Asset Allocation

Highlights Uncertainty & Yields: Global bond yields, driven to all-time lows as investors seek safety amid rioting markets, now discount a multi-year period of very weak global growth and inflation. Bond Portfolio Strategy: Maintain overall neutral portfolio duration exposure with so much bad news already priced into yields. Downgrade overall global spread product exposure to underweight versus governments on a tactical (0-3 months) basis given intense uncertainties on COVID-19 and oil markets. Model Bond Portfolio Changes – Governments: Upgrade countries that are more responsive to changes in the level of overall global bond yields and with room to cut interest rates (the US & Canada) to overweight, while downgrading sovereign debt with a lower “global yield beta” and less policy flexibility (Germany, France, Japan) to underweight. Model Bond Portfolio Changes – Credit: Downgrade US high-yield, euro area corporates and emerging market USD sovereigns & corporates to underweight. Feature Chart of the WeekOn The Verge Of Global ZIRP On The Verge Of Global ZIRP On The Verge Of Global ZIRP The title of this report is a quote from a worried BCA client this morning, discussing his daily commute into Manhattan from the New York suburbs. We can think of no better analogy for the mood of investors in the current market panic. After having enjoyed a decade of riding the gravy train of recession-free growth and robust returns on risk assets, all underwritten by accommodative monetary policies, worries about a deflationary bust following the boom have intensified. The global spread of COVID-19, the ebbs and flows of the US presidential election and, now, a stunning collapse in oil prices – markets have simply been unable to process the investment implications of these unpredictable events all at once. At times of such stress, the obvious thing to do is to stand aside and hedge portfolios while awaiting better visibility on the uncertainties. At times of such stress, the obvious thing to do is to stand aside and hedge portfolios while awaiting better visibility on the uncertainties. It is clear that global government bonds have been a preferred hedge, with yields collapsing to record lows worldwide. While most of the market attention has been on the breathtaking fall in US yields that has pushed the entire Treasury curve below 1% as the market has moved to discount a swift move to a 0% fed funds rate. New lows were also hit yesterday in countries that had been lagging the Treasury rally: the 10-year German bund reached -0.85% yesterday, while the 10-year UK Gilt fell to an intraday all-time low of 0.08% with some shorter-maturity Gilt yields actually dipping into negative territory (Chart of the Week). The common driver of yesterday’s yield declines was the 25% plunge in global oil prices after the weekend collapse of the OPEC 2.0 alliance between Russia and Saudi Arabia. The inflation expectations component of global bond yields fell accordingly, continuing the correlation with energy prices seen over the past decade. Yet the real component of global bond yields has also been falling, with markets increasingly pricing in an extended period of weak growth and negative real interest rates – especially in the US. Collapsing US Treasury Yields Discount A Recession, Not A Financial Crisis Chart 2Re-opening Old Wounds Re-opening Old Wounds Re-opening Old Wounds While this latest plunge in US equity markets has been both rapid and powerful, the damage only takes us back to levels on the S&P 500 last seen as recently as January 2019 (Chart 2). The turmoil, however, has reopened old wounds in markets that had suffered their own crises over the past decade, with European bank stocks hitting new all-time lows and credit spreads on US high-yield Energy bonds and Italian sovereign debt (versus Germany) sharply blowing out. The backdrop remains treacherous and global equity markets will likely remain under pressure until the number of new COVID-19 cases peaks outside of China (especially in the US). If there is one silver lining amidst the market carnage, it is that there appears to be few signs of 2008-style systemic financial stress. If there is one silver lining amidst the market carnage, it is that there appears to be few signs of 2008-style systemic financial stress. Bank funding indicators like Libor-OIS spreads and bank debt spreads have widened a bit over the past week but remain at very subdued levels (Chart 3). This is in sharp contrast to classic risk aversion indicators like the price of gold and the value of the Japanese yen versus the Australian dollar, which are closing in on the highs seen during the 2008 global financial crisis and 2012 European debt crisis. Chart 3A Growth Downturn, Not A Systemic Crisis A Growth Downturn, Not A Systemic Crisis A Growth Downturn, Not A Systemic Crisis We interpret this as investors being far more worried about a deep global recession than another major financial crisis. That is also confirmed in the pricing of US Treasury yields, especially when looking at the real yield. Chart 4Does The UST Market Think R* Is Negative? Does The UST Market Think R* Is Negative? Does The UST Market Think R* Is Negative? Chart 5Another Convexity-Fueled Bond Rally Another Convexity-Fueled Bond Rally Another Convexity-Fueled Bond Rally The entire TIPS yield curve is now negative for the first time, even with the real fed funds rate below the Fed’s estimate of the “r*” neutral real rate (Chart 4). The combination of low and falling inflation expectations, and plunging real yields, indicates that the Treasury market now believes that the neutral real funds rate is not 0.8%, as suggested by the Fed’s estimate of r*, but is somewhere well below 0%. With the fed funds rate now down to 0.75% after last week’s intermeeting 50bps cut, the Treasury market is not only pricing the Fed quickly returning to the zero lower bound on the funds rate, but staying trapped at zero for a very long time. The Treasury market is not only pricing the Fed quickly returning to the zero lower bound on the funds rate, but staying trapped at zero for a very long time. Yet that may be too literal an interpretation of the incredible collapse of US Treasury yields. The power of negative convexity is also at work, driving intense demand for long-duration bonds that puts additional downward pressure on yields. Large owners of US mortgage backed securities (MBS) like the big commercial banks have seen the duration of their MBS holdings collapse as yields have fallen. The result is that banks are forced to buy huge amounts of Treasuries (or receive US dollar interest rate swaps) to hedge their duration exposure of negative convexity MBS, hyper-charging the fall in Treasury yields – perhaps over $1 trillion worth of buying, by some estimates.1 This is a similar dynamic to what occurred last summer in Europe, when sharply falling bond yields triggered convexity-related demand for duration from large asset-liability managers like pension funds, further fueling the decline in bond yields (Chart 5). Yet even allowing that some of the Treasury yield decline has been driven by a mechanical demand for duration, a 10-year US Treasury yield of 0.56% clearly discounts expectations of a US recession, as well – which appears justified by the recent performance of some critical US economic data. In Charts 6 & 7, we show a “cycle-on-cycle” analysis of some key US financial and indicators and how they behave before and after the start of the past five US recessions. The charts are set up so the vertical line represents the start of the recession, and we line up the data for the current business cycle as if the latest data point represents the start of a recession. Done this way, we can see if the current data is evolving in a similar fashion to past US economic downturns. Chart 6The US Business Cycle Looks Toppy The US Business Cycle Looks Toppy The US Business Cycle Looks Toppy Chart 7COVID-19 Will Likely Trigger A Confidence-Driven US Recession COVID-19 Will Likely Trigger A Confidence-Driven US Recession COVID-19 Will Likely Trigger A Confidence-Driven US Recession The charts show that the current flat 10-year/3-month US Treasury curve and steady decline in corporate profit growth are both accurately following the path entering past US recessions. Other indicators like the NFIB Small Business confidence survey, the Conference Board’s leading economic indicator and consumer confidence series typically peak between 12-18 months prior to the start of a recession, but appear to be only be peaking now. The same argument goes for initial jobless claims, which are usually rising for several months heading into a recession but remain surprisingly steady of late – a condition that seems unlikely to continue as more companies suffer virus-related hits to their sales and profits and begin to shed labor. Net-net, these reliable cyclical US data suggest that the Treasury market is right to be pricing in elevated recession risk – especially with US cases of COVID-19 starting to increase more rapidly and US financial conditions having tightened sharply in the latest market rout. Bottom Line: Global bond yields, driven to all-time lows as investors seek safety amid rioting markets, now discount a multi-year period of very weak global growth and inflation – most notably in the US. Allocation Changes To Our Model Bond Portfolio The stunning fall in global bond yields has already gone a long way. Yet it is very difficult to forecast a bottom in yields, even with central banks easing monetary policy to try and boost confidence, before there is evidence that the global COVID-19 outbreak is being contained (i.e. a decreasing total number of confirmed cases). By the same token, corporate bonds (and equities) will continue to be under selling pressure until the worst of the viral outbreak has passed. We raised our recommended overall global duration stance to neutral last week – a move that was more tactical in nature as a near-term hedge to our strategic overweight corporate bond allocations in our Model Bond Portfolio amid growing market volatility. Yet with the new stresses coming from the collapse in oil prices and increasing spread of COVID-19 in the US and Europe, we are moving to a much more cautious near-term stance on global credit. Yet with the new stresses coming from the collapse in oil prices and increasing spread of COVID-19 in the US and Europe, we are moving to a much more cautious near-term stance on global credit. This week, we are making the following additional changes to our model bond portfolio to reflect the growing odds of a global recession: Downgrade global corporates to underweight versus global governments Maintain a neutral overall portfolio duration, but favor countries within the government bond allocation that are more highly correlated to changes in to the overall level of global bond yields. Chart 8Favor Higher-Beta Bond Markets With Room To Cut Rates Favor Higher-Beta Bond Markets With Room To Cut Rates Favor Higher-Beta Bond Markets With Room To Cut Rates Given how far yields have declined already, we think raising allocations to “high yield beta” countries that can still cut interest rates, at the expense of reduced weightings toward low beta countries that have limited scope to ease policy, offers a better risk/reward profile than simply raising duration exposure across the board. Such a nuanced argument is less applicable to global corporates, where elevated market volatility, poor investor risk appetite and deteriorating global growth momentum all argue for continued near-term underperformance of corporates versus government bonds. Specifically, we are making the following changes to our recommended allocations, presented with a brief rationale for each move: Upgrade US Treasuries and Canadian government bonds to overweight: Both Treasuries and Canadian bonds are higher beta markets, as we define by a regression of monthly yield changes to changes in the yield of the overall Bloomberg Barclays Global Treasury index (Chart 8). The Fed cut 50bps last week as an emergency measure and has 75bps to go before reaching the zero bound, which the market now expects by mid-year. Additional bond bullish moves after reaching the zero bound, like aggressive forward guidance, restarting quantitative easing and even anchoring Treasury yields in a BoJ-like form of yield curve control, are all possible if the US enters a recession. Meanwhile, the Bank of Canada (BoC) followed the Fed’s cut with a 50bp easing the next day and signaled that additional rate cuts are likely to prevent a plunge in Canadian consumer confidence. The collapsing oil price likely seals the deal for additional rate cuts by the BoC in the next few months. Downgrade Japanese government bonds to maximum underweight: Japanese government bonds (JGBs) are the most defensive low-beta market in model bond portfolio universe, thanks to the Bank of Japan’s Yield Curve Control policy that anchors the 10yr JGB yield around 0%. This makes JGBs the best candidate for a maximum underweight stance when global bond yields are not expected to rise in the near term, as we expect. Downgrade Germany and France to Underweight: The ECB meets this week and will be under pressure to ease policy given recent moves by other major central banks. A -10bps rate cut is expected, which may happen to counteract the recent increase in the euro versus the US dollar, but there is also possibility that ECB will increase and/or extend the size and scope of its current Asset Purchase Program. Given the ECB’s lack of overall monetary policy flexibility, and low level of inflation expectations, we see limited scope for the lower-beta German and French government bonds to outperform their global peers. Remain overweight UK and Australia: While both Australian government bonds and UK Gilts have a “median” yield beta in our model bond portfolio universe, both deserve moderate overweights as there is still the potential for rate cuts in both countries. The Reserve Bank of Australia (RBA) cut the Cash Rate by -25bps last week and they are still open to cut further to boost a sluggish economy hurt by wildfires and weak export demand from China. The RBA will stay more dovish for longer until we will see clear signs of a rebound of the Chinese economy from the COVID-19 outbreak. The Bank of England (BoE) will likely cut its policy rate later this month, or even before the next scheduled policy meeting, as COVID-19 is starting to spread through the UK. Downgrade US High-Yield To Underweight: US junk bonds had already taken a hit during the global market selloff in recent weeks, but the collapse in oil prices pummeled the market given the high weighting of US shale producers in the index (Chart 9). With additional weakness in oil prices likely as Russia and Saudi Arabia are now in a full-fledged price war, US high-yield will come under additional spread widening pressure focused on the weaker Caa-rated segment that contains most of the energy names. We recommend a zero weight in the Caa-rated US junk bonds, within an overall underweight allocation to the entire asset class. Downgrade euro area investment grade and high-yield corporates to underweight: COVID-19 is now spreading faster in Germany and France, after leaving Italy in a full-blown national crisis. The export-oriented economies of the euro area were already vulnerable to a global growth slowdown, but now domestic growth weakness raises the odds of a full-blown recession – not a good environment to own corporate bonds, especially with the euro now appreciating. Downgrade emerging market (EM) USD-denominated sovereigns and corporates to underweight: EM debt remains a levered play on global growth, so the increased odds of a global recession are a problem for the asset class – even with sharply lower interest rates and early signs of a softening in the US dollar (Chart 10). Chart 9Downgrade US Junk Bonds To Underweight Downgrade US Junk Bonds To Underweight Downgrade US Junk Bonds To Underweight Chart 10Still Not Much Broad-Based Weakness In The USD Still Not Much Broad-Based Weakness In The USD Still Not Much Broad-Based Weakness In The USD We will present the new specific model bond portfolio weightings, along with a discussion of the risk management implications of these changes, in next week’s report. Bottom Line: Maintain overall neutral portfolio duration exposure with so much bad news already priced into yields. Downgrade overall global spread product exposure to underweight versus governments on a tactical (0-3 months) basis given intense uncertainties on COVID-19 and oil markets. Upgrade high-beta countries with room to cut interest rates (the US & Canada) to overweight, while downgrading lower-beta countries with less policy flexibility (Germany, France, Japan) to underweight. Downgrade US high-yield, euro area corporates and emerging market USD sovereigns & corporates to underweight.