Banks

Highlights The potential range of book value outcomes for large banks is enormous, … : Total credit losses will be a function of the virus’ persistence, the intensity and duration of the social distancing actions taken to combat it, and the efficacy of monetary and fiscal policy measures meant to mitigate the economic pain. … making it almost impossible to assess their equity valuations: With the uncertainty around each of the three independent variables, estimating default rates and recovery rates is a guessing game. This is the most sudden recession on record, … : Nearly 10 million people have filed initial jobless claims in the last two weeks, more than the average over the first 26 weeks of the last seven recessions. … but the biggest banks have entered it on more stable footing than they typically would, and they have a few things going for them: The biggest banks are nowhere near as extended as they typically are after expansions, with unusually conservative asset portfolios and a large stockpile of equity capital. Feature “It depends” is always the answer to quite a few questions in economics, but right now, it’s the answer to just about all of them. Global economic activity is hostage to the COVID-19 outbreak, and the social distancing measures that have been implemented in an attempt to impede its progress. No one can say for sure how long those measures will have to remain in place, though their impact has been starkly apparent on the broad swath of businesses that they have rendered unviable. Non-essential retailers, pro sports leagues, movie theaters, concert venues, gyms, barbers, nail salons, bars and restaurants have had their revenue streams cut off entirely. Nearly all of them have some fixed costs: rent if they don’t own their space; maintenance, mortgage payments and property taxes if they do. Table 1A Half-Year Of Jobless Claims In Two Weeks How Vulnerable Are US Banks? Part 2: It’s Complicated How Vulnerable Are US Banks? Part 2: It’s Complicated Monthly rent and mortgage obligations pose a thorny issue for the banking system, because they could lead to a surge of defaults among retailers and their landlords. The unprecedentedly rapid rise in unemployment (Table 1) could trigger a tsunami of home mortgage, credit card and auto loan delinquencies. Congress, the Fed, and various executive-branch departments and agencies are doing their best to protect the individuals and businesses sucked into the vortex, but the ultimate success of their efforts is uncertain. That uncertainty makes it impossible to project the SIFI banks’ credit losses within a reasonably useful confidence interval. To take an extreme example, what if the collateral securing auto loans were reduced to its scrap value because consumers developed an aversion to previously-owned vehicles? Getting less far-fetched, what if all used cars had to be marked down by 20 or 30% to entice drivers to swallow their discomfort, and the value of soon-to-be-vacant homes and apartments faced similar haircuts? Neither is our base-case scenario, but the fact that the markdown scenario is at least plausible illustrates the difficulty of estimating credit losses, and the challenge of coming up with decent estimates of SIFI banks’ earnings and capital adequacy. For the time being, we cannot say if the SIFI banks are better bought or sold at their current prices because we don’t know how 1Q loan-loss provisions will affect their March 31st book value, or what June 30th book might be. Our thinking has evolved in the week since we published Part 1 of this Special Report on the biggest US banks’ vulnerability. Initially, 50 years of Wells Fargo’s financials led us to believe that the SIFI bank de-rating over the last month and a half was excessive, and we concluded that buying SIFI banks at or below their December 31st tangible book value provided investors with a significant margin of safety. The chance to buy at or below tangible book would be a gift even in a bad recession, but the current episode threatens to go well beyond bad. Though we still lean to buying the SIFIs rather than selling them, we now recommend that investors watch and wait before committing, as they should with risk assets more generally. We hold to that bias because our review of system-wide data revealed ample instances of how the largest banks have entered this recession in better shape than normal. We also take heart from the idea that the Fed and elected officials will vigorously pursue policies that directly and indirectly benefit the banks. The banking system is considerably more solid than it was ahead of the 2007-8 crisis. It’s not immune to the shocks that are roiling the economy, but it will not be a driver of them. A Lack Of Banking Excesses Back in 2007, the last time that a recession/financial crisis was taking aim at the US, a bank-examiner-turned-analyst told us that, “Banks create value on the liability side of the balance sheet [via deposits], and destroy it on the asset side.” At the time, the destruction was centered on subprime mortgages and the securities they spawned, but the story plays itself out in every cycle. Bad loans are made in good times, as bankers let their guard down after an extended period of low defaults and market share takes precedence over lending standards. Banks exercised more restraint over the last 10-plus years than they have in any prior postwar expansion. 11 years of zero- and negative-interest-rate policy have promoted plenty of credit excesses, as many investors have gone far afield in search of yield. Bond covenants have been shredded, and corporate leverage has duly risen. Yet banks have largely stayed out of the fray. Bank lending grew at a markedly slower rate between July 2009 and February 2020 than it has in any other postwar expansion1 (Chart 1, top panel). Chart 1An Especially Restrained Expansion An Especially Restrained Expansion An Especially Restrained Expansion Total loan growth slid all the way to 3.8% annualized versus 9.7% in prior postwar expansions. While real estate lending slowed the most, following the frenzy that precipitated the 2007-8 crisis (Chart 1, bottom panel), C&I (Chart 1, second panel) and consumer lending (Chart 1, third panel) also fell well short of their postwar expansion pace, and only consumer lending failed to set a new postwar expansion low (Table 2). From the examiner-analyst’s perspective, banks behaved less self-destructively in the last ten-plus years than they have in any other postwar expansion. Regulatory efforts to curb banking excesses really did get some traction. Table 2Core Bank Lending Growth During Expansions How Vulnerable Are US Banks? Part 2: It’s Complicated How Vulnerable Are US Banks? Part 2: It’s Complicated Setting An Uncharacteristically Good Example Historically, the largest banks are at the center of the excesses that make the banking system vulnerable and help set the stage for crises. It wasn’t a community banker, after all, who smugly declared that countries don’t go bust after having plunged headfirst into lending to shaky Latin American governments. It has been the biggest players who have hatched dubious financial innovations and scaled them to the extremes that trigger systemic rumbles. Since the 2007-8 crisis, however, the biggest banks have demonstrated uncommon restraint. As we noted in Part 1, loan-to-deposit ratios around 100% and above are a sign of instability because they have to be funded with capital flows that are here today but gone tomorrow. Lower loan-to-deposit ratios hold down profits, but they buffer banks’ exposure to the business cycle, provided that deposit funding isn’t diverted to uses that are riskier than straightforward loans. The FDIC and the Fed maintain data series that offer insight into different-sized banks’ use of their lending capacity. The FDIC’s Quarterly Banking Profile, published since the mid-‘90s, breaks out total system loan-to-deposit ratios into categories based on the size of individual banks’ assets. Using its data, we were able to compare the largest banks’ activity with all other FDIC-insured banks’ activity since 1997. The comparison showed that the largest banks performed an about-face after the subprime crisis, going from operating with uniformly higher loan-to-deposit ratios than all other banks to operating with uniformly – and significantly – lower loan-to-deposit ratios (Chart 2). Chart 2The Biggest Banks Are Using Less Of Their Lending Capacity ... The Biggest Banks Are Using Less Of Their Lending Capacity ... The Biggest Banks Are Using Less Of Their Lending Capacity ... The Fed’s commercial bank balance sheet data covering large and small banks extend back another decade. The data do not align perfectly with the FDIC’s, as the Fed’s large-bank subset (the top 25 banks by assets) has been broader than the FDIC’s since 2016 (top 9 or 10 banks) and was narrower in prior years (the FDIC’s top subset included 66 to 119 banks). The Fed’s data do not show large banks making fuller use of their deposit capacity in the ‘90s and most of last decade, but they echo the post-2007-8 drop-off in the FDIC data (Chart 3). The biggest banks have operated with less risk under the Basel 3/Dodd-Frank/Volcker Rule regime, allocating less of their capacity to loans, and considerably more to Treasuries, agencies and cash (Chart 4). Chart 3... No Matter How They're Defined ... ... No Matter How They're Defined ... ... No Matter How They're Defined ... Chart 4... And They're Directing It To Safer, More Liquid Assets ... And They're Directing It To Safer, More Liquid Assets ... And They're Directing It To Safer, More Liquid Assets Banks Are Better Capitalized Than They Used To Be The overall banking system is operating with considerably less leverage than it did in the ‘80s or ‘90s, as equity capital now accounts for 12% of total assets (Chart 5). Wells Fargo’s leverage history as shown in Part 1 suggests that banks were even more thinly capitalized in the ‘70s. An increased proportion of equity capital makes a bank more resilient to loan losses and other operational stumbles. Critically for the stability of the system, the SIFI banks are forced to maintain additional capital buffers. The combination of increased equity capital and increased holdings of liquid assets with little to no credit risk like Treasury and agency securities has made all of the largest banks safer. Chart 5Increased Equity Financing Has Made Banks More Resilient Increased Equity Financing Has Made Banks More Resilient Increased Equity Financing Has Made Banks More Resilient Some Fears Seem Overblown We reiterate from Part 1 that larger banks do not borrow short to lend long, and have not for a long time. According to the latest Quarterly Banking Profile, barely a sixth of the 4,400 banks with assets of less than $1 billion report having any derivatives exposure. A considerable majority of community banks must therefore take their asset and liability maturity profiles as given, leaving them exposed to the vagaries of shifts in the yield curve. No management team at a decently-sized publicly traded bank would dare to run anything more than a very narrow mismatch in asset and liability duration, however, as evidenced by the gargantuan interest-rate swaps market. Bank stocks may trade with 10-year Treasury yields, but the slope of the curve has very little bearing on bank earnings.2 During recessions, banks usually encounter more customers trying to park money than businesses trying to borrow it.  