the Western economies follow the Chinese recovery path, then the world will be open for business by the end of the summer (Chart I-10). One way to play an early restart in Asia relative to the West is to go long the Australian dollar, relative to a basket of the Canadian dollar and the euro.  Part of the slowdown in global demand is being reflected through elevated oil inventories. However, part of the inventory building has also been a function of refinery maintenance (Chart I-11). Chinese oil imports continue to hold up well, and should easier financial conditions continue to put a floor under the manufacturing cycle, overall consumption will follow suit. Chart I-10Some Optimism For The West Some Optimism For The West Some Optimism For The West Chart I-11Watch For A Peak In Inventories Watch For A Peak In Inventories Watch For A Peak In Inventories One way to play an early restart in Asia relative to the West is to go long the Australian dollar, relative to a basket of the Canadian dollar and the euro. There are three key reasons which support this trade: Liquefied natural gas will become the most important component of Australia’s export mix in the next few years (Chart I-12). As Beijing restarts its economy and electricity production picks up, Aussie exports will benefit. Beijing has a clear environmental push to shift its economy away from coal electricity generation and towards natural gas. The massive drop in pollution resulting from the shutdown will all but assure that this push occurs sooner rather than later. Chart I-12LNG Will Be A Game-Changer For Australia LNG Will Be A Game-Changer For Australia LNG Will Be A Game-Changer For Australia There was already pent-up demand in the Australian economy going into the crisis, given the destruction of the capital stock from the fires. With an economy that was already running well below capacity, construction activity should see a V-shaped rebound once social distancing measures are relaxed. As the currency of the now largest oil producer in the world, the US dollar is becoming a petrocurrency itself. In this new paradigm, a better strategy for playing oil upside is to be long a basket of energy producers versus energy consumers. AUD/EUR benefits from this. Chart I-13 shows that a currency basket of oil producers versus consumers has both had a strong positive correlation with the oil price and has outperformed a traditional petrocurrency basket. Rising oil prices are a terms-of-trade boost for oil exporters but lead to demand destruction for oil importers. Chart I-13Buy Oil Producers Versus Oil Consumers Buy Oil Producers Versus Oil Consumers Buy Oil Producers Versus Oil Consumers Eventually, a pickup in manufacturing activity will be a global phenomenon rather than localized within Asia. When this happens, other petrocurrencies will begin to benefit. This will especially be the case for producers where production is more landlocked. Bottom Line: A recovery in global transport will help revive oil demand. This should be positive for oil prices in general and petrocurrencies in particular. One way to play the recovery in Asia relative to the West for now is to go long AUD/CAD and AUD/EUR. On CAD, NOK, MXN, RUB And COP Chart I-14NOK Will Outperform CAD NOK Will Outperform CAD NOK Will Outperform CAD While Canadian crude is likely to remain trapped in the oil sands, North Sea crude will face less transportation bottlenecks in the near term. This suggests the path of least resistance for CAD/NOK is down (Chart I-14). We were stopped out of our short CAD/NOK trade, but still recommend this position as a play on this dynamic. We are already long the Norwegian krone versus a basket of the euro and dollar. CAD/USD has been displaying a series of higher lows since the March 18 bottom, but the double-top formation in place since then suggests we could see some weakness in the near term. Should CAD/USD retest its recent lows, driven by a relapse in oil prices, we will be buyers.  Many petrocurrencies, including the Mexican and Colombian pesos, have become quite cheap and are attractive on a longer-term basis (Chart I-15). Given the uncertainty surrounding the nearer-term outlook, we a placing a limit buy on a broad basket of these currencies at -5%. Should oil prices retest the lows in the coming weeks/months, it will imply an 18% drop. Given the correlation between petrocurrencies and oil of 0.3, this suggests a 5.3% move lower.  Chart I-15ASome Petrocurrencies Are Very Cheap Some Petrocurrencies Are Very Cheap Some Petrocurrencies Are Very Cheap Chart I-15BSome Petrocurrencies Are Very Cheap Some Petrocurrencies Are Very Cheap Some Petrocurrencies Are Very Cheap Bottom Line: Place a limit buy on a petrocurrency basket at -5%.    Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Please see Commodity & Energy Strategy Weekly Report, “The Birth Of WOPEC,” dated April 9, 2020, available at ces.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 Recent data in the US have been negative: The unemployment rate soared from 3.5% to 4.4% in March. Nonfarm payrolls recorded a total loss of 701K jobs, the first decline in payrolls since September 2010. The NFIB business optimism index plunged from 104.5 to 96.4 in March. Initial jobless claims surged by 6.6 million last week, higher than the expected 5.3 million. Michigan consumer sentiment declined to 71 from 89.1 in April. The DXY index fell by 0.7% this week. Risk assets have recovered, fueled by an extra USD $2.3 trillion stimulus from the Federal Reserve. The lesson we are learning is that the deeper the perceived slowdown, the more the Fed will do to assuage any economic damage. As for currencies, what matters is relative monetary policies. The key variable to stem the rise in the USD is that the liquidity crisis does not morph into a solvency one. Report Links: Capitulation? - April 3, 2020 The Dollar Funding Crisis - March 19, 2020 Are Competitive Devaluations Next? - March 6, 2020 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Recent data in the euro area have been mostly negative: Markit services PMI fell further to 26.4 in March from 28.4 the previous month. The Sentix investor confidence dived to -42.9 from -17.1 in April. Moreover, the Sentix current situation index fell from -15 to -66 in April, while the outlook index moved up slightly from -20 to -15. EUR/USD appreciated by 0.5% this week. The euro zone members failed to reach an agreement on the joint EU debt issuance. On the other hand, the ECB adopted an unprecedented set of collateral measures to mitigate the negative impacts from COVID-19 across the euro area, including easing collateral conditions for credit claims, reduction of collateral valuation haircut, and waiver to accept Greek sovereign debt instruments as collateral.  Report Links: On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 On Money Velocity, EUR/USD And Silver - October 11, 2019 Japanese Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data in Japan have been negative: Consumer confidence fell to 30.9 from 38.4 in March. Labor cash earnings grew by 1% year-on-year in February, but slowed from 1.2% in January. The Eco Watchers Survey current index fell from 27.4 to 14.2 in March. The outlook index also declined from 24.6 to 18.8. The Japanese yen fell by 1% against the US dollar this week. On Wednesday, the BoJ announced that it would scale back some non-urgent operations such as long-term research and studies for academic papers, following the government’s decision to declare a state of emergency. The Reuters poll forecasted the Q1 GDP to shrink by 3.7% quarter-on-quarter and Q2 by 6.1%. Report Links: The Near-Term Bull Case For The Dollar - February 28, 2020 Building A Protector Currency Portfolio - February 7, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data in the UK have been dismal: Markit construction PMI plunged to 39.3 from 52.6 in March. GfK consumer confidence crashed to -34 from -9 in March. Total trade balance (including EU) shifted to a deficit of £2.8 billion from a surplus of £2.4 billion in February. The goods trade deficit widened from £5.8 billion to £11.5 billion. GBP/USD rose by 0.6% this week. After being told to cut dividends last week, the UK banks are now pressuring the BoE on fresh capital relief to help fight the COVID-19. The BoE has also agreed to temporarily lend the government money, funded through money printing. The details suggest the operations are temporary, but the BoE might be the first central bank to formally step closer to MMT. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 A Few Trade Ideas - Sept. 27, 2019 United Kingdom: Cyclical Slowdown Or Structural Malaise? - Sept. 20, 2019 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Recent data in Australia have been negative: The AiG services performance index fell from 47 to 38.7 in March. Imports and exports both slumped 4% and 5% month-on-month respectively in February. The trade surplus narrowed from A$5.2 billion to A$4.4 billion.  The Australian dollar surged by 3.8% against the US dollar, making it the best performing G10 currency this week. The RBA held interest rate steady at 0.25% on Tuesday, while warning the country is in for a “very large” economic contraction. Lowe also suggested that the economy will “much depend on the success of the efforts to contain the virus and how long the social distancing measures need to remain in place”. Report Links: On AUD And CNY - January 17, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 A Contrarian View On The Australian Dollar - May 24, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 Recent data in New Zealand have been dismal: NZIER business confidence survey reported that a net 70% of firms expect general business conditions to deteriorate in Q1, compared to 21% in the previous quarter. Electronic card retail sales contracted by 1.8% year-on-year in March, down from 8.6% growth the previous month. The New Zealand dollar recovered by 1.7% against the US dollar this week. In addition to the NZ$30 billion purchases of central government bonds, the RBNZ is stepping up the QE program by offering to buy up to NZ$3 billion of local government bonds to support liquidity. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Place A Limit Sell On DXY At 100 - November 15, 2019 USD/CNY And Market Turbulence - August 9, 2019 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Recent data in Canada have been dismal: Bloomberg Nanos confidence fell further from 46.9 to 42.7 the week ended April 3. Housing starts increased by 195K year-on-year in March, down from 211K in February. Building permits contracted by 7.3% month-on-month in February. On the labor market front, the pandemic has caused the unemployment rate to rise sharply from 5.6% to 7.8% in March, higher than the expected 7.2%. Employment fell by more than one million (-1,011,000 or -5.3%). The Canadian dollar rose by 1.2% against the US dollar this week, supported by the tentative rebound in oil prices. The BoC spring Business Outlook Survey shows that business sentiment had softened even before COVID-19 concerns intensified in Canada. The overall survey indicator fell below 0 to -0.68 in Q1. Businesses tied to the energy sector were hit the most due to falling oil prices. Report Links: The Loonie: Upside Versus The Dollar, But Downside At The Crosses Updating Our Balance Of Payments Monitor - November 29, 2019 Making Money With Petrocurrencies - November 8, 2019 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Recent data in Switzerland have been negative: Total sight deposits were little changed at CHF 627 billion for the week ended April 3. The unemployment rate jumped from 2.5% to 2.9% in March, above expectations of 2.8%. The number of total unemployed increased by 15%, now reaching 136K. The Swiss franc appreciated by 0.6% against the US dollar this week. The Swiss government forecasted the output to slump 10% this year under the worst-case scenario, given the incoming data proved worse than expected. On the positive side, the government said it would gradually relax restriction measures later this month should the current situation improve. Report Links: On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 Portfolio Tweaks Before The Chinese New Year - January 24, 2020 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Recent data in Norway have been negative: The unemployment rate surged to 10.7% in March from 2.3%. Manufacturing output fell by 0.5% month-on-month in February. Headline inflation fell from 0.9% to 0.7% year-on-year in March, while core inflation remained unchanged at 2.1%.  The Norwegian krone rose by 2.8% against the US dollar this week, up 18% from its recent low three weeks ago. Norway will likely relax some restrictions later this month while the ban on public gatherings will still remain in place. The loosening of COVID-19 measures, together with oil prices recovering and cheap valuations all underpin the Norwegian krone in the long run. Please refer to our front section this week for more detailed analysis. Report Links: Building A Protector Currency Portfolio - February 7, 2020 On Oil, Growth And The Dollar - January 10, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1   Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2   Recent data in Sweden have been mixed: Industrial production fell by 0.2% year-on-year in February. Manufacturing new orders increased by 6% year-on-year in February. Household consumption increased by 2.3% year-on-year in February, up from 1.6% the previous month. The Swedish krona increased by 1% against the US dollar this week. The recent efforts in buying up bonds by the Riksbank to increase liquidity amid COVID-19 is likely to increase the debt burden in Sweden. The stock of Swedish Treasury bills held by the Riksbank is estimated to be SEK 300 billion by the end of this year, compared to only 55 billion in February. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019 Balance Of Payments Across The G10 - February 15, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights Global growth should bounce back in the third quarter, as mass COVID-19 testing allows more people to return to work. Temporary layoffs have accounted for the vast majority of the increase in unemployment so far. Ample fiscal and monetary support should prevent these layoffs from becoming permanent. The equity risk premium remains quite high, which warrants overweighting equities relative to bonds over a 12-month horizon. The near-term outlook for stocks is less flattering, given the strong rally in equities over the past two weeks and the fact that earnings estimates are likely to fall sharply once companies begin to report first quarter results. Accordingly, we recommend that investors take some chips off the table in preparation for a temporary stock market pullback. We are also shifting our near-term regional equity allocation and currency views in a somewhat more defensive direction. As Bad As It Gets? Chart 1Nosedive In High-Frequency Activity Indicators Nosedive In High-Frequency Activity Indicators Nosedive In High-Frequency Activity Indicators The global economy has plunged into a deep recession. The New York Fed’s weekly economic index, which tracks a variety of high-frequency activity indicators such as same-store retail sales, consumer sentiment, fuel sales, and unemployment insurance claims, has plunged below its 2008 lows (Chart 1). Service-sector purchasing manager indices have collapsed to the weakest levels on record (Chart 2). The OECD estimates that the shutdowns have reduced the level of output by between one-fifth and one-quarter in most advanced economies (Chart 3).1 If business closures were to last three months, this would shave between 4-to-6 percentage points from annual growth in the OECD in 2020.   Chart 2Service-Sector Activity Has Collapsed To Unprecedented Lows Service-Sector Activity Has Collapsed To Unprecedented Lows Service-Sector Activity Has Collapsed To Unprecedented Lows Chart 3Severe Economic Consequences Resulting From World War V Testing Times Testing Times At times like these, it is easy to despair about the future. Yet, there are three reasons to think that the worst of the economic damage will be over within the next few months: The measures necessary to control the virus are likely to be relaxed without this leading to a new wave of infections. Recessions following exogenous shocks, such the one we are currently experiencing, tend to produce faster recoveries than those stemming from endogenous slowdowns. Policy will remain highly supportive, mitigating possible adverse second-round effects. Quarantine Measures Are Likely To Be Relaxed In our recently published Q2 Strategy Outlook, we likened the current situation to one where a cyclist fails to apply the brakes when starting to descend a steep hill. Not only does the cyclist need to squeeze the brake levers to slow down, he needs to squeeze them harder than he would otherwise have in order to compensate for failing to squeeze them at the outset. Only once the bicycle has decelerated to a safe speed can he ease off the brakes a bit. Most countries find themselves in the position of the cyclist. Policymakers were too slow to react at the outset of the pandemic, and now have to compensate for their inaction by imposing draconian containment measures. In epidemiological language, policymakers are seeking to reduce the effective reproduction number – the average number of people a carrier of the virus will infect – from well above one to well below one. As long as the reproduction number stays below one, the number of new infections will keep falling. Once the number of new cases has declined to a level that no longer overwhelms hospitals, policymakers will be able to relax containment measures by just enough to bring the reproduction number back to one. This will create a new steady state where the number of new infections remains at a stable and manageable level.  The good news is that the strategy appears to be working. The number of new cases and deaths have started to decline in both Italy and Spain, the two hardest hit European countries. In the US, while the number of new cases has yet to show a clear downward trend, there are glimmers of hope (Chart 4). For example, the net number of people admitted to New York hospitals has declined sharply since the beginning of April (Chart 5). Chart 4New Cases And Deaths: Have We Turned The Corner? Testing Times Testing Times Chart 5Glimmer Of Hope Emanating From The Big Apple? Testing Times Testing Times Test, Test, Test While keeping the reproduction number from rising above one will still require a variety of containment measures, the economic burden of these measures will decline over time. Using the bicycle analogy above, this is equivalent to saying that the road will become flatter the further down we go. To some extent, we will be able to relax containment measures because the virus will find it more difficult to propagate as more people are infected. However, unless it turns out that the number of asymptomatic cases is currently much greater than most estimates suggest, the benefits from this effect are likely to be small. The bigger impact will come not from making headway towards herd immunity, but from scaling up existing testing technologies to figure out who is dangerous to others and who is not. Forcing almost everyone who is not deemed to be an “essential worker” to stay at home is hardly an optimal strategy. Rather than trying to isolate most people, it would be preferable to isolate only those who are infected. The problem is that we currently do not know who those people are. That will change as testing capacity ramps up. Right now, we are in the same predicament as if there had been a major terrorist attack using an explosive device that was invisible to conventional detectors. Just like there would have been a temptation to stop all air travel until we figured out how to detect the new type of bomb, we have decided to stop most commerce because we do not know who may be carrying the virus. The good news is that the technology to test people for COVID-19 exists. Abbott Labs has already unveiled a PCR test, which detects specific genetic material within the virus, that can render a positive result in as little as five minutes and a negative one in thirteen minutes. Last Wednesday, the FDA authorized a rapid antibody blood test for COVID-19 developed by Cellex, which can determine if someone previously had the virus and has recovered. Pessimists would highlight that there is currently a severe shortage of test kits. That is true, but we should avoid the trap of linear thinking that got us into this mess to begin with. Producing more tests is an engineering problem that will be solved. As the number of tests performed begins to increase exponentially, testing will become ubiquitous. How much would mass testing help? The answer is a lot. Paul Romer has shown that a strategy of randomly testing everyone roughly once every two weeks would bring down the total number of people who contract the virus to under 20% of the population.2 In his simulation, only 5%-to-10% of the population would need to be quarantined at any given time. In the absence of mass testing, 50% of the population would need to be quarantined to yield the same result (See Appendix 1 for details). The economy