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com   Ray Park, CFA Research Analyst ray@bcaresearch.com Footnotes 1https://www.wsj.com/articles/fear-isnt-the-only-driver-of-the-treasury-rally-banks-need-to-hedge-their-mortgages-1158347080 Recommendations Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Duration: It is too soon to call the bottom in bond yields. To help make that call we will be looking for when: daily new COVID-19 infections reach zero, global growth indicators improve, US economic indicators worsen, technical indicators signal a reversal. Fed: Low inflation expectations mean that the Fed is unconstrained when it comes to easing policy. Rate cuts will continue until either the funds rate reaches zero, or financial markets signal that enough stimulus has been delivered. Spread Product: Investors with 12-month investment horizons should neutralize allocations to spread product versus Treasuries, including high-yield where the recent oil supply shock will weigh heavily on returns. Investors should also downgrade exposure to MBS with the goal of re-deploying into corporate credit once the current risk-off episode runs its course. Feature Risk off sentiment prevailed in financial markets again last week, as COVID-19 continues to spread throughout the world. Most recently, the city of Milan has been placed under quarantine and New York state has declared a state of emergency. It is difficult to have much certainty about the virus’ ultimate economic impact, but the prospect of US recession looms larger and larger. In bond markets, the 10-year Treasury yield has fallen to 0.54% and the yield curve is pricing-in 91 bps of Fed rate cuts over the next 12 months (Chart 1). If those expectations are met, it would bring the funds rate down to 0.18%, only slightly above the zero-lower-bound. Chart 1Market Priced For A Return To The Zero-Lower-Bound Market Priced For A Return To The Zero-Lower-Bound Market Priced For A Return To The Zero-Lower-Bound On the bright side, there is ample evidence that global economic growth was trending up before the virus struck in late January, and we remain confident that a large amount of pent-up demand will be unleashed once its impact fades. However, we have no clarity on how much longer COVID-19 might weigh on growth. For this reason, we recommend a much more defensive US bond portfolio allocation, even for investors with 12-month horizons. Specifically, investors should keep portfolio duration close to benchmark and reduce spread product allocations to neutral. The market is sending the message that more rate cuts are needed. We will be quick to re-initiate a below-benchmark duration recommendation when we think that bond yields are close to bottoming. In the below section titled “How To Call The Bottom In Yields”, we discuss the factors that will help us make that decision. A State Of Monetary Policy Emergency The Fed took quick action last week, delivering an inter-meeting 50 basis point rate cut as the stock market tumbled on Tuesday morning. Alas, the market is sending the message that those 50 bps won’t be enough. Fed funds futures are pricing-in another 82 bps of easing by the end of next week’s FOMC meeting, followed by further cuts in April (Table 1). Table 1Expectations Priced Into The Fed Funds Futures Curve When And Where Will Bond Yields Trough? When And Where Will Bond Yields Trough? Of course, easier monetary policy is not the solution to what ails the global economy. At his press conference last week, Fed Chair Powell justified the emergency cut by saying that it will help “avoid a tightening of financial conditions which can weigh on activity, and it will help boost household and business confidence.” This is a fair assessment of what monetary policy can hope to accomplish in the current environment. At most, monetary policy can limit the damage in financial markets, which is a worthwhile goal given the strong historical correlation between financial conditions and economic growth (Chart 2). Chart 2Fed Must Do Its Best To Support Financial Conditions Fed Must Do Its Best To Support Financial Conditions Fed Must Do Its Best To Support Financial Conditions What’s more, with inflation expectations at very low levels – as we go to press the 10-year TIPS breakeven inflation rate is a mere 1.03% – there is no reason for the Fed to resist easing policy, even if the expected benefits from easing are small. Chart 3Markets Demand More Easing Markets Demand More Easing Markets Demand More Easing From our perch, the only possible reason for the Fed to refrain from cutting rates quickly all the way back to zero would be to preserve some monetary policy ammunition for when it is needed most. The Fed probably doesn’t see things this way. In conventional economic models it is the level of interest rates that influences economic activity. Therefore, the way to get the most bang for your stimulus buck is to cut rates to zero as quickly as possible. However, if monetary policy is primarily influencing the economy via its impact on financial conditions and investor sentiment, as Chair Powell claimed, then it would be advisable to only deliver rate cuts when financial conditions are tightening rapidly. That is, don’t cut rates if the stock market is rebounding, save your ammo for when equities are in free fall and panic is widespread. We can’t know for certain what the Fed will do between now and the next FOMC meeting. But we can say that, with inflation pressures low, there are no constraints against cutting rates back to the zero bound. The safest takeaway for bond investors is to assume that rate cuts will continue until either (i) the fed funds rate hits zero or (ii) we see signs that the markets and economy are no longer calling for further stimulus. Those signs would be (Chart 3): Yield curve steepening, particularly at the short end. Stocks outperforming bonds. A rising gold price. A falling US dollar. Bottom Line: More rate cuts are coming, and they won’t stop until either the fed funds rate hits zero or financial markets signal that sufficient stimulus has been delivered. We can’t be certain whether that will occur with more or less than the 91 bps of rate cuts that are currently priced for the next 12 months. As such, we recommend keeping portfolio duration close to benchmark. How To Call The Bottom In Yields The US economy is on the cusp of entering a downturn of uncertain duration that will likely be followed by a rapid recovery. Given that outlook, the next big call to make is: When will bond yields put in a bottom? We identify four catalysts that we will monitor to make that call. 1. Virus Panic Abates This is the most important catalyst that could lead us to re-initiate a below-benchmark duration recommendation. The pattern of past viral outbreaks is that bond yields tend to fall until the number of daily new cases reaches zero. This is precisely what happened during the 2003 SARS epidemic (Chart 4A). As for COVID-19, the number of daily new cases looked like it was approaching zero a few weeks ago, but then reversed course as the virus moved on from China to the rest of the world (Chart 4B). One ray of hope is that the number of new cases in China is approaching zero. This suggests that it will also be possible for other countries to contain the virus, but right now it is unclear how long that will take. Chart 4AYields Will Bottom When New Cases Reach Zero Yields Will Bottom When New Cases Reach Zero Yields Will Bottom When New Cases Reach Zero Chart 4BNew COVID-19 Cases Still ##br##Rising New COVID-19 Cases Still Rising New COVID-19 Cases Still Rising   In sum, we will keep tracking the global daily number of new cases and will shift to a below-benchmark duration recommendation as it approaches zero. 2. Global Economic Data Improve (Especially China) Chart 5Waiting For A Global Growth Rebound Waiting For A Global Growth Rebound Waiting For A Global Growth Rebound China is where the COVID-19 outbreak started and it is also where we are now seeing the impact in the economic data. The Global Manufacturing PMI dropped from 50.4 to 47.2 in February, due in large part to the plunge in China’s index from 51.1 to 40.3 (Chart 5). In order to call the bottom in US bond yields we will need to see evidence that China can come out the other side of the economic downturn. This means seeing an improvement in the Chinese and Global Manufacturing PMIs. We would also like to see improvement in other global growth indicators such as the CRB Raw Industrials index (Chart 5, panel 2) and the relative performance of cyclical versus defensive equity sectors (Chart 5, bottom panel). Aggressive Chinese stimulus (both monetary and fiscal) might help speed this process along. China’s credit impulse is on the rise (Chart 5, panel 2), and our China Investment Strategy service observed that recently announced policy initiatives related to infrastructure, housing and the automobile sector resemble those that led to a V-shaped Chinese economic recovery in 2016.1  We will be inclined to shift back to below-benchmark portfolio duration when the Global Manufacturing PMI, CRB Raw Industrials index and the relative performance of cyclical versus defensive equities move higher. 3. The US Economic Data Worsen Chart 6Waiting For Weaker US Data Waiting For Weaker US Data Waiting For Weaker US Data While the Global and Chinese economic data are currently in the doldrums, we still haven’t seen COVID’s impact on the US economy. The US ISM Manufacturing PMI is in expansionary territory and the Services PMI is at a healthy 57.3 (Chart 6). Meanwhile, US employment growth has averaged +200k during the past 12 months (Chart 6, panel 2) and the US Economic Surprise Index is above 60 (Chart 6, bottom panel)! Until the US economic data take a hit, another downleg in US bond yields is likely. Looking ahead, if the Global and Chinese economic data are improving as the US data are weakening, financial markets will extrapolate from the Chinese experience and start to price-in an eventual US recovery. Therefore, bond yields will probably start to move higher while the US economic data are still weak. For this reason, one catalyst for us to re-initiate below-benchmark portfolio duration will be when the US economic data weaken. 4. Technical Signals Table 2The 3-Month Golden Rule When And Where Will Bond Yields Trough? When And Where Will Bond Yields Trough? We don’t recommend relying on technical trading rules when forming a 12-month investment view, but technical signals can help add discipline to investment strategies, especially when calling tops and bottoms. One framework with a decent track record is our Golden Rule of Bond Investing applied to a shorter 3-month investment horizon.2 While this 3-month rule doesn’t work as well as when it is applied to a 12-month horizon, we still find that if you correctly predict whether the Fed will deliver a hawkish or dovish surprise relative to market expectations during the next three months, you will make the right duration call 63% of the time (Table 2). The 3-month Golden Rule worked better for dovish surprises than for hawkish surprises in our sample but delivered solid results in both cases. The median 3-month excess Treasury index return versus cash was -1.09% (annualized) when there was a hawkish Fed surprise, compared to +2.56% (annualized) when there was a dovish Fed surprise. For context, the median annualized 3-month excess Treasury index return versus cash during our sample period was +1.79%. Until the US economic data take a hit, another downleg in US bond yields is likely. The overnight index swap curve is currently priced for 94 bps of rate cuts during the next three months, which would essentially take the funds rate back to the zero bound. As of now, we cannot rule out this possibility and are therefore not inclined to look for higher yields during the next 3 months. Momentum, Positioning & Sentiment Other technical signals can also help call tops and bottoms in bond yields. One such signal comes from our Composite Technical Indicator, an indicator that is based on yield changes, investor sentiment surveys and positioning in bond futures markets. Right now, the indicator is sending a strong “overbought” signal with a reading below -1 (Chart 7). Chart 7Technical Treasury Signals Technical Treasury Signals Technical Treasury Signals In isolation, an overbought signal from our Composite Technical Indicator is not a strong reason to call for higher yields. We found that, historically, a reading below -1 from our indicator precedes a 3-month move higher in the 10-year Treasury yield only 53% of the time (Table 3). Table 3Technical Treasury Indicator Performance (1995 – Present) When And Where Will Bond Yields Trough? When And Where Will Bond Yields Trough? One reason for the Composite Technical Indicator’s mediocre performance is that, even at low levels, the market can always become more overbought. But we can partially control for this by combining the overbought signal from our indicator with simple momentum measures that might signal a trend reversal. For example, a reading below -1 from our Composite Technical Indicator combined with a 1-week increase in the 10-year yield precedes a higher 10-year yield during the next three months 58% of the time. If we wait for a 2-week increase in the 10-year yield the rule’s success rate rises to 60%, and it rises to 71% if we wait for the 10-year yield to break above its 4-week moving average. At present, our Composite Technical Indicator shows that Treasuries are extremely overbought, but momentum measures are sending no signals about an imminent trend change (Chart 7, bottom 3 panels). Bottom Line: It is too soon to call the bottom in bond yields. To help make that call we will be looking for when: daily new COVID-19 infections reach zero, global growth indicators improve, US economic indicators worsen, technical indicators signal a reversal. Some Quick Notes On TIPS, MBS And Spread Product Allocations Along with raising recommended portfolio duration to benchmark on a 12-month horizon, we also recommend neutralizing exposure to spread product in US bond portfolios. This includes reducing exposure to high-yield corporate bonds. High-yield remains attractively valued but will continue to sell off as long as risk-off market sentiment prevails. The looming oil price war will also weigh heavily on the sector, which is highly exposed to the US shale energy space. Once again using the SARS epidemic as a comparable, we see that – like Treasury yields – junk excess returns bottomed when the number of daily new cases approached zero (Chart 8). We could still be relatively far from this point, so taking risk off the table makes sense.  New all-time lows in Treasury yields will drag mortgage rates lower and lead to a spike in refinancing activity. We also recommend moving MBS allocations to underweight. New all-time lows in Treasury yields will drag mortgage rates lower and lead to a spike in refinancing activity. This spike is not yet fully reflected in MBS spreads, which remain relatively tight (Chart 9) Chart 8Too Soon To Call For Peak Junk Spreads Too Soon To Call For Peak Junk Spreads Too Soon To Call For Peak Junk Spreads Chart 9Downgrade MBS Downgrade MBS Downgrade MBS . Going forward, even after the economic fallout from COVID-19 has passed and it is time to increase exposure to spread product, we will likely continue to recommend an underweight allocation to MBS because better opportunities will be available in investment grade and high-yield corporate bonds where spreads will be much more attractive. On TIPS, last weekend’s oil supply shock – combined with the demand shock from COVID-19 – will conspire to keep long-maturity TIPS breakeven inflation rates well below their “fundamental fair value” for some time yet. But for investors with longer time horizons we see exceptional value in TIPS relative to nominal Treasuries. Even before yesterday’s big drop in oil, the 10-year TIPS breakeven inflation rate was 52 bps cheap relative to the fair value reading from our Adaptive Expectations Model (Chart 10).3 Chart 10TIPS Offer A Ton Of Long-Run Value TIPS Offer A Ton Of Long-Run Value TIPS Offer A Ton Of Long-Run Value Investors with 12-month investment horizons should continue to favor TIPS over nominal Treasuries, but those with shorter horizons may be advised to stand aside and wait for the daily number of new COVID-19 cases to reach zero before re-initiating the position.