Unused loan commitments have provoked much agita among investors in recent weeks. A floundering company, desperately trying to stay afloat, may well draw down all of its available credit lines. Line drawdowns could force banks to make good on loan commitments made in better times that now have little prospect of repayment. While they do not appear to have been a significant issue in the ’90-’91 or 2001 recessions, lines were drawn down sharply in 2007-8 (Chart 6). Chart 6Much Ado About Nothing? Much Ado About Nothing? Much Ado About Nothing? The positive news for banks is that their exposure to untapped commitments is considerably smaller than it was heading into the last recession. They may also be less likely to be drawn, thanks to multiple Fed initiatives aimed at ensuring the availability of credit, like its ambitious plan to backstop investment-grade corporate borrowers, and the CARES Act’s expansion of Small Business Administration funding and provision of loans and loan guarantees for ailing companies in industries related to national security. There are going to be considerably more strapped borrowers, but they will have more non-bank avenues to obtain funding than they have had in prior recessions. Banks know that line demand may spike soon after the business cycle peaks; they reserve for unused commitments and will not be caught entirely unawares. Finally, not all of the unused commitments are to suffering C&I borrowers that investors most fear; Wells Fargo’s commitment history suggests that the largest share of the outstanding commitments are to individual credit card borrowers. Despite rising distress, lending has increased at a fairly modest rate during recessions, as households and businesses broadly shrink from risk, while deposits have grown at a faster rate, as the safety of FDIC-insured accounts gains appeal (Table 3). We do not expect that increased consumption of credit line capacity will materially alter the banking system’s credit exposures. Table 3Core Bank Lending And Deposit Growth During Recessions How Vulnerable Are US Banks? Part 2: It’s Complicated How Vulnerable Are US Banks? Part 2: It’s Complicated Investment Implications The banking system, anchored by the SIFI banks, is in considerably better shape now than it was in 2007, and does not pose an active threat to the financial system this time around. The banking system is not only better capitalized than it has been in the past, but large banks have invested far more conservatively. We cannot assess how expensive SIFI stocks are without having a better handle on potential loan losses, however, and we need to get a sense at how successful the Fed’s and Congress’ interventions to stem the building economic distress will be. We hope for the best, but the last-mile issues are complicated, and we expect that the mitigation efforts will have to work out some kinks before they begin to get traction. Don't worry about the banks, but give it some time before buying them. Congress and the Fed are trying to perform challenging new routines, and it's unlikely they'll stick the landing on their first try. Table 4Comfortably In The Money How Vulnerable Are US Banks? Part 2: It’s Complicated How Vulnerable Are US Banks? Part 2: It’s Complicated Our no-rush-to-buy take on the broad market applies to the SIFI banks, as well. We have high conviction that Congress and the administration will do whatever it takes to shore up the most vulnerable parts of the economy as they reveal themselves, and the Fed has already moved to a war footing. Stocks can go lower as they climb the learning curve, and may have to do so to signal the need for further intervention. We would not be concerned in the slightest if the SIFI banks were to cut or suspend their dividends. Husbanding cash is a good idea in times of uncertainty, and a couple of quarters without dividends is far preferable to shareholders than a dilutive secondary equity offering or rights issue. To the extent that it may leave elected officials more favorably disposed to the banking sector, it would be a plus. One may as well stay on the good side of legislators doling out goodies. Finally, our newly increased sense of caution does not extend to the put-writing idea we detailed two weeks ago. If implied volatility in the SIFI banks’ stocks returns to the triple-digit level, investors selling put options would be generously compensated for assuming the inherent risks. Even though the SIFIs have stumbled over the last six sessions, time decay and the steep decline in the VIX have the contracts we highlighted well in the money (Table 4).   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 Until the NBER makes the official designation, our working assumption is that the recession began in March. 2 Please see the February 28, 2011 US Investment Strategy Special Report, "Banks And The Yield Curve," available at usis.bcaresearch.com.

Highlights Recommended Allocation Quarterly Portfolio Outlook: Playing The Optionality Quarterly Portfolio Outlook: Playing The Optionality The outlook for markets over the next few months is highly uncertain. On the optimistic side, new COVID-19 cases are probably close to peaking (for now), and so equities could continue to rally. But there are many risks too. Growth numbers will be horrendous for some months. Second-round effects (corporate defaults, problems in EM and with euro zone banks, for example) will emerge. We recommend a balanced portfolio, robust both for risk-on rallies and a further sell-off. We stay overweight equities versus bonds. Government bonds will not provide significantly positive returns even in a severe recession. Thus, over the next 12-months, equities are likely to outperform them. But we leaven the equity overweight with a “minimum volatility” strategy, overweight the low-beta US market, and more stable sectors such as Healthcare and Technology. Within bonds, we stay underweight government bonds, and raise Investment Grade credit to overweight, given the Fed’s backstop. Even in a risk-on rally, government yields will not rise quickly so we recommend a neutral stance on duration. The massive stimulus will eventually be inflationary, so we recommend TIPS, which are very cheaply valued. We are overweight cash and gold as hedges against further market turbulence. Among alternatives, macro hedge funds and farmland look attractively defensive now. We would start to look for opportunities in private debt (especially distressed debt) as the recession advances. Commodity futures are attractive as an inflation hedge. Overview Playing The Optionality From the start of the crisis, we argued that markets would bottom around the time when new cases of COVID-19 peaked. At the end of March, there were clear signs that this would happen in April, with Italy and Spain having probably already peaked and the US, if it follows the same trajectory, being only two or three weeks away (Chart 1). Chart 1Close To A Peak In New Cases? Quarterly Portfolio Outlook: Playing The Optionality Quarterly Portfolio Outlook: Playing The Optionality But what happens next? A relief rally is likely, as often happens in bear markets – and indeed one probably started with the three-day 18% rise in US equities in the last week of March. Note, for example, the strong rallies in spring 2008 and summer 2000 before the second leg down in those bear markets (Chart 2). Chart 2Mid Bear Market Rallies Are Common Mid Bear Market Rallies Are Common Mid Bear Market Rallies Are Common However, there is still a lot of potential bad news for markets to digest. Global growth has collapsed, as a result of people in many countries being forced to stay at home. US GDP growth in Q2 could fall by as much as 10% quarter-on-quarter (unannualized). Horrendously bad data will come as a shock to investors over the coming months. Despite the unprecedented stimulus measures from central banks and governments worldwide (Chart 3), nasty second-round effects are inevitable. Given the high level of corporate debt in the US, defaults will rise, to perhaps above the level of 2008-9 (Chart 4). EM borrowers have almost $4 trillion of foreign-currency debt outstanding, and will struggle to service this after the rise in the dollar and wider credit spreads. Euro area banks are poorly capitalized and have high non-performing debt levels left over from the last recession; they will be hit by a new wave of bankruptcies. Undoubtedly, there are some banks and hedge funds sitting on big trading losses after the drastic sell-off and stomach-churning volatility. Mid-East sovereign wealth funds will unload more assets to fill fiscal holes left by the collapsed oil price. Chart 3Massive Stimulus Everywhere Quarterly Portfolio Outlook: Playing The Optionality Quarterly Portfolio Outlook: Playing The Optionality Chart 4Possible Second-Round Effects Possible Second-Round Effects Possible Second-Round Effects     There is also the question of when the pandemic will end. We are not epidemiologists, so find this hard to judge (but please refer to the answers from an authority in our recent Special Report1). The coronavirus will disappear only when either enough people in a community have had the disease to produce “herd immunity,” or there is a vaccine – which is probably 18 months away.  Some epidemiologists argue that in the UK and Italy 40%-60% of the population may have already had COVID-19 and are therefore immune.2 But an influential paper from researchers at Imperial College suggested that repeated periods of lockdown will be necessary each time a new wave of cases emerges3 (Chart 5). Chart 5More Waves Of The Pandemic To Come? Quarterly Portfolio Outlook: Playing The Optionality Quarterly Portfolio Outlook: Playing The Optionality At the end of March, global equities were only 23% off their mid-February record high – and were down only 34% even at their low point. That doesn’t seem like enough to fully discount all the potential pitfalls over coming months. This sort of highly uncertain environment is where portfolio construction comes in. We recommend that clients position their portfolios with optionality to remain robust in any likely outcome. There are likely to be rallies in risk assets over coming months, particularly when the coronavirus shows signs of petering out. There is significant asymmetric career risk for portfolio managers here. No portfolio manager will be fired for missing the pandemic and underperforming year-to-date (though some may because their firms go out of business or retrench). But a PM who misses a V-shaped rebound in risk assets over the rest of the year could lose their job.  