can handle isolating 5%-to-10% of its population at any given time. It cannot handle isolating half its population. Just like you have to X-ray your luggage at the airport, you may end up having to take a COVID-19 test before boarding a flight. Children will be tested at school several times a week; first responders more often than that. It will be a nuisance, but the alternative of a Great Depression is much worse. And if it is any consolation, at least this is one test you won’t have to study for! Unemployment Dynamics Following Exogenous Shocks Chart 6Historically, It Has Taken Some Time For Employment To Return To Pre-Recession Levels Historically, It Has Taken Some Time For Employment To Return To Pre-Recession Levels Historically, It Has Taken Some Time For Employment To Return To Pre-Recession Levels Economic life is full of asymmetries. It is easier to go bankrupt than to start a new business. It is also easier to lose a job than to find a new one. Once the links between companies and workers are severed, it can be difficult to restore them. This is partly because it is time-consuming and costly to match available workers with open positions. It is also because there are feedback loops at work: If someone is unemployed and not earning an income, they have less money to spend. If people are not spending much, there is less incentive for firms to hire new workers. In the United States, it took more than six years for the level of employment to return to its January 2008 peak. Even during the fairly mild 2001 downturn, employment did not return to pre-recession levels until February 2005 (Chart 6). Given the recent steep drop in output, it is likely that the unemployment rate will eclipse 10% in the US and most other economies during the coming months. Does this mean that it will take many years for the labor market to heal? Not necessarily. So far, most of the workers who have lost their jobs have been furloughed rather than permanently dismissed. According to the Bureau of Labor Statistics, 86% of the roughly 1.2 million US workers who lost their jobs in March were laid off temporarily (Chart 7). As a share of all unemployed, the number of workers on temporary layoff doubled in March to the highest level on record (Chart 8). Chart 7US Job Losses: Furlough Or Permanent Dismissal? Testing Times Testing Times Chart 8US Temporary Job Losses Have Skyrocketed US Temporary Job Losses Have Skyrocketed US Temporary Job Losses Have Skyrocketed The Role Of Stimulus Of course, it is possible that temporary layoffs will turn into permanent ones. This is where governments need to step in. Nothing can be done about the near-term decline in economic activity. That is the price which needs to be paid to keep the virus under control. However, transfers of income from governments to struggling households and firms can alleviate a lot of needless hardship, while making sure there is enough pent-up demand around for when businesses reopen their doors. We have discussed at length the various monetary and fiscal measures that have been introduced to combat the crisis.3 We will not get into the nitty-gritty of that discussion now, other than to note that the sizes of the various rescue packages have generally been in the ballpark of what is needed. And if it turns out that more help is necessary, it will be forthcoming. Chart 9 shows that there is widespread bipartisan support for further stimulus among US voters of all ages and backgrounds. Chart 9US: Support For Further Stimulus Is Widespread Testing Times Testing Times The WWII Comparison In some economic respects, the pandemic may end up resembling World War II. Just like today, the volume of nonessential goods and services was greatly curtailed during the war in order to make room for essential production (Chart 10). Instead of an exponential increase in facemasks and test kits, there was an exponential increase in the production of military equipment (Chart 11). Chart 10WW2 Versus World War V WW2 Versus World War V WW2 Versus World War V Chart 11Now Let's Do The Same For Test Kits And Ventilators Testing Times Testing Times Similar to today, the US government ran massive budget deficits to finance the war effort. The ratio of federal debt-to-GDP rose from 45% in 1942 to more than 100% by the end of 1945. Today there is widespread fear that returning workers will find themselves out of a job. Back then, people worried that returning soldiers would be unable to secure work, leading to a second Great Depression. Future Nobel laureate Paul Samuelson warned that the US faced the “greatest period of unemployment and industrial dislocation” unless wartime controls were extended. Gunnar Myrdal, another future Nobel laureate, predicted an “epidemic of violence” stemming from mass unemployment. Looking back, while the unemployment rate did rise briefly after the war, it quickly fell back, as the pent-up demand from years of frugality and a slew of war-time inventions ushered in two decades of unprecedented growth. Policy also did its part. Even though government spending fell by 75% in real terms between 1944 and 1947, the GI Bill, which provided free education, low-cost mortgages, and unemployment benefits to returning soldiers, cushioned the blow. The Marshall Plan also helped rebuild post-war Europe, boosting US exports in the process. We are not predicting that the pandemic will usher in a period of unparalleled prosperity. Nevertheless, just like the bleak forecasts following WWII proved to be unfounded, today’s forecasts of prolonged mass unemployment will likely not materialize. Gauging The Fair Value Of Equities To what extent has the recession reduced the fair value of corporate equities? Let us try to answer this question analytically. Consider a baseline where earnings grow by 2% per year, the risk-free rate is 2%, and the equity risk premium is 5%. Now suppose that the recession temporarily reduces corporate profits by 60% this year, 40% next year, and 20% the year after next relative to the aforementioned baseline, with earnings returning to trend beyond then. Chart 12 shows that such a recessionary shock would reduce the present value of earnings by 5.4%. Now let’s consider a more ominous scenario where corporate profits fall by 60% this year, 40% next year, 20% the year after that, and then remain 10% lower relative to the baseline forever. In that case, the present value of future earnings would fall by 14.1%. One might notice that even in this ominous scenario, the present value of future earnings falls less than one might have assumed. And this is before we take into account any possible mitigating effects from a drop in the risk-free rate. For example, suppose that the risk-free rate declines by one percentage point, which is roughly how much both the US 30-year Treasury yield and our 5-year/5-year forward terminal rate proxy have fallen since the start of the year (Chart 13). In that case, the present value of earnings would increase by 7.3% even if profits followed the ominous path described above.   Chart 12What Happens To Earnings During A Recessionary Shock? Testing Times Testing Times Chart 13Long-Term Rates Have Dropped This Year Long-Term Rates Have Dropped This Year Long-Term Rates Have Dropped This Year Of course, in practice, stocks tend to fall a lot more during recessions than you would expect based on the sort of fair value calculations described above. This is because the equity risk premium, which we have kept constant in our examples, usually rises in periods of economic turmoil. A higher risk premium increases the discount rate applied to future earnings, leading to lower stock prices. The equity risk premium is mean reverting. This explains why the prospective return to equities is usually highest during recessions and lowest following long economic booms. The equity risk premium is quite high at present, which warrants overweighting equities relative to bonds over a 12-month horizon (Chart 14). That said, the high equity risk premium mainly reflects exceptionally low bond yields. In absolute terms, stocks are not especially cheap, particularly in the US, where the S&P 500 trades at 17.3-forward earnings (Chart 15). That is actually above the P/E ratio of 15.1 that the S&P 500 reached in October 2007 at the peak of the bull market before the start of the Global Financial Crisis. Chart 14The Equity Risk Premium Is Quite High, Especially Outside The US The Equity Risk Premium Is Quite High, Especially Outside The US The Equity Risk Premium Is Quite High, Especially Outside The US Chart 15US Stocks Are Not Particularly Cheap In Absolute Terms US Stocks Are Not Particularly Cheap In Absolute Terms US Stocks Are Not Particularly Cheap In Absolute Terms     Moreover, today’s forward P/E ratio is based on stale earnings estimates which will come down over the coming weeks. The bottom-up consensus calls for S&P 500 companies to earn $153 per share this year. Our US equity strategists expect something closer to $100. We noted earlier this month that we would be aggressive buyers of stocks if the S&P 500 fell below 2250, but would turn neutral if the S&P 500 rose above 2750. The index briefly fell below 2250 on March 23, only to surge to 2789 as of the close of trading today. As such, we are downgrading our tactical 3-month view on global equities back to neutral. We are also trimming our tactical 3-month recommendation on the more cyclical currencies and stock markets such as those in Europe and EM. For now, we are maintaining our overweight stance on global stocks over a 12-month horizon, but will consider curbing that too if the S&P 500 rises above 3000 without a corresponding improvement in the news flow. Our full slate of views is shown in the matrix at the end of this report. Going forward, we will use this matrix as the primary tool for communicating our market views, reserving trade recommendations only for special situations that are not well covered by the views expressed in the matrix. To enhance accountability, we will start tracking all the positions in the matrix versus an appropriate market benchmark.   Peter Berezin Chief Global Strategist peterb@bcaresearch.com APPENDIX 1: Testing Versus Mass Quarantines (I) In a series of blog posts, Paul Romer presented a model that simulates and visualizes the effects of various policies aimed at containing the spread of Covid-19. At its core, similar to models used by epidemiologists, Romer’s model shows that without any intervention, a vast majority of populations will end up becoming infected. His simulations suggest that the policy of isolation based on random testing can be as effective in containing the virus as mass indiscriminate isolation. However, the economic and social costs of the latter are much higher than they are for the former. In Romer’s simulations, the policy of test-based isolation keeps the cumulative fraction of the population that is infected at below 20%. This policy relies on frequent testing where 7% of the population is randomly tested every day, equivalent to testing everyone roughly once every two weeks. Those who test positive are isolated. It is further assumed that these tests are imperfect: they yield 20% false negatives and 1% false positives. To achieve a similar profile of virus propagation without tests, Romer finds that a random isolation policy would require an average isolation rate in the population of about 50%. Appendix Chart 1 provides a graphical comparison of the intensity of the quarantining that is required under the two policy simulations. It shows that an isolation policy relying on tests results in much less disruption to normal patterns of social interactions.   Appendix Chart 1 Testing Times Testing Times Testing Times Testing Times APPENDIX 1: Testing Versus Mass Quarantines (II) The following two animations visualize the differences between the two policies: The blue inverted triangles show those who are vulnerable to catching the virus; the red circles signify those who are infectious; the purple squares mark those who were previously infectious but have now recovered and can neither catch nor transmit the virus; and the hollow orange box illustrates isolation. Isolating Based On Test Results .iframe-container{ position: relative; width 100%; padding-bottom: 56.25%; height: 0; } .iframe-container iframe{ position: absolute; top:0; left:0; width:100%; height: 100%; }   Isolating At Random .iframe-container{ position: relative; width 100%; padding-bottom: 56.25%; height: 0; } .iframe-container iframe{ position: absolute; top:0; left:0; width:100%; height: 100%; }   Source: Paul Romer, “Simulating Covid-19: Part 2,” March 24, 2020. For more details about the models and simulations as well as sensitivity analysis, please visit: https://paulromer.net/. Footnotes 1  “Evaluating The Initial Impact Of Covid-19 Containment Measures On Economic Activity,” OECD, 2020. 2 Paul Romer, “Simulating Covid-19: Part 2,” March 24, 2020. 3 Please see Global Investment Strategy, “Second Quarter 2020 Strategy Outlook: World War V,” dated March 27, 2020. Global Investment Strategy View Matrix Testing Times Testing Times Current MacroQuant Model Scores Testing Times Testing Times

Highlights Bond Yield Differentials: The deepening global recession has prompted aggressive monetary easing measures by virtually every developed economy central bank. With policy rates now near zero everywhere, government bond yield differentials between countries have been reduced substantially. Currency Hedged vs Unhedged Yields: Opportunities still exist in some countries to create synthetically “higher” yields relative to low local rates by hedging the currency exposure of foreign bonds. Country Allocation: Italy and Spain government bonds offer the most attractive yields, hedged into any of the major currencies (USD, EUR, GBP, JPY). Among the lower yielders, Canadian, Australian, French and Japanese government bonds offer the most attractive yield pickups, on a currency-hedged basis, versus yields in the US, Germany, and the UK. Feature Chart 1A Synchronized Collapse A Synchronized Collapse A Synchronized Collapse The COVID-19 economic downturn is already shaping up to be one of the deepest global recessions in history. While there have been worldwide industrial slowdowns and manufacturing recessions in the past, what is happening now is different in that all countries are suffering sharp contractions in activity in the much larger services sectors that employ far more workers. The result will be massive increases in unemployment, as is already happening in the US where a staggering 10 million workers have filed for jobless benefits over just the past two weeks. Central bankers have responded to the shock to growth by following essentially the same playbook: cutting interest rates to zero as rapidly as possible, followed up with quantitative easing and other programs to support financial markets. With a synchronized economic collapse leading to policy convergence, government bond yields have plunged worldwide, but yield differentials between countries have also fallen sharply as a result (Chart of the Week). In this report, we will present the case for using currency hedging more actively than usual to create more attractive global bond yields. What can a global government bond investor do in this environment of tiny-but-highly-correlated bond yields to squeeze out some incremental additional return? In this report, we will present the case for using currency hedging more actively than usual to create more attractive global bond yields. A Fundamentally Driven Yield Convergence Chart 2Yields Are Low Everywhere Yields Are Low Everywhere Yields Are Low Everywhere As a simple starting point, just looking at the level of government bond yields in the developed economies is a good indication of how little there is to choose from between countries right now. For example, a 10-year government bond in the US was yielding 0.67% yesterday, compared to a 10-year yield in Australia, Canada and the UK of 0.82%, 0.75%, and 0.33% respectively (Chart 2). Not only are those low absolute yields, but those spreads versus US Treasuries are very narrow in an historical context. Another way to see how similar interest rate structures have become within the major developed markets is by looking at market expectations of future policy rates. Our proxy for the market’s pricing of the terminal nominal policy rate – the 5-year overnight index swap (OIS) rate, 5-years forward – shows that interest rate markets are expecting policy rates to stay very low over the next few years. The fall in the terminal rate estimate has been the largest in the US and Canada, where the markets were still pricing in a “peak” policy rate level around 2% as late as December – the figure is now 0.6% in the US and 1.1% in Canada (Chart 3). Chart 3Global Policy Rate Convergence Global Policy Rate Convergence Global Policy Rate Convergence So if the bond markets now believe that the current levels of bond yields will be sustained for longer, is that a realistic belief? There is already a considerable amount of both monetary and fiscal stimulus that has been introduced by policymakers. At some point, this stimulus should begin to stabilize and boost economic growth, but only after the immediate public health crisis of the COVID-19 outbreak has begun to subside. That will eventually help put a floor under developed market government bond yields. Chart 4The Backdrop Remains Conducive To Global Bond Yields Staying Low The Backdrop Remains Conducive To Global Bond Yields Staying Low The Backdrop Remains Conducive To Global Bond Yields Staying Low As we discussed in a recent weekly report, three elements must all happen before a true and lasting bottom for both risk assets and bond yields can begin to take place (Chart 4):1   The net number of new COVID-19 cases must begin to slow in critical countries like the US and Italy, a first step before the lockdown restrictions can start to be lifted; The US dollar (USD) must peak out and begin to roll over, taking stress off non-US borrowers of USD-denominated debt; The VIX must sustainably fall back from the levels above 40 that imply very volatile markets and continued investor nervousness about the future. Global government bond yields are likely to remain relatively range bound over the next month or two, at least.  Out of this list, the slowing in the number of new cases of the virus in Italy is a positive sign, as is the VIX falling back to the mid-40s. The sticky USD is still a major issue, however, particularly for borrowers with major dollar debts in the emerging world. There is not yet an “all clear” from this checklist, suggesting that global government bond yields are likely to remain relatively range bound over the next month or two, at least. This means bond investors need to consider alternative strategies to boost the yield of their government bond portfolios. Bottom Line: The deepening global recession has prompted similar monetary easing measures by virtually every developed economy central bank. With policy rates near zero everywhere, government bond yield differentials between countries have been largely eliminated. Searching For More Attractive Yields - With Currency Hedging When discussing our country allocation strategy, we have always looked at the yields and relative returns of government bonds in each country in hedged currency terms rather than in local currency terms. This is to remove the significant return volatility coming from currency exposure, while also making an appropriate “apples-to-apples” comparison of the yields on offer in each country. We have chosen the USD as the “base currency” for all these comparisons. In Chart 5, we show a static snapshot of the government bond yield curves, in local currency terms, for the US, Germany, France, Italy, the UK, Japan, Canada and Australia. The US, Canada and Australia remain the relative high-yielders within the major developed markets, although the “riskier” credits of Italy and Spain offer the highest outright yields. Unhedged German yields look particularly unattractive here, with the entire yield curve offering yields below 0%. Chart 5Currency-Unhedged Global Government Bond Yield Curves Get Out The Magnifying Glass: Finding Value In Government Bond Yields Get Out The Magnifying Glass: Finding Value In Government Bond Yields Chart 6USD-Hedged Global Government Bond Yield Curves Get Out The Magnifying Glass: Finding Value In Government Bond Yields Get Out The Magnifying Glass: Finding Value In Government Bond Yields In Chart 6, we show those same yield curves, but with the non-US yields all shown on a USD-hedged basis. The yields include the net gain/cost of hedging foreign currency back into US dollars using 3-month currency forwards. Shown this way, the non-US yield curves can be more directly compared to the “base” US Treasury curve. Looking at those yields shows that there is a much tighter convergence of yields with the US for most countries, but in a relative narrower range between 0.5% and 1.25% across the full maturity spectrum. The Fed’s rapid easing cycle, which started with the 75bps of rate cuts in the summer of 2019 and continued with the rapid move to a near-zero funds rate during the COVID-19 crisis, has dramatically altered the calculus for both global bond country allocation and currency hedging. Chart 7Fed Rate Cuts Have Reduced The Yield Advantage of USTs Fed Rate Cuts Have Reduced The Yield Advantage of USTs Fed Rate Cuts Have Reduced The Yield Advantage of USTs Chart 8Fed Rate Cuts Have Taken The Carry Out Of The USD Fed Rate Cuts Have Taken The Carry Out Of The USD Fed Rate Cuts Have Taken The Carry Out Of The USD First, the Fed’s easing cycle triggered a major decline in US Treasury yields that was not matched in other countries, eliminating much of the unhedged yield advantage of Treasuries over non-US peers (Chart 7). At the same time, the Fed’s rate cuts eliminated much of the interest rate “carry” of owning US dollars versus other currencies. The amount of that reduction was significant, with the gain of hedging a euro or yen currency exposure into dollars reduced from nearly around 250bps in the spring of 2019 to just over 100bps today (Chart 8). That dramatically alters the attractiveness of even negative-yielding German and Japanese government bonds, whose yields could once have been transformed into a relatively high USD-based yield via currency hedging. The Fed’s easing cycle triggered a major decline in US Treasury yields that was not matched in other countries, eliminating much of the unhedged yield advantage of Treasuries over non-US peers.  