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see China Investment Strategy Weekly Report, “China: Back To Its Old Economic Playbook?”, dated February 26, 2020, available at cis.bcaresearch.com 2  For more details on our Golden Rule of Bond Investing please see US Bond Strategy Special Report, “The Golden Rule of Bond Investing", dated July 24, 2018, available at usbs.bcaresearch.com 3 For more details on our Adaptive Expectations Model please see US Bond Strategy Weekly Report, “How Are Inflation Expectations Adapting?”, dated February 11, 2020, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights An analysis on Colombia is available below. If EM share prices hold at current levels, a major rally will likely unfold. If they are unable to hold, a substantial breakdown will likely ensue. The direction of EM US dollar and local currency bond yields will be the key to whether EM share prices break down or not. We expect continuous EM currency depreciation that will likely trigger foreign capital outflows from both EM credit markets and domestic bonds. This leads us to reiterate our short position in EM stocks. We are booking profits on the long implied EM equity volatility and the short Colombian peso/long Russian ruble positions. Feature The Federal Reserve’s intra-meeting rate cut this week might temporarily boost EM risk assets and currencies. However, it is also possible that investors might begin questioning the ability of policymakers in general and the Fed in particular to continuously boost risk assets. In recent years, investors have been operating under the implicit assumption that policymakers in the US, China and Europe have complete control over financial markets and global growth, and will not allow things to get out of hand. Investors have been ignoring contracting global ex-US profits as well as exceedingly high US equity multiples and extremely low corporate spreads worldwide. In the past 12 months, investors have been ignoring contracting global ex-US profits (Chart I-1) as well as exceedingly high US equity multiples. This has been occurring because of the infamous ‘policymakers put’ on risk assets. As doubts about policymakers’ ability to defend global growth and financial markets from COVID-19 heighten, investors will likely throw in the towel and trim risk exposure. A sudden stop in capital flows into EM is a distinct possibility. The Last Line Of Defense EM share prices are at a critical juncture (Chart I-2). If they hold at current levels, a major rally will likely unfold. If they are unable to hold at current levels, a substantial breakdown will likely ensue. Chart I-1Profitless Rally In 2019 Makes Stocks Vulnerable Profitless Rally In 2019 Makes Stocks Vulnerable Profitless Rally In 2019 Makes Stocks Vulnerable Chart I-2EM Share Prices Are At A Critical Juncture EM Share Prices Are At A Critical Juncture EM Share Prices Are At A Critical Juncture   What should investors be looking at to determine whether EM share prices will find a bottom close to current levels, or whether another major down-leg is in the cards? In our opinion, the direction of EM sovereign and corporate US dollar bond yields as well as EM local currency government bond yields will be the key to whether EM share prices break down or not. Chart I-3 illustrates that EM equity prices move in tandem with EM corporate US dollar bond yields as well as EM local currency bond yields (bond yields are shown inverted on both panels). Falling EM fixed income yields have helped EM share prices tremendously in the past year. Chart I-3EM Equities Drop When EM US Dollar & Domestic Bond Yields Are Rising EM Equities Drop When EM US Dollar & Domestic Bond Yields Are Rising EM Equities Drop When EM US Dollar & Domestic Bond Yields Are Rising EM corporate US dollar bond yields can rise under the following circumstances: (1) when US Treasury yields are ascending more than corporate credit spreads are tightening; (2) when EM credit spreads are widening more than Treasury yields are falling; or (3) when both US government bond yields and EM credit spreads are increasing simultaneously. Provided the backdrop of weaker growth is bullish for US government bonds, presently EM corporate US dollar bond yields can only rise if their credit spreads widen by more than the drop in Treasury yields. In short, the destiny of EM equities currently rests with EM corporate spreads. EM corporate and sovereign credit spreads are breaking above a major technical resistance (Chart I-4). The direction of these credit spreads is contingent on EM exchange rates and commodities prices as demonstrated in Chart I-5. Credit spreads are shown inverted in both panels of this chart. Chart I-4A Breakout In EM Sovereign And Corporate Credit Spreads? A Breakout In EM Sovereign And Corporate Credit Spreads? A Breakout In EM Sovereign And Corporate Credit Spreads? Chart I-5Falling EM Currencies And Commodities Herald Wider EM Credit Spreads Falling EM Currencies And Commodities Herald Wider EM Credit Spreads Falling EM Currencies And Commodities Herald Wider EM Credit Spreads   EM exchange rates are also crucial for foreign investors’ in EM domestic bonds. The top panel of Chart I-6 demonstrates that even though the total return on the JP Morgan EM GBI domestic bond index has been surging in local currency terms, the same measure in US dollar terms is still below its 2012 level. The gap is due to EM exchange rates. EM local currency bond yields are at all-time lows (Chart I-6, bottom panel), reflecting very subdued nominal income growth and low inflation in many developing economies (Chart I-7). Chart I-6EM Currencies Are Key To EM Domestic Bonds Total Returns EM Currencies Are Key To EM Domestic Bonds Total Returns EM Currencies Are Key To EM Domestic Bonds Total Returns Chart I-7Inflation Is Undershooting In EM Ex-China Inflation Is Undershooting In EM Ex-China Inflation Is Undershooting In EM Ex-China   Hence, low EM domestic bond yields are justified by their fundamentals. Yet foreign investors are very large players in EM local bonds, and their willingness to hold these instruments is contingent on EM exchange rates’ outlook. The sensitivity of international capital flows into EM US dollar and local currency bonds to EM exchange rates has diminished in recent years because of global investors’ unrelenting search for yield. As QE policies by DM central banks have removed some $9 trillion in high-quality securities from circulation, the volume of fixed-income securities available in the markets has shrunk. This has led to unrelenting capital inflows into EM fixed-income markets, despite lingering weakness in their exchange rates. Nonetheless, sensitivity of fund flows into EM fixed-income markets to EM exchange rates has diminished but has not yet outright vanished. If EM currencies depreciate further, odds are that there will be a sudden stop in capital flows into EM fixed-income markets. Outside of some basket cases, we do not expect the majority of EM governments or corporations to default on their debt. Yet, we foresee further meaningful EM currency depreciation which will simply raise the cost of servicing foreign currency debt. It would be natural for sovereign and corporate credit spreads to widen as they begin pricing in diminished creditworthiness among EM debtors in foreign currency terms.     Bottom Line: Unlike EM equities, EM fixed-income markets are a crowded trade and are overbought. Hence, any selloff in these markets could trigger an exodus of capital pushing up their yields. Rising yields will in turn push EM equities over the cliff. EM Currencies: More Downside We expect EM currencies to continue depreciating. EM ex-China currencies’ total return index (including carry) versus the US dollar is breaking down (Chart I-8, top panel). This is occurring despite the plunge in US interest rates. Notably, as illustrated in the bottom panel of Chart I-8, EM ex-China currencies have not been correlated with US bond yields. The breakdown in correlation between EM exchange rates and US interest rates is not new. This means that the Fed's easing will not prevent EM currency depreciation. EM currencies correlate with commodities prices generally and industrial metals prices in particular (Chart I-9, top panel). The latter has formed a head-and-shoulders pattern and has broken down (Chart I-9, bottom panel). The path of least resistance for industrial metal prices is down. Chart I-8More downside In EM Ex-China Currencies More downside In EM Ex-China Currencies More downside In EM Ex-China Currencies Chart I-9A Breakdown In Commodities Points To A Relapse In EM Currencies A Breakdown In Commodities Points To A Relapse In EM Currencies A Breakdown In Commodities Points To A Relapse In EM Currencies Chart I-10Chinese Imports Are Key To EM Currencies Chinese Imports Are Key To EM Currencies Chinese Imports Are Key To EM Currencies EM currencies’ cyclical fluctuations occur in-sync with global trade and Chinese imports (Chart I-10). Both will stay very weak for now. Finally, China is stimulating, and we believe the pace of stimulus will accelerate. However, the measures announced by the authorities so far are insufficient to project a rapid and lasting growth recovery. In particular, the most prominent measure announced in China is the PBoC’s special re-lending quota of RMB 300 billion to enterprises fighting the coronavirus outbreak. However, this amount should be put into perspective. In 2019, private and public net credit flows were RMB 23.8 trillion, and net new broad money (M2) creation was RMB 16 trillion. Thus, this re-lending quota will boost aggregate public and private credit flow by only 1.2% and broad money flow by mere 2%. This is simply not sufficient to meaningfully boost growth in China. Notably, daily, commodities prices in China do not yet confirm any growth recovery (Chart I-11). Barring an irrigation-type of credit and fiscal stimulus, the mainland economy will disappoint. Bottom Line: The selloff in EM exchange rates will persist. As discussed above, this will likely lead to outflows from both EM credit markets and domestic bonds. Reading Markets’ Tea Leaves It is impossible to forecast the pace and scope of the spread of COVID-19 as well as the precautionary actions taken by consumers and businesses around the world. In brief, it is unfeasible to assess the COVID-19’s impact on the global economy. The direction of EM sovereign and corporate US dollar bond yields as well as EM local currency government bond yields will be the key to whether EM share prices break down or not. Rather than throwing darts with our eyes closed, we examine profiles of various financial markets with the goal of detecting subtle messages that financial markets often send: Aggregate EM small-cap and Chinese investable small-cap stocks seem to be breaking down (Chart I-12). Chart I-11Daily Commodities Prices In China: No Sign Of Revival Daily Commodities Prices In China: No Sign Of Revival Daily Commodities Prices In China: No Sign Of Revival Chart I-12Investable Small Cap Stocks Seem To Be Breaking Down Investable Small Cap Stocks Seem To Be Breaking Down Investable Small Cap Stocks Seem To Be Breaking Down   The technical profiles of various EM currencies versus the US dollar on a total return basis (including the carry) are consistent with a genuine bear market (Chart I-13). Hence, their weakness has further to go. Global industrial stocks’ relative performance against the global equity benchmark has broken below its previous technical support (Chart I-14). This is a bad omen for global growth. Chart I-13EM Currencies Are In A Genuine Bear Market EM Currencies Are In A Genuine Bear Market EM Currencies Are In A Genuine Bear Market Chart I-14A Breakdown In Global Industrials Relative Performance A Breakdown In Global Industrials Relative Performance A Breakdown In Global Industrials Relative Performance   Finally, Korean tech stocks as well as the Nikkei index seem to have formed a major top (Chart I-15). This technical configuration suggests that their relapse will very likely last longer and go further. Chart I-15A Major Top in Korean And Japanese Stocks? A Major Top in Korean And Japanese Stocks? A Major Top in Korean And Japanese Stocks? All these signposts relay a downbeat message on global growth and, consequently, EM risk assets and currencies. A pertinent question to ask is whether the currently extremely high level of the VIX is a contrarian signal to buy stocks? Investors often buy the VIX to hedge their underlying equity portfolios from short-term downside. However, when and as they begin to view the equity selloff as enduring, they close their long VIX positions and simultaneously sell stocks. In brief, the VIX’s current elevated levels are likely to be a sign that many investors are still long stocks. When investors trim their equity holdings, they will likely also liquidate their long VIX positions. Thereby, share prices could drop alongside a falling VIX. Therefore, we are using the recent surge in equity volatility to close our long position in implied EM equity volatility. Even though risks to EM share prices are still skewed to the downside, their selloff may not be accompanied by substantially higher EM equity volatility. However, we continue to recommend betting on higher implied volatility in EM currencies. The latter still remains very low. Investment Conclusions We reinstated our short position on the EM equity index on January 30, and this trade remains intact. For global equity portfolios, we continue to recommend underweighting EM versus DM. Within the EM equity universe, our overweights are Korea, Thailand, Russia, central Europe, Mexico, Vietnam, Pakistan and the UAE. Our underweights are Indonesia, the Philippines, South Africa, Turkey and Colombia. We are contemplating downgrading Brazilian equities from neutral to underweight. The change is primarily driven by our downbeat view on banks (Chart I-16). This is in addition to our existing bearish view on commodities. We will publish a Special Report on Brazilian banks in the coming weeks. Barring an irrigation-type of credit and fiscal stimulus, the mainland economy will disappoint. Among the EM equity sectors, we continue to recommend a long EM consumer staples/short banks trade (Chart I-17, top panel) as well as a short both EM and Chinese banks versus their US peers positions (Chart I-17, middle and bottom panels). Chart I-16Brazilian Bank Stocks Are Breaking Down? Brazilian Bank Stocks Are Breaking Down? Brazilian Bank Stocks Are Breaking Down? Chart I-17Our Favored EM Equity Sector Bets Our Favored EM Equity Sector Bets Our Favored EM Equity Sector Bets   We continue to recommend a short position in a basket of the following currencies versus the US dollar: BRL, CLP, ZAR, PHP, IDR and KRW. We are also structurally bearish on the RMB. Today we are booking profits on the short Colombian peso / long Russian ruble trade (please refer to section on Colombia on pages 13-17). With respect to EM local currency bonds and EM sovereign credit, our overweights are Mexico, Russia, Colombia, Thailand, Malaysia and Korea. Our underweights are South Africa, Turkey, Indonesia, and the Philippines. The remaining markets warrant a neutral allocation. As always, the list of recommendations is available at end of each week’s report and on our web page. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Colombia: Upgrade Domestic Bonds; Take Profits On Short Peso Trade Chart II-1Oil Makes A Huge Difference To Colombia's Current Account Oil Makes A Huge Difference To Colombia's Current Account Oil Makes A Huge Difference To Colombia's Current Account Today we recommend upgrading local currency bonds and booking profits on the short Colombian peso / long Russian ruble trade. The reason is tight fiscal and monetary policies are positive for bonds and the currency. Although we are structurally bullish on Colombia’s economy, we remain underweight this bourse relative the EM equity benchmark. The primary reason is the high sensitivity of Colombia’s balance of payments to oil prices. In particular, oil accounts for a large share (40%) of Colombia’s exports. As of Q4 2019, the current account deficit was $14 billion or 4% of GDP with oil, and $25 billion or 7.5% of GDP excluding oil (Chart II-1). In short, each dollar drop in oil prices substantially widens the nation’s current account deficit and weighs on the exchange rate. Besides, the current hawkish monetary stance and overly tight fiscal policy will produce a growth downtrend. The Colombian economy has reached a top in its business cycle: The flattening yield curve is foreshadowing a major economic slowdown (Chart II-2, top panel). Our proxy for the marginal propensity to spend for businesses and households leads the business cycle by about six months and is presently indicating that growth will roll over soon (Chart II-2, bottom panel). Moreover, the corporate loan impulse has already relapsed, weighing on companies’ capital expenditures (Chart II-3).  