This will provide a strong incentive to try to pick the bottom. Chart 6Bond Yields Can't Go Much Lower Bond Yields Can't Go Much Lower Bond Yields Can't Go Much Lower Government bond yields are close to their theoretical lows. The 10-year US Treasury yield is 0.6% and it unlikely to fall below 0% even in a severe recession (since the Fed has stated that it will not cut short-term rates below 0%). In other countries, the low for yields has turned out to be around -0.3% to -0.9% (Chart 6). The total return from risk-free bonds, therefore, will be close to zero even in a dire economic environment (Table 1). This means that the call between bonds and equities comes down to whether equity prices will be higher or lower in 12-months. Quite likely, they will be higher. Given this, and the optionality of participating in rebounds, we maintain our overweight on equities versus bonds. We would, however, be inclined to lower our equity weighting in the event of a big rally in stocks over the next few months.   Table 1Not Much Room For Upside From Bonds Quarterly Portfolio Outlook: Playing The Optionality Quarterly Portfolio Outlook: Playing The Optionality Table 2Bear Markets Are Often Much Worse Quarterly Portfolio Outlook: Playing The Optionality Quarterly Portfolio Outlook: Playing The Optionality But there are also many downside risks. In the past two recessions, global equities fell by 50%-60% (Table 2). Despite the much worse economic environment this time, the peak-to-trough decline is so far much more limited. Moreover, valuations are not particularly compelling yet (Chart 7). To leaven our overall overweight on equities, we recommend a “minimum volatility” strategy, with tilts towards the low-beta US market, and some more defensive sectors such as Healthcare and Technology. China and China-related stocks also look somewhat attractive, since that country got over the coronavirus first, and is responding with a big increase in infrastructure spending (Chart 8). To hedge against downside risk, we also leave in place our overweights in cash and gold. Chart 7Equities Are Not Yet Super Cheap Equities Are Not Yet Super Cheap Equities Are Not Yet Super Cheap Chart 8China Infra Spending To Rise China Infra Spending To Rise China Infra Spending To Rise Garry Evans, Senior Vice President Chief Global Asset Allocation Strategist garry@bcaresearch.com What Our Clients Are Asking – About The Coronavirus Have We Seen The Bottom In Equity Markets?  Chart 9Watch Closely COVID-19 Quarterly Portfolio Outlook: Playing The Optionality Quarterly Portfolio Outlook: Playing The Optionality After hitting a low on March 23, global equities have recovered more than one-third of their loss during this particularly rapid bear market, in response to the massive monetary and fiscal stimulus around the globe. It’s very hard to pinpoint the exact bottom of any equity bear market.  The current one is particularly difficult in two ways: First, it was largely due to the exogenous shock from the COVID-19 pandemic. If history is any guide, we will first need to see a peak in infected cases globally before we can call a true bottom in equities (Chart 9). Second, the massive and coordinated response from central banks and governments around the world is unprecedented, as the global “lockdown” freezes the global economy. It’s encouraging to see the Chinese PMI bouncing back to 52 in March after a sharp drop to deep contraction level in February. However, the bounce back was mostly from production. Both export orders and imports remain weak. US initial jobless claims have skyrocketed to 3.3 million. If the peak of infection in the US follows similar patterns in China and Italy, then it would be another encouraging sign even if the US economic data continued to get worse. BCA Research’s base-case is for this recession to have a U-shaped recovery. This means that equity markets are likely to be range bound until we have a better handle on the future course of the pandemic. As such, we suggest investors actively manage risk by adding to positions when the S&P 500 gets close to 2250 and reducing risk when it gets close to 2750 during the bottoming process. What Will Be The Long-Term Consequences? Maybe it seems too early to think about this, but the coronavirus pandemic will change the world at least as profoundly as did the 1970s inflation, 9/11, and the Global Financial Crisis (GFC). Here are some things that might change: Chart 10Government Debt Will Rise Significantly Government Debt Will Rise Significantly Government Debt Will Rise Significantly Government debt levels will rise dramatically, as a result of the huge fiscal packages being (rightly) implemented by many countries. In the US, after the $2 trillion spending increase and a fall in tax revenues, the annual fiscal deficit will rise from 6% of GDP to 15%-20%. Government debt/GDP could exceed the 122% reached at the end of WW2 (Chart 10). Ultimately, central banks will have to monetize this debt, perhaps by capping long-term rates or by buying a substantial part of issuance. This could prove to be inflationary. Households and companies may want to build in greater cushions and no longer live “on the edge”. US households have repaired their balance-sheets since 2009, raising the savings rate to 8% (Chart 11). But surveys suggest that almost one-third of US households have less than $1,000 in savings. They may, therefore, now save more. This could depress consumption further in coming years. Companies have maximized profitability over the past decades, under pressure from shareholders, by keeping inventories, spare cash, and excess workers to a minimum. Given the sudden stop caused by the pandemic (and who is to say that there will not be more pandemics in future), companies may want to protect themselves from future shocks. The inventory/sales ratio, which had been falling for decades, has picked up a little since the GFC (Chart 12). Inventory levels are likely to be raised further. Companies may also run less leveraged balance-sheets, rather than hold the maximum amount of debt their targeted credit rating can bear. This is all likely to reduce long-term profit growth. Chart 11Households May Become Even More Cautious Households May Become Even More Cautious Households May Become Even More Cautious Chart 12Companies Will Run With Higher Inventories Companies Will Run With Higher Inventories Companies Will Run With Higher Inventories The pandemic has highlighted the vulnerability of healthcare systems. China still spends only 5% of GDP on health, compared to 9% in Brazil and 8% in South Africa (Chart 13). The lack of intensive care beds and woefully inadequate epidemic plans in the US and other developed countries will also need to be tackled. Healthcare stocks should benefit. Chart 13Healthcare Spending Will Need To Rise Healthcare Spending Will Need To Rise Healthcare Spending Will Need To Rise How Risky Are Euro Area Banks? Chart 14Euro Area Banks Are Quite Fragile Euro Area Banks Are Quite Fragile Euro Area Banks Are Quite Fragile Banks in the euro area have underperformed their developed market peers by over 65% since the Global Financial Crisis (GFC) (Chart 14, panel 1). Their structural issues – many of which we highlighted in a previous Special Report – remain unsolved.  Euro area banks remain highly leveraged compared to their US counterparts (panel 2). Their exposure to emerging economies is high (panel 3), and they continue to be a major provider of European corporate funding. US corporates, by contrast, are mainly funded through capital markets. The sector is also highly fragmented with both outward and inward M&A activity declining post the GFC. Profitability continues to be a key long-term concern, despite having recently stabilized (panel 4). The ECB’s ultra-dovish monetary stance and negative policy rates do not help banks’ performance either.  Banks’ relative return has been correlated to the ECB policy rate since the GFC (panel 5). Following the coronavirus outbreak, the ECB is likely to remain dovish for a prolonged period. The ECB’s recently announced measures should, however, provide banks with ample liquidity to hold and spur economic activity through increased lending to households and corporates. Absent consolidation in the European banking sector, competition is likely to dampen banks’ profits. Additionally, the severity of the economic downturn caused by the coronavirus outbreak will determine if their significant exposure to emerging economies, the energy sector, and domestic corporates will hurt them further. For now, we would recommend investors underweight euro area banks. Where Can I Get Income In This Low-Yield World? Chart 15The Bear Market Has Unveiled Attractive Income Opportunities The Bear Market Has Unveiled Attractive Income Opportunities The Bear Market Has Unveiled Attractive Income Opportunities For long-term investors who can tolerate price volatility, there is currently an opportunity to invest in high-income securities at relatively cheap prices. Below we list three of our favorite assets to obtain income returns: Dividend Aristocrats: The S&P 500 Dividend Aristocrats Index is composed of S&P 500 companies which have increased dividend payouts for 25 consecutive years or more. In order to provide such a steady stream of income through a such long timeframe, and even provide dividend increases in recessions, the companies in this index need to have a track record of running cashflow-rich businesses. Thus, the risk of dividend cuts is relatively low in these companies. Currently, the Dividend Aristocrat Index has a trailing dividend yield of 3.2% (Chart 15 – top panel). Fallen Angels: As we discussed in our November Special Report, fallen angels have attractive characteristics that separate them from the rest of the junk market. They tend to have longer maturities as well as a higher credit quality than the overall index. Crucially, fallen angels often enter the high-yield index at a discount, since certain institutional investors are forced to sell them when they are no longer IG-rated (middle panel). Thus, selected fallen angels which are not at a substantial risk of default could be a tremendous income opportunity. Currently fallen angels have a yield to worst of 10.65%. Sovereign US dollar EM debt: Our Emerging Markets Strategy service has argued that most EM sovereigns are unlikely to default on their debts, and instead will use their currencies as a release valve to ease financial conditions in their economies. Thus, hard-currency sovereign issues could prove to be attractive income investments if held to maturity. The bottom panel of Chart 15 (panel 3) shows the current yield-to-worst of the EM sovereign hard currency debt that has an overweight rating by our Emerging Markets service. Global Economy Chart 16The Collapse Begins The Collapse Begins The Collapse Begins Overview: The global economy in early January looked on the cusp of a strong manufacturing pickup, driven by the natural cycle and by moderate fiscal stimulus out of China. The coronavirus changed all that. We now face a recession of a severity unseen since the 1930s. The fiscal and monetary response has been similarly rapid and radical. This will tackle immediate liquidity and even solvency risks. But, with consumers in many countries confined to their homes, a recovery is entirely dependent on when the number of new cases of COVID-19 peaks. In an optimistic scenario, this might be in late April or May. On a pessimistic one, the pandemic will continue in waves for several quarters.  