At the same time, the Fed’s rate cuts eliminated much of the interest rate “carry” of owning US dollars versus other currencies. Country Allocation Strategy Implications For dedicated global government bond investors, the only way to earn meaningfully higher yields in the current environment is to consider selective currency hedging of bond exposures. In Tables 1-4, we show 2-year, 5-year, 10-year and 30-year government bond yields for the major developed economy bond markets. The yields are hedged into USD, EUR, GBP and JPY, to allow comparisons of foreign yields for investors with those four base currencies. Table 1Currency-Hedged 2-Year Government Bond Yields Get Out The Magnifying Glass: Finding Value In Government Bond Yields Get Out The Magnifying Glass: Finding Value In Government Bond Yields Table 2Currency-Hedged 5-Year Government Bond Yields Get Out The Magnifying Glass: Finding Value In Government Bond Yields Get Out The Magnifying Glass: Finding Value In Government Bond Yields Table 3Currency-Hedged 10-Year Government Bond Yields Get Out The Magnifying Glass: Finding Value In Government Bond Yields Get Out The Magnifying Glass: Finding Value In Government Bond Yields Table 4Currency-Hedged 30-Year Government Bond Yields Get Out The Magnifying Glass: Finding Value In Government Bond Yields Get Out The Magnifying Glass: Finding Value In Government Bond Yields For USD-based investors, there are still some interesting opportunities available to find a USD-hedged foreign yield that can exceed that of US Treasuries. The higher-yielding European markets like Italy and Spain are the obvious places to find yield, and we continue to recommend those bonds with the ECB now buying more of the riskier euro area government bonds as part of its new Pandemic Emergency Purchase Program. However, Canadian, Australian and French bonds – hedged into USD – all offer intriguing yield pickups over US Treasuries. Even the negative yields available in Japan and Switzerland look interesting when expressed in USD terms, although that is not the case for negative yielding German bonds. Canadian, Australian and French bonds – hedged into USD – all offer intriguing yield pickups over US Treasuries. Even the negative yields available in Japan and Switzerland look interesting when expressed in USD terms, although that is not the case for negative yielding German bonds. In Tables 5-8, the currency-hedged yields for each country are shown as a spread to the relevant “base” bond yield for each currency. For example, under the “EUR” column in Table 6, the cells show the yield spread between 5-year government bonds hedged into euros and 5-year German bonds. Here, we can see that there are far fewer opportunities for euro-based bond investors to find non-European yields that offer adequate yield pickups versus German yields. The pickings are even less slim for Japanese investors, with many non-Japanese yields trading below Japanese yields on a JPY-hedged basis. Table 5Currency-Hedged 2-Year Govt. Bond Yield Spreads Versus The Get Out The Magnifying Glass: Finding Value In Government Bond Yields Get Out The Magnifying Glass: Finding Value In Government Bond Yields Table 6Currency-Hedged 5-Year Govt. Bond Yield Spreads Versus The Get Out The Magnifying Glass: Finding Value In Government Bond Yields Get Out The Magnifying Glass: Finding Value In Government Bond Yields Table 7Currency-Hedged 10-Year Govt. Bond Yield Spreads Versus The Get Out The Magnifying Glass: Finding Value In Government Bond Yields Get Out The Magnifying Glass: Finding Value In Government Bond Yields Table 8Currency-Hedged 30-Year Govt. Bond Yield Spreads Versus The Get Out The Magnifying Glass: Finding Value In Government Bond Yields Get Out The Magnifying Glass: Finding Value In Government Bond Yields In sum, looking across all eight tables shown, the most consistently attractive yields, across all currencies and maturities, can be found in Australia, Canada, France, Italy and Spain. Bottom Line: Opportunities still exist in some countries to create synthetically “higher” yields relative to low local rates by hedging the currency exposure of foreign bonds. Italy and Spain government bonds offer the most attractive yields, hedged into any of the major currencies (USD, EUR, GBP, JPY). Among the lower yielders, Canadian, Australian, French and Japanese government bonds offer the most attractive yield pickups, on a currency-hedged basis, versus yields in the US, Germany, and the UK.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Please see BCA Global Fixed Income Strategy Weekly Report, "Central Banks To Markets: Redefining "Whatever It Takes"", dated March 24, 2020, available at gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Get Out The Magnifying Glass: Finding Value In Government Bond Yields Get Out The Magnifying Glass: Finding Value In Government Bond Yields Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Chart 1Will Fed Purchases Mark The Top? Will Fed Purchases Mark The Top? Will Fed Purchases Mark The Top? Policymakers can’t do much to boost economic activity when the entire population is under quarantine, but they can take steps to contain the ongoing credit shock and mitigate the risk of widespread corporate bankruptcy. If most firms can stay afloat, then at least there will be jobs to return to when shelter in place restrictions are lifted. Are the steps taken so far by the Federal Reserve and Congress sufficient in this regard? We expect that the Fed’s announcement of investment grade corporate bond purchases will mark the peak in investment grade corporate bond spreads (Chart 1). However, the Fed is doing nothing for high-yield issuers and its purchases only lower borrowing costs for investment grade firms, they don’t clean up highly levered balance sheets. Similarly, much of Congress’ fiscal stimulus package comes in the form of loans instead of grants. As such, ratings downgrades will surge and high-yield spreads probably have more near-term upside. Investors should keep portfolio duration close to benchmark, overweight investment grade corporate bonds and remain cautious vis-à-vis high-yield. Investors should also take advantage of the attractive long-run value in TIPS. Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment grade corporate bonds underperformed the duration-equivalent Treasury index by 1040 basis points in March, dragging year-to-date excess returns down to -1268 bps. The average index spread widened 251 bps from the beginning of the month until the Fed announced its corporate bond purchase programs. It then tightened by 90 bps. It currently sits at 283 bps. Even after the recent tightening, investment grade spreads are extremely high relative to history. Our measure of the 12-month breakeven spread adjusted for changing index credit quality ranks at its 89th percentile since 1989 (Chart 2).1 This means that the sector has only been cheaper 11% of the time since 1989. As we wrote in last week’s Special Report, the Fed’s two new corporate bond purchase programs could be thought of as adding an agency guarantee to eligible securities (those with 5-years to maturity or less).2  We would also expect ineligible (longer maturity) securities to benefit from some knock-on effects, since many firms issue at both the short and long ends of the curve. As such, we recommend an overweight allocation to investment grade corporate bonds, with a preference for the short-end of the curve (5-years or less). The Fed’s purchases should lead to spread tightening, and a steepening of the spread curve (panel 4).  Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Containing The Credit Shock Containing The Credit Shock Table 3BCorporate Sector Risk Vs. Reward* Containing The Credit Shock Containing The Credit Shock High-Yield: Neutral Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield underperformed the duration-equivalent Treasury index by 1330 basis points in March, dragging year-to-date excess returns down to -1659 bps. The average index spread widened 600 bps from the beginning of the month until the Fed announced its corporate bond purchase programs. It then tightened by 158 bps. It currently sits at 942 bps. As we wrote in last week’s Special Report, the Fed’s corporate bond purchases will cause investment grade corporate spreads to tighten, but so far, high-yield has been left out in the cold.3 This means that we must view high-yield spreads in the context of what sort of default cycle we expect for the next 12 months. To do that, we use our Default-Adjusted Spread – the excess spread available in the index after accounting for default losses. At current spreads, our base case expectation of an 11%-13% default rate and 20%-25% recovery rate implies a Default-Adjusted Spread between -98 bps and +117bps (Chart 3). For a true buying opportunity, we would prefer a Default-Adjusted Spread above its historical average of 250 bps. This means that we would consider upgrading high-yield to overweight if the index spread widens to a range of 1075 bps – 1290 bps, in the near-term. Until then, junk investors should stay cautious. MBS: Underweight Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 22 basis points in March, dragging year-to-date excess returns down to -81 bps. The conventional 30-year zero-volatility spread widened 13 bps on the month, driven by a 16 bps widening of the option-adjusted spread that was offset by a 3 bps decline in expected prepayment losses (aka option cost). Like investment grade corporates, MBS spreads will benefit from aggressive Fed purchases for the foreseeable future. However, we prefer investment grade corporates over MBS because of much more attractive valuations. Notice that the option-adjusted spread offered by a Aa-rated corporate bond is 98 bps greater than that offered by a conventional 30-year MBS (Chart 4). Further, servicer back-log is currently keeping primary mortgage rates elevated compared to both Treasury and MBS yields (panels 4 & 5). This is preventing many homeowners from refinancing, despite the Fed’s dramatic rate cuts. However, we expect these homeowners will eventually get their chance. The Fed will be very cautious about raising rates in the future, and primary mortgage spreads will tighten as servicers add capacity. This means that there is a significant amount of refi risk that is not yet priced into MBS. Government-Related: Underweight Chart 5Government-Related Market Overview Government-Related Market Overview Government-Related Market Overview The Government-Related Index underperformed the duration-equivalent Treasury index by 574 basis points in March, dragging year-to-date excess returns down to -667 bps. Sovereign debt underperformed duration-equivalent Treasuries by 1046 bps in March, dragging year-to-date excess returns down to -1375 bps. Foreign Agencies underperformed the Treasury benchmark by 850 bps on the month, dragging year-to-date excess returns down to -1023 bps. Local Authority debt underperformed Treasuries by 990 bps in March, dragging year-to-date excess returns down to -948 bps. Domestic Agency bonds underperformed by 96 bps in March, dragging year-to-date excess returns down to -103 bps. Supranationals underperformed by 70 bps on the month, dragging year-to-date excess returns down to -63 bps. USD-denominated Sovereigns handily outperformed Baa-rated corporate bonds during last month’s market riot (Chart 5). But going forward, we prefer to grab the extra spread available in Baa-rated corporates, with the added bonus that the corporate sector now benefits from direct Fed purchases. The Fed’s dollar swap lines should remove some of the liquidity premium priced into sovereign spreads, but these swap lines only extend to 14 countries (Euro Area, Canada, UK, Japan, Switzerland, Australia, Brazil, Denmark, Korea, Mexico, Norway, New Zealand, Singapore and Sweden) and further dollar appreciation is possible until global growth recovers. One silver lining of last month’s indiscriminate spread widening is that some value has been created in traditionally low-risk sectors. Specifically, the Domestic Agency and Supranational option-adjusted spreads are at 46 bps and 31 bps, respectively (bottom panel). Both look like attractive buying opportunities. Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds underperformed the duration-equivalent Treasury index by a whopping 649 basis points in March, dragging year-to-date excess returns down to -755 bps (before adjusting for the tax advantage). In fact, Aaa-rated Municipal / Treasury yield ratios have blown out across the entire curve and have made new all-time highs, above where they were during the 2008 financial crisis (Chart 6). While the spread levels are alarming, it’s not hard to understand why muni spread widening has been so dramatic. State and local governments are not only shouldering massive expenses fighting the COVID-19 crisis, but will also see tax revenues plunge as economic activity grinds to a halt. This opens up a massive whole in state & local government budgets and municipal bond prices are reacting in kind. Support in the form of Fed municipal bond purchases and direct cash injections from the federal government is required to right the ship. So far, the Fed is only supporting municipal debt with less than six months to maturity and federal government aid has come in the form of grants directed at specific spending areas. Ideally, the Fed will start purchasing long-dated municipal bonds (as it is doing with corporates) and the federal government will provide more direct aid to fill budget gaps. We expect both of those policies to be launched in the coming weeks, and thus think it is a good time to buy municipal bonds on the expectation that the “policy put” will drive spreads lower. Treasury Curve: Buy 5-Year Bullet Versus 2/10 Barbell Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve underwent a massive bull-steepening in March, as the Fed cut rates by 100 bps, all the way back to the zero bound. The 2-year/10-year Treasury slope steepened 20 bps on the month. It currently sits at 39 bps. The 5-year/30-year Treasury slope steepened 22 bps on the month. It currently sits at 85 bps. One good thing about the fed funds rate being pinned at zero is that it greatly simplifies yield curve strategy. As we showed in a recent report, when the funds rate is at its lower bound the Treasury slope will trade directionally with yields.4 That is, the yield curve will steepen when yields rise and flatten when they fall. Therefore, if you want to put on a position that will profit from lower yields but that doesn’t increase the average duration of your portfolio, you can enter a duration-neutral flattener: long a 2/10 or 2/30 barbell and short the 5-year or 7-year bullet, in duration-matched terms. Or, if like us, you do not want to make a large duration bet but suspect that Treasury yields will be higher in 12 months, you can enter a duration-neutral steepener: long the 5-year bullet and short a duration-matched 2/10 barbell.5 In terms of value, the 5-year yield no longer trades deeply negative relative to the 2/10 and 2/30 barbells (Chart 7), though it remains somewhat expensive according to our models (see Appendix B). TIPS: Overweight Chart 8Inflation Compensation Inflation Compensation Inflation Compensation TIPS underperformed the duration-equivalent nominal Treasury index by 515 basis points in March, dragging year-to-date excess returns down to -735 bps. The 10-year TIPS breakeven inflation rate fell 55 bps on the month. It currently sits at 1.09%. The 5-year/5-year forward TIPS breakeven inflation rate fell 24 bps on the month. It currently sits at 1.39%. As we noted in a recent report, the market crash has created an extraordinary amount of long-run value in TIPS.6 For example, the 10-year and 5-year TIPS breakeven inflation rates have fallen to 1.09% and 0.78%, respectively. This means that a buy & hold position long the TIPS and short the equivalent-maturity nominal Treasury will make money if average annual inflation is greater than 0.78% for the next five years, or greater than 1.09% for the next ten (Chart 8). This seems like a slam dunk. Even on a 1-year horizon, we would argue that TIPS trades make sense. We calculate that the TIPS note maturing in April 2021 will deliver greater returns than a 12-month T-bill as long as headline CPI inflation is above -1.25% during the next 12 months (panel 4). Granted, the oil price collapse is a significant drag on CPI (bottom panel). But, we would also note that the worst year-over-year CPI print during the 2008 financial crisis was -2.1% and this included deflation in the shelter component. Shelter accounts for 33% of the CPI, compared to only 7% for Energy. ABS: Underweight  Overweight Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities underperformed the duration-equivalent Treasury index by 342 basis points in March, dragging year-to-date excess returns down to -317 bps. The index option-adjusted spread for Aaa-rated ABS soared 158 bps on the month. It currently sits at 163 bps, well above average historical levels (Chart 9). Aaa-rated consumer ABS were not immune to the recent sell-off, but we think today’s elevated spreads signal an opportunity to increase exposure to the sector. In addition to the value argument, the Fed’s re-launched Term Asset-Backed Securities Loan Facility (TALF) should cause Aaa-rated ABS spreads to tighten in the coming months. Through TALF, eligible private investors can take out non-recourse loans from the Fed and use the proceeds to purchase Aaa-rated ABS. In our view, the combination of elevated spreads and direct Fed support for the sector suggests a buying opportunity in Aaa-rated consumer ABS. Non-Agency CMBS: Neutral  Underweight Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-agency Commercial Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 786 basis points in March, dragging year-to-date excess returns down to -785 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS widened 133 bps on the month. It currently sits at 217 bps, well above typical historical levels (Chart 10). Despite wide spreads, we are hesitant about stepping into the sector. The Fed has so far not extended its asset purchases to non-agency CMBS. There are other sectors – such as consumer ABS, Agency CMBS, and investment grade corporate bonds – that also offer attractive spreads and are benefitting directly from Fed support. Agency CMBS: Overweight Agency CMBS underperformed the duration-equivalent Treasury index by 394 basis points in March, dragging year-to-date excess returns down to -361 bps. The average index spread for Agency CMBS widened 74 bps on the month. It currently sits at 121 bps, well above typical historical levels (panel 3). Unlike its non-agency counterpart, the Fed is buying Agency CMBS as part of its mortgage-backed securities purchase program. The combination of an elevated spread and direct Fed support makes the Agency CMBS sector a high conviction overweight. Appendix A: The Golden Rule Of Bond Investing With the federal funds rate pinned at its effective lower bound for the foreseeable future, yield volatility at the front-end of the curve will decline markedly. This means that the 12-month fed funds rate expectations embedded in the yield curve provide little useful information. As such, our Golden Rule of Bond Investing is not a useful framework for implementing duration trades when the fed funds rate is pinned at zero. We will therefore temporarily stop updating the Golden Rule tables that were previously shown in Appendix A of our monthly Portfolio Allocation Summary. The Golden Rule framework will return when the fed funds rate is close to lifting off from zero. Please feel free to contact us if you have any questions.     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 April 3, 2020) Containing The Credit Shock Containing The Credit Shock 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 April 3, 2020) Containing The Credit Shock Containing The Credit Shock 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 46 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 46 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) Containing The Credit Shock Containing The Credit Shock 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 11Excess Return Bond Map (As Of April 3, 2020) The Golden Rule's Track Record The Golden Rule's Track Record   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 The 12-month breakeven spread is the spread widening required to deliver negative excess returns versus duration-matched Treasuries on a 12-month horizon. 2 Please see US Bond Strategy/Global Fixed Income Strategy Special Report, “Trading The US Corporate Bond Market In A Time Of Crisis”, dated March 31, 2020, available at usbs.bcaresearch.com 3 Please see US Bond Strategy/Global Fixed Income Strategy Special Report, “Trading The US Corporate Bond Market In A Time Of Crisis”, dated March 31, 2020, available at usbs.bcaresearch.com 4 Please see US Bond Strategy Weekly Report, “Life At The Zero Bound”, dated March 24, 2020, available at usbs.bcaresearch.com 5 The rationale for why barbell positions profit from curve flattening and bullet positions profit from curve steepening is found in US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation

Highlights The Federal Reserve’s temporary FIMA repo facility will go a long way in helping ease dollar-funding stress outside the US. However, with the duration of the lockdown highly uncertain, a liquidity crisis could rapidly evolve into a solvency one. If the containment measures prove successful by summer, then the global economy will be awash with much stimulus, which will be fertile ground for pro-cyclical currencies. However, in the event that we receive indications of a more malignant outcome, we could retest and break above the recent highs in the DXY. We assign a one-third probability to this outcome. For now, a barbell strategy is warranted. Hold a basket of the cheapest currencies, along with some safe-havens. Crude oil has approached capitulation lows, but conditions are not yet in place for a durable bottom. Stand aside on petrocurrencies for now. Feature Chart I-1The Fed's Liquidity Injections Are Working The Fed's Liquidity Injections Are Working The Fed's Liquidity Injections Are Working The DXY index has once again broken above the psychological 100 level. This has occurred alongside the backdrop of very generous swap lines offered by the Federal Reserve to foreign central banks, as well as a temporary repo facility for foreign and international monetary authorities (FIMA). In fact, the euro-dollar cross-currency basis swap is now in positive territory, suggesting that a key funnel for offshore dollar liquidity has now significantly widened (Chart I-1). Why then has the dollar continued to strengthen, despite a concerted effort by the Fed to flood the global system with dollars? We offer and explore three reasons: The Fed’s actions are still insufficient. The dollar crisis is evolving from a liquidity one to a solvency one. The liquidity-to-growth transmission mechanism needs time. The Fed’s Actions Are Still Insufficient The Fed’s actions so far to ease the offshore dollar funding stress have been to: Offer unlimited funding through swap lines to five major central banks at the overnight index swap + 25 basis points.1  This was effective the week of March 16. Extend the swap lines to nine more central banks, with a cap of US$60 billion and a maturity of 84 days.2 This was announced March 19. Allow FIMA account holders to temporarily exchange their Treasury securities held with the Fed for US dollars. This was announced on Tuesday. Have these actions been sufficient? For most developed market currencies, yes. Chart I-2 shows that the currencies that have been most hit in the first quarter were of the countries initially excluded from the swap agreement such as Australia, Norway and New Zealand. Since the March 19 agreement, these currencies have staged significant rallies. Chart I-2Very Few Winners In Q1 Capitulation? Capitulation? However, there are three reasons why the Fed’s actions are still insufficient. First, they are limited to only 14 central banks, and need to be expanded further. While currencies such as the Brazilian real and Mexican peso have stabilized, others like the Turkish lira or South African rand continue their freefall. In short, many emerging market central banks do not have swap agreements with the US. These are countries with huge dollar liabilities that could continue to see their currencies fall, pushing up the  aggregate dollar index. Developed market commodity currencies tend to be highly correlated to emerging market currencies (Chart I-3). There is a huge pool within the financial architecture unable to access funding through central bank swap lines.  The second reason is that the pool of Treasury securities available to swap for US dollars has shrunk significantly. This has been on the back of slowing global trade, which sapped the current account surpluses of many countries, dampening their foreign exchange reserves. Thus, while the Fed’s latest actions may prevent an international dumping of US Treasurys, it may be insufficient to completely assuage funding stresses (Chart I-4). Chart I-3Commodity Currencies Still At Risk Commodity Currencies Still At Risk Commodity Currencies Still At Risk Chart I-4A Smaller Pool Of Treasurys To Sell A Smaller Pool Of Treasurys To Sell A Smaller Pool Of Treasurys To Sell Finally, a recent report by the Bank of International Settlements3 showed that of the US$86 trillion in outstanding foreign exchange swaps/forwards, about 60% is among non-bank financial and other institutions. This suggests there is a huge pool within the financial architecture unable to access funding through central bank swap lines. Given that hedge funds are included in this group, this category entails a lot more credit risk than any central bank will be willing to bear (Chart I-5). Chart I-5Can The Fed Bail Out Non-Banks? Capitulation? Capitulation? Bottom Line: While the Fed’s injection of dollar liquidity has been massive and significant, access to these funds may be limited to entities that have significant credit risk. There is not much the Fed can do about this. But at the same time, it also suggests the Fed’s actions have been insufficient to quench the global thirst for dollar liquidity. From A Liquidity To A Solvency Crisis If the containment measures prove successful by summer, then the global economy will be awash with much stimulus, which will be fertile ground for pro-cyclical currencies. As a counter-cyclical currency, the dollar will buckle, lighting a fire under our favorites such as the Norwegian krone and the Swedish krona. The euro will be the most liquid beneficiary of this move. However, the DXY index has effortlessly broken above the psychological 100 level, suggesting we could catapult to new highs. When massive amounts of stimulus are injected into markets but prices keep falling (and the dollar keeps rallying), this portends a liquidity crisis morphing into a solvency one. What ensues is a liquidation phase where the only guiding signposts are technical indicators and valuation extremes. There are a few indications we could be stepping into this phase: During recessions, the dollar rally has tended to occur in two phases. The first phase prompts the US authorities to act, usually by dropping interest rates, which dampens the rally. The next phase epitomizes indiscriminate liquidation by financial markets (Chart I-6). Enter 2008. The US first introduced swap lines with a few central banks in December 2007. But from March to October 2008, the dollar soared by about 25%. This prompted the Fed to expand its swap lines to include even some emerging markets. Despite the knee-jerk fall in the dollar of 11%, we eventually made new highs by rallying 15%. While the Fed’s injection of dollar liquidity has been massive and significant, access to these funds may be limited. As the dollar rises, it takes time for economies to implode due to strong monetary and fiscal frameworks. The implosion of the euro area economy only surfaced well after the 2008 crisis. Specifically, there has been an epic rise in global nonfinancial corporate debt. As a result, credit default swaps across many countries are surging (Chart I-7). High-yield spreads are blowing out. Our bond strategists believe that even though there is value in investment-grade debt, high-yield paper remains at risk.4  Historically, whenever the default rate has breached 4% (as is the case now), a self-reinforcing feedback loop of higher refinancing rates and defaults ensues (Chart I-8). With a recovery rate that is going to be much lower than historical standards due to bloated balance sheets, this is worrisome. Chart I-6The Dollar Rally Occurs In Two Phases The Dollar Rally Occurs In Two Phases The Dollar Rally Occurs In Two Phases Chart I-7CDS Spreads Are Widening Significantly CDS Spreads Are Widening Significantly CDS Spreads Are Widening Significantly Chart I-8Large Defaults Are Ahead Large Defaults Are Ahead Large Defaults Are Ahead It is difficult to pinpoint where the epicenter of the potential default wave will be. The energy sector looks like a prime candidate, putting many commodity currencies at risk. Bottom Line: There is a non-negligible risk that the liquidity crisis evolves into a solvency one. Though this is not our base case, we assign a one-third probability to this outcome. Liquidity To Growth Transmission Channel Monetary stimulus only affects the economy with a lag, and fiscal stimulus is so far unlikely to completely plug the hole from economic disruption. This leaves currency technicals and valuation as among the only few guiding signposts towards a peak in the DXY. There is usually a significant lag between easing in offshore dollar funding costs and a respective bottom in the domestic currency (Chart I-1). The AUD/JPY cross has broken below the key support zone of 70-72. This defensive line held notably during the European debt crisis, China’s industrial recession and, more recently, the global trade war. This pins the next level of support in the 55-57 zone, on par with the recessions of 2001 and 2008. The USD/JPY is weakening again and will likely hit 100. A rising yen is usually accompanied by a dollar rally against other procyclical currencies. Outside of the Fukushima crisis, this has been a key indicator that the investment environment is becoming precarious (Chart I-9). Chart I-9The Yen Could Touch 100 The Yen Could Touch 100 The Yen Could Touch 100 Some high-beta currencies such as the USD/TRY, USD/ZAR, and USD/IDR are still in freefall. These currencies are usually good at sniffing out a change in the investment landscape, specifically one becoming perilous for carry trades. Similarly, the USD/CNY has tested and has failed to break above 7.12. This will be a key level to watch since a break above will send Asian currencies into the abyss. “Doctor” copper has failed to stage a meaningful rebound. In fact, the copper-to-gold and oil-to-gold ratios continue to head lower from oversold levels.  Whenever cyclical sectors are underperforming defensives at the same time as non-US markets underperforming US ones, this has signaled that the marginal dollar is rotating towards the US. This is usually dollar bullish (Chart I-10A and Chart I-10B). “Doctor” copper has failed to stage a meaningful rebound. In fact, the copper-to-gold and oil-to-gold ratios continue to head lower from oversold levels. This signifies impairment in the liquidity-to-growth transmission mechanism (Chart I-11). Earnings revisions continue to head lower across all markets. Chart I-10ACyclical Markets Are Not Confirming A Dollar Top Cyclical Markets Are Not Confirming A Dollar Top Cyclical Markets Are Not Confirming A Dollar Top Chart I-10BCyclical Markets Are Not Confirming A Dollar Top Cyclical Markets Are Not Confirming A Dollar Top Cyclical Markets Are Not Confirming A Dollar Top   Chart I-11Dr Copper Is Sick Dr Copper Is Sick Dr Copper Is Sick Bottom Line: Historically, signs of capitulation can usually be observed by paying close attention to market internals and currency technicals. While we have had some marginal improvement, we are not out of the woods yet. Portfolio Strategy Chart I-12Go Short CAD/NOK Go Short CAD/NOK Go Short CAD/NOK We recommend maintaining a barbell strategy – a basket of the cheapest currencies, along with some safe-havens such as the yen and Swiss franc. Overall, investors should maintain a small upward bias in the dollar in the near term. Meanwhile, short USD/JPY positions make sense. Oil plays are becoming attractive, but conditions for a durable bottom are not yet in place. The strong rebound in the NOK/SEK cross is just an unwinding of the flash crash. If the dollar and oil have been at the epicenter of these moves, then the cross is still at risk of relapsing in the near term. We were stopped out of a long position in this cross, and will discuss oil and petrocurrencies next week. That said, a short CAD/NOK position is a much safer way to express a longer-term bearish view on the dollar (Chart I-12). We are going short this cross today with a stop-loss at 7.5. Finally, the pound remains extremely cheap versus the dollar, but the rally in recent days has eroded the potential for tactical upside. We will await better opportunities to own sterling.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 These include the Bank Of Canada, Bank Of Japan, Bank Of England, European Central Bank, and the Swiss National Bank. 2 These include the Reserve Bank of Australia, the Banco Central do Brasil, the Danmarks Nationalbank (Denmark), the Bank of Korea, the Banco de Mexico, the Norges Bank, the Reserve Bank of New Zealand, the Monetary Authority of Singapore, and the Sveriges Riksbank. 3  Stefan Avdjiev, Egemen Eren and Patrick McGuire, “Dollar Funding Costs during the Covid-19 Crisis through the Lens of the FX Swap Market,” BIS Bulletin, dated April 1, 2020. 4 Please see US Bond Strategy and Global Fixed Income Strategy Joint Special Report, “Trading The US Corporate Bond Market In A Time Of Crisis,” dated March 31, 2020, available at usbs.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 Recent data in the US have been negative: The University of Michigan's consumer sentiment index plunged to 89.1 in March from 101 the previous month, the fourth largest monthly decline over the past half a century. ADP employment recorded a loss of 27K jobs in total nonfarm private sector, including a 90K decrease in small businesses payroll which was offset by the 48K increase in healthcare. Initial jobless claims surged to 6.6 million for the week ended March 27. The ISM manufacturing index came in at a relatively benign 49.1, but this was boosted by supplier deliveries. The DXY index appreciated by 1.1% this week amid growing concerns over COVID-19 and disappointing data releases. Shortly after the $2 trillion coronavirus rescue package last week, President Trump is now calling for another "very big and bold" $2 trillion "Phase 4" package on infrastructure spending. Report Links: The Dollar Funding Crisis - March 19, 2020 Are Competitive Devaluations Next? - March 6, 2020 The Near-Term Bull Case For The Dollar - February 28, 2020 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Recent data in the euro area have been negative: The business climate indicator dropped to -0.28 from -0.06 in March, as the COVID-19 crisis deepens. The March consumer price inflation fell across the euro area: headline inflation fell from 1.2% to 0.7% year-on-year and core inflation decreased from 1.2% to 1%.  EUR/USD depreciated by 1.1% this week. Euro zone countries have until April 9 to design another stimulus package to support the economy which might consist of financial loans and a short-term work scheme. The biggest challenge being faced is that while some member countries (including France, Italy and Spain) are calling for joint debt issuance, others (including Germany and Austria) are fiercely against it. Report Links: On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 On Money Velocity, EUR/USD And Silver - October 11, 2019 Japanese Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data in Japan have been negative: The jobs-to-applicants ratio dropped from 1.49 to 1.45 in February. Industrial production contracted by 4.7% year-on-year in February, down from -2.3% the previous month. Housing starts fell by 12.3% year-on-year in February.  The Japanese yen appreciated by 1.6% against the US dollar this week, supported by growing concerns over COVID-19 and a global recession. The quarterly Tankan Survey shows that the sentiment index fell to a 7-year low of -8 in Q1 among large manufacturers, and dived to 8 from 20 among non-manufacturers. Besides, the survey points to a further deterioration of confidence over the next three months. Report Links: The Near-Term Bull Case For The Dollar - February 28, 2020 Building A Protector Currency Portfolio - February 7, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data in the UK have been negative, despite some positive releases for Q4: Consumer confidence dropped from -7 to -9 in March. Markit manufacturing PMI slipped from 48 to 47.8 in March. The current account deficit narrowed from £15.9 billion to £5.6 billion in Q4. Annualized GDP growth was unchanged at 1.1% year-on-year in Q4. The British pound soared by 2% against the US dollar this week. To preserve cash during the pandemic, the BoE's Prudential Regulation Authority (PRA) suggested commercial banks to suspend dividends and buybacks until the end of this year in addition to cancelling outstanding 2019 dividends. Moreover, the PRA also expects banks not to pay any cash bonuses to senior staff. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 A Few Trade Ideas - Sept. 27, 2019 United Kingdom: Cyclical Slowdown Or Structural Malaise? - Sept. 20, 2019 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Recent data in Australia have been mixed: Consumer confidence dropped from 72.2 to 65.3 in March. Manufacturing PMI slipped from 50.1 to 49.7 in March. New home sales increased by 6.2% month-on-month in February, up from 5.7% the previous month. Building permits grew by 20% month-on-month in February. However, we expect housing activities to slow down in March. The Australian dollar fell further by 0.4% against the US dollar this week. In the minutes released this Wednesday, the RBA warned that a "very material contraction" in economic activity was ahead. While the RBA said it was not possible to provide an update of the macro forecast given the "fluidity of the situation", it also expressed concerns that the contraction might linger beyond the June quarter. Report Links: On AUD And CNY - January 17, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 A Contrarian View On The Australian Dollar - May 24, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 Recent data in New Zealand have been negative: Building permits grew by 4.7% month-on-month in February. However, business confidence plunged from -19.4 to -63.5 in March. The activity outlook index also dived from 12 to -26.7 in March. The New Zealand dollar fell by 0.8% against the US dollar this week. Similar to the BoE, the RBNZ is now restricting all locally-incorporated banks from paying dividends on ordinary shares until the economy has sufficiently recovered in order to preserve cash and support the stability of the financial system. The RBNZ is also taking measures to help support banks to lend to businesses. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Place A Limit Sell On DXY At 100 - November 15, 2019 USD/CNY And Market Turbulence - August 9, 2019 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Recent data in Canada have been negative: Bloomberg Nanos confidence dropped from 51.3 to 46.9 for the week ended March 27. Markit manufacturing PMI fell below 50 for the first time since last September to 46.1 in March. The Canadian dollar fell by 1.2% against the US dollar this week, weighed down by the sharp decline in oil prices. The BoC lowered the overnight target rate by another 50 bps in an emergency meeting last Friday. It also joined the QE club by launching the Commercial Paper Purchase Program (CPPP) which aims to ease short-term funding stress. Report Links: The Loonie: Upside Versus The Dollar, But Downside At The Crosses Updating Our Balance Of Payments Monitor - November 29, 2019 Making Money With Petrocurrencies - November 8, 2019 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Recent data in Switzerland have been negative: KOF leading indicator dropped from 100.9 to 92.9 in March. Total sight deposits increased from CHF 609 billion to CHF 621 billion for the week ended March 27. The manufacturing PMI plunged from 49.5 to 43.7 in March. Headline consumer prices fell by 0.5% year-on-year in March, further down from the 0.1% decline in February. The Swiss franc fell by 1.5% against the US dollar this week. The SNB is not only battling a weaker economic backdrop, but also strong demand for safe-haven currencies. While the SNB has less room to further lower interest rates, it is taking part in easing funding stress from the pandemic. Report Links: On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 Portfolio Tweaks Before The Chinese New Year - January 24, 2020 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Recent data in Norway have been negative: Retail sales increased by 2% month-on-month in February, up from 0.5% the previous month. Manufacturing PMI fell to 41.9 from 51.6 in March, the lowest since the Great Financial Crisis. The new orders, production and employment components all plunged below 40, while suppliers' delivery index soared to 74. The Norwegian krone rebounded by 2% against the US dollar this week, following the brutal selloff in recent weeks weighed by the sharp decline in oil prices. The Norges Bank is stepping up in currency intervention to reduce volatility including buying the krone in exchange for the US dollar. We believe there is now tremendous value in the krone once oil prices stabilize. Report Links: Building A Protector Currency Portfolio - February 7, 2020 On Oil, Growth And The Dollar - January 10, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Recent data in Sweden have been negative: Retail sales grew by 2.8% year-on-year in February. Manufacturing PMI crashed to 43.2 in March from 52.7. The Swedish krona fell by 0.5% against the US dollar this week. In the Swedish Economy Report released on Wednesday, the NIER (Swedish National Institute of Economic Research) estimates that Sweden's GDP will fall by just over 6% in the second quarter. While the NIER believes that the current central bank measures are appropriate in supporting the economy in a wave of bankruptcies and mass unemployment, Sweden has more room to act with relatively lower government debt to its advantage. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019 Balance Of Payments Across The G10 - February 15, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Making predictions about the economic and market outlook seems a futile exercise in the midst of such massive uncertainty. The deluge of articles about COVID-19 merely serves to highlight that nobody really knows how things will play out in the year ahead. Much depends on whether an effective vaccine or treatment becomes available within a reasonable timescale and that remains an open question. Social and economic disruption will continue to intensify until the spread of the virus starts to abate. One thing is certain. Economic activity around the world faces its biggest contraction in modern times. Declines in second quarter GDP will be mind-numbingly bad in a wide range of countries, especially those that have instituted lockdowns and the closure of non-essential businesses. According to the OECD, the median economy faces an initial output decline of around 25% as a result of shutdowns and restrictions.1 Chart 1A Meltdown In Economic Activity A Meltdown In Economic Activity A Meltdown In Economic Activity Estimates for the drop in US real GDP in the second quarter range as high as 50% at an annual rate. To put this into perspective, the peak-to-trough decline in US real GDP in the 2007-09 recession was a mere 4% over six quarters, and that felt catastrophic at the time. The New York Fed’s weekly economic index2 has already fallen to the lows of 2008 and worse is still to come (Chart 1). Could things be as bad as the 1930s Great Depression when US real GDP contracted by 25% over a three-year period? That would require an extreme apocalyptic view about the progression of the virus and does not bear thinking about. I am not that gloomy. Policymakers are acting aggressively to limit the economic damage. Central banks are flooding the system with liquidity and the cost of money is negligible. Meanwhile, fiscal caution has been thrown to the wind with massive government stimulus in many countries. While this will not prevent a deep recession, it will minimize the downside risks and support the eventual rebound. Markets are understandably in a deep funk because it is hard to price unknown risks. If this is no more than a two-quarter economic downturn followed by a sharp recovery, then a good buying opportunity in risk assets is in place given that monetary policy will stay hyper accommodative for a considerable time. If the downturn lingers much longer than that, then equities remain at risk. While loath to make a prediction, I am uncharacteristically tending to the more optimistic side. Let’s make the heroic assumption that we are not in an end of days scenario and that this crisis will pass at some point in the next year- hopefully sooner than later. What are some of the longer-run implications? A few come to mind. The backlash against globalization will gather impetus. Public sector debt will rise to unimaginable peacetime levels. Meanwhile, the crisis puts the final nail in the coffin of the private sector Debt Supercycle. Monetary policy will err on the side of ease for a very long time. The way that companies and other institutions have been forced to adapt to the crisis could trigger lasting changes in how they operate. Globalization In Full Retreat Chart 2A Retreat From Globalization A Retreat From Globalization A Retreat From Globalization The peak of globalization has been a central part of the BCA view for several years.3 Long before the current crisis, it was clear that anti-globalization forces were gathering strength, illustrated by increased trade barriers, a backlash against inward migration in many countries, and reduced flows of foreign direct investment (Chart 2). The Trump Administration’s imposition of tariffs and the Brexit vote were two of the more obvious examples of the change in attitudes. The supply-chain interruptions caused by factory shutdowns in China will reinforce the view that shifting production to cheaper-cost countries overseas went too far. At a minimum, it seems inevitable that many companies will seek to reduce their reliance on a single producer for critical components. On the medical front, one striking fact to emerge was that China supplies around 80% of US antibiotics. There will be massive pressure to develop greater homegrown supplies of medical supplies and other products deemed critical for economic and national security. The crisis also has led to a breakdown of the Schengen Area of open borders within the European Union (EU). Many member countries have reinstituted border controls and it is unclear when these might be removed. The free movement of people is a core principle of the EU. Meanwhile, the Maastricht Treaty rules on fiscal discipline, a key element of economic union, have been thrown out of the window. Even Germany has bowed to the pressure of relaxing fiscal constraints. Finally, a worsening situation for the already troubled Italian banking system will threaten EU financial stability. Overall, the crisis will leave a huge question mark over the long-term viability of the EU. Globalization was a major force behind disinflation as production shifted to low-cost producers. A reversal of this trend will thus be inflationary, at the margin. For many, this will be a price worth paying if it means increased job security and reduced vulnerability of supply chains. But the shift away from globalization will not be the only trend that threatens an eventual resurgence of inflation. The Explosion In Government Debt: Last Gasp Of  The Debt Supercycle BCA introduced the concept of the Debt Supercycle more than 40 years ago to describe the actions of policymakers to pump up demand rather than allow financial imbalances to be fully unwound during economic downturns. This inevitably meant that each new cycle began with a higher level of financial imbalances. As indebtedness rose, the economic costs of a financial cleansing increased, requiring ever-more desperate policy measures to shore things up. Unfortunately, such actions merely created the conditions for greater excesses and imbalances down the road. For example, the Federal Reserve’s aggressive response to the bursting of the tech bubble in 2000 helped set the scene for the even bigger housing bubble later in the decade. In that sense, the Debt Supercycle was a self-reinforcing trap that was bound to end badly, and that occurred in 2007. Chart 3The US Household Love Affair With Debt Died A Decade Ago The US Household Love Affair With Debt Died A Decade Ago The US Household Love Affair With Debt Died A Decade Ago Our discussion of the US Debt Supercycle was focused largely on the private sector because that is where rising imbalances posed the greatest threat to economic and financial stability. Rising public sector imbalances were less of a concern because governments do not finance themselves through the banking sector. Moreover, unlike the private sector, taxes can always be raised to boost revenues or, in extremis, the authorities can resort to the printing press. At the end of 2014, we wrote that the Debt Supercycle was dead. By that, we meant that easing policy would no longer be able to encourage a new cycle of leverage-financed private-sector spending. The downturn of 2007-09 was a turning point in attitudes toward debt, much in the way that those who lived through the Great Depression were financially conservative for the rest of their lives. Our view has been vindicated by the fact the ratio of household debt to income has decisively broken its pre-housing bubble uptrend and has failed to revive in the face of record-low interest rates (Chart 3). Corporate borrowing has been strong, but largely to finance stock buybacks and M&A activity. Capital spending has been disappointing this cycle, despite strong profits and margins. The current deep downturn will add a further nail in the coffin of the private sector Debt Supercycle. The shock of the recession and destruction of wealth will leave a legacy of increased financial caution with households wanting to build precautionary savings and companies striving to repair damaged balance sheets. It would not be a surprise to see the US personal saving rate head back to the double-digit levels of the early 1980s. While the private sector embraces greater financial conservatism, we are witnessing the start of an extraordinary surge in public sector deficits and debt from already high levels. Chart 4A Bad Starting Point For A Surge In The Federal Deficit A Bad Starting Point For A Surge In The Federal Deficit A Bad Starting Point For A Surge In The Federal Deficit Budget deficits automatically rise during recessions because tax receipts drop and spending on unemployment and welfare programs goes up (Chart 4). In the past, the starting point for deficits generally was low before a recession took hold. This time, the federal deficit has breached 5% of GDP when the economy was doing fine. With the current recession set to be deeper than in 2007-09 and fiscal stimulus likely to end up much more than the initial $2 trillion package, the deficit will far exceed the previous post-WWII peak of almost 10% of GDP, reached in fiscal 2009. The ratio of federal debt to GDP will soar past 100% within the next few years, exceeding the peak reached in WWII. A speedy decline in WWII debt burdens was helped by a sharp rebound in economic activity, supported by a powerful combination of demographics (the post-WWII baby boom) and pent-up demand. Real GDP grew at an average annualized pace of 4.3% in both the 1950s and 1960s. Unfortunately, slower population growth means that growth in the next one and two decades will be less than half that pace. At the same time, the federal deficit will be under upward pressure because of the impact of an aging population on healthcare and social security. In other words, restoring order to fiscal finances through normal measures (growth and/or austerity) will be an impossible task. High levels of government debt are perfectly manageable when private sector savings are plentiful, interest rates are negligible, and investors seek the safety of low-risk bonds. Thus, $1 trillion US federal deficits have not prevented Treasury yields from falling to all-time lows. However, such conditions will not last indefinitely. The timing of when bloated budget deficits start to impact markets and thus the economy will partly depend on the actions of the Fed. Monetary Policy: Is There  A Limit To What It Can Do? Gone are the days when monetary policy was a rather technical exercise: tweaking the level of interest rates to ensure that money and credit trends delivered the economic growth consistent with low and stable inflation. In the past decade, the old rule book has been discarded with policymakers forced to take ever-more extreme measures to prevent total collapse of the economic and financial system. The 2007-9 downturn was easier to deal with than the current crisis. The primary problem a decade ago was a financial rather than economic seizure. While policymakers had to be creative, the main task was to shore up systemically important financial institutions and inject enough liquidity into the system to restore normal market functioning. And it worked. This time, the issue is an economic not financial seizure and associated liquidity strains are a symptom, not the primary problem. The immediate role of central banks is again to ensure that the financial system continues to function by injecting whatever amounts of liquidity are necessary. But monetary policy cannot directly bail out all the businesses that face bankruptcy or help those that have lost their jobs. That is the role of fiscal policy. What central banks can do is print money to finance the rise in budget deficits. During WWII, the Fed had an agreement with the Treasury Department to peg the level of long-term yields below 2.5% and this arrangement persisted until 1951, long after the war ended. This ensured that a post-war rebound in private credit demand would not cause a spike in interest rates that might short-circuit the recovery. We could well see a similar arrangement in the coming years, though it might be an informal rather than publicized agreement. The key point is that the Fed will be massively biased toward easy policy for many years. The current generation of central bankers have experienced periodic threats of deflation rather than inflation during the past 20 years and that will shape how they perceive the balance of risks going forward. After the Great Depression of the 1930s, fears of deflation lingered well into the 1950s and policymakers’ resulting complacency toward inflation led to the inflation spike of the 1970s. We are at a similar point again. The Fed will remain a massive buyer of Treasury bonds, even as the economy recovers because it will not want to risk higher yields undermining growth. Even if inflation starts to rise, the Fed will justify a continued easy stance on the grounds that inflation has fallen far short of its 2% target for many years. Given the combination of a global blowout in central bank balance sheets and the retreat from globalization, the scene will be set for inflation to surprise on the upside. But this may not occur for several years because the recession will create a lot of spare capacity and deflation is a greater near-term threat than inflation. We have long argued that a sustained upturn in inflation would be preceded by a final bout of deflation. The revival of inflation may be gradual but its insidious nature ultimately will make it more dangerous. It seems inevitable that there will have to be monetization of public sector debt, not only in the US but in other major economies. Once investor confidence returns, the demand for government bonds will recede and yields will be under upward pressure. Financial repression may help contain the rise, but that cannot be a long-term solution. In the end, central banks will be the bond buyers of last resort and ultimately it will have to be written off via making the debt effectively non-maturing. If the economic picture continues to deteriorate could central banks use quantitative easing to start buying assets such as equities and real estate? Current legislation prevents such purchases in the case of the Fed and European Central Bank. Of course, legislation can always be changed but the Fed would be reluctant for Congress to change the Federal Reserve Act. That could open a can of worms including amendments such as requiring regular audits of policy decisions and altering how regional presidents are chosen. But it will not be the Fed’s decision and if things get bad enough then nothing should be ruled out. An Accelerated Move To Virtual Activity? The restrictions on travel and public meetings and the closure of many businesses have forced companies to embrace online ways of conducting operations. And the same applies to schools and universities. In many cases, companies may find that virtual meetings between far-flung offices work rather well. This could cause a major rethink about future spending on business travel. Replacing travel with virtual meetings not only saves on airfares but also frees up employee time and reduces stress. And the improvements in communication technology make virtual meetings almost as good as the real thing. Of course, this is not a great story for airlines. The same arguments can be made for education but are slightly less compelling because of the social dimension. Mixing with friends and peers is one of the big attractions for students and most would be loath to give this up. And for working parents, it is not feasible to have children stuck at home. Nonetheless, at the post-secondary level, there could be a move to more online teaching. Another consequence of the current crisis has been a forced shift to more online shopping. This trend was already well established but is now likely to accelerate. Those retailers who fail to adapt will fall by the wayside. Market Implications As noted at the outset, it is hard to make predictions without knowing how the virus will progress. But we know a few things. First, there is not much scope for bond yields to fall from current levels. Second, equity valuations have improved as a result of the collapse in prices. Third, monetary policy will remain supportive of markets for a long time. On this basis, it is easy to conclude that stocks should beat bonds handsomely over the medium and long term. The short-term picture is cloudier. If the recession is short-lived and economic activity rebounds strongly, then we currently have a good buying opportunity for stocks. But there is no way to make a prediction about this with any conviction. The case for a strong recovery is that policy is massively stimulative and there will be a lot of pent-up demand. The case for a slow and drawn-out recovery is that consumers and businesses will be left with greatly weakened balance sheets and the loss of small businesses and associated jobs could be a lasting problem. A final issue is that fears of another virus wave could weigh on consumer and business confidence. Initially, there will be some extremely strong quarters of growth but beyond that, the odds favor a drawn-out recovery rather than a vigorous one. Faced with such uncertainty, one strategy is to rely on technical indicators rather than economic forecasts as a judge of whether it is safe to rebuild positions in risk assets. This gives some reason for encouragement as measures of sentiment are at depressed extremes, typically seen only at major bottoms. And this is supported by momentum indicators at oversold extremes. However, a word of caution: these indicators make the case for a near-term bounce but say nothing about the durability of any rally. For some time, non-US markets have looked more appealing than Wall Street from a valuation perspective. That remains the case, but there is an important caveat. Thus far, the virus has been more of a problem for the developed countries than emerging ones (China and Iran excepted). It remains to be seen whether Africa, and Latin America and other countries in Asia and the Middle East can avoid a catastrophic spread of the virus. It could potentially be disastrous given the poor infrastructure and lack of government resources in those regions. Moreover, a shift away from globalization is not bullish for the emerging world. Some positions in gold are a good hedge given current uncertainties and the fact that inflation fears will rise long before actual inflation picks up. In normal circumstances, the extraordinary rise in the US budget deficit would be bearish for the US dollar. But other countries are following the same path so in relative terms, the US is no worse off. And there is still no serious competition to the dollar as the global reserve currency. Thus, while the dollar might weaken somewhat, it should not be a major source of risk to US assets. In closing, it is impossible to provide the certainty and high-conviction predictions that investors crave. That makes it rash to make aggressive bets on how things will play out in the economy and markets. At BCA, we favor equities over bonds but advise continued near-term caution. The bottoming process in equities could be volatile and drawn-out. Building positions gradually seems the most sensible strategy.   Martin H. Barnes, Senior Vice President Chief Economist mbarnes@bcaresearch.com   Footnotes 1 For an estimate of the virus impact on a range of economies, please see the recent OECD report “Evaluating the initial impact of COVID-19 containment measures on economic activity”. Available at: www.oecd.org 2 The report and underlying data are available at www.newyorkfed.org. 3 For example, the retreat from globalization was discussed in our 2015 Outlook report published at the end of 2014.