Chart II-2The Business Cycle Has Peaked The Business Cycle Has Peaked The Business Cycle Has Peaked Chart II-3Investment Expenditures Heading South Investment Expenditures Heading South Investment Expenditures Heading South   The government considerably tightened fiscal policy in the past year and will continue to do so in 2020. The primary fiscal balance has surged to above 1% of GDP as primary fiscal expenditures have stagnated in nominal terms and shrunk in real terms last year (Chart II-4). In regards to monetary policy, the prime lending rate is 12% in nominal and 8.5-9% in real (inflation-adjusted) terms. Such high borrowing costs are restrictive as evidenced by several business cycle indicators that are in a full-fledged downtrend: manufacturing production, imports of consumer and capital goods, vehicle sales and housing starts (Chart II-5). Chart II-4Hawkish Fiscal Policy Hawkish Fiscal Policy Hawkish Fiscal Policy Chart II-5The Economy Is In The Doldrums The Economy Is In The Doldrums The Economy Is In The Doldrums Chart II-6Consumer Spending Has Been Supported By Borrowing Consumer Spending Has Been Supported By Borrowing Consumer Spending Has Been Supported By Borrowing Overall, economic growth has been held up solely by very robust household spending, which accounts for 65% of GDP. Critically, consumer borrowing has financed such buoyant consumer expenditures (Chart II-6). However, the pace of household borrowing is unsustainable with consumer lending rates at 18%. Moreover, nominal and real (deflated by core CPI) wage growth are decelerating markedly and hiring will slow down in line with reduced capital spending.  Besides, disinflationary dynamics in this country will be amplified due to the massive influx of immigration from Venezuela in the past two years. Currently, the number of immigrants from the neighboring country stands at 1.4 million people, or 5% of Colombia’s labor force. Such an enormous increase in labor supply introduces deflationary pressures in the Colombian economy by depressing wage growth. Therefore, despite the depreciating currency, core measures of inflation will likely drop to the lower end of the central bank’s target range in next 18-24 months. Investment Recommendations The economy is heading into a cyclical slump but monetary and fiscal policies will remain restrictive. Such a backdrop is bullish for the domestic bond market and structurally, albeit not cyclically, positive for the currency. We have been recommending fixed-income investors to bet on a yield curve flattening by receiving 10-year and paying 1-year swap rates. This trade has returned 77 basis points since its initiation on January 17, 2019. Given the central bank will stay behind the curve, this strategy remains intact. Today we recommend upgrading Colombian local currency bonds from neutral to overweight. Further currency depreciation and an exodus by foreign investors remain a risk. However, on a relative basis – versus its EM peers – this market is attractive. The share of foreign ownership of local currency government bonds in Colombia is 25%, smaller than in many other EMs. Additionally, Colombian bond yields are 80 basis points above the J.P. Morgan EM GBI domestic bonds benchmark and its currency is one standard deviation below its fair value (Chart II-7). We are also overweighting Colombian sovereign credit within an EM credit portfolio. Fiscal policy is very tight and government debt is at a manageable 50% of GDP. The government considerably tightened fiscal policy in the past year and will continue to do so in 2020. Continue to underweight Colombian equities relative to the emerging markets benchmark. We will be looking for a final capitulation in the oil market to upgrade this bourse. Finally, we are booking profits on our short COP versus RUB trade, which has returned a 19% gain since May 31, 2018 (Chart II-8). As mentioned earlier, the peso has already cheapened a lot according to the real effective exchange rate based on unit labor costs (Chart II-7). Meanwhile, Colombia’s macro policy mix is positive for the currency. Chart II-7The Colombian Peso Has Depreciated Substantially The Colombian Peso Has Depreciated Substantially The Colombian Peso Has Depreciated Substantially Chart II-8Taking Profits On Our Short COP / Long RUB Trade Taking Profits On Our Short COP / Long RUB Trade Taking Profits On Our Short COP / Long RUB Trade   In contrast, Russia is relaxing its fiscal policy – which is marginally negative for the ruble – and the currency has become a crowded trade. Juan Egaña Research Associate juane@bcaresearch.com Footnotes   Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights Financial markets are now fully priced for an economic downturn lasting one quarter… …but they are not fully priced for a recession. To go tactically long equities versus bonds requires a high conviction that the coronavirus induced downturn will last no longer than one quarter. The big risk is that the coronavirus incubation period might be very long, rendering containment strategies ineffective. Hence, a better investment play is to go long positive yielding US T-bonds and/or UK gilts versus negative yielding Swiss bonds and/or German bunds… …or go long negative yielding currencies versus positive yielding currencies. Our favoured expression is long CHF/USD. Fractal trade: overweight Poland versus Portugal. Feature Chart I-1AFinancial Markets Are Priced For A One-Quarter Downturn... Financial Markets Are Priced For A One-Quarter Downturn... Financial Markets Are Priced For A One-Quarter Downturn... Chart I-1B...But Not For A ##br##Recession ...But Not For A Recession ...But Not For A Recession They say that when China sneezes, the rest of the world catches a cold. But the saying was meant as an economic metaphor, not as a literal medical truth.1 The current coronavirus crisis has two potential happy endings: ‘containment’, in which its worldwide contagion is halted; or ‘normalisation’, in which it becomes accepted as just another type of winter flu. The virus crisis also has a potential unhappy ending in which neither containment nor normalisation can happen. Containing Contagion To determine whether the virus crisis has a happy or unhappy ending, we must answer three crucial questions: 1. Does the virus thrive only in cold weather? If yes, then the onset of spring and summer should naturally contain the contagion (in the northern hemisphere). We are not experts in epidemiology or immunology, but we understand that the Covid-19 virus surface is a lipid (fat) which could become fragile at higher temperatures. Albeit this might just be a temporary containment until temperatures drop again. 2. Does the virus have a short incubation period before symptoms arise? If yes, then quarantining and containment will be effective because infected people are quickly identified. But if, after infection, there is a long asymptomatic period, then containment would be impossible – because for an extended period the virus would be ‘under cover’. In this regard, the dispersion of infections is as important as the number of infections. A thousand cases across a hundred countries is much more worrying than a thousand cases concentrated in two or three countries (Chart I-2). Chart I-2Covid-19 Has Spread To 80 Countries Covid-19 Has Spread To 80 Countries Covid-19 Has Spread To 80 Countries 3. Are most infections going undetected because the symptoms are very mild? If yes, then the true mortality rate of the Covid-19 virus is much lower than we think, and perhaps not that different to the mortality rate of winter flu, at around 1 in a 1000. In which case, the new virus could become ‘normalised’ as a variant of the flu. But if the current mortality rate, at ten times deadlier than the flu, is accurate, then it would be difficult to normalise (Chart I-3). Chart I-3The Covid-19 Mortality Rate Is Ten Times Deadlier Than The Flu. Or Is It? The Covid-19 Mortality Rate Is Ten Times Deadlier Than The Flu. Or Is It? The Covid-19 Mortality Rate Is Ten Times Deadlier Than The Flu. Or Is It? An unhappy ending to the crisis will happen if the answer to all three questions is ‘no’. The main risk is that the asymptomatic incubation period appears to be quite long, rendering containment strategies ineffective. Still, even if the happy ending happens, there are two further questions. How much disruption will the economy suffer before the happy ending? And what have the financial markets priced? The Economic Disruption The disruption to the economy comes from both the supply side and the demand side: the supply side because containment strategies such as quarantining entire towns, shuttering factories, and cancelling major sports and social events hurt output; the demand side because a fearful public’s reluctance to use public transport, visit crowded places such as shopping malls, or travel abroad hurt spending. In this way, both production and consumption will suffer a large hit in the first quarter, at the very least. However, when normal activity eventually resumes, production and consumption will bounce back to pre-crisis levels, and in some cases overshoot pre-crisis levels. For example, if the crisis lasts for a quarter, movie-goers will return to the cinemas as usual in the second quarter, albeit they will not compensate for the visit they missed in the first quarter; but for manufacturers, the backlog of components that were not made during the first quarter will mean that twice as many will be made in the second quarter. For the financial markets, it is not the depth of the V that is important so much as its length. Therefore, economic output will experience a ‘V’ (Chart I-4): a lurch down followed by a symmetrical, or potentially even larger, snapback. However, for the financial markets, it is not the depth of the V that is important so much as its length. Chart I-4Economic Output Will Experience A 'V' Economic Output Will Experience A 'V' Economic Output Will Experience A 'V' The Financial Market Disruption Anticipating the economy to experience a V, investors respond to the crisis according to the expected length of the V versus the different lengths of their investment horizons. By length of investment horizon, we mean the minimum timeframe over which the investor cares about a price move, or ‘marks to market’. Say the market expects the downturn to last three months, followed by a full recovery. A three-month investor, caring about the price in three months, will capitulate. He will sell all his equities and buy bonds. Whereas a six-month investor, caring about the price only in six months, will not capitulate because he will factor in both the down-leg and subsequent up-leg of the V. Meanwhile, a twelve-month investor will be completely unfazed by the short-lived downturn. Therefore, if the downturn lasts one quarter only, the market will bottom when all the three-month investors have capitulated, which is to say become indistinguishable in their behaviour from a 1-day trader. In technical terms, the tell-tale sign for this capitulation is that three-month (65-day) fractal structure of the market totally collapses. Last Friday, the financial markets reached this point, meaning that financial markets are now fully priced for an economic downturn lasting one quarter (Chart I-5). Chart I-5When 3-Month Investors Capitulate It Usually Signals A Trend-Reversal... When 3-Month Investors Capitulate It Usually Signals A Trend-Reversal... When 3-Month Investors Capitulate It Usually Signals A Trend-Reversal... However, six-month and longer horizon investors are still a long way from capitulation. Meaning that the markets are not yet priced for a recession – defined as a contraction in activity lasting two or more straight quarters. It follows that if the down-leg of the V lasts significantly longer than a quarter then equities and other risk-assets have further downside versus high-quality bonds (Chart of the Week). During the global financial crisis, three-month investors had fully capitulated by September 3 2008 when equities had underperformed bonds by a seemingly huge 20 percent. However, equities went on to underperform bonds by a further 50 percent and only found a bottom when eighteen-month investors had fully capitulated in early 2009 (Chart I-6). This makes perfect sense, because profits contracted for a full eighteen months (Chart I-7). Chart I-6...But In The Global Financial Crisis The Market Turned Only When 18-Month Investors Had Capitulated... ...But In The Global Financial Crisis The Market Turned Only When 18-Month Investors Had Capitulated... ...But In The Global Financial Crisis The Market Turned Only When 18-Month Investors Had Capitulated... Chart I-7...Because In The Global Financial Crisis, Profits Contracted For 18 Months ...Because In The Global Financial Crisis, Profits Contracted For 18 Months ...Because In The Global Financial Crisis, Profits Contracted For 18 Months All of which brings us to a very powerful investment identity: Financial markets have fully priced a downturn when the time horizon of investors that have fully capitulated = the length of the downturn. The message right today is to go tactically long equities versus bonds if you have high conviction that the coronavirus induced downturn will last no longer than one quarter. Given that the coronavirus incubation period appears to be quite long, rendering containment strategies ineffective, we do not have such a high conviction on this tactical trade. Central banks that are already at the limits of monetary policy easing cannot ease much more. Instead, we have much higher conviction that those central banks that are already at the limits of monetary policy easing cannot ease much relative to those that have the scope to ease. The conclusion is: go long positive yielding US T-bonds and/or UK gilts versus negative yielding Swiss bonds and/or German bunds. Conversely, go long negative yielding currencies versus positive yielding currencies. Our favoured expression is long CHF/USD (Chart I-8). Chart I-8Overweight Positive-Yielding Bonds, And Overweight Negative-Yielding Currencies Overweight Positive-Yielding Bonds, And Overweight Negative-Yielding Currencies Overweight Positive-Yielding Bonds, And Overweight Negative-Yielding Currencies Fractal Trading System* This week’s recommended trade is to overweight Poland versus Portugal. Set the profit target at 3.5 percent with a symmetrical stop-loss. In other trades, long EUR/GBP achieved its 2 percent profit target at which it was closed. And short palladium has quickly gone into profit, given that the palladium price is down 10 percent in the last week. The rolling 1-year win ratio now stands at 62 percent. Chart I-9Poland Vs. Portugal Poland Vs. Portugal Poland Vs. Portugal When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated  December 11, 2014, available at eis.bcaresearch.com.   Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com   Footnotes 1 The original version of the metaphor is attributed to the nineteenth century Austrian diplomat Klemens Metternich who said: “When France sneezes all of Europe catches a cold”. Subsequently, the Metternich metaphor has been adapted for any economy with outsized influence on the rest of the world. Fractal Trading Model Is The Contagion Containable? Is The Contagion Containable? Is The Contagion Containable? Is The Contagion Containable? Cyclical Recommendations Structural Recommendations Is The Contagion Containable? Is The Contagion Containable? Is The Contagion Containable? Is The Contagion Containable? Is The Contagion Containable? Is The Contagion Containable? Is The Contagion Containable? Is The Contagion Containable? Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields   Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations  

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

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

Highlights Portfolio Strategy It is still early to bottom fish, and trying to catch the proverbial falling knife does not interest us for cyclically oriented capital. Uncertainty surrounding the coronavirus epidemic and its effects on economic and profit growth, and uncertainty with regard to US elections both signal that it still pays to be cautious on the prospects of the broad equity market on a cyclical 9-12 month time horizon. Lofty valuations, stretched technicals, souring macro and cresting capex, underscore that the time is ripe to take profits in software stocks and move to the sidelines. Faltering operating metrics, stretched relative valuations, a firming greenback, looming fed funds rate cuts and a contracting capex backdrop, all suggest that an underweight stance is now warranted in tech stocks. Recent Changes Book gains of 51% in the S&P software index and downgrade to neutral, today. Downgrade the S&P tech sector to underweight, today. We got stopped out and booked gains of 10% in the Global Gold Mining index. It is now neutral, from previously overweight. Table 1 From "Stairway To Heaven" To "Highway To Hell"? From "Stairway To Heaven" To "Highway To Hell"? Feature The SPX convulsed last week, as investors grappled with the risk of the coronavirus epidemic becoming a true pandemic (Chart 1A), and with Bernie Sanders likely clinching the Democratic nomination (Chart 1B). While a technical reflex rebound is in order as indiscriminate selling took center stage and we are looking to deploy short term oriented capital from current SPX levels all the way down to 2714 (or 20% SPX correction from recent peak), the cyclical outlook for the broad equity market remains grim. Chart 1ABlame The Virus…. Blame The Virus…. Blame The Virus…. Chart 1B…And Bernie …And Bernie …And Bernie We have been cautioning investors all year long in our reports, warning that the stock market’s advance has been precarious on a number of fronts and have been recommending investors sell the market’s strength. First, the extreme concentration of returns in a handful of teflon-tech stocks has been disconcerting, heralding an equity market wobble.1 Likely, a mania has taken root in certain tech stocks and the inevitable bursting of the “ATLAS” mania (Apple, Tesla, Lam Research, AMD and Salesforce) would end in tears.2 As an update, as we went to press these five stocks were down 21% from their all-time highs. Second, on January 13 we highlighted that gold has been trumping the SPX and sniffing out two-to-three fed funds rate cuts, leading the fed fund futures market, similar to last spring (top & middle panels, Chart 2).3 Third, we highlighted that the recent positive correlation between the VIX and the SPX was disquieting and signaling that a pullback was nearing.4 Now the jump in the VIX along with the vol curve inversion and the collapse in the stock-to-bond ratio all warn that the path of least resistance for the market and the forward multiple remains lower (Chart 3). Chart 2Gold Sniffed Out Fed Cuts First Gold Sniffed Out Fed Cuts First Gold Sniffed Out Fed Cuts First Chart 3Financial Conditions Are … Financial Conditions Are … Financial Conditions Are … This has already tightened financial conditions according to the soaring junk spread (top panel, Chart 4), and we deem that unless the Fed relents and eases monetary policy, the stock market will remain in melt down mode. Fourth, market internals have been screaming “get out” of the broad equity market for some time now (bottom panel, Chart 4) and the epitome was when semi stocks stalled versus the NASDAQ 100 (middle panel, Chart 4).5 Fifth, the “tenuous trio” as we have coined it (stock prices, bond prices and the US dollar) cannot all rise simultaneously. Typically we cautioned, this gets resolved with an equity market pullback as a rising greenback is deflationary for US profits (bottom panel, Chart 2). Finally, in our “Sell The Rip” report, we worried about extreme investor complacency and showed that the economic backdrop was soft owing to the collapse in imports in Q4 2019, predating the coronavirus epidemic.6 Tying everything together, ultimately what matters most to equity investors is profit growth. On that front we have heavily relied on the message of our four-factor EPS growth model, which has consistently delivered. Chart 4…Tightening Rapidly …Tightening Rapidly …Tightening Rapidly   In mid-January, our SPX profit growth model continued to have no pulse, warning that the Street’s 10% profit growth estimate for calendar 2020 was unattainable. Our analysis of three EPS scenarios showed that at the time the SPX was overvalued by 8% according to the SPX 3,049 expected value for end-2020 that was actually hit last week.7 Recently, we have been inundated with client requests to update our analysis and incorporate the coronavirus epidemic to our adverse EPS scenario. Chart 5 shows that in our worst case scenario, EPS will contract by 2.41% in calendar 2020. Assuming final 2019 EPS comes in at 162.95, using I/B/E/S’ latest estimate, then the 2020 EPS level falls to 159.02. Assigning a trough multiple of 16x results in a 2,544 SPX ending value as a worst case outcome. Chart 5Our EPS Model Has Delivered Our EPS Model Has Delivered Our EPS Model Has Delivered Importantly, our newly weighted expected 2020 EPS falls to 164.48 versus 169.40 previously as we penciled in a 60% and 50% probability that our worst case scenario materializes in EPS and multiple assumptions, respectively (Chart 6). As a result our expected end-2020 SPX value falls to 2,755 which makes the S&P 500 still 4% overvalued (please find the assumptions on the four factor model along with the updated table of expected outcomes in the Appendix below). While no one really knows how this virus outbreak will evolve, there are two predominant market narratives that can serve as positive catalysts: a.) China will massively ease both on the monetary and fiscal policy fronts (Chart 7) and b.) the Fed (and likely other CBs) will be forced to cut interest rates despite the fact that lower fed funds rates will likely not fix the supply side global problems owing to the corona virus. In other words, liquidity injections will remain upbeat. However, if these measures – especially on the Fed’s side – prove ineffective to generate GDP growth, then the risk of a recession will skyrocket for 2020, a presidential election year. Chart 6Updated Three EPS Scenarios Updated Three EPS Scenarios Updated Three EPS Scenarios   Chart 7How Much Will China Stimulate? How Much Will China Stimulate? How Much Will China Stimulate? As a reminder, parts of the US yield curve (YC) first inverted in December 2018 and currently the 2-year/fed funds rate slope is inverted, implying that the bond market deems the Fed will ease monetary policy. In fact, the latest CME probability of a 50bps cut on March 18 last stood at 100%. Importantly, the YC inversions did not predict the oil embargoes of the 70s, or the 9/11 attacks or the sub-prime crisis or the coronavirus outbreak. Typically, the YC inverts at the point of maximum economic strength and signals that the cycle is long in the tooth, i.e. in the current episode, 2018 registered roughly 3% real GDP growth and 25% SPX EPS growth. Put differently, the YC inversion suggests that the economy is, at the margin, vulnerable to an external shock as economic growth settles down to a lower rate trajectory. While the YC inversion does not predict recession, it forewarns recession and we continue to heed this message (Chart 8). It will not be different this time. In sum, it is still early to bottom fish, and trying to catch the proverbial falling knife does not interest us for cyclically oriented capital. Uncertainty surrounding the coronavirus epidemic and its effects on economic and profit growth, and uncertainty with regard to US elections both signal that it still pays to be cautious on the prospects of the broad equity market on a cyclical 9-12 month time horizon. This week we are making some tech sector adjustments. Chart 8The Yield Curve is ALWAYS Right! The Yield Curve is ALWAYS Right! The Yield Curve is ALWAYS Right! Crystalize Software Gains And Downgrade To Neutral… Market events last week compel us to take profits of 51% in the S&P software index above and beyond the S&P 500’s return since the late-2017 inception and downgrade exposure to neutral. The multiyear juggernaut in software stocks is primed for a much needed pause. Its appeal is well known as within the tech space software is considered a defensive holding owing to the productivity enhancing properties it enjoys in both good and bad times. Anecdotally, it was disquieting that the Standard & Poor’s decided to add two additional cloud stocks to the S&P 500 recently, further boosting the software group’s weight in the tech sector and in the SPX. Likely, the reason was the flurry of M&A deals that has been ongoing for years. Most recently however, this M&A frenzy hit a wall (top panel, Chart 9). Meanwhile, last Monday we wrote that AAPL’s profit warning was the tip of the iceberg and an avalanche of warnings would ensue.8 MSFT followed suit and issued their own profit warning and this negative backdrop is not yet reflected in the sell side’s S&P software profit and revenue forecasts. Tack on the message from the contracting software sector deflator and odds are high that sales will underwhelm in the coming quarters (middle panel, Chart 9). The latest GDP report also revealed that, up to recently bulletproof, software capex growth sunk to nil in Q4 (bottom panel, Chart 9). Not only in absolute, but also in relative terms software outlays have petered out and have been decreasing in intensity as measured by the decelerating contribution to GDP growth (Chart 10). Chart 9Softening… Softening… Softening… Chart 10…Software Capex …Software Capex …Software Capex Beyond investment, the recent plunge in the Markit services PMI that really ignited the recent selling in equities, warns that the time is ripe to cement software gains and move to the sidelines (Chart 11). Moreover, there is a high chance that IPOs peaked last year and will dry up in 2020, which is slightly negative for overall market sentiment in general and for market darlings software stocks in particular (Chart 11). From a technical perspective, software equities went ballistic. Relative momentum surged north of 25%/annum, a nineteen-year high (middle panel, Chart 12). Similarly, relative valuations went parabolic. The S&P software index trades at a 60% premium to the broad market on a forward P/E basis (bottom panel, Chart 12). Such overvaluation was last seen in 2003. Chart 11Do Not Overstay… Do Not Overstay… Do Not Overstay… Chart 12…Your Welcome …Your Welcome …Your Welcome Finally, we refrain from getting bearish this heavyweight tech subindex. Our long-held belief is that SaaS, the broader push to the cloud, augmented reality, AI and autonomous driving, which are all software dependent, are not fads, but are here to stay.  Netting it all out, we do not want to overstay our welcome in the S&P software index and are cementing gains and moving to the sidelines, for now. Bottom Line: Take profits of 51% since inception in the S&P software index and downgrade to neutral. The ticker symbols for the stocks in this index are: BLBG: S5SOFT – MSFT, ADBE, CRM, ORCL, INTU, NOW, ADSK, ANSS, SNPS, CDNS, FTNT, PAYC, CTXS, NLOK.   …Which Pushes Tech To Underweight Our intra-sector positioning shifts with the recent S&P tech hardware storage & peripherals downgrade to underweight9 and today’s trimming of the S&P software index to neutral, reduce the S&P tech sector to a below benchmark allocation. Tech stocks are stretched, trading near two standard deviations above the historical time trend, a level that has marked three previous peaks since 1960 (top panel, Chart 13). From a macro perspective, when the Fed cuts rates as the end of the cycle is nearing it has been a treacherous time to own tech stocks. If we are entering a recession owing to the coronavirus epidemic, underweighting tech stocks is the right portfolio strategy to generate alpha (Chart 13). Chart 13End Of Cycle Dynamics End Of Cycle Dynamics End Of Cycle Dynamics Business investment in tech has been losing market share for the better part of the last year and according to the national accounts tech capex is contracting. Excluding the software industry, capital outlays are in dire straits (top & second panels, Chart 14). Meanwhile, lofty valuations, with the tech forward P/E trading at a 20% premium to the overall market, signal that there is no cushion for this deep cyclical sector that has 60% of sales originating abroad, the largest among its GICS1 peers (third panel, Chart 14). While the Fed will likely cut interest rates soon, the stampede in the US dollar, the reserve currency of the world, is unwelcome news for the heavily export-dependent US technology sector (trade-weighted US dollar shown inverted, middle panel, Chart 15). Chart 14Red Flag: Crumbling Tech Capex Red Flag: Crumbling Tech Capex Red Flag: Crumbling Tech Capex Chart 15Large Foreign Sales Exposure Is Problematic Large Foreign Sales Exposure Is Problematic Large Foreign Sales Exposure Is Problematic Turning over to tech-heavy Korean and Taiwanese exports, they peaked in 2017, and the coronavirus epidemic guarantees that they will suffer a steep decline in the coming months, dealing a blow to the tech sector’s top line growth prospects (bottom panel, Chart 15). If supply chain breakdowns increase over the course of the next few weeks as the coronavirus related shut downs accelerate, then more tech profit warnings are looming and the resulting hit to still ultra-wide relative profit margins and EPS will likely be severe (bottom panel, Chart 14). In more detail on the operating front, the coincident San Francisco Fed Tech Pulse Index is sinking like a stone and this weakness predates the coronavirus epidemic. The implication is that highly inflated relative share prices are vulnerable to a sizable pullback (second panel, Chart 16). Worrisomely, the industry’s new orders-to-inventories ratio is contracting at the fastest pace in eight years and bodes ill for still accelerating relative forward profit growth estimates (bottom panel, Chart 16). Finally, given the severity of recent market moves, when investors typically get margin calls they tend to sell their high flying stocks that currently are mostly concentrated in the tech space. Tack on the proliferation of passive investment, and as everyone is headed for the exit doors simultaneously, tech stocks that dominate hundreds of popular and large capitalization exchange traded funds are at risk of liquidation. Adding it all up, faltering operating metrics, stretched relative valuations, a firming greenback, looming fed funds rate cuts and a contracting capex backdrop, all signal that an underweight stance is now warranted in tech stocks. Bottom Line: Trim the S&P tech sector to underweight, today. Chart 16Weakening Operating Metrics Weakening Operating Metrics Weakening Operating Metrics Housekeeping Our long GDX:US / short ACWI:US portfolio position got stopped out at a 10% gain. The global gold mining index is now back to neutral, from previously overweight.   Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com   Appendix Table A1 From "Stairway To Heaven" To "Highway To Hell"? From "Stairway To Heaven" To "Highway To Hell"? Table A2 From "Stairway To Heaven" To "Highway To Hell"? From "Stairway To Heaven" To "Highway To Hell"? Table A3 From "Stairway To Heaven" To "Highway To Hell"? From "Stairway To Heaven" To "Highway To Hell"?     Footnotes 1     Please see BCA US Equity Strategy Weekly Report, “Three EPS Scenarios”, dated January 13, 2020, available at uses.bcaresearch.com. 2     Please see BCA US Equity Strategy Weekly Report, “When The Music Stops…” dated January 27, 2020, available at uses.bcaresearch.com 3    Please see BCA US Equity Strategy Weekly Report, “Three EPS Scenarios” dated January 13, 2020, available at uses.bcaresearch.com. 4    Please see BCA US Equity Strategy Weekly Report, “Will The Fed Save The Day, Again?” dated February 18, 2020, available at uses.bcaresearch.com. 5    Please see BCA US Equity Strategy Weekly Report, “Crosscurrents” dated February 3, 2020, available at uses.bcaresearch.com. 6    Please see BCA US Equity Strategy Weekly Report, “Sell The Rip” dated February 10, 2020, available at uses.bcaresearch.com. 7     Please see BCA US Equity Strategy Weekly Report, “Three EPS Scenarios”, dated January 13, 2020, available at uses.bcaresearch.com. 8    Please see BCA US Equity Strategy Weekly Report, “Vertigo” dated February 24, 2020, available at uses.bcaresearch.com. 9    Please see BCA US Equity Strategy Weekly Report, “Crosscurrents” dated February 3, 2020, available at uses.bcaresearch.com. Current Recommendations Current Trades Strategic (10-Year) Trade Recommendations From "Stairway To Heaven" To "Highway To Hell"? From "Stairway To Heaven" To "Highway To Hell"? Size And Style Views June 3, 2019 Stay neutral cyclicals over defensives (downgrade alert)  January 22, 2018 Favor value over growth May 10, 2018 Favor large over small caps (Stop 10%) June 11, 2018 Long the BCA  Millennial basket  The ticker symbols are: (AAPL, AMZN, UBER, HD, LEN, MSFT, NFLX, SPOT, TSLA, V).

Highlights The near-term path for the DXY remains up. Uncertainty about the trajectory of global growth is a potent tailwind. Central bank ammunition will eventually put a floor under global growth, but it remains a powerless weapon until animal spirits are revived. The signal on when to sell the DXY will originate from the internal dynamics of financial markets. We elaborate on a few key indicators in this report. Long-yen bets remain cheap insurance against a rise in FX volatility. Remain short USD/JPY and CHF/JPY. Until recently, the CAD had proved resilient amid the recent market turmoil. With close ties to the US, the safe-haven umbrella had sheltered the CAD from the vicious downdraft in other commodity currencies. The forces of mean reversion will pressure the CAD at the crosses. We were stopped out of our long AUD/USD trade with a loss of 2.9%. The important lesson is to stand aside when markets start to deviate from fundamentals. Feature Chart I-1Mixed Messages From Bond And Currency Markets Mixed Messages From Bond And Currency Markets Mixed Messages From Bond And Currency Markets Various market participants will look at the recent market action through different lenses. Long equity investors could easily consider this to be a healthy correction necessary to sustain the bull market in stocks. After all, the S&P 500 remains 29% above its 2018 lows, making the 10% peak-to-trough decline essential to flush out stale longs. Bond investors could see the decline in yields through two lenses: 1) a goldilocks scenario where growth eventually rebounds but central banks remain accommodative or 2) a malignant scenario where the cascading resurgence of the virus outside of Wuhan, China tethers the global economy to recession. The inversion of the yield curve in the US certainly supports  scenario 2. As for currency markets, it is becoming more and more evident that pro-cyclical pairs are pricing in an Armageddon scenario (Chart I-1). It is implausible to accurately discern the collective data being discounted in financial markets, especially when the turnover of information is as fluid and rapid as today. That said, there have been a few key market signals that have been sending a consistent message that one can pay heed to. The collective assessment is to stand aside on the dollar (and risk assets) for now. The Message From Financial Markets As a countercyclical currency, the message from high frequency growth/liquidity indicators is that the path of least resistance for the DXY remains up over the next few weeks. Chart I-2Mixed Messages From Stocks And Currencies Mixed Messages From Stocks And Currencies Mixed Messages From Stocks And Currencies Chart I-2 shows that the rise in global stocks was already discounting an improvement in global manufacturing in an order of magnitude similar to the 2012 and 2016 episodes. However, currency markets had been discounting a much more subdued recovery (bottom panel). What has become evident in recent days in that the stock market got the story wrong, at least in terms of timing. Currently, stocks are still pricing a continued cyclical bounce in global manufacturing activity (albeit less impressive), while currency markets are pricing in outright deterioration. So directionally, both markets are sending the same message, but they disagree in terms of magnitude.  What is remarkable is that over the past few days, currency markets that were already poised for a malignant growth outcome are still selling off indiscriminately, with our favorite greed/fear barometers making fresh lows. If we had a strong certainty that global growth was on a path toward a V-shaped recovery, then currency performance could be interpreted as a sign of capitulation. But given the uncertainty now tainted around the nascent recovery we witnessed early this year it also warns against bottom-fishing at current levels. For example, peak-to-trough, the AUD/JPY, a key barometer of greed versus fear in currency markets, is down 28% and on the verge of breaking below the key 70-72 support zone. The performances of even more high-octane currency pairs such as the RUB/JPY, the ZAR/JPY or even the BRL/JPY have been dismal. As these pairs break through key support zones, it could trigger a flurry of sell orders that would reinforce the downtrend. Europe, Asia and emerging markets have a much higher concentration of cyclical stocks in their bourses compared to the US. Thus, whenever cyclical sectors are underperforming defensives at the same time that non-US markets are underperforming US ones, it is a clear sign that the marginal dollar is rotating towards the US. In a nutshell, the performance of more cyclical currencies will require confirmation of a breakout in their relative equity market performance. This applies to both emerging and developed market currencies (Chart I-3). So far, this has not been the case. The backdrop could be extremely attractive valuations, but the catalyst will have to be capitulation from current sellers of cyclical stocks. The performance of more cyclical currencies will require confirmation of a breakout in their relative equity market performance. Chart I-3ACapital Keeps Flowing Out Of Cyclical Markets Capital Keeps Flowing Out Of Cyclical Markets Capital Keeps Flowing Out Of Cyclical Markets Chart I-3BCapital Keeps Flowing Out Of Cyclical Markets Capital Keeps Flowing Out Of Cyclical Markets Capital Keeps Flowing Out Of Cyclical Markets The 2015-2016 roadmap was instructive on when such a capitulation might occur. Even as the market was selling off, certain cyclical sectors such as industrials started to outperform defensives ones (Chart I-4). This was a clear sign that selling pressure in cyclical sectors had been exhausted. The overall market bottomed eight months later, along with a peak in the dollar. The signal from bond yields is that non-US currencies should be outperforming. This is reflected by the fact that the drop in bond yields has been much more pronounced in the US across the curve spectrum. Currencies tend to rise with relative yields for the simple reason that markets need to make an investor indifferent between buying the currency today or in the future. If yields are higher today, the forward rate will be lower, discounting expected depreciation in the higher-yielding currency. Since the financial crisis, it has been rare that this correlation breaks down (Chart I-5). The only way one can square falling US rates with a rising dollar today is that Federal Reserve rate cuts will be most potent on the US domestic sector, helping the US consumer charge the eventual rebound in global growth. My colleague Mathieu Savary argues that this could indeed be the backdrop for the dollar over the next two-to-three years. Chart I-4Pay Heed To Subtle Divergences Pay Heed To Subtle Divergences Pay Heed To Subtle Divergences Chart I-5Interest Rates And The Dollar Interest Rates And The Dollar Interest Rates And The Dollar As for the near term, what is clear is that US growth continues to outperform, which is supportive of the dollar. The sharp drop in the economic surprise index for the G10 relative to the US supports this view (Chart 6). In commodity markets, the copper-to-gold and oil-to-gold ratios are breaking down along with government bond yields. This clearly signifies that the liquidity-to-growth transmission mechanism is impaired (Chart I-7). “Force majeures” are rare, so the fact that China has already issued more than 1,600 certificates covering copper, liquefied natural gas, and coal imports reveals an inherent belief that the slowdown will be genuine and meaningful. Chart I-6The US Still Has Positive Growth ##br##Surprises The US Still Has Positive Growth Surprises The US Still Has Positive Growth Surprises Chart I-7Commodity Markets Are Sending A Distress Signal Commodity Markets Are Sending A Distress Signal Commodity Markets Are Sending A Distress Signal Earnings revisions are heading lower across a swathe of geographies. Bottom-up analysts are usually less certain about the level of earnings but spot on about the direction (Chart I-8). Not surprisingly, the downgrades have been driven by emerging markets, meaning that return on capital will be best sought in less-cyclical bourses such as the US. Momentum-wise, being long the US dollar is becoming a captivating trade. 75% of currencies are currently falling versus the dollar. The history of this indicator is that it has usually required a move into overbought conditions before a bet on a playable reversal can be justified (Chart I-9). Chart I-8Earnings Revisions In EM Have Fallen Off A Cliff Earnings Revisions In EM Have Fallen Off A Cliff Earnings Revisions In EM Have Fallen Off A Cliff Chart I-9A Growing Consensus Of Short Dollar ##br##Trades A Growing Consensus Of Short Dollar Trades A Growing Consensus Of Short Dollar Trades On a cyclical horizon (over the next year), we remain dollar bears given our inherent belief that the shock from the virus will soon dissipate, and green shoots from global growth will reemerge. However, for more tactical investors, momentum currently favors the greenback. In addition to the indicators above, we are also monitoring global growth economic barometers on when to time a shift away from the DXY. On Volatility And Safe Havens The dollar is expensive across most measures of purchasing power, but less so when other fundamental factors such as interest-rate differentials and productivity trends are taken into consideration. The risk is that, as a reserve currency, the dollar rally continues unimpeded by valuation and sentiment concerns for the time being (Chart I-10). This is not our base case, but the probability of such a scenario is not zero. More importantly, currency volatility remains near record lows as the latest dollar rally simply supercharges a trend in place over the past decade (Chart I-11). Every seasoned investor does and should pay attention to low volatility. Over the last three episodes where volatility dropped to these levels, the dollar soared and pro-cyclical currencies suffered severe losses. Everyone remembers 1997-1998, 2007-2008, and 2014-2015. So far, the risk is that this time will be the same. Chart I-10The Dollar Is Expensive, But Not Excessively So The Dollar Is Expensive, But Not Excessively So The Dollar Is Expensive, But Not Excessively So Chart I-11Currency Volatility Remains ##br##Depressed Currency Volatility Remains Depressed Currency Volatility Remains Depressed Most clients acknowledge that recent US dollar purchases have been on an unhedged basis. This means as long as nominal US yields remain above those in the rest of the world, this trend can continue. That said, the prospect for real capital losses should the consensus long-dollar trade be wrong is non-negligible. The dollar has been in a bull market since 2011, but the shift in valuations has simply unwound the undervaluation gap. The dollar tends to run in long cycles, and a decisive move into much overvalued territory is possible (though again, not our base case). US Treasurys have started to outperform gold, suggesting the US dollar is becoming, at the margin, the currency of preference for safety (Chart I-12).   The gap between the USD/JPY and real rates has opened up a rare arbitrage opportunity. The yen provides valuable portfolio insurance at this economic crossroads. One of the most potent moves in rate markets has been the +135-basis-point move in favor of Japanese yields (Chart I-13). More importantly, the gap between the USD/JPY and real rates has opened up a rare arbitrage opportunity. Should a selloff in global risk assets materialize, the yen will strengthen. On the other hand, if global growth does eventually accelerate, the yen will surely weaken on its crosses but could still strengthen vis-à-vis the dollar. Chart I-12The Signal From Bonds Versus Gold The Signal From Bonds Versus Gold The Signal From Bonds Versus Gold Chart I-13JGBs Are Becoming Attractive JGBs Are Becoming Attractive JGBs Are Becoming Attractive This win-win situation for the yen hinges on three key pivotal developments: For most of the past five years, the Bank of Japan was one of the most aggressive central banks in terms of asset purchases. This was a huge catalyst for a downturn in the trade-weighted yen (Chart I-14). With renewed expansion of the Fed’s balance sheet, monetary policy is tightening on a relative basis in Japan. Movements in the yen are as influenced by external conditions as what is happening domestically, given Japan’s huge export sector. For example, the yen reacts very potently to moves in the VIX (Chart I-15). The yen is a very cheap currency, and the latest selloff has all but assured further depreciation into undervalued territory. As we will illustrate in an upcoming report, it pays to be contrarian when it comes to currency valuations, albeit over the longer term (Chart I-16). Chart I-14The BoJ And QE: No More Bullets The BoJ And QE: No More Bullets The BoJ And QE: No More Bullets Chart I-15The Yen Is Still A Risk Off Currency The Yen Is Still A Risk Off Currency The Yen Is Still A Risk Off Currency Chart I-16A Win-Win Dynamic For Long Yen Positions A Win-Win Dynamic For Long Yen Positions A Win-Win Dynamic For Long Yen Positions In a situation where global growth does improve, the yen will tend to weaken, given that it is usually used to fund carry trades. That said, our contention is that the yen will surely weaken at the crosses but could still strengthen versus the dollar. This is because the USD/JPY and the DXY tend to have a positive correlation, since the dollar drives the yen most of the time. More conservative investors can remain short CHF/JPY. The authorities at the Swiss National Bank must be pacing up and down over the impact of a strong currency in a deflationary world. Given that Swiss interest rates are the lowest in the G10, the CHF becomes the only tool of adjustment to inflate domestic prices. Selling the franc and loading up on US and international stocks as they correct is a foolproof way cushion the business cycle in Switzerland. Meanwhile, inflation differentials with the US have been lower in Japan compared to Switzerland, but the franc has been stronger. This suggests that, as a safe haven, the franc is incrementally more expensive than the yen. Bottom Line: The yen is the most attractive safe-haven currency at the moment. Remain short USD/JPY and CHF/JPY. We are widening our stops on both trades to account for the rise in market volatility.    Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Currencies US 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 mostly positive: The Markit preliminary manufacturing PMI decreased to 50.8 from 51.9 in February. New home sales jumped by 7.9% month-on-month in January.  Consumer confidence increased slightly to 130.7 from 130.4 in February. Durable goods orders slipped 0.2% month-on-month while nondefense capital goods orders excluding aircraft grew 1.1% month-on-month in January. The DXY index depreciated by 1.2% this week. Markets sold off dramatically on the back of renewed fears about Covid-19. While markets are pricing in 71 basis points of easing over the next 12 months, Fed Vice Chair Clarida emphasized a wait-and-see approach. Fed inaction places a near-term bid on the dollar, though longer term, we remain bearish. Avoid outright dollar bets for now.   Report Links: On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Building A Protector Currency Portfolio - February 7, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 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 positive: The Markit manufacturing PMI improved to 49.1 from 47.9 while the services PMI increased to 52.8 from 52.5 in January. This nudged the composite PMI further into expansion territory at 51.6. Core CPI came in at 1.4% year-on-year in January. Sentiment improved in the euro area this week. In February, the economic sentiment indicator increased to 103.5 from 102.6, the business climate indicator improved to -0.04 from -0.19, and the industrial confidence moved up to -6.1 from -7.    In Germany, the closely watched IFO survey bounced to 96.1, driven by the expectations component. So far, the V-shaped recovery in European manufacturing expectations appears un-derailed. The euro appreciated by 1.4% against the US dollar this week. Following the powerful upward momentum that we saw in the DXY index over the last few days, some specter of mean reversion is not a surprise. This week, President Lagarde reiterated the need for fiscal measures to combat climate change, which will also be euro-bullish beyond Covid-19.    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 The 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 mostly negative: The national CPI grew by 0.7% in January, decreasing slightly from 0.8% the previous month. More instructive will be the Tokyo CPI print released as we go to press. The Jibun Bank manufacturing PMI declined to 47.6 from 48.8 in February. The coincident index decreased to 94.1 while the leading economic index increased to 91.6 in December. The Japanese yen appreciated by 2% against the US dollar this week. As we go to press, Japan is temporarily closing all schools to temper the spread of the coronavirus. Domestically, data were weak already with the PMI weighed down by new orders and output prices. Tourism, a key source of domestic demand, has also been hit hard. As a safe-haven currency, a risk-off scenario will only trigger repatriation flows benefitting the yen.   Report Links: Building A Protector Currency Portfolio - February 7, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 Portfolio Tweaks Before The Chinese New Year - January 24, 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 positive: The Markit manufacturing PMI increased to 51.9 from 50 while the services PMI decreased to 53.3 from 53.9 in February. That still underpinned a solid composite PMI at 53.3. The BRC shop price index declined by 0.6% year-on-year in January.   The British pound was flat against the US dollar this week. BoE deputy governor Cunliffe took a somewhat hawkish tone, stating that “there is not much monetary policy can do” in the case of a supply shock from Covid-19. Uncertainty over monetary policy, Brexit and Covid-19 are now compounding influences on pound volatility.  Our bias is a trading range for GBP-USD between 1.28-1.32 until a clear catalyst emerges.   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: The value of construction work done in Q4 2019 contracted by 3% quarter-on-quarter, improving from a contraction of 7.4% the previous quarter. Private capital expenditure contracted by 2.8% quarter-on-quarter in Q4 2019, worsening from a contraction of 0.4% the previous quarter. The Australian dollar depreciated by 0.6% against the US dollar this week. Australia is more exposed to negative developments regarding Covid-19, given strong ties to China. Weak data on investment and consumption have also suppressed the Australian dollar recently. Notwithstanding, AUD/USD, now at post-crisis lows, looks deeply oversold. We were stopped out of our long AUD/USD trade for a loss of 2.9%. For risk management purposes, we are standing aside.   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 mixed: Exports decreased to NZD 4.7 billion from NZD 5.5 billion while imports were flat at NZD 5.1billion in January. The monthly trade balance was in a deficit of NZD 340 million in January.   The ANZ business confidence indicator worsened to -19.4 from -13.2 in January. Retail sales grew by 0.7% quarter-on-quarter in Q4 2019, declining from a 1.7% expansion in Q3 2019. The New Zealand dollar depreciated by 0.1% against the US dollar this week. Like its antipodean partner, New Zealand is highly exposed to the slowdown in the Chinese economy. In the short-term, tourism will be hit hard, as will other service industries. This environment will not be favorable for long NZD trades.      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 mixed: Retail sales growth remained flat month-on-month at 0.5% in December, slowing significantly from growth of 1.1% the previous month. Wholesale sales grew by 0.9% month-on-month in December, improving from a contraction of 1.1% the previous month. The current account deficit narrowed to CAD 8.76 billion from CAD 10.86 billion in Q4 2019. We get GDP data this Friday morning, and we anticipate a nascent recovery put at risk from Covid-19.  The Canadian dollar depreciated by 0.7% against the US dollar this week. In addition to global risk-off flows, the Canadian dollar was hurt by the sharp decline in oil prices, which are now close to 2019 lows. Uncertainty has led markets to price in 52 basis points of further easing from the BoC. This will support our long EUR/CAD trade going forward.   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 There is scant data out of Switzerland this week: The expectations component of the ZEW survey declined to 7.7 from 8.3 while the current situation component declined to 15.4 from 29.2 in February. The Swiss franc appreciated by 1.5% against the US dollar this week. This must be sending shock waves along SNB corridors. Domestic data remain weak but, as with the Japanese yen, the franc was propped up by safe-haven flows. In the near-term, expect the franc to trade more on global sentiment rather than economic fundamentals. EUR/CHF strengthened slightly over the past few days but remains close to historic lows. The SNB will be watching carefully for signs of sustained strength in the franc and will act as needed to prevent rampant appreciation.   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 positive: The unemployment rate decreased to 3.9% from 4% in December.  Retail sales grew by 0.5% month-on-month in January, improving from a contraction of 2% in the previous month. The Norwegian krone depreciated by 0.7% against the US dollar this week. The petrocurrency was hurt by falling oil prices which triggered a 9.7% decline in the Oslo Bors All-Share Index this week. At 1.5%, the Norway’s policy rate is among the highest in developed markets. If the economy remains weak and there is another global easing cycle, the Norges Bank will feel the pressure. We remain short USD/NOK but acknowledge that this trade could continue to underperform in the next few days.    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 positive: Consumer confidence improved to 98.5 from 92.6 in February. The producer price index contracted by 0.4% year-on-year in January. The trade balance moved into a surplus of SEK 9.9 billion from a deficit of 2.3 billion. Retail sales grew by 2.7% year-on-year in January, slowing slightly from 2.8% the previous month. Capacity utilization decreased to -2.1% in Q4 2019 from 0.5% the previous quarter. The Swedish krona appreciated by 1.3% against the US dollar this week. Usually, when a currency is cheap, the undervaluation starts to show up in external balances as was the case with Sweden trade data. The key concern for the Riksbank at the moment will be the impact of the negative oil price shock on its inflation forecast as well as the impact of Covid-19 on external demand.   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   Footnotes Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

We published a report titled “Markets Too Complacent About The Coronavirus” before US stocks opened for trading on Friday, February 21st. In that piece, we argued that equities were at risk of swooning as investors came to grips with the severe near-term dislocations the COVID-19 outbreak would have on the global economy and the rising likelihood that the virus would spread around the world. Since then, global stocks have fallen by 13%. The S&P 500 has dropped 15%. We indicated in yesterday’s report that we would turn more bullish if global equities were to fall another 5%-to-8%. I wrote those words around noon Montreal time. As of 10:40 am EST today, global equities have sunk a further 6%, bringing us within the recommended buying range. No one knows how this virus will evolve. In a worst-case scenario where the outbreak becomes a global pandemic, the resulting economic downturn will be severe. However, it will also be quite brief. The fatality rate for people under the age of 60, who make up the vast majority of the global workforce, appears to be fairly low. Once all workers are in the same boat, the need for mass quarantines, business shutdowns, and travel bans will subside. Economic imbalances are generally smaller now than a decade ago. In most countries, including China, the private sector earns more than it spends. Monetary policy also remains highly accommodative. It is likely the Fed will lower rates next month, with an emergency cut quite possible before then. Market-based inflation expectations remain well below the Fed’s target zone. There is little reason not to ease. Granted, neither monetary nor fiscal stimulus can do much to address supply shocks. However, stimulus will prove very useful in jumpstarting growth once businesses resume operations. We downgraded our near-term view on risk assets on January 10th. Now that equity valuations have become more attractive and credit spreads have widened, we are upgrading our 3-month recommendation on global equities and spread product back to overweight. We are also downgrading our view on government bonds to underweight.   Peter Berezin Chief Global Strategist peterb@bcaresearch.com

Highlights Investors’ hunt for yield over the past few years has increasingly led them to view emerging markets debt (EMD) as an attractive component of portfolios. EMD should not be viewed as one homogeneous asset class. Investors should distinguish between its key segments: hard-currency sovereign debt, hard-currency corporate debt, and local-currency sovereign debt. EMD allows investors to own bonds with higher yields than DM sovereign or corporate bonds. But it comes with specific risks that investors need to understand. EMD, being a highly cyclical asset class, should perform well in an environment of accelerating global growth – which we expect to see during 2020. Within this asset class, we favor EM hard-currency sovereign bonds over both EM hard-currency corporate debt and local-currency sovereign bonds. However, the coronavirus outbreak makes us reluctant to pull the trigger on this recommendation now. Rather, we are placing EM hard-currency sovereign debt on upgrade watch. Feature Emerging markets debt (EMD) as an asset class has grown over the past decades to over US$24 trillion in bonds outstanding – becoming an integral part of the global investment universe, and presenting an interesting investment opportunity for investors. The EMD universe, which was previously dominated by sovereign issues in hard currencies, has become more diverse, and consequently, difficult for investors to ignore. In this Special Report, we identify the segments that make up EMD and the various exposures that investors face when allocating to it. We analyze their risk-return characteristics and the drivers contributing to their returns, and compare EMD to other asset classes. We conclude by identifying any diversification benefits that investors can reap as the hunt for yield continues. Introduction Estimates value total debt in emerging markets at over $24 trillion as of Q2 2019. This includes both sovereign and corporate debt, in both local and hard currencies (Chart 1).1  The bulk of EMD, however, is in local currencies – almost 90%. Chart 1Estimates Of Total EMD Understanding Emerging Markets Debt Understanding Emerging Markets Debt In this Special Report, we focus on the following three segments of emerging markets debt (EMD): Sovereign debt issued in hard currency – the majority of which is USD denominated – estimated at $2 trillion. I. We distinguish between “pure”            sovereigns and quasi-sovereign bonds. Corporate debt2  issued in hard currency – mainly in USD – estimated to be $1.5 trillion. Sovereign debt issued in local currency – estimated at $10.3 trillion. We do not cover local-currency corporate debt, as more than half of it – estimated to be $8.1 trillion – is issued by Chinese firms and is hard to access for most investors. Each of these segments offers an array of opportunities, is driven by different dynamics, and bears risks that investors must recognize before allocating to it. We recommend clients view the segments of EMD as different asset classes, rather than an aggregate. Hard-Currency Debt Hard-currency EMD refers to debt issued by governments and firms in emerging markets that is denominated in a currency other than their local currency. Estimates suggest 90%-95% of total hard-currency debt is USD denominated, with the remaining in euros and yen. The main feature of hard-currency EMD is that it provides investors with protection against currency depreciation risk. Nevertheless, it is important to highlight that currency movements can affect spreads, default risk, as well as liquidity. If a country’s currency depreciates, its ability to service its foreign debt deteriorates. This is crucial, as exemplified by currency crises over the past few years in countries such as Argentina, Turkey, Egypt, and Venezuela. Hard-Currency Sovereign Debt Since 2004, EM hard-currency sovereign bond investors have enjoyed an annualized total return of 7.4%, much higher than the 3.2% from the global Treasury index. Even on a risk-adjusted return basis, the incremental performance compensates for the additional 1.7% of annualized volatility. Investing in EM hard-currency sovereigns allows investors to find higher-yielding debt than government bonds in developed economies. Since 2004, the average yield on EM hard-currency sovereign debt was 6.1%, 3.8 percentage points higher than the 2.3% on their DM counterparts. Investors received positive returns even in real terms, as inflation in DM and the US have averaged 2.2% and 2.1% respectively, since 2004 (Chart 2). This has been extremely useful, particularly in the past few years, when bond yields in many developed economies reached zero or turned negative, and investors increasingly hunted for yield. The risk profile of the aggregate EM sovereign debt index is balanced between the safer Middle Eastern economies such as Saudi Arabia, UAE, and Qatar, and the riskier Latin American economies such as Mexico, Brazil, and Argentina. Those two buckets each comprise approximately 30% of the index, with the remainder of the index split between Asia, Emerging Europe, and Africa at 17%, 11%, and 10%, respectively (Chart 3). Other portfolios are benchmarked to J.P. Morgan’s indexes where Gulf countries have very little weight. Chart 2EM USD-Sovereigns Provide Value To DM Investors Understanding Emerging Markets Debt Understanding Emerging Markets Debt Chart 3Risk Profile Of EM USD-Sovereigns Understanding Emerging Markets Debt Understanding Emerging Markets Debt We believe it is reasonable to compare hard-currency EM sovereign debt to US investment-grade bonds due to their shared characteristics. Both have comparable duration (approximately eight years) and similar credit qualities, despite EM sovereign debt being a little riskier on average than the US corporate market (Chart 4). Nevertheless, since 2004, EM sovereign hard-currency debt has outperformed US investment-grade bonds by 40% – although its outperformance has lost steam over the past few years (Chart 5). Chart 4EM USD-Sovereigns Are Slightly Riskier Than US Investment-Grade Bonds Understanding Emerging Markets Debt Understanding Emerging Markets Debt Chart 5EM USD-Sovereigns Have Outperformed US IG Bonds... Understanding Emerging Markets Debt Understanding Emerging Markets Debt This does not mean that EM debt is immune to problems.3 The cumulative average default rate of EM foreign-currency sovereign debt – while lower than US corporates – remains high and is more pronounced as one goes down the credit-rating curve (Table 1). Idiosyncratic country risks can skew the data. If one excludes Argentina – currently weighted at only 3.5% – from the index, almost 100 basis points of spread get shaved off (Chart 6). Table 1…However, Beware Of The Default Rates Understanding Emerging Markets Debt Understanding Emerging Markets Debt Chart 6Excluding Argentina, Spreads Are Much Lower Understanding Emerging Markets Debt Understanding Emerging Markets Debt Given that most of our clients invest through passive vehicles, throughout this report, we focus on the EM aggregate indexes rather than on specific countries. However, it is important to identify over/undervalued countries, given the wide-ranging risk-profile spectrum of emerging economies. By drawing a US corporate credit curve, based on credit ratings and breakeven spreads, one can spot over- or undervalued countries relative to US investment-grade bonds. Currently, the sovereign bonds of Poland, UAE, Qatar, and Saudi Arabia appear to be more attractively valued than those of Russia, Hungary, and Brazil. The charts also show the transition of these countries across time (Chart 7, A,B,C,D). Chart 7Country Selection Is Important… Understanding Emerging Markets Debt Understanding Emerging Markets Debt Chart 8...With The UAE And Saudi As Good Examples Understanding Emerging Markets Debt Understanding Emerging Markets Debt For example, South African sovereign bonds – given their current credit rating and spreads – have moved from being overvalued relative to US corporates to undervalued over the past five years. This implies a buying opportunity, or simply that they are getting cheaper ahead of a potential downgrade. For investors with less restricted mandates, country selection can be very valuable. For example, the UAE and Saudi Arabia, two highly rated economies at Aa2 and A1 respectively, trade at 23 and 30 basis points over similarly rated US corporate bonds (Chart 8). We find that EM hard-currency sovereign spreads are mainly driven by global growth cycles, something BCA Research’s Emerging Market strategists have often highlighted.4  We rely on several key indicators to gauge where we are in the cycle. These include Germany’s IFO manufacturing business expectations, global and emerging market PMIs, as well as OECD’s Leading Economic Indicators (LEI) (Chart 9). Upward moves in these indicators have historically led to a tightening in EM sovereign spreads. Chart 9Spreads Will Tighten Once Global Growth Picks Up Understanding Emerging Markets Debt Understanding Emerging Markets Debt Quasi-Sovereign Bonds Chart 10Quasi-Sovereigns Are Focused In The Energy Sector Understanding Emerging Markets Debt Understanding Emerging Markets Debt Investors need to differentiate between EM sovereign bonds and quasi-sovereign bonds. While formal definitions vary among market participants and academics, the most common definition of “quasi-sovereign” is bonds issued by an entity where the government either fully owns the institution, controls more than 50% of its equity, or has a majority of its voting rights.5 Examples of such companies include Brazil’s Petrobras, Mexico’s Pemex, and Venezuela’s PDVSA. One reason why we highlight quasi-sovereigns is the rapid growth in the amount of such debt outstanding.6 As of January 2020, the quasi-sovereign bond market has grown by over US$630 billion throughout the past decade to US$714 billion and it now makes up over 42% of the combined EM Sovereign amd Quasi-Sovereign Bloomberg Barclays index. The oil & gas sector represents over a third of quasi-sovereign entities (Chart 10). Chart 11Quasi-Sovereigns...A Defensive Play On Corporate Bonds Understanding Emerging Markets Debt Understanding Emerging Markets Debt Some investors assume that a quasi-sovereign entity would have the full backing of its government. While that is true in most cases, the majority of quasi-sovereign bonds only have an “implicit” backing from the issuer’s government, meaning that the government holds no legal liability in case of default. Dubai World, a state-owned conglomerate, was a perfect example of this during the aftermath of the Global Financial Crisis. The government stood on the sidelines as the firm went through financial distress, forcing billions of dollars of debt to be restructured.7 Given this additional level of uncertainty and corporate risk, EM quasi-sovereign bonds trade at higher spreads than their sovereign counterparts (Chart 11). Nonetheless, bonds with even the simplest implicit backing from the government are considered a more defensive play than “pure” corporate bonds, which trade at even higher spreads. Hard-Currency Corporate Debt The increase in quasi-sovereign issuance has been a big factor in the growth of the hard-currency corporate-debt universe – a segment that became of interest to investors in the early 2000s. The outstanding amount of hard-currency corporate debt has surpassed hard-currency sovereign debt, according to the Bank Of International Settlements (BIS) (Chart 1). The EM corporate debt index8 has similar sector exposure to the MSCI EM equity index. Almost 69% of the bond index is concentrated in the Industrials category,9 with the Financial/Banking and Utilities sectors making up the remaining 26% and 5%, respectively (Chart 12). The Technology sector is an exception – comprising only 5% of the corporate bond index compared to over 16% in the equity index. The country exposure, however, is less skewed to Asian economies compared to equities (Chart 13). Chart 12EM Corporates Provide Similar Sector Exposure To Equities… Understanding Emerging Markets Debt Understanding Emerging Markets Debt Chart 13…Yet With Different Country Exposure Understanding Emerging Markets Debt Understanding Emerging Markets Debt Chart 14EM Corporates: A Defensive Play On Equities... Understanding Emerging Markets Debt Understanding Emerging Markets Debt   The overlap in sector coverage can be advantageous to investors who want quasi-exposure to EM equities but with much lower volatility. The same can be said for DM corporate bonds, whose return is highly correlated to equities but with about one-third the beta.10 The correlation between EM corporate bonds and EM equities is currently close to its post-2003 average of 0.61, and the beta of EM corporate bonds to EM equities has averaged only 0.13 (Chart 14). Despite having a lower annualized return11  than EM equities, 5.6% versus 8.3%, EM corporate bonds had almost half the realized volatility, and so outperformed equities on a risk-adjusted basis. In fact, since late 2007, they have generally outperformed EM equities even in absolute terms, despite a few periods of EM equity outperformance. Like sovereigns, EM corporate bonds provided investors with a cushion against equity downside risk. For example, during the 2015/2016 slowdown in China and emerging economies, EM equities fell by almost 28%, whereas EM corporate bonds fell by only 5% (Chart 15). Chart 15...With Lower Drawdowns Understanding Emerging Markets Debt Understanding Emerging Markets Debt On a valuation basis, however, EM corporate bonds have looked unattractive relative to EM equities, providing investors with 4% real yield, compared to an equity earnings yield of 7% since 2004 (Chart 16). Nevertheless, the current level of spreads points to moderate returns for the asset class, slightly below 4% annualized over the next five years, assuming that historical default and recovery rates remain the same, and no change in spreads (Chart 17). This implies that exposure to emerging markets via corporate bonds should be more attractive than equities on a risk-adjusted basis.12 Chart 16EM Corporate Bonds Are Unattractive Compared To Equities Understanding Emerging Markets Debt Understanding Emerging Markets Debt Chart 17Forward Returns Driven By The Spread Understanding Emerging Markets Debt Understanding Emerging Markets Debt EM corporate debt is similar to its sovereign counterpart in the range of risk profiles of its constituents. Default figures vary significantly by region and during different crises. For example, the hard-currency corporate default rate for Argentinian corporates peaked at slightly over 50% during the 2001/2002 sovereign debt crisis, while for Chile and Mexico it remained below 10%. Surprisingly, default rates in emerging market corporate speculative-grade debt have on average been below those of both the US and Europe (Chart 18). Additionally, the 12-month trailing default rate for the overall EM corporate universe, as measured by Moodys’ Investors Service, at the end of 2018 was lower than for advanced economies – at 1.4% versus 1.6%.13 Chart 18Default Rates In EM Are Surprisingly Lower Than In DM Understanding Emerging Markets Debt Understanding Emerging Markets Debt Chart 19EM Corporates Suffer From Weaker Balance Sheets Understanding Emerging Markets Debt Understanding Emerging Markets Debt   EM corporate spreads are driven by a few main variables – revenue and profit growth, the business cycle, and the exchange rate. The health of EM corporates is also an important factor. This is an area of concern as corporate leverage levels have risen since 2010, and EM firms’ ability to service debt – gauged by their interest-coverage ratio – has fallen to below 2008 levels (Chart 19). Political turmoil can upset markets. Even though investors do not face the risk of currency depreciation with hard-currency debt, EM corporates with revenues mostly in local currency, face higher debt-repayment risk during a slowdown in their economies. Local-Currency Sovereign Debt Chart 20There Is Value In EM Local-Currency Bonds Understanding Emerging Markets Debt Understanding Emerging Markets Debt Emerging-market governments, to avoid foreign currency liquidity crunches, have in recent years shifted some of their debt issuance to their own currency. However, to attract investors, yields on local-currency sovereign bonds have to compensate for the added layer of currency risk as well as conventional sovereign risk. Over the lifetime of the index,14 since 2003, yields on local-currency sovereign debt have averaged 6.7%, compared to 2.5% for the US Treasury index, 2.4% for the euro area treasury index, and 0.63% for the Japanese treasury index (Chart 20). Since 2004, EM local sovereign bonds have provided investors with attractive returns. On an annualized basis, they have returned 8.4% and 6.8% in local terms and dollar terms, respectively, albeit with higher volatility than their hard-currency counterparts on a common-currency basis (Table 2). However, those returns remain higher than those of government bonds in developed economies such as Germany and Japan, both in local- currency terms and on an unhedged basis from a USD perspective. Table 2EM Local-Currency Bonds Outperforming Other DM Government Bonds In USD And Local Currency Terms Understanding Emerging Markets Debt Understanding Emerging Markets Debt Investors allocating to this segment assume a simple yet plausible notion: that EM economies will never default on debt issued in their own currency, as they can easily “print more money”. This is partially correct: default rates across rated EM sovereign local debt remain lower than for foreign-currency sovereign debt (Table 3). Table 3Default Rates: Local-Currency Debt Versus Hard-Currency Debt Understanding Emerging Markets Debt Understanding Emerging Markets Debt Most interestingly, the gap in default rates between B- and CCC-rated bonds illustrates the “near certainty” of default for low-credit-rated sovereigns ahead of time. However, proponents of the notion that governments will not default neglect the consequences those economies will suffer if they monetize public debt: currency devaluation and high inflation, which turn into weak economic growth and tightening monetary policy, leading to a further weakening in growth.  The case of Argentina between 1998 and 2002 is a perfect example of this mechanism. The economy was hurting under an uncompetitive pegged currency as well as a large debt burden. The government’s move to increase taxes, as a solution to boost government revenues, triggered a cascade of events which resulted in faltering economic growth, increased unemployment, abandonment of the currency peg, and interest rates as high as 100%, ultimately leading to Argentina’s default on its local-currency sovereign debt (Chart 21). Chart 21Argentina: A Case Study Understanding Emerging Markets Debt Understanding Emerging Markets Debt Chart 22Country Breakdown Of Local-Currency EM Sovereigns Understanding Emerging Markets Debt Understanding Emerging Markets Debt Argentina was recently removed from J.P. Morgan’s EM local-currency sovereign index due to the capital controls the authorities have instituted. As of mid-February, Mexico was the largest issuer in the index along with Indonesia, Brazil, and Thailand close behind (Chart 22). J.P. Morgan also announced that it would gradually add Chinese government bonds to its local sovereign bond indexes over a period of 10 months starting February 2020, up to the 10% country cap.15 This move is likely to push the index’s yield lower as Chinese yields are below the current yield on the index. There is some overlap between the drivers of local- and hard-currency sovereign spreads. The most important factor for investors to consider is the direction of emerging market currencies versus the US dollar. This relationship closely tracks inflation differentials between the US and EM economies (Chart 23). Chart 23The Link Between EM Currencies And Inflation Understanding Emerging Markets Debt Understanding Emerging Markets Debt Chart 24The USD Is The Most Important Factor To Consider Understanding Emerging Markets Debt Understanding Emerging Markets Debt   The top panel in Chart 24 emphasizes this point. It shows that EM local-currency sovereign bonds from a USD perspective have returned -2.8% since the peak in EM currencies in early 2013. This coincides with a time when EM currencies, on a real effective exchange rate basis, weakened against the US dollar (Chart 24, bottom panel). Other drivers of local-currency sovereign yields include commodity prices, global trade, and EM sovereign bond yields. However, this year has witnessed a significant decoupling between local bond yields and these drivers (Chart 25). Chart 25Sustainable Divergence? Understanding Emerging Markets Debt Understanding Emerging Markets Debt Chart 26Investors Continue To Hunt For Yield In Emerging Markets Understanding Emerging Markets Debt Understanding Emerging Markets Debt Our EM strategists wonder whether we are seeing a “new normal” for EM local bond yields – a paradigm in which they fall, not rise, during periods of slowing global growth and behave similarly to DM yields.16  This, however, would imply that investors view EM local debt as a safe haven rather than a risky asset class. We agree with their conclusion that the recent rally in EM local sovereign bonds – hence the decline in yields – was due, rather, to investors’ hunt for yield in an environment of over $10 trillion of negative-yielding debt (Chart 26). This trend is likely to continue in the short term until there is a sustained pickup in global growth. Once that happens, long-term yields are likely to rise in tandem (Chart 27). Chart 27ALong Term Yields Will Rise When Global Growth Picks Up Understanding Emerging Markets Debt Understanding Emerging Markets Debt Chart 27BLong Term Yields Will Rise When Global Growth Picks Up Understanding Emerging Markets Debt Understanding Emerging Markets Debt Diversification And Portfolio Impact Investors with a broad mandate can think about EMD as part of their overall portfolios. We analyze how the addition of EMD to a monthly rebalanced “conventional” portfolio, consisting of 50% global equities, 30% global treasurys, and 20% global corporate debt (split equally between investment-grade and high-yield bonds), would have performed since 2003. We found that the incremental additions of each of the three segments of EMD – from 5% to 20% each – produced a higher portfolio risk-adjusted return relative to the conventional portfolio. In all cases, replacing global equities, treasurys, and corporate bonds with EM debt, led either to a higher annualized portfolio return, reduced volatility, or sometimes both (Table 4). Unsurprisingly, given the cyclicality of EM assets, the “enhanced” portfolios have a higher correlation with global equities, as well as with DM corporate bonds (Table 5). Table 4Portfolio Simulation: Risk-Return Profiles (Feb. 2003 – Feb. 2020) Understanding Emerging Markets Debt Understanding Emerging Markets Debt Table 5EMD Is Highly Correlated With Global Equities And Corporate Bonds Understanding Emerging Markets Debt Understanding Emerging Markets Debt It is important to note, however, that most of the outperformance from the enhanced portfolios – particularly in the most heavily EMD-tilted portfolios – occurred before the slowdown in emerging economies beginning in 2013 (Chart 28). Since 2013, as the USD appreciated against EM currencies, allocating to EM local-currency sovereign bonds detracted from portfolio returns. During this period other EM risk assets, such as equities and corporate bonds, also underperformed their DM counterparts. Chart 28Allocating To EMD Adds Some Value Understanding Emerging Markets Debt Understanding Emerging Markets Debt Our Current View Over the past few years, GAA has been structurally negative on EM risk assets – both equity and debt. Productivity levels, far below historical averages, have been a key reason for this view (Chart 29). In a previous Special Report, we argued that productivity needs to mean-revert to its historical average for emerging markets to perform well, but that this is unlikely without structural reform. 17 Chart 29Global Productivity Growth Levels Understanding Emerging Markets Debt Understanding Emerging Markets Debt Chart 30Divergence Between Spreads And Growth Understanding Emerging Markets Debt Understanding Emerging Markets Debt   Tactically, however, there are times when EM assets can outperform despite the structural headwinds (2016-2017 was an example of this). This could happen again later this year, if global growth continues to rebound. Nonetheless, this optimistic view is on hold due to the risk to global growth in the short term from the coronavirus outbreak. Our global strategists expect global growth to fall to zero in the first quarter of 2020, before picking up throughout the rest of the year – assuming the outbreak is contained within the next few weeks.18  Providing this happens, and our view of global growth reaccelerating pans out, EMD should perform well. Within the asset class, segment selection is key. The environment is likely to be more favorable for EM hard-currency sovereign debt than hard-currency corporate debt or local-currency sovereign bonds. The recent divergence between hard-currency sovereign spreads and growth metric could point to an attractive entry point for investors (Chart 30). We remain cautious on EM corporate bonds, which are vulnerable in the face of sluggish domestic demand in most emerging economies, leading to contracting profits (Chart 31). A weaker USD, when global growth recovers, helped by a dovish stance from the Fed, should keep US financial conditions loose and help EM local-currency sovereign debt perform well (Chart 32). However, relative financial conditions between the US and emerging markets are just as important to monitor. If growth in EM economies fails to pick up, EM currencies could depreciate, putting downward pressure on local-currency sovereign bonds.  Chart 31EM Corporates Face Weak Domestic Demand Understanding Emerging Markets Debt Understanding Emerging Markets Debt Chart 32Easier US Financial Conditions Lead To Better EM LC Sovereign Returns Understanding Emerging Markets Debt Understanding Emerging Markets Debt We will wait to pull the trigger on this recommendation until we get further clarity regarding the impact on growth of the coronavirus outbreak. Conclusion EMD has grown to become an interesting asset class for allocators, allowing them to capitalize on bonds with higher yields than their DM counterparts. Not only has EMD provided higher returns, it gives equity-like exposure to emerging markets with significantly reduced downside during recessions and market selloffs. We recommend clients view EMD as three separate segments – hard-currency sovereign debt, hard-currency corporate debt, and local-currency sovereign debt – due to the different dynamics that influence each segment. Global growth, the direction of EM currencies versus the US dollar, and EM domestic demand are the three most important overall factors to consider when allocating to any of the segments of EMD.   Amr Hanafy, Senior Analyst amrh@bcaresearch.com   Footnotes 1We use the BIS’s definition of international debt securities (IDS) for hard-currency debt, and domestic debt securities (DDS) for local-currency debt. 2Includes both financial and nonfinancial corporations. 3For the purpose of assessing this segment, we use the broad EM and regional Bloomberg Barclays USD Aggregate Sovereign Indices, which track USD-denominated bonds issued by EM governments. Another commonly used index is the J.P. Morgan Chase & Co.’s EMBI Global Diversified Index, which tracks EM hard-currency sovereign debt, as well as fully owned and explicitly guaranteed quasi-issuers. Additionally, J.P. Morgan Chase & Co’s suite of indices following EM Sovereign debt includes their EMBI+ index. This index is primarily focused on EM sovereign issuers, however with a stricter liquidity requirement for inclusion. The reason why we do not rely on this index is due to its tilt towards LATAM and away from Middle Eastern and Asian economies. 4Please see Emerging Markets Strategy Special Report titled, “A Primer On EM External Debt,” available at ems.bcaresearch.com. 5Commercial index providers treat such distinctions by separating quasi-sovereign entities that are/are not fully owned by governments. For example, J.P. Morgan Chase & Co.’s EMBI Global Diversified Index, probably the most widely used index in tracking EM hard-currency sovereign debt, includes sovereign debt as well as fully owned and explicitly guaranteed quasi-issuers in its index. 6Please see “Fears mount over rise of sovereign-backed corporate debt,” Financial Times, dated January 5, 2016. 7Please see “Dubai World secures deal to restructure $14.6bn debt” Financial Times, dated January 12, 2015. 8For the purpose of assessing this segment, we use the broad EM and regional USD Aggregate Corporate Indices, which track USD-denominated bonds issued by EM corporates. 9Includes Basic Industry, Capital Goods, Communication, Consumer Cyclical, Consumer Non-Cyclical, Energy, Technology, and Transportation sectors. 10Please see Global Asset Allocation Special Report, “High-Yield Bonds: Low Volatility Equities?”, available at gaa.bcaresearch.com 11Annualized returns since 2004. 12Please see Global Asset Allocation Special Report, “Return Assumptions – Refreshed and Refined,” available at gaa.bcaresearch.com 13Please see “Emerging market corporate default and recovery rates, 1995 – 2018,” Moody’s Investors Service, dated January 30, 2019. 14For the purpose of assessing this segment, we use the J.P Morgan GBI-EM global diversified index, an investable benchmark accessible to most investors. This index tracks local-currency bonds issued by EM governments. 15Please see “JP Morgan to add China bonds to GBI-EM indexes from February 2020,” Reuters, dated September 4, 2019. 16Please see Emerging Markets Strategy Weekly Report titled, “EM Local Bonds: A New Normal?”, available at ems.bcaresearch.com. 17Please see Global Asset Allocation Special Report titled, “Return Assumptions – Refreshed and Refined,” available at gaa.bcaresearch.com. 18Please see Global Investment Strategy Report titled, “Markets Too Complacent About The Coronavirus,” available at gis.bcaresearch.com.