US: It is highly likely that the NBER will eventually declare that the US entered recession in March 2020. With many states in lockdown, consumption (which comprises 70% of GDP) will slump: only half of consumption is non-discretionary (rent, food, utility bills etc.); the other half is likely to shrink significantly while lockdowns continue. Judged by the 3.3 million initial claims in the week of March 16-21, unemployment will jump from its February level of 3.5% very rapidly towards 10%. Fiscal and monetary stimulus measures will cushion the downside (enabling households to pay rent and companies to service debt). But whether the recession is V-shaped or prolonged will be dependent on the length of the pandemic. Euro Area: European manufacturing growth was showing clear signs of picking up before the coronavirus pandemic hit (Chart 16 panel 1). But lockdowns in Italy, Spain and other countries will clearly push growth way into negative territory. The severity is clear from the first datapoints to reflect March activity, such as the ZEW survey. The ECB, after an initially disappointing response, has promised EUR750 billion (and more if needed) in bond purchases. The fiscal response so far has been more lukewarm, although Germany has now scrapped its requirement to run a budget surplus. One key question: will the stronger nothern European economies agree to “euro bonds”, joint and severally guaranteed, to finance fiscal spending in the weaker periphery?   Chart 17...With Chinese Data Leading The Way ...With Chinese Data Leading The Way ...With Chinese Data Leading The Way Japan: Japan’s economy was performing poorly even before the coronavirus pandemic, mainly because of the side-effects of last October’s consumption tax hike, and the slowdown in China (Chart 17, panel 2). So far, Japan has seen fewer cases of COIVD-19 than other large countries, but this may just reflect a lack of testing. Japan also has less room for policy response. Government debt is already 250% of GDP. The Bank of Japan has moderately increased purchases of equity ETFs and remains committed to maintaining government bonds yields around 0%. But Japan seems culturally and institutionally unable to roll out the sort of ultra-radical measures taken in other developed economies. Emerging Markets: China’s economy was severely disrupted in January and February, as reflected in an unprecedented collapse of the Caixin Services PMI to 26.5 (Chart 17, panel 3). However, big data (such as traffic congestion) suggest that in March people were gradually returning to work and companies restarting manufacturing operations. Q1 GDP growth will clearly be negative, and growth for the year may be barely above 0%. The authorities are ramping up infrastructure spending, which BCA expects to grow by 6-8% this year.4 Interest rates have also fallen below their 2015 levels, but not yet to their 2009 lows. Both fiscal and monetary policy are likely to be eased further. Elsewhere in Emerging Markets, the key question is whether central banks will cut rates to support rapidly weakening economies, or keep rates steady to prop up collapsing currencies. This is not an easy choice. Interest Rates: Central banks in developed markets have cut rates to their lowest possible levels with the Fed, for example, slashing from 1.25%-1.5% to 0%-0.25% within just 10 days in March. The Fed has signalled that it will not go below zero. Short-term policy rates globally, therefore, have essentially hit their lower bounds. Long-term rates have been volatile, with the 10-year US Treasury yield swinging down to 0.6% before jumping to 1.2%. While uncertainty continues, long-term risk-free rates are unlikely to rise substantially and, in the event of a prolonged severe recession, we would see the US 10-year yield falling to zero – but no lower. Global Equities Chart 18Is The V-Shaped Recovery Sustainable? Quarterly Portfolio Outlook: Playing The Optionality Quarterly Portfolio Outlook: Playing The Optionality What’s Next?  Global equities lost 32.8% year-to-date as of March 23, 2020. All countries and sectors in our coverage were in the red. Even the best performing country (Japan) and the best performing global sector (Consumer Staples) lost 26.7% and 23.2% respectively.  From March 24 to March 26, however, equities made the best three-day gains since the Great Depression, recouping about one-third of the loss,  even though US initial jobless claims came in at 3.3 million and also the US reported a higher number of cumulative infected people than China, with a much higher number of deaths per million people (Chart 18). So have we reached the bottom of the bear market? Is this “V-shaped” recovery sustainable? How should an investor construct a multi-asset global portfolio that’s sound for the next 9-12 months given the uncertainty associated with COVID-19 and the massive monetary and fiscal stimulus around the world? Based on our long-held philosophy of taking risks where risks will most likely be rewarded, we are most comfortable taking risk at the asset class level, by overweighting equities versus bonds, together with overweights in cash and gold as hedges. Within the equity portfolio, we are reducing risk by making the following adjustments: Upgrade US to overweight from underweight financed by downgrading the euro zone to underweight from overweight. Upgrade Tech to overweight, while closing two overweight bets on Financials and Energy and one underweight on consumer staples to benchmark weighting.   Country Allocation: Becoming More Defensive Chart 19US And Euro Area: Trading Places US And Euro Area: Trading Places US And Euro Area: Trading Places In December 2019 we added risk by upgrading the euro area to overweight and Emerging Markets to neutral based on our macro view that the global economy was on its way to recovery.  Data releases in January did show signs of recovery in the global economy. However, the COVID-19 outbreak has changed the global landscape, and we are clearly in a recession now.  When conditions change, we change our recommendations. We must make a judgment call because the economic data will not give us any timely, useful readings for some time to come. Back in December, the key reason to upgrade the euro area was the recovery of China which flows into the exports of the euro area. We think China will continue to stimulate its economy. However, given the global growth collapse, the “flow through” effect to the euro area will be delayed for some time. We prefer to play the China effect directly rather than indirectly. That’s why we maintain the neutral weighting of EM versus DM, but downgrade the euro area to underweight, and upgrade US to overweight. We also note the two following factors: First, as shown in Chart 19, panel 1, the relative performance between the euro area and the US is highly correlated with the relative performance between global Financials and Technology. This is not surprising given the sector composition of the two region’s equity indices. As such, this country adjustment is in line with our sector adjustment of upgrading Technology and downgrading Financials. Second, with a lower beta, US equities provide a better defense when economic uncertainty and financial market volatility are high. The risk to this adjustment, however, is valuation. As shown in panel 4, euro area valuation is extremely cheap compared to the US. However, PMI releases as well as forward earnings estimates are likely to get worse again before they get better, given the region’s reliance on exports to China and the structural issues in its banking system. Global Sector Allocation: Getting Closer To Benchmark Chart 20Reducing Sector Bets Reducing Sector Bets Reducing Sector Bets We make four changes in the global sector portfolio to reduce sector bets, since we do not have a high conviction given market volatility and our house view that recovery out of this recession will be U-shaped. These are downgrading Financials to neutral, while upgrading Technology to overweight. We also close the overweight in Energy and underweight in Consumer Staples, leaving them both at benchmark weighting. Financials: We upgraded Financials in October last year as an upside hedge. This move did not pan out as bond yields plummeted. BCA Research’s US Bond Strategy service upgraded duration to neutral from underweight on March 10 as they do not see a high likelihood for yields to move significantly higher over the next 9-12 months. This does not bode well for Financials’ performance (Chart 20, panel 1). Even though the Fed and other central banks have come in as the lenders of last resort, loan growth could be weak going forward and non-performing loans could increase, especially in the euro area. Valuation, however, is very attractive. Technology: DRAM prices started to improve even before the COVID-19 outbreak. The global lockdown to fight against the pandemic is further spurring demand for both software and hardware, which should support better earnings growth (panel 2). The risk is that relative valuation is still not cheap, even though absolute valuation has come down after the recent selloff. Energy:  The outlook for oil prices is too uncertain. The fight between Saudi Arabia and Russia is weighing on the supply side, while the global lockdown is denting demand prospect. The earnings outlook for energy companies is dire, while valuations are very attractive (panel 3). Consumer Staples: This is a classic defensive sector that does well in recessions. In addition, its relative valuation has improved to neutral from very expensive (panel 4).   