Dear Client, This week’s report is written by BCA’s chief economist, Martin Barnes. Martin explores the myriad ways the pandemic could influence long-term economic and financial trends. I trust you will find his report very insightful. Best regards, Peter Berezin, Chief Global Strategist Making predictions about the economic and market outlook seems a futile exercise in the midst of such massive uncertainty. The deluge of articles about COVID-19 merely serves to highlight that nobody really knows how things will play out in the year ahead. Much depends on whether an effective vaccine or treatment becomes available within a reasonable timescale and that remains an open question. Social and economic disruption will continue to intensify until the spread of the virus starts to abate. One thing is certain. Economic activity around the world faces its biggest contraction in modern times. Declines in second quarter GDP will be mind-numbingly bad in a wide range of countries, especially those that have instituted lockdowns and the closure of non-essential businesses. According to the OECD, the median economy faces an initial output decline of around 25% as a result of shutdowns and restrictions.1 Chart 1A Meltdown In Economic Activity A Meltdown In Economic Activity A Meltdown In Economic Activity Estimates for the drop in US real GDP in the second quarter range as high as 50% at an annual rate. To put this into perspective, the peak-to-trough decline in US real GDP in the 2007-09 recession was a mere 4% over six quarters, and that felt catastrophic at the time. The New York Fed’s weekly economic index2 has already fallen to the lows of 2008 and worse is still to come (Chart 1). Could things be as bad as the 1930s Great Depression when US real GDP contracted by 25% over a three-year period? That would require an extreme apocalyptic view about the progression of the virus and does not bear thinking about. I am not that gloomy. Policymakers are acting aggressively to limit the economic damage. Central banks are flooding the system with liquidity and the cost of money is negligible. Meanwhile, fiscal caution has been thrown to the wind with massive government stimulus in many countries. While this will not prevent a deep recession, it will minimize the downside risks and support the eventual rebound. Markets are understandably in a deep funk because it is hard to price unknown risks. If this is no more than a two-quarter economic downturn followed by a sharp recovery, then a good buying opportunity in risk assets is in place given that monetary policy will stay hyper accommodative for a considerable time. If the downturn lingers much longer than that, then equities remain at risk. While loath to make a prediction, I am uncharacteristically tending to the more optimistic side. Let’s make the heroic assumption that we are not in an end of days scenario and that this crisis will pass at some point in the next year- hopefully sooner than later. What are some of the longer-run implications? A few come to mind. The backlash against globalization will gather impetus. Public sector debt will rise to unimaginable peacetime levels. Meanwhile, the crisis puts the final nail in the coffin of the private sector Debt Supercycle. Monetary policy will err on the side of ease for a very long time. The way that companies and other institutions have been forced to adapt to the crisis could trigger lasting changes in how they operate. Globalization In Full Retreat Chart 2A Retreat From Globalization A Retreat From Globalization A Retreat From Globalization The peak of globalization has been a central part of the BCA view for several years.3 Long before the current crisis, it was clear that anti-globalization forces were gathering strength, illustrated by increased trade barriers, a backlash against inward migration in many countries, and reduced flows of foreign direct investment (Chart 2). The Trump Administration’s imposition of tariffs and the Brexit vote were two of the more obvious examples of the change in attitudes. The supply-chain interruptions caused by factory shutdowns in China will reinforce the view that shifting production to cheaper-cost countries overseas went too far. At a minimum, it seems inevitable that many companies will seek to reduce their reliance on a single producer for critical components. On the medical front, one striking fact to emerge was that China supplies around 80% of US antibiotics. There will be massive pressure to develop greater homegrown supplies of medical supplies and other products deemed critical for economic and national security. The crisis also has led to a breakdown of the Schengen Area of open borders within the European Union (EU). Many member countries have reinstituted border controls and it is unclear when these might be removed. The free movement of people is a core principle of the EU. Meanwhile, the Maastricht Treaty rules on fiscal discipline, a key element of economic union, have been thrown out of the window. Even Germany has bowed to the pressure of relaxing fiscal constraints. Finally, a worsening situation for the already troubled Italian banking system will threaten EU financial stability. Overall, the crisis will leave a huge question mark over the long-term viability of the EU. Globalization was a major force behind disinflation as production shifted to low-cost producers. A reversal of this trend will thus be inflationary, at the margin. For many, this will be a price worth paying if it means increased job security and reduced vulnerability of supply chains. But the shift away from globalization will not be the only trend that threatens an eventual resurgence of inflation. The Explosion In Government Debt: Last Gasp Of  The Debt Supercycle BCA introduced the concept of the Debt Supercycle more than 40 years ago to describe the actions of policymakers to pump up demand rather than allow financial imbalances to be fully unwound during economic downturns. This inevitably meant that each new cycle began with a higher level of financial imbalances. As indebtedness rose, the economic costs of a financial cleansing increased, requiring ever-more desperate policy measures to shore things up. Unfortunately, such actions merely created the conditions for greater excesses and imbalances down the road. For example, the Federal Reserve’s aggressive response to the bursting of the tech bubble in 2000 helped set the scene for the even bigger housing bubble later in the decade. In that sense, the Debt Supercycle was a self-reinforcing trap that was bound to end badly, and that occurred in 2007. Chart 3The US Household Love Affair With Debt Died A Decade Ago The US Household Love Affair With Debt Died A Decade Ago The US Household Love Affair With Debt Died A Decade Ago Our discussion of the US Debt Supercycle was focused largely on the private sector because that is where rising imbalances posed the greatest threat to economic and financial stability. Rising public sector imbalances were less of a concern because governments do not finance themselves through the banking sector. Moreover, unlike the private sector, taxes can always be raised to boost revenues or, in extremis, the authorities can resort to the printing press. At the end of 2014, we wrote that the Debt Supercycle was dead. By that, we meant that easing policy would no longer be able to encourage a new cycle of leverage-financed private-sector spending. The downturn of 2007-09 was a turning point in attitudes toward debt, much in the way that those who lived through the Great Depression were financially conservative for the rest of their lives. Our view has been vindicated by the fact the ratio of household debt to income has decisively broken its pre-housing bubble uptrend and has failed to revive in the face of record-low interest rates (Chart 3). Corporate borrowing has been strong, but largely to finance stock buybacks and M&A activity. Capital spending has been disappointing this cycle, despite strong profits and margins. The current deep downturn will add a further nail in the coffin of the private sector Debt Supercycle. The shock of the recession and destruction of wealth will leave a legacy of increased financial caution with households wanting to build precautionary savings and companies striving to repair damaged balance sheets. It would not be a surprise to see the US personal saving rate head back to the double-digit levels of the early 1980s. While the private sector embraces greater financial conservatism, we are witnessing the start of an extraordinary surge in public sector deficits and debt from already high levels. Chart 4A Bad Starting Point For A Surge In The Federal Deficit A Bad Starting Point For A Surge In The Federal Deficit A Bad Starting Point For A Surge In The Federal Deficit Budget deficits automatically rise during recessions because tax receipts drop and spending on unemployment and welfare programs goes up (Chart 4). In the past, the starting point for deficits generally was low before a recession took hold. This time, the federal deficit has breached 5% of GDP when the economy was doing fine. With the current recession set to be deeper than in 2007-09 and fiscal stimulus likely to end up much more than the initial $2 trillion package, the deficit will far exceed the previous post-WWII peak of almost 10% of GDP, reached in fiscal 2009. The ratio of federal debt to GDP will soar past 100% within the next few years, exceeding the peak reached in WWII. A speedy decline in WWII debt burdens was helped by a sharp rebound in economic activity, supported by a powerful combination of demographics (the post-WWII baby boom) and pent-up demand. Real GDP grew at an average annualized pace of 4.3% in both the 1950s and 1960s. Unfortunately, slower population growth means that growth in the next one and two decades will be less than half that pace. At the same time, the federal deficit will be under upward pressure because of the impact of an aging population on healthcare and social security. In other words, restoring order to fiscal finances through normal measures (growth and/or austerity) will be an impossible task. High levels of government debt are perfectly manageable when private sector savings are plentiful, interest rates are negligible, and investors seek the safety of low-risk bonds. Thus, $1 trillion US federal deficits have not prevented Treasury yields from falling to all-time lows. However, such conditions will not last indefinitely. The timing of when bloated budget deficits start to impact markets and thus the economy will partly depend on the actions of the Fed. Monetary Policy: Is There  A Limit To What It Can Do? Gone are the days when monetary policy was a rather technical exercise: tweaking the level of interest rates to ensure that money and credit trends delivered the economic growth consistent with low and stable inflation. In the past decade, the old rule book has been discarded with policymakers forced to take ever-more extreme measures to prevent total collapse of the economic and financial system. The 2007-9 downturn was easier to deal with than the current crisis. The primary problem a decade ago was a financial rather than economic seizure. While policymakers had to be creative, the main task was to shore up systemically important financial institutions and inject enough liquidity into the system to restore normal market functioning. And it worked. This time, the issue is an economic not financial seizure and associated liquidity strains are a symptom, not the primary problem. The immediate role of central banks is again to ensure that the financial system continues to function by injecting whatever amounts of liquidity are necessary. But monetary policy cannot directly bail out all the businesses that face bankruptcy or help those that have lost their jobs. That is the role of fiscal policy. What central banks can do is print money to finance the rise in budget deficits. During WWII, the Fed had an agreement with the Treasury Department to peg the level of long-term yields below 2.5% and this arrangement persisted until 1951, long after the war ended. This ensured that a post-war rebound in private credit demand would not cause a spike in interest rates that might short-circuit the recovery. We could well see a similar arrangement in the coming years, though it might be an informal rather than publicized agreement. The key point is that the Fed will be massively biased toward easy policy for many years. The current generation of central bankers have experienced periodic threats of deflation rather than inflation during the past 20 years and that will shape how they perceive the balance of risks going forward. After the Great Depression of the 1930s, fears of deflation lingered well into the 1950s and policymakers’ resulting complacency toward inflation led to the inflation spike of the 1970s. We are at a similar point again. The Fed will remain a massive buyer of Treasury bonds, even as the economy recovers because it will not want to risk higher yields undermining growth. Even if inflation starts to rise, the Fed will justify a continued easy stance on the grounds that inflation has fallen far short of its 2% target for many years. Given the combination of a global blowout in central bank balance sheets and the retreat from globalization, the scene will be set for inflation to surprise on the upside. But this may not occur for several years because the recession will create a lot of spare capacity and deflation is a greater near-term threat than inflation. We have long argued that a sustained upturn in inflation would be preceded by a final bout of deflation. The revival of inflation may be gradual but its insidious nature ultimately will make it more dangerous. It seems inevitable that there will have to be monetization of public sector debt, not only in the US but in other major economies. Once investor confidence returns, the demand for government bonds will recede and yields will be under upward pressure. Financial repression may help contain the rise, but that cannot be a long-term solution. In the end, central banks will be the bond buyers of last resort and ultimately it will have to be written off via making the debt effectively non-maturing. If the economic picture continues to deteriorate could central banks use quantitative easing to start buying assets such as equities and real estate? Current legislation prevents such purchases in the case of the Fed and European Central Bank. Of course, legislation can always be changed but the Fed would be reluctant for Congress to change the Federal Reserve Act. That could open a can of worms including amendments such as requiring regular audits of policy decisions and altering how regional presidents are chosen. But it will not be the Fed’s decision and if things get bad enough then nothing should be ruled out. An Accelerated Move To Virtual Activity? The restrictions on travel and public meetings and the closure of many businesses have forced companies to embrace online ways of conducting operations. And the same applies to schools and universities. In many cases, companies may find that virtual meetings between far-flung offices work rather well. This could cause a major rethink about future spending on business travel. Replacing travel with virtual meetings not only saves on airfares but also frees up employee time and reduces stress. And the improvements in communication technology make virtual meetings almost as good as the real thing. Of course, this is not a great story for airlines. The same arguments can be made for education but are slightly less compelling because of the social dimension. Mixing with friends and peers is one of the big attractions for students and most would be loath to give this up. And for working parents, it is not feasible to have children stuck at home. Nonetheless, at the post-secondary level, there could be a move to more online teaching. Another consequence of the current crisis has been a forced shift to more online shopping. This trend was already well established but is now likely to accelerate. Those retailers who fail to adapt will fall by the wayside. Market Implications As noted at the outset, it is hard to make predictions without knowing how the virus will progress. But we know a few things. First, there is not much scope for bond yields to fall from current levels. Second, equity valuations have improved as a result of the collapse in prices. Third, monetary policy will remain supportive of markets for a long time. On this basis, it is easy to conclude that stocks should beat bonds handsomely over the medium and long term. The short-term picture is cloudier. If the recession is short-lived and economic activity rebounds strongly, then we currently have a good buying opportunity for stocks. But there is no way to make a prediction about this with any conviction. The case for a strong recovery is that policy is massively stimulative and there will be a lot of pent-up demand. The case for a slow and drawn-out recovery is that consumers and businesses will be left with greatly weakened balance sheets and the loss of small businesses and associated jobs could be a lasting problem. A final issue is that fears of another virus wave could weigh on consumer and business confidence. Initially, there will be some extremely strong quarters of growth but beyond that, the odds favor a drawn-out recovery rather than a vigorous one. Faced with such uncertainty, one strategy is to rely on technical indicators rather than economic forecasts as a judge of whether it is safe to rebuild positions in risk assets. This gives some reason for encouragement as measures of sentiment are at depressed extremes, typically seen only at major bottoms. And this is supported by momentum indicators at oversold extremes. However, a word of caution: these indicators make the case for a near-term bounce but say nothing about the durability of any rally. For some time, non-US markets have looked more appealing than Wall Street from a valuation perspective. That remains the case, but there is an important caveat. Thus far, the virus has been more of a problem for the developed countries than emerging ones (China and Iran excepted). It remains to be seen whether Africa, and Latin America and other countries in Asia and the Middle East can avoid a catastrophic spread of the virus. It could potentially be disastrous given the poor infrastructure and lack of government resources in those regions. Moreover, a shift away from globalization is not bullish for the emerging world. Some positions in gold are a good hedge given current uncertainties and the fact that inflation fears will rise long before actual inflation picks up. In normal circumstances, the extraordinary rise in the US budget deficit would be bearish for the US dollar. But other countries are following the same path so in relative terms, the US is no worse off. And there is still no serious competition to the dollar as the global reserve currency. Thus, while the dollar might weaken somewhat, it should not be a major source of risk to US assets. In closing, it is impossible to provide the certainty and high-conviction predictions that investors crave. That makes it rash to make aggressive bets on how things will play out in the economy and markets. At BCA, we favor equities over bonds but advise continued near-term caution. The bottoming process in equities could be volatile and drawn-out. Building positions gradually seems the most sensible strategy.   Martin H. Barnes, Senior Vice President Chief Economist mbarnes@bcaresearch.com   Footnotes 1    For an estimate of the virus impact on a range of economies, please see the recent OECD report “Evaluating the initial impact of COVID-19 containment measures on economic activity”. Available at: www.oecd.org 2   The report and underlying data are available at www.newyorkfed.org. 3   For example, the retreat from globalization was discussed in our 2015 Outlook report published at the end of 2014.

Highlights Please note that we published a Special Report early this week titled Brazilian Banks: Falling Angels, and an analysis on India. Please also note that we are publishing an analysis on Indonesia below. Given uncertainty over the depth and duration of the unfolding global recession, a sustainable equity bull run is now unlikely. It is still early to lift EM equity and EM credit allocations from underweight to overweight within global equity and global credit portfolios, respectively. EM currencies and EM fixed-income markets will remain under selling pressure. Feature The question investors now face is whether the recent rebound will endure for a few months or it will just be a bear market rebound that is already fading. BCA’s Emerging Market Strategy service believes it is the latter. EM and DM share prices will likely make new lows.  A Tale Of Two Charts Chart I-1and I-2 overlay the current S&P 500 selloff with the market crashes of 1987 and 1929, respectively. The speed and ferocity of the current selloff is on a par with both. In 1987, following the 33% crash, share prices rebounded 14% but then relapsed without breaking below previous lows (Chart I-1). That was a hint that US share prices were entering a major bull market that indeed ensued. We do not know if the S&P 500 will make a lower low, but a retest of the recent lows is very likely. In 1929, US share prices collapsed by 36% over several weeks. Then, the overall index staged an 18% rebound within a couple of weeks, rolled over and plunged to new lows. The magnitude of the second downleg was 27% (Chart I-2). Chart I-1S&P 500: Now Versus 1987 S&P 500: Now Versus 1987 S&P 500: Now Versus 1987 Chart I-2S&P 500: Now Versus 1929 S&P 500: Now Versus 1929 S&P 500: Now Versus 1929   Fast forward to today, the S&P 500 plummeted 34% in a matter of only four weeks and then staged a 17.5% rebound in only a few days. We do not know if the S&P 500 will make a lower low, but a retest of the recent lows is very likely. In fact, we are assigning a higher probability to share prices in EM and DM breaking down to new lows than for the recent lows to hold. Chart I-3S&P 500: Now Versus 1929-32 S&P 500: Now Versus 1929-32 S&P 500: Now Versus 1929-32 Readers may question why we are comparing the current episode with the 1929 bear market. The argument against this comparison stresses that policymakers made numerous mistakes between 1929 and 1932, refusing to ease policy even after the crisis commenced. That led to debt deflation and a banking crisis, which in turn produced a vicious equity bear market of 85% lasting 3 years. At present, authorities around the world have reacted swiftly, providing enormous fiscal and monetary stimulus. We agree with this reasoning, but our point is as follows: Due to the US’s ongoing aggressive and timely policy response, stocks will avoid the protracted second phase of the 1930-‘32 bear market when share prices plummeted by another 80% (Chart I-3). Nonetheless, the US equity market could still repeat what occurred in the initial part of the 1929 bear market, as illustrated in Chart I-2 and Chart I-3. The Fundamentals The basis for our expectations of continued weakness in share prices is as follows: The selloff in the S&P 500 began from overbought and expensive levels (Chart I-4). The duration of the selloff so far has been only four weeks. We doubt that such a short, albeit vicious, selloff was enough to clear out valuation and positioning excesses. For example, even though by March 24 net long positions in US equity futures had dropped significantly, they were still above their 2011 and 2015/16 lows (Chart I-5). Chart I-4S&P 500: Correcting From Expensive Levels S&P 500: Correcting From Expensive Levels S&P 500: Correcting From Expensive Levels Chart I-5Net Long Positions In US Equity Indexes Futures Net Long Positions In US Equity Indexes Futures Net Long Positions In US Equity Indexes Futures   Besides, US equity valuations are still elevated. The cyclically adjusted P/E ratio for the S&P 500 – based on operating profits – is 25 compared with its historical mean of 16.5, as demonstrated in the top panel of Chart I-4. While this valuation model does not take into account interest rates, our hunch is as follows: facing such high uncertainty over the profit outlook, investors will require higher than usual risk premiums to invest in equities. In short, the ongoing profit collapse and the extreme uncertainty over the cyclical outlook heralds a higher risk premium. The discount rate – which is the sum of the risk-free rate and risk premium – presently should not be lower than its average over the past 20 years. We are experiencing a sort of natural disaster, and there is little policymakers can do amid lockdowns. Natural disasters require time to play out, and financial markets are attempting to price in this downturn.  Most stimulus measures taken worldwide to boost demand will only gain traction after the lockdowns are over. At the moment, global output and demand remain in freefall. The recovery will be hesitant and is unlikely to be V-shaped for two reasons: (1) social distancing measures will be eased only gradually; and (2) the lost household income and corporate profits from weeks and months of shutdowns will continue to weigh on consumer and business sentiment and their spending patterns for several months. China’s economy is a case in point. Both manufacturing and services PMIs for March posted readings in the 50-52 range. These are rather underwhelming numbers. Following stringent lockdowns in February when the level of economic output literally collapsed, only 52% of companies surveyed reported an improvement in their business activity/new orders in March relative to February. Chart I-6Our Reflation Confirming Indicator Is Downbeat Our Reflation Confirming Indicator Is Downbeat Our Reflation Confirming Indicator Is Downbeat If true, these PMI readings imply a level of output and demand in China that is still well below March 2019 levels. It seems China has not been able to engineer a V-shaped recovery in demand and output. Therefore, the odds are that, outside China, economic activity will come back only slowly. This entails that some businesses will not reach their breakeven points anytime soon, and that their profits will be contracting for some time to come. We do not think this is reflected in today’s asset prices.       Finally, our Reflation Confirming Indicator – which is composed of equally-weighted prices of industrial metals, platinum and US lumber – is pointing down (Chart I-6). Bottom Line: This bear market has been ferocious, but too short in duration. It is unlikely that share prices have already bottomed, given uncertainty over the depth and duration of the unfolding global recession. EM Versus DM: Stay Underweight Chart I-7EM Versus DM: Relative Equity Prices EM Versus DM: Relative Equity Prices EM Versus DM: Relative Equity Prices EM stocks have failed to outperform DM equities in the recent rebound. As a result, EM versus DM relative share prices are testing new lows (Chart I-7). Odds are that EM will underperform DM in the coming weeks or months. Outside North Asian economies (China, Korea and Taiwan), EM countries have less capacity to deal with the COVID-19 pandemic than advanced countries. First, health care systems in developing countries are far less equipped to deal with the pandemic than DM ones. Chart I-8 shows the number of hospital beds per 1,000 people in India, Indonesia, Brazil and Mexico are significantly lower than in Europe and the US. Chart I-8Many EMs Have Poor Health Infrastructure Downside Risks Prevail Downside Risks Prevail Second, EM ex-North Asian economies lack both the social safety net of Europe and the US’s capacity to inject large amounts of fiscal and monetary stimulus into the system. With the US dollar being the world reserve currency, the US has no problem monetizing its public debt and fiscal deficits. The same is true for the European Central Bank (ECB). If current account-deficit EM countries following in the footsteps of the US and monetize fiscal deficits/public debt, their currencies will likely depreciate. Last week, the South African central bank announced that it will buy local currency government bonds to cap their yields and inject liquidity into the system. This is of little help to foreign investors in domestic bonds because the rand has continued to sell off, eroding the US dollar value of their government bond holdings. Hence, the foreign investor exodus from the local currency bond market will likely continue. The same would be true for many other EM countries if they contemplate QE-type policies. Most stimulus measures taken worldwide to boost demand will only gain traction after the lockdowns are over. Third, unlike the Fed and the ECB, EM ex-North Asia central banks have limited capacity to alleviate funding stress for their companies. The Fed is also purchasing investment-grade corporate bonds and is setting up structures to channel credit to companies. All of this will marginally help ease financial and credit stress in the US. In contrast, central banks in EM ex-North Asia are unlikely to adopt similar policies on a comparable scale as the US. While DM countries do not mind seeing their currencies depreciate, authorities in many developing countries are fearful of further depreciation. The latter will inflict more stress on EM companies and banks that have large foreign currency debt. We will publish a report on EM foreign currency debt next week. Further, corporate bonds in DM are issued in local currency, allowing their central banks to purchase corporate bonds in unlimited quantities by creating money “out of thin air.” Chart I-9EM Performance Correlates With Commodities EM Performance Correlates With Commodities EM Performance Correlates With Commodities In contrast, outside of China and Korea, the majority of EM corporate bonds are issued in US dollars. This means that to bring down their corporate US borrowing costs, central banks in developing countries need to spend their finite US dollar reserves. Finally, commodities prices are critical to EM financial markets’ absolute and relative performance (Chart I-9). The outlook for commodities prices remains dismal. As the global economy has experienced a sudden stop, demand for raw materials and energy has literally evaporated. Liquidity provisions by the Fed and other key central banks may at a certain point help financial assets but will not help commodities. The basis is that demand for equities and bonds is entirely driven by investors, but in the case of commodities a large share of demand comes from the real economy. In bad times like these, central banks’ liquidity provisions can at a certain point persuade investors to look through the recession and begin buying financial assets before the real economy bottoms. In the case of commodities, when real demand is collapsing, financial demand will not be able to revive commodities prices. Bottom Line: It is still early to lift EM equity and EM credit allocations from underweight to overweight within global equity and global credit portfolios, respectively. Technicals: Old Support = New Resistance? Calling tops and bottoms in financial markets is never easy. When formulating investment strategy it is helpful to examine both market price actions and other subtle clues that financial markets often provide. The global equity index and global industrial stocks have rebounded to levels that acted as supports during previous selloffs. We have detected the following patterns that suggest the recent rebound is facing major resistance, and new lower lows are likely: The global equity index and global industrial stocks have rebounded to levels that acted as supports during previous selloffs (Chart I-10). Unless these equity indexes decisively break above these lines, the odds favor retesting their recent lows or even falling to new lows. Many other equity indexes and individual stocks are also displaying similar technical patterns. The Korean won versus the US dollar as well as silver prices exhibit a similar technical profile (Chart I-11). Chart I-10Ominous Technical Signals Ominous Technical Signals Ominous Technical Signals Chart I-11New Lows Ahead New Lows Ahead New Lows Ahead   Global materials have decisively broken below their long-term moving average that served as a major support in 2002, 2008 and 2015 (Chart I-12). The same multi-year moving average is now likely to act as a resistance. Hence, any rebound in global materials stocks – that extremely closely correlate with EM share prices – is very unlikely to prove durable until this support-turned-resistance level is decisively breached. US FAANGM (FB, AMZN, APPL, NFLX, GOOG, MSFT) equally-weighted stock prices have dropped below their 200-day moving average that served as a major support in recent years (Chart I-13). They did rebound but have not yet broken above the same line. Odds are that this line will become a resistance. If true, this will entail new lows in FAANGM stocks. Chart I-12Global Materials Broke Below Their Long-Term Defense Line Global Materials Broke Below Their Long-Term Defense Line Global Materials Broke Below Their Long-Term Defense Line Chart I-13FAANGM: Previous Support Has Become New Resistance FAANGM: Previous Support Has Become New Resistance FAANGM: Previous Support Has Become New Resistance   Bottom Line: Various financial markets are exhibiting technical patterns consistent with retesting recent lows or making lower lows. Stay put. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Indonesia: A Fallen Angel Chart II-1Indonesian Equities Are In Freefall In Absolute & Relative Terms Indonesian Equities Are In Freefall In Absolute & Relative Terms Indonesian Equities Are In Freefall In Absolute & Relative Terms Indonesian stock prices are in freefall - both in absolute terms and relative to EM - with no visible support (Chart II-1). We recommend that investors maintain an underweight position in both Indonesian equities and fixed-income and continue to short the rupiah versus the US dollar. We explain the reasoning behind this recommendation below. First, the key vulnerability of Indonesian financial markets is that they had been supported by massive foreign inflows stirred by falling US interest rates, despite deteriorating domestic fundamentals and falling commodities prices. We discussed this at length in our previous reports. However, the COVID-19 pandemic has brought these weak fundamentals to light. The latter have overshadowed falling US interest rates (Chart II-2) triggering an exodus of foreign portfolio capital and a plunge in the exchange rate. Currency depreciation has in turn mounted foreign investors losses resulting in a vicious feedback loop. As of the end of February, foreigners held about 37% of local currency bonds. Meanwhile, they held 56% of equities as of last week. Ongoing currency weakness and continued jitters in global financial markets will likely generate more foreign capital outflows.                    Second, the Indonesian economy - both domestic demand and exports - were already weak even before the breakout of COVID-19 occurred (Chart II-3).  Chart II-2Indonesia: Falling US Rates Stopped Mattering Indonesia: Falling US Rates Stopped Mattering Indonesia: Falling US Rates Stopped Mattering Chart II-3Indonesia: Domestic Demand Was Weak Before COVID-19 Outbreak Indonesia: Domestic Demand Was Weak Before COVID-19 Outbreak Indonesia: Domestic Demand Was Weak Before COVID-19 Outbreak   Chart II-4Indonesia: Struggling Under High Lending Rates Indonesia: Struggling Under High Lending Rates Indonesia: Struggling Under High Lending Rates With imposition of social distancing measures, output and nominal incomes will contract (Chart II-4). Third, the nation’s very underdeveloped health care system makes it more vulnerable to a pandemic compared to other mainstream EM countries. For example, the number of hospital beds per 1000 people - at 1.2 - is among the lowest within the mainstream EM universe. We discuss this issue for EM in greater detail in our most recent weekly report. In brief, it will take a longer time for this nation to overcome the pandemic and get its economy back on track. Fourth, Indonesia - as with many EM countries - is short on both social safety programs and fiscal stabilizers that are available in North Asian countries, Europe and the US. Moreover, the country lacks the administrative system needed to promptly execute fiscal stimulus. Besides, the economic stimulus announced by the Indonesian authorities is so far insufficient to meaningfully moderate the economic blow. The government announced a fiscal stimulus that barely amounts to 1% of GDP. This will do little to counter the recession that the nation’s economy is now entering. On the monetary policy front, though the central bank has been cutting policy rates and injecting local currency liquidity into the system, this will only help reduce liquidity stress. It will not directly aid ailing households and small businesses suffering from an income shock. Critically, prime lending rates have not dropped despite dramatic cuts in policy rates (Chart II-4). Chart II-5Bank Stocks - Last Shoe To Drop - Are Unraveling Now Bank Stocks - Last Shoe To Drop - Are Unraveling Now Bank Stocks - Last Shoe To Drop - Are Unraveling Now Meanwhile, the government’s decision to grant a debt servicing holiday to borrowers will only help temporarily. These borrowers will still need to repay their debts at some point down the line. Given the magnitude and uncertain duration of their income loss, there is no guarantee they will be in a position to service their debt after the pandemic is over. Eventually, Indonesian commercial banks will experience a large increase in non-performing loans (NPLs). Overall, the plunge in domestic demand combined with the fall in global trade and commodities prices entails that Indonesia is heading into its first recession since 1998. Given Indonesia has for many years been one of the darlings of EM investors, a recession in Indonesia and global flight to safety herald continued liquidation in its financial markets. Both local government bond yields and corporate US dollar bonds yields are breaking out. Rising borrowing costs amidst the recession will escalate the selloff in equities. Remarkably, non-financial stocks and small-caps have already fallen by 40% and 55% in US dollar terms, respectively (Chart II-5, top two panels). It was banks stocks – which comprise 35% of total market cap – that were holding up the overall index (Chart II-5, bottom panel). Given banks will likely experience rising defaults as discussed above, their share prices have more risk to the downside. Bottom Line: Absolute return investors should stay put on Indonesian risk assets for now. We maintain our short position on the rupiah versus the US dollar. EM-dedicated equity investors should keep underweighting Indonesian equities within an EM equity portfolio. Meanwhile, EM-dedicated fixed income investors should continue to underweight Indonesian local currency bonds as well as sovereign and corporate credit. Ayman Kawtharani Editor/Strategist ayman@bcaresearch.com   Footnotes Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights Extreme global economic uncertainty has pushed demand for USD higher, and forced investors to liquidate gold holdings to raise cash for margin calls and to provide precautionary balances. Gold endured a succession of down moves that elected our stop, leaving us with a 24% gain on the long-standing portfolio-hedge recommendation. Gold failed to deliver on portfolio protection at the onset of the market drop, but we believe this is largely a result of liquidation of positions in the wake of the record price volatility in commodities generally that has attended the COVID-19 pandemic. In the run-up to the GFC in 2008 and the COVID-19 crises, gold reached cyclical highs and was amongst the best performing assets. Once these crises hit and liquidity collapsed, investors were forced to book gains on their winners – including gold – to cover losses elsewhere. Additionally, the yellow metal provided a liquid source of US dollars to foreign investors and sovereigns with large dollar debts and expanding holes in their budgets. We remain constructive toward gold and will be re-opening our long position at tonight’s close. Feature The US dollar is essential to the global economy due to its dominant use in international trade invoicing and to a massive – $12 Trillion – foreign dollar-denominated pile of debt.1 As extreme global economic stress pushed up the demand for dollars, a market risk-off period has been transformed into a broad-based asset liquidation. In this report, we revisit our tactical and strategic stance on gold considering the global COVID-19-induced selloff and ongoing monetary and fiscal policy responses to it. COVID-19-Induced Uncertainty Upends Asset Correlations As investors rushed for liquid dollar assets amid rising worries re the length of the pause in global economic activity, past cross-asset correlations were disrupted and traditional safe-assets contributed to portfolio volatility. The recent equity selloff dragged gold and other safe assets in its wake. As investors rushed for liquid dollar assets amid rising worries re the length of the pause in global economic activity, past cross-asset correlations were disrupted and traditional safe-assets contributed to portfolio volatility (Chart of the Week).2 Gold prices, in particular, experienced a succession of rapid shifts in value since the beginning of this year: Up 10% from Jan 1 to Feb 24, down 12% from Feb 24 to Mar 19, and up 10% since Mar 19 (Chart 2, panel 1). These massive moves pushed gold’s implied volatility to its highest level since 2008. Chart of the WeekVolatility In Safe Assets Volatility In Safe Assets Volatility In Safe Assets Chart 2Large Moves In Gold Prices YTD Large Moves In Gold Prices YTD Large Moves In Gold Prices YTD A $1,575/oz stop to our long-standing gold recommendation was triggered on March 13, leaving us with a 24% gain, ahead of gold’s decline to $1,475/oz. We argued in previous reports the probability of a technical pullback remained elevated based on our Tactical Composite Indicator (Chart 2, panel 2). The dollar’s appreciation – driven by heightened uncertainty and pronounced illiquidity in offshore dollar markets – acted as a catalyst to the gold correction. A continued dollar shortage remains a chief risk to both our bullish gold and 2H20 EM activity rebound views. Global non-US banks’ reliance on US dollar and wholesale funding has greatly expanded since the Global Financial Crisis (GFC) (Chart 3, panel 1). This increases bank’s reliance on foreign exchange swap markets to secure marginal funding, which pushes up financing costs when demand for dollar asset spikes (Chart 3, panel 2). Chart 3Greater Non-US Banks’ Funding Fragility Returning To Gold As A Portfolio Hedge Returning To Gold As A Portfolio Hedge Chart 4USD Gains From Rising Market-Wide Risk Aversion USD Gains From Rising Market-Wide Risk Aversion USD Gains From Rising Market-Wide Risk Aversion Generally, when USD supply ex-US expands in the so-called Eurodollar market, the global trade and banking systems function properly. In periods of low systematic volatility – an indication of low market-wide risk aversion – capital flows from safe US assets to stocks, high-yield bonds, and foreign markets in the search for stronger returns. In times of stress, however, risk-aversion spikes and demand for dollar surges as foreigners pile into liquid assets (Chart 4). Since global banks are highly interdependent, a troubled non-US bank unable to cover its dollar liabilities will be forced to dump assets to acquire USD at any price, creating additional stress amongst banks and increasing the convenience yield of holding on to dollar assets (Chart 5). Chart 5USD shortage Forces Foreign Banks To Sell Dollar Assets USD shortage Forces Foreign Banks To Sell Dollar Assets USD shortage Forces Foreign Banks To Sell Dollar Assets The USD As A Momentum Currency The global dominance of the US dollar in trade, funding and invoicing can create a vicious feedback loop. The global dominance of the US dollar in trade, funding and invoicing can create a vicious feedback loop (Diagram 1). Diagram 1Dollar Strength And Weak Global Growth Loop Returning To Gold As A Portfolio Hedge Returning To Gold As A Portfolio Hedge This makes the dollar a momentum and counter-cyclical currency (Chart 6). It also explains gold’s recent price movements. The recent global liquidation of financial assets for USD is the result of the most severe liquidity crunch since the onset of the GFC in 2008 (Chart 7). Again, gold failed to provide much-needed portfolio protection at the onset of the market drop, since gold holdings often were liquidated to meet margin calls or by sovereigns to fill budget gaps (Chart 8). Chart 6A Weaker Dollar Bodes Well For Commodities The Dollar Is A Counter-Cyclical Currency A Weaker Dollar Bodes Well For Commodities The Dollar Is A Counter-Cyclical Currency A Weaker Dollar Bodes Well For Commodities The Dollar Is A Counter-Cyclical Currency Chart 7Liquidity Proxies To Watch Liquidity Proxies To Watch Liquidity Proxies To Watch A dearth of collateral in repo markets – proxied by rapid increases in primary dealers’ repo fails – typically leads to short-term plunges in gold prices, as the metal is used as an alternative source of loan collateral. Still, we do not interpret this liquidation as a sign that gold’s safe-haven status is fading. In the run-up to both crises, gold was reaching cyclical highs and was amongst the best performing assets. Once the crisis hit and liquidity collapsed, investors were forced to book gains on their winners – including gold – to cover losses elsewhere. Additionally, the yellow metal provided a liquid source of US dollars to foreign investors and sovereigns with large dollar debts and expanding (unfunded) budget obligations. These pressures were particularly acute among EM commodity-exporting countries, which saw revenues compress during the severe drop in cyclical commodities. Chart 8Gold Plunges At the Onset Of Severe Crisis Returning To Gold As A Portfolio Hedge Returning To Gold As A Portfolio Hedge Chart 9Gold Provides Liquidity During Crisis Returning To Gold As A Portfolio Hedge Returning To Gold As A Portfolio Hedge Lastly, scarce high-quality collateral in wholesale markets makes gold swaps a liquid funding source. A dearth of collateral in repo markets – proxied by rapid increases in primary dealers’ repo fails – typically leads to short-term plunges in gold prices, as the metal is used as an alternative source of loan and swap collateral (Chart 9). Swaps effectively release gold previously held in storage to markets, increasing its supply. Gauging The Recovery In Gold Prices Calling the bottom in gold prices depends on how the Fed responds to dollar-funding stress abroad and banks’ reluctance to lend. In the current circumstances, we believe the plunge in gold will be limited compared to the GFC. First, the latest shocks to markets globally come from outside the financial system. There are no pronounced quality concerns in high-quality collateral. Current disruptions are mainly a result of low capital deployment to market-making activities by the financial system. Importantly, banks are now more capitalized, due to tighter post-GFC regulations limiting bank risk-taking. Second, the Fed responded much more rapidly to the current market disruptions. It is taking steps to alleviate liquidity concerns by filling the role of market maker – acting as a dealer of last resort – and encouraging banks to use their available capital to conduct market-making activities. The Fed also acts as the global dollar lender of last resort by providing liquidity globally via swap lines (Chart 10). When the world is short of dollars, funding costs can increase drastically (Chart 11). Swap lines will ease oversea funding pressures, and we expect these will be expanded to more countries if needed. Chart 10Swap Lines Alleviate Funding Stress Swap Lines Alleviate Funding Stress Swap Lines Alleviate Funding Stress Chart 11A Rising USD Increases Funding Cost Abroad A Rising USD Increases Funding Cost Abroad A Rising USD Increases Funding Cost Abroad A few indicators are signaling some liquidity and dollar funding stress remains in the system. We believe the rapid intervention by global central banks over the course of the current market stress will keep any liquidity squeeze from becoming a solvency and collateral quality crisis (Chart 12). However, it is difficult to know the exact level central banks are targeting, and given the nature of the shock, a lot will depend on the fiscal policy response. We believe gold prices – along with the indicators shown in Chart 7 – provide valuable information on the effectiveness of central banks’ actions. Thus, gold’s recent recovery is a prescient signal. Still, a few indicators are signaling some liquidity and dollar funding stress remains in the system. With prices back at $1580/oz, it is possible gold prices would be liquidated in a renewed equity selloff. However, our tactical composite indicator is slightly better positioned now and with US treasury yields now close to zero, gold’s ability to hedge market risk will increase relative to bonds. This inclines us to think the move would be less severe compared to the early March 11% plunge. Chart 12Fiscal And Monetary Actions Will Ease Credit Shock Fiscal And Monetary Actions Will Ease Credit Shock Fiscal And Monetary Actions Will Ease Credit Shock Given these considerations, we recommend going long gold at tonight’s close. Longer-Term, Gold’s Upside Potential Is Attractive The expanding fiscal deficit also tackles the lack of collateral by increasing the issuance of Treasury Notes and Bills. Strategically, gold’s appeal has increased sharply following the unprecedented monetary and fiscal responses to the COVID-19 shock. Over the next 6-12 months, we expect the US dollar will weaken and respond to interest rate differentials as uncertainty dissipates – presuming, of course, the COVID-19 shock is controlled and contained in most countries (Chart 13). The global supply of US dollars will increase from the Fed’s balance sheet expansion, swap lines to foreign banks, and a deepening US current account deficit following the unprecedented $2 trillion fiscal-stimulus package approved by the US Congress. Importantly, the expanding fiscal deficit also tackles the lack of collateral by increasing the issuance of Treasury Notes and Bills. Chart 13The USD Is Diverging From Rates Differentials The USD Is Diverging From Rates Differentials The USD Is Diverging From Rates Differentials Longer-term, the odds of higher inflation have risen. Consequently, we expect the vicious circle illustrated above will work in reverse (Diagram 2). EM Asia economic growth – led by a recovery in China – will outpace that of the US. This will generate capital outflows from the US to riskier emerging markets, forcing the dollar down until the Fed moves to raise rates – something we do not expect over the next 12 months. Thus, the opportunity cost of holding gold likely will remain low for an extended period (Chart 14). Diagram 2A Virtuous Cycle Will Start In 2H20 Returning To Gold As A Portfolio Hedge Returning To Gold As A Portfolio Hedge Longer-term, the odds of higher inflation have risen. However, our base case is the inflationary scenario is more likely to develop over the next 2 years. Low and falling inflation expectations can be expected for an extended period – the result of the global shut-down and collapsed commodity prices, particularly oil. This would suggest fixed-income markets will be pricing in low rates for the foreseeable future until an actual inflation threat is apparent. Still, if our call on oil is correct – i.e., our expectation Brent crude oil will be trading at $45/bbl by year-end, and clear $60/bbl by 2Q21 as the global economy recovers from the COVID-19 pandemic and the OPEC 2.0 market-share war ceases – markets could be pricing to higher inflation expectations next year, which would benefit gold.3 In addition, the massive fiscal and monetary stimulus being deployed globally will remain in the system for an extended period, which could stoke inflationary pressures. Chart 14Gold's Opportunity Cost Will Remain Low Gold's Opportunity Cost Will Remain Low Gold's Opportunity Cost Will Remain Low Chart 15Gold Will Be Supported In A Savings Glut Gold Will Be Supported In A Savings Glut Gold Will Be Supported In A Savings Glut Conversely, there is a non-negligible deflation risk stemming from a semi-permanent increase in precautionary savings as a result of the traumatic pandemic episode.4 Even so, gold can benefit from an increasing pool of savings (Chart 15). Bottom Line: We are going long gold at tonight’s close. The tactical (easing in dollar-funding crisis), cyclical (weakening US dollar and low real interest rates), and strategic (policy-induced inflationary pressure) horizons are all supportive for adding gold positions to a diversified portfolio.   Hugo Bélanger Associate Editor Commodity & Energy Strategy HugoB@bcaresearch.com   Commodities Round-Up Energy: Overweight The makings of a deal among the three largest oil producers in the world – the US, Russia and the Kingdom of Saudi Arabia (KSA) continue to fall into place. Russia earlier this week leaked it would not be increasing output after the OPEC 2.0 1Q20 production cuts expired March 31, saying such an increase would be unprofitable. US President Donald Trump is offering to broker talks between KSA and Russia, with the Texas Railroad Commission – the historical regulator of output in the Lone Star State – indicating it would be willing to resume its prior role provided other states and countries got on board. For its part, KSA has made it clear it will not bear the burden of re-balancing global markets unless this burden is shared by all producers – including the US (Chart 16). Base Metals: Neutral Copper prices remain relatively well supported, even as other commodities are pressured lower. COVID-19-induced shipping delays at South African, particularly out of Durban, could tighten copper markets, just as major economies begin recovering from lockdowns and ramp infrastructure projects. Fastmarkets MB noted refining charges are weakening as supply contracts due to shipping delays. Precious Metals: Neutral We are leaving a standing buy order for spot Palladium if it trades to $2,000/oz. Once the COVID-19 pandemic has bee contained and economies begin returning to normal, the fundamental tightness we outlined in our February 27 report our February 27 report – falling supplies exacerbated by a derelict South African power-grid trying to cover steadily increasing demand and more stringent pollution restrictions – will re-assert itself (Chart 17). Ags/Softs:  Underweight CBOT Corn futures hedged lower on Tuesday after the USDA predicted corn acreage will reach 97mm in 2020, the largest in eight years and well above market expectations of 94mm. This comes at a time when numerous American ethanol plants – which account for 40% of corn usage – are closing in response to the diminished demand for biofuels used for gasoline, due to the COVID-19 outbreak. Corn futures ended the month down 7.1%, the largest decline since August. The USDA sees soybeans acres planted rising 10% in 2020, below average expectations and wheat acres planted slipping 1% to 44.7mm, the lowest since 1919. Wheat was down 0.75¢, while soybeans were up 3.75¢ at Tuesday’s close. Chart 16Oil Prices Collapsed After the Market-Share War Oil Prices Collapsed After the Market-Share War Oil Prices Collapsed After the Market-Share War Chart 17Palladium Deficit To Widen This Year Palladium Deficit To Widen This Year Palladium Deficit To Widen This Year     Footnotes 1     Please see our weekly report titled OPEC 2.0 Cuts, Fed Rate Cuts Will Support Oil Prices published March 5, 2020. 2     Following our US Bond strategist, the liquidity shock discussed in this report means investors are finding it more expensive or difficult to transact in certain markets because of scares amount of capital being deployed to those areas. This does not necessarily imply a lack of buyers of credit risk. Please see BCA Research’s US Bond Strategy report entitled Life At The Zero Bound published by BCA Research’s US Bond Strategy March 24, 2020. 3    Please see the Special Report we published with BCA Research’s Geopolitical Strategy March 30, 2020, entitled OPEC 3.0 In the Offing? It is available at ces.bcaresearch.com. 4    Please see BCA Research’s Global Investment Strategy report entitled Second Quarter 2020 Strategy Outlook: World War V published March 27, 2020.     Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 2019 Q4 Returning To Gold As A Portfolio Hedge Returning To Gold As A Portfolio Hedge Commodity Prices and Plays Reference Table Trades Closed in 2020 Summary of Closed Trades Returning To Gold As A Portfolio Hedge Returning To Gold As A Portfolio Hedge