Government Bonds Chart 21Stay Aside On Duration Stay Aside On Duration Stay Aside On Duration Upgrade Duration To Neutral. Global bond yields had a wild ride in Q1 as equities plummeted into bear market territory. The 10-year US Treasury yield made an historical low of 0.32% overnight on March 9, then quickly reversed back up to 1.27% on March 18, closing the quarter at 0.67%, compared to 1.88% at the beginning of the quarter (Chart 21). We are already in a recession and BCA’s house view is for a U-shaped recovery. This implies that global bond yields will likely follow a bottoming process similar to global equities, as new infections peak and high-frequency economic data start to recover. As such, we upgrade our duration call to neutral, to be in line with the position of BCA Research’s US Bond Strategy (USBS) service. Favor Linkers Vs. Nominal Bonds.  The combined effect of the plummet in oil prices and the coronavirus outbreak has crushed inflation expectation to an extremely low level. As shown in Chart 22, the 10-year breakeven inflation rate is currently at 0.95%, 88 bps lower than its fair value. The fair value is estimated based on USBS’s Adaptive Expectations Model.  Investors with a 12-month investment horizon 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. Chart 22TIPS Offer A Ton Of Long-Run Value Extremely Cheap Inflation Protection TIPS Offer A Ton Of Long-Run Value Extremely Cheap Inflation Protection TIPS Offer A Ton Of Long-Run Value Extremely Cheap Inflation Protection   Corporate Bonds Chart 23High Quality Junk High Quality Junk High Quality Junk It is undeniable that the dearth of cashflow caused by the lockdowns will spur a ferocious wave of defaults, particularly in the high-yield sector. It also is not clear that this risk is adequately compensated for. Currently, our US bond strategist believes that spreads are pricing an 11% default rate – in line with the default rate of the 2000/2001 recession. While it is not our base case, a default cycle like 2008, where 14% of companies in the index defaulted is a very clear possibility, as revenues have ground to a halt. However, several positive factors in the junk space must also be considered. Roughly 1% of the high-yield index matures in less than one year, which means that refinancing risk for junk credits should remain relatively subdued (Chart 23, top panel). Moreover, the quality of junk bonds is relatively high compared to previous periods of stress: when the market peaked in 2000 and 2007, Ba-rated credit (the highest quality of high yield) stood at 30% and 37% of the overall index respectively (middle panel). Today this credit quality stands at 49% of the high yield market, indicating a relatively healthier credit profile for junk. Additionally, the high-risk energy sector, which is likely to experience a substantial amount of defaults given the collapse in oil prices, now represents less than 8% of the market capitalization of the whole index (bottom panel). Taking these positive factors into consideration, we believe that a downgrade to underweight is not warranted, and instead we are downgrading high-yield credit from overweight to neutral. What about the investment-grade space? the massive stimulus package announced by the Fed, which effectively allows IG issuers to roll over their entire stock of debt, should provide a backstop to this market. One valid concern is that credit agencies can still downgrade a large number of issuers, making them ineligible to receive support. However, it seems that the credit agencies are aware of how much hinges on their ratings, and are communicating that they will factor the measures taken by various government programs into their credit analysis.5 Thus, considering that spreads are already extended, the Fed is providing unprecedent support and credit agencies are unlikely to knock out many companies out of investment-grade ratings, we are upgrading investment-grade credit from neutral to overweight.   Commodities Chart 24Oil Prices & Politics Do Not Mix Oil Prices & Politics Do Not Mix Oil Prices & Politics Do Not Mix Energy (Overweight): Oil markets were driven by supply/demand dynamics until a third factor, politics, shifted the market equilibrium. The recent clash between Saudi Arabia and Russia led to the breakdown of the OPEC 2.0 coalition and to Brent prices tanking by over 60% to $26 in March. The length of this breakdown is unknown. However, we believe the parties are likely to return to the negotiation table within the next months as the damage to countries which are dependent on oil begins to appear. The fiscal budget breakeven point remains much higher than the current oil price – it is around $83 for Saudi Arabia and $47 for Russia. Weakness in global crude demand will continue to put further downward pressure on prices, until economic activity recovers from the COVID-19 slowdown. Our Commodity & Energy Strategists expect the Brent crude oil price to average $36/bbl, with WTI trading some $3-$4 below that, in 2020 (Chart 24, panels 1 & 2). Industrial Metals (Neutral): Industrial metals prices were on track to pick up until the coronavirus hit global activity at the beginning of the year. Prices face further short-term headwinds as global manufacturing remains suppressed. Once the global social distancing ends and activity resumes, industrial metal prices should pick up as fiscal stimulus and infrastructure spending, especially in China, is implemented (panel 3). Precious Metals (Neutral):  As the coronavirus spread, global risk assets have tumbled. Over the past 12 months, we have recommended investors increase their allocation to gold as both an inflation hedge and a beneficiary of accommodative monetary policy globally. However, we also recently highlighted that gold was reaching overbought territory and that a pullback was possible in the short-term. Nevertheless, investors should continue to maintain gold exposure to hedge against the eventuality that the pandemic is not contained within the coming weeks (panels 4 & 5).   Currencies Chart 25Competing Forces Pushing The US Dollar In Different Directions Competing Forces Pushing The US Dollar In Different Directions Competing Forces Pushing The US Dollar In Different Directions The USD has gone through a rollercoaster during the coronavirus crisis. Initially, the DXY fell by 4.8%, as rate differentials moved violently against the dollar when the Fed cut rates to zero. But this fall didn’t last long: as liquidity dried up, the cost for dollar funding surged, causing the dollar to skyrocket by almost 8.3%. Since then, the liquidity measures taken by monetary authorities have made the dollar reverse course once more. At this point there are multiple forces pulling the greenback in opposing directions. On the one hand, the collapse in global growth caused by the shutdowns should push the dollar higher. Moreover, momentum – one of the most reliable directional indicators for the dollar – continues to point to further upside (Chart 25, panels 1 and 2). However, the Fed’s generous USD swap lines with other major central banks as well as the massive pool of liquidity deployed have already stabilized funding costs in European and British currency markets, and look poised to do the same in others (Chart 25, panel 3). Thus, since there is no clarity on which force will prevail in this tug of war, we are remaining neutral on the US dollar. That being said, long-term investors can begin to buy some of the most depressed currencies, such as AUD/USD. This cross is currently trading at a 12% discount to PPP according to the OECD – the steepest discount that this currency has had in 17 years. Additionally, our China Investment Strategy projects that China will accelerate infrastructure investment this year to counteract the negative economic effects of the lockdown. This pick up in investment should increase base-metal demand, proving a boost to the Australian dollar in the process.   Alternatives Chart 26Favor Macro Hedge Funds Over Private Equity During Recessions Favor Macro Hedge Funds Over Private Equity During Recessions Favor Macro Hedge Funds Over Private Equity During Recessions Intro: The coronavirus outbreak caused tremendous market volatility and huge declines in liquid assets. Many clients have asked over the past few weeks which illiquid assets make sense in the current environment. To answer that, we stick to our usual recommendation framework, dividing illiquid assets into three buckets: Return Enhancers: Over the past year, we have been recommending clients to pare back private-equity exposure and increase allocation to hedge funds – particularly macro hedge funds, which often outperform other risky alternative assets during economic slowdowns and recessions (Chart 26, panel 1). Private debt – particularly distressed debt – could become a beneficiary of the current environment. The market turmoil will leave some assets heavily discounted, which can provide an opportunity for nimble funds to make investments at attractive valuations. In a previous Special Report, we highlighted Business Development Companies (BDCs) as a liquid alternative to direct private lending.6 They have taken a hit over the past month, even compared to equities and junk bonds. However, their recovery as markets bottom is usually significant (panels 2 & 3). Inflation Hedges: The coordinated “whatever-it-takes” stance implemented by global governments and central banks to mitigate the coronavirus crisis is likely to have inflationary consequences in the long-term. In that environment, investors should favor commodity futures over real estate (panel 4). As global growth reaccelerates in response to stimulus and resumed manufacturing activity over the next 12 months, the USD should weaken, and commodity prices should rise. Volatility Dampeners: Timberland and farmland remain our long-time favorite assets within this bucket. We have previously shown that both assets outperform other traditional and alternative assets during recessions and equity bear markets (panel 5). Farmland particularly should fare well in this environment, being more insulated from the economy, given food’s inelastic demand Risks To Our View Chart 27Dollar Would Fall In A Strong Recovery Dollar Would Fall In A Strong Recovery Dollar Would Fall In A Strong Recovery Since our recommendations are based on a middle course, hedging both upside and downside risks, we need to consider how extreme these two eventualities could be. On the upside, the most optimistic scenario would be one in which the coronavirus largely disappears after April or May. The massive amount of fiscal and monetary stimulus would produce a jet-fuelled rally in risk assets. The dollar has soared over the past few weeks, as a risk-off currency (Chart 27), and would likely fall sharply. This would be very positive for commodities and Emerging Markets assets. The strong cyclical recovery would also help euro zone and Japanese equities relative to the more defensive US. Value stocks and small caps would outperform. Chart 28Could It Get Worse Than 2008 - Or Even 1932? Could It Get Worse Than 2008 - Or Even 1932? Could It Get Worse Than 2008 - Or Even 1932? Downside risks are less easy to forecast. As Warren Buffet wrote in 2002: “you only find out who is swimming naked when the tide goes out.” The shock to the system caused by the coronavirus is certainly larger than the Global Financial Crisis of 2007-9 and could approach that caused by the Great Depression (Chart 28), though hopefully without the egregious policy errors of the latter. It is hard, therefore, to know where problems will emerge: US corporate debt, EM borrowers, and euro zone banks would be our most likely candidates. But there could be others. The oil price is another key uncertainty. Demand could collapse by at least 10% as a result of the severe recession. The breakdown of the production agreement between Saudi Arabia and Russia could produce a supply increase of 4-5%.  Given this, Brent crude would fall to $20 a barrel. That would represent a strong tailwind to global recovery (Chart 29). On the other hand, a rapprochement between Saudi and Russia (and even with regulators in Texas) could push oil prices back up again – a positive for markets such as Canada and Mexico. Chart 29Cheap Oil Boosts Growth Cheap Oil Boosts Growth Cheap Oil Boosts Growth   Footnotes 1   Please see BCA Special Report, "Questions On The Coronavirus: An Expert Answers," dated 31 March 2020, available at bcaresearch.com 2   https://www.medrxiv.org/content/10.1101/2020.03.24.20042291v1 3    https://www.imperial.ac.uk/media/imperial-college/medicine/sph/ide/gida-fellowships/Imperial-College-COVID19-NPI-modelling-16-03-2020.pdf 4    Please see China Investment Strategy Weekly Report, “Chinese Economic Stimulus: How Much For Infrastructure And The Property Market,” dated 25th March 2020, available at cis.bcaresarch.com 5    A release by Moody’s on March 25 stated that their actions “will be more tempered for higher-rated companies that are likely to benefit from policy intervention or extraordinary government support.” 6    Please see Global Asset Allocation Special Report, “Private Debt: An Investment Primer,” dated June 6, 2018, available at gaa.bcaresearch.com GAA Asset Allocation  

Highlights Wells Fargo’s path, before and after deregulation, has been similar to every other SIFI bank’s: It began by serving a single area in a single state, expanded within the state, and then pieced together its regional and national footprint via combinations. A review of 50 years of Wells Fargo’s financials offers multiple insights into the way that banking has evolved at the regional and SIFI bank level: Several community banks are at risk amidst the economy’s unprecedentedly sudden stop, but the overall banking system’s health turns on the condition of the regional banks and the SIFIs. Larger banks are far less reliant on lending than they used to be, … : Net interest income has contributed just 53% of Wells Fargo’s revenues since 2009. The banks would prefer wider net interest margins, but narrow ones won’t wreck their earnings power. … have considerably more capital, and are holding more cash, Treasury and agency securities to stabilize the asset side of the balance sheet: The big banks have two sources of additional ballast: more equity capital to absorb losses, and more stable asset portfolios to limit them in the first place. Feature We are top-down researchers at BCA, using macro data to make conclusions about how financial markets will fare against the economic backdrop they’ll face in the future. We also occasionally glean macro insights from micro data, which we are happy to incorporate into our process when it helps augment our understanding. Wells Fargo is a good proxy for the SIFIs and regional banks which make up the heart of the banking system, because it traveled the same serial acquisition path as its peers once prohibitions on interstate banking began to be eased in the mid-‘80s, and were wiped away for good in 1994. Wells Fargo makes all of its annual reports since 1969 available on its website, and their balance-sheet and income-statement detail fills in some gaps in the system-wide data available from the FDIC and the Fed. We will dig into the system-wide data in next week’s second installment of our examination of banking system vulnerability. This week, we focus on five decades of Wells Fargo data for insight into how banks have fared during the last seven recessions, and how they’re positioned heading into the current one. Banking, Then And Now A time-traveling visitor who worked in banking between the New Deal and the beginning of bank deregulation in the late seventies would find that banks fulfill the same two primary functions as they did in his/her day. They still promote financial intermediation by turning savers’ deposits into fuel for investment and accelerated consumption via loans to businesses and households, and they still administer the payments system. S/he might be unfamiliar with many of the ways they carry out those duties, however, and especially surprised at the way that lending and maturity transformation have been eclipsed. The biggest banks have become far less reliant on lending over the last 50 years, and they no longer engage in maturity transformation, ... At the largest banks, lending is no longer the be-all and the end-all, as revenue from fees has very nearly caught up to net interest income (Chart 1). After adjusting net interest income for loan-loss provisions, lending accounted for just 44% and 48% of Wells Fargo’s revenues in the 2000s in the 2010s, respectively. On that basis, fee revenue exceeded net interest income every year from 2007-2013, inclusive. The rise of fee income has made bank earnings more stable and bank capital levels less dependent on borrower fitness. Chart 1Lending Is No Longer The Only Game In Town Lending Is No Longer The Only Game In Town Lending Is No Longer The Only Game In Town Banks also no longer engage in maturity transformation, or borrowing short to lend long, which placed them at the mercy of the yield curve. When it inverted, profitability was squeezed as new deposit-taking-and-lending activity became less lucrative. When the curve shifted out, even if it remained upward-sloping, there was a risk that interest expense on new short-term borrowings would exceed interest income on legacy portfolio assets. The latter is what killed the savings and loans, which were chartered expressly to channel household savings into 30-year fixed-rate home mortgages. ... so investors shouldn't obsess over the yield curve's every wiggle. There is no doubt that bank stocks have closely followed moves in the 10-year Treasury yield for the last several years, and the correlation makes some sense. With deposit rates stuck at zero, the spread between the rate banks pay for funds and the rate at which they lend them out (net interest margin), should move with long yields. Over the last two decades, however, Wells Fargo’s profitability (Chart 2, top panel) has largely detached from net interest margins (Chart 2, bottom panel). It and other banks would welcome higher long yields, but equity investors’ fixation on them is misplaced in a banking industry which has rigorously matched the duration of its assets and liabilities for decades. Chart 2NIM's Influence Has Faded NIM's Influence Has Faded NIM's Influence Has Faded Bank Balance Sheets Have Become Considerably More Conservative In the wake of the 2008-9 crisis, Wells Fargo and other banks have been managed much more cautiously. The share of Wells Fargo’s assets held in cash, Treasury and agency securities is at its highest level in the last 50 years (Chart 3). Its loan-to-deposit ratio is around 50-year lows, indicating that sticky core deposits1 are amply capable of funding its loan book (Chart 4). Wells’ overall leverage,2 or the value of assets supported by each dollar of common equity, is also way down (Chart 5). All banks have de-levered from their peaks, as mandated by regulators after the 2008-9 crisis, making the banking system safer, if less profitable. Mitigating some of the drag on profits brought about by lessened leverage, banks have become considerably more efficient since the early ‘70s. The ATM has reduced the need for physical branches and staff, check processing has been streamlined, and online banking is continuing to help push costs even lower. Chart 3Playing It Safe Playing It Safe Playing It Safe Chart 4Not Anywhere Close To Extended Not Anywhere Close To Extended Not Anywhere Close To Extended Chart 5Safety First Safety First Safety First Credit Costs: The Elephant In The Room The main concern for bank stability, profitability and capital adequacy is the effect of the economic sudden stop on credit performance. Credit performance is acutely sensitive to the business cycle, and banks have headed into this recession, as always, with very low loan-loss reserve balances (Chart 6, top panel). Loan-loss provisions, which reduce net income and chip away at capital positions, are bound to rise, suddenly and significantly (Chart 6, middle panel). (Please see the Box, below, for a brief description of the mechanics of accounting for credit impairments.) Chart 6Banks Have A Lot Of Catching Up To Do Banks Have A Lot Of Catching Up To Do Banks Have A Lot Of Catching Up To Do Box: Accounting For Lending Losses Every business that makes sales on credit maintains an allowance for doubtful accounts to reflect the fact that not every bill will be paid in full. That allowance reduces the carrying value of its accounts receivable to something below their aggregate face value. Using a loan-loss reserve account, banks apply the same principle to loan repayments. The loan-loss reserve is increased by provisions for loan losses, projections of future loan losses that are immediately recognized as an expense. At the time that a bank provisions for future losses, it does not map the as-yet unrealized losses to individual loans. The value of the loans that are not going to be fully repaid are marked down once they reveal themselves, and the sum of all of the individual write-downs is aggregated as a net charge-off. Identifying individual loan impairments reduces the pool of unspecified loan-loss reserves represented by the reserve account. Net charge-offs do not have any direct impact on bank earnings or bank capital, but by consuming existing reserves, they herald a rebuild of the reserve buffer. Table 1 shows the accounting entries involved in recognizing credit losses, demonstrating the underlying rules. Provisions increase reserves and charge-offs reduce them, triggering a need for more provisions, and ensuring a continuing drain on income and equity capital. Table 1Loan-Loss Accounting How Vulnerable Are US Banks? Part 1: A 50-Year Bottom-Up Case Study How Vulnerable Are US Banks? Part 1: A 50-Year Bottom-Up Case Study The current recession, emerging from the widespread shutdown of economic activity to counter COVID-19, will mark the sharpest downturn since the Great Depression. The sudden stop in activity, and borrowers’ revenue streams, should induce a high level of defaults. Perhaps Wells Fargo’s loan-loss reserves as a share of outstanding loans will ultimately exceed their 1993 peak of nearly 6.5%, following the 1990-91 recession, which wreaked particular havoc on real estate, and in California, where the bank conducted substantially all of its business. Banks would be in a tricky spot if the economy were left to face the coronavirus crisis by itself, but policymakers are doing their utmost to support it. Chart 7There's Nothing Unusual About Credit Line Exposures There's Nothing Unusual About Credit Line Exposures There's Nothing Unusual About Credit Line Exposures Wells Fargo barely broke even in 1991, and its book value declined by 6%. Investors seem to fear that it, and other banks, are at risk of net losses and book value declines in 2020. With nearly $1 trillion of outstanding loans, and an annual earnings run rate of around $20 billion, Wells Fargo would appear to be at risk of a nasty capital hit if the economic effects were left alone to play themselves out. The CARES Act coronavirus relief measure, however, clearly signals that the federal government is not going to leave the economy on its own to face the recession’s ravages. As a part of the act, banks were granted the option of delaying the implementation of CECL, the new credit loss recognition standard, which would have had the effect of speeding up the recognition of losses, until the virus emergency passes. The act also provided relief from a loan modification rule, thereby encouraging banks to work out new, easier terms to prevent defaults, and allowed community banks to operate with a reduced minimum equity capital cushion. The $850 billion dedicated to supporting small business borrowers ($350 billon) and other borrowers, including airlines and companies deemed critical to national security ($500 billion) will also benefit their creditors. It is clear to us that forbearance, which will help debtors and creditors weather the social-distancing storm, has been established as a guiding principle for managing through the crisis. Policymakers are out to help banks, not to clip their wings. Investors should also recognize that a lot of lending to small businesses and industrial borrowers has migrated away from banks. They do not stand as squarely in the path of the default storm as they would have in the ‘70s, ‘80s and ‘90s. Direct-lending funds sprung up in the wake of the 2008-9 crisis like mushrooms after the rain, and publicly-traded business development companies (BDCs) have steadily grown their SMID lending share. The biggest industrial borrowers are much more likely to turn to the bond market than they are to call on a syndicate of banks. Finally, the existence of unused loan commitments has occasioned concern among commentators and investors over the last several weeks. If corporate borrowers were to tap their credit lines en masse, would banks find themselves significantly more leveraged? Not at Wells Fargo, where total unfunded lending commitments are about at the middle of their range over the past 25 years (Chart 7, top panel), and its commitments to corporate borrowers are at the low end of their range (Chart 7, second panel). Credit card borrowers may be more inclined to max out their capacity (Chart 7, bottom panel), but that may not be a bad thing for bank profits. Interest on unpaid card balances produces juicy returns, and the 2005 bankruptcy overhaul makes it more difficult to discharge credit card debt. Bullish Or Bearish? Based on what we know now, we do not expect that the SIFI banks will pose a systemic threat to the financial system. Entire industries are at risk, and a multitude of small businesses are reeling, but banks have less exposure than they have in the past, and the Fed and Congress are on a war footing to try to protect the most vulnerable parts of the economy. The looming hit to the banks may be less severe than markets expect. Banks are especially exposed to the business cycle, and the market rule is to avoid them ahead of recessions. From a fundamental perspective, though, the last seven recessions have not been so bad for Wells Fargo. Its per-share book value managed to rise in all of them except the ’90-’91 recession3 (Chart 8). The stock slid in recessions because its book value multiple was slashed (Chart 9). Chart 8Book Value Doesn't Suffer Too Much In Recessions, ... Book Value Doesn't Suffer Too Much In Recessions, ... Book Value Doesn't Suffer Too Much In Recessions, ... Chart 9... But Multiples Are Regularly Crushed ... But Multiples Are Regularly Crushed ... But Multiples Are Regularly Crushed Wells Fargo’s multiple has been slashed again; as of Friday’s close, using its December 31st book value, it had fallen by 44%, from 1.33 to 0.75, and it had been more than halved as of last Monday. It trades at just 90% of its year-end tangible book value. On our first day on an equity trading desk, an old-timer told us that you “buy ‘em at one [times book], and sell ‘em at two.” He was talking about the investment banks, but Wells Fargo’s history suggests the maxim applies to commercial banks, too. In our view, SIFI banks offer an appealing margin of safety to investors who buy them at or below their tangible book value. The degree to which individual banks’ book values fall in this quarter and beyond depends on the size of their loan-loss provisions, but the selloff appears extreme. We noted the appeal of writing out-of-the-money puts on the SIFI banks last week, when the VIX was in the high 70s. Selling those options has lost some appeal after the S&P 500’s 10% surge last week, but writing them could again be alluring if the SIFIs revisit their lows in the coming days and weeks.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 Loans that exceed deposits, or very nearly match them, are a sign of potential instability because banks often rely on “hot-money” flows to fund them by offering above-market interest rates on instruments like CDs. A bank must continue to pay above-market rates to retain these flows, which are prone to leave the bank for higher interest rates elsewhere. Loan-to-deposit ratios well below 100% can be funded entirely with core deposits, like checking and savings accounts, or market-rate CDs placed with core banking customers who are unlikely to move their business. 2 A bank’s leverage is calculated by dividing its total assets by its common shareholders’ equity. 3 Book value would have shrunk in 2008 if not for the purchase of Wachovia Bank at a significant discount.

Highlights Duration: Bond yields will stay low until the daily number of new COVID-19 cases falls to zero, at which point a sell-off is likely. We therefore recommend maintaining below-benchmark portfolio duration on a 6-12 month horizon. Rising odds of a Bernie Sanders presidential win could prevent bond yields from rising at all this year. We may adjust our recommendations in the coming months if this risk increases. Spread Product: Investors should maintain an overweight allocation to spread product versus Treasuries, with a preference for high-yield. Accommodative monetary conditions will ensure that the supply of credit remains ample for some time yet. This will keep defaults low and spreads tight. Monetary Policy: The Fed is in no rush to tighten policy, but has also set a high bar for further cuts. Investors should short August 2020 fed funds futures.  Yields Will Move Higher … But Not Yet Chart 1A Peak In New Cases? A Peak In New Cases? A Peak In New Cases? Uncertainty about the economic impact of the coronavirus – now officially called COVID-19 – is the cloud that continues to hang over financial markets. Last week, bond yields fell when a change in the definition of what constitutes a confirmed infection caused the number of reported cases to spike. However, even after revisions, the daily number of new cases looks like it may have peaked (Chart 1). The end result is that the 10-year Treasury yield sits at 1.58%, not far from where it was last week (Chart 2). Notably, the 10-year yield continues to shrug off the notable improvement in US economic data (Chart 2, bottom panel), taking its cues instead from COVID-19 headline risk. Even if the downtrend in new COVID-19 cases continues, it is too soon to be looking for higher bond yields. For one thing, the most up-to-date economic data releases were collected during January, before the outbreak. Weaker readings during the next 1-2 months are assured, and investors may not look through the weakness given that many were already skeptical about the prospects for global economic recovery. Our read of the data is that global growth was in the process of bottoming when COVID-19 struck. We therefore expect global growth to move higher once the virus’ impact abates. In terms of timing, using the 2003 SARS outbreak as a comparable, we expect bonds to remain bid until the daily number of new cases falls to zero, at which point a sell-off is likely. Yields continue to shrug off improvements in economic data. It’s not just the long-end of the curve that has responded to COVID-19. The front-end has also moved to price-in high odds of a rate cut in the coming months. Specifically, the overnight index swap curve is priced for a 42 bps decline in the fed funds rate during the next 12 months (Chart 2, panel 2), and the fed funds futures market is pricing a 74% chance of a rate cut by the end of the summer. As we discussed last week, given that any economic impact from COVID-19 will be temporary, we think the bar for a Fed rate cut this year is quite high.1 As such, our Golden Rule of Bond Investing dictates that investors should keep portfolio duration low on a 12-month horizon.2 We also recommend shorting August 2020 fed funds futures, a trade that will earn 23 bps of unlevered return if the Fed stands pat between now and August (Chart 2, panel 3). Turning to corporate credit, we see that, so far, COVID-19’s impact on spreads has been minor. The investment grade corporate bond index spread is only 3 bps wider than at the start of the year, and the junk index spread is only 8 bps wider (Chart 3). Value remains stretched in the investment grade space, but high-yield spreads look quite attractive. The sell-off in the energy sector has boosted the high-yield index spread considerably (Chart 3, bottom 2 panels). We view this as a medium-term buying opportunity for junk. Once the COVID outbreak abates and global growth ticks higher, the oil price is bound to increase, leading to some tightening in energy spreads. Chart 2Bond Yields Driven By COVID Bond Yields Driven By COVID Bond Yields Driven By COVID Chart 3HY More Attractive Than IG HY More Attractive Than IG HY More Attractive Than IG Will Bonds Feel The Bern? Beyond COVID-19, there is one more risk on the horizon this year. Specifically, the risk that Bernie Sanders is elected President in November. This outcome is far from certain. Sanders is currently leading all other candidates in the Democratic Primary, but fivethirtyeight.com’s model puts the odds of a brokered convention at 38%.3 This means that the race is still wide open and might only be settled at the convention in July. But given Sanders’ lead, it is worth considering the bond market implications if he were to become the next President. The most obvious implication is that risk assets (equities and corporate spreads) would respond to Sanders’ agenda of wealth redistribution by selling off. This could spur a flight-to-quality into government bonds, causing Treasury yields to fall. However, that flight-to-quality won’t occur if markets also start to price-in the long-run implications of Sanders’ agenda. I.e. the fact that the redistribution of wealth from capital to labor would lower the economy’s marginal propensity to save, and likely raise inflation expectations, leading to higher interest rates. It’s important to note that there are a lot of hurdles to overcome before Sanders’ full policy agenda is implemented. First he must secure the Democratic nomination, then defeat Donald Trump in the general election. Even after that, he will still need to convince the House and Senate to pass non-watered down versions of his proposals. With such a long road ahead, we don’t think Sanders’ momentum will push bond yields higher in 2020. Rather, the risk is that Sanders’ rise keeps bond yields low in 2020 as risk assets sell off. If Bernie Sanders looks poised to win the nomination, we will consider reducing our 6-12 month allocation to spread product and increasing our recommended portfolio duration. The outlook for the Democratic Primary should become clearer after Super Tuesday on March 3. If Sanders looks poised to win the nomination we will consider reducing our recommended 6-12 month allocation to spread product and increasing our recommended portfolio duration. Bottom Line: Bond yields will stay low until the daily number of new COVID-19 cases falls to zero, at which point a sell-off is likely. We therefore recommend maintaining below-benchmark portfolio duration on a 6-12 month horizon. Rising odds of a Bernie Sanders presidential win could prevent bond yields from rising at all this year. We may adjust our recommendations in the coming months if this risk increases. Investors should maintain an overweight allocation to spread product versus Treasuries, with a preference for junk. Though the credit cycle is far from over (see next section), we may reduce our recommended allocation to spread product versus Treasuries if Sanders’ election chances rise.  Bank Lending Standards Won’t Push Credit Spreads Wider In 2020 The net change in commercial & industrial (C&I) bank lending standards, as reported in the Fed’s quarterly Senior Loan Officer Survey, is a vitally important indicator for the credit cycle. Easing lending standards tend to coincide with a low default rate and falling credit spreads, while tightening lending standards usually coincide with spread widening and a rising default rate. With that in mind, it is mildly concerning that bank lending standards have been fluctuating around neutral levels for quite some time, and have in fact tightened in two of the past five quarters (Chart 4). In this week’s report we consider whether tighter bank lending standards could pose a risk to our overweight spread product view in 2020. Chart 4Bank Lending Standards And Monetary Variables Bank Lending Standards And Monetary Variables Bank Lending Standards And Monetary Variables Bank lending standards are such an important credit cycle variable because they tell us about the supply of credit. A corporate default only occurs when credit supply is lower than the amount required for that firm’s survival. On a macro scale, we can think of two main reasons why lenders might restrict the credit supply: They perceive the monetary environment as restrictive. That is, they worry about higher interest rates and slower growth in the future. They perceive corporate balance sheets as being in poor health. That is, they worry that firms won’t be sufficiently profitable to make good on their debts. We find that monetary indicators do a very good job of predicting when lending standards will tighten. Looking back at the past two cycles, lending standards didn’t tighten until after: The yield curve inverted (Chart 4, panel 2). The real fed funds rate was above its estimated equilibrium level (Chart 4, panel 3). Inflation expectations were at or above target levels (Chart 4, bottom panel). Presently, all three of these monetary indicators are supportive. Some portions of the yield curve have been inverted at various times during the past year. But in general, the inversion signal from the yield curve has not been as strong as it was when lending standards tightened in prior cycles. For instance, the 3-year/10-year Treasury slope has not inverted this cycle, and it currently sits at +20 bps (Chart 4, panel 2). Further, the real fed funds rate is below most estimates of its neutral level and the Fed is signaling that it will keep it there for a long time yet. This dovish posture is justified by inflation expectations that remain well below target. It is conceivable that, despite the accommodative monetary environment, banks might be so concerned about poor balance sheet health that they are becoming more cautious with their lending. However, a survey of corporate health metrics doesn’t point to an imminent tightening of bank lending standards either (Chart 5). Chart 5Bank Lending Standards And Corporate Balance Sheet Variables Bank Lending Standards And Corporate Balance Sheet Variables Bank Lending Standards And Corporate Balance Sheet Variables In past cycles, tighter bank lending standards were preceded by: A trough in gross leverage (pre-tax profits over total debt) (Chart 5, panel 2). A peak in interest coverage (Chart 5, panel 3). Negative pre-tax profit growth (Chart 5, panel 4). A peak in profit margins (Chart 5, bottom panel). Currently, gross leverage is the only one of the above four variables that is clearly sending a negative signal. As for the other three, interest coverage and profit margins are barely off their cyclical highs, and profit growth has been fluctuating around zero for three years. If global growth rebounds during the next 12 months, as we expect, then profit growth will also move modestly higher. Bottom Line: Neither monetary nor balance sheet variables point to an imminent tightening of bank lending standards. We expect that the supply of credit will remain ample in 2020, keeping the default rate low and credit spreads tight. A Note On Falling C&I Loan Demand In addition to questions about lending standards, the Fed’s Senior Loan Officer Survey also asks banks to report whether they are seeing stronger or weaker demand for C&I loans. In response, banks have reported weaker C&I loan demand for six consecutive quarters, ending in Q4 2019. Historically, it is unusual for C&I loan demand to fall without a concurrent tightening in lending standards (Chart 6). Chart 6Explaining Weakening Loan Demand Explaining Weakening Loan Demand Explaining Weakening Loan Demand We also see the impact of weaker loan demand in the hard data. C&I loan growth has been falling since early 2019 (Chart 6, panel 2) and net corporate bond issuance had been on a sharp downtrend since 2015, before moving higher last year (Chart 6, bottom panel). So what’s going on with C&I loan demand? We can think of two reasons why firms might seek out less credit. First, they may face a dearth of investment opportunities, or alternatively, they might perceive some benefit from carrying less debt on their balance sheets. On the first point, we find that new orders for core capital goods do a very good job explaining the swings in C&I lending (Chart 7). Specifically, we see that the global growth slowdown of 2015/16 drove both investment spending and C&I lending lower. Then, both series recovered in 2017/18 before moving down again during last year’s slowdown. Surveys about firms’ capital spending plans also dropped last year, consistent with the deceleration in C&I lending, but remain at high levels (Chart 7, bottom three panels). All of this suggests that C&I loan growth will recover this year as global growth improves and the investment landscape brightens. Capital goods new orders do a good job explaining C&I lending. Corporate bond issuance has followed a different path from C&I lending during the past few years. Specifically, bond issuance slowed in 2015/16 as investment spending dried up. But it did not recover in 2017/18 the way that investment spending and C&I lending did. This appears to be a result of the 2018 corporate tax cuts and repatriation holiday. Chart 8 shows that the Financing Gap – the difference between capex spending and retained earnings – plunged in 2018 because firms suddenly received a huge influx of retained earnings. The influx came in part from the lower tax rate, but mostly from repatriated cash that had been stranded overseas. Simply, firms didn’t need to issue bonds to finance their investment plans in 2018 because they had a lot more cash on hand. Chart 7C&I Lending Follows ##br##Investment C&I Lending Follows Investment C&I Lending Follows Investment Chart 8A Negative Financing Gap Limits The Need For Debt A Negative Financing Gap Limits The Need For Debt A Negative Financing Gap Limits The Need For Debt What about the possibility that firms are demanding less debt because they are trying to clean up their balance sheets? Beyond a few anecdotes, we don’t see much support for this idea. In fact, an equity index of firms with low debt/asset ratios has been underperforming an index of firms with high debt/asset ratios (Chart 9). This suggests that there is currently little reward for firms that are paying down debt. Chart 9Firms Not Rewarded For Healthy Balance Sheets Firms Not Rewarded For Healthy Balance Sheets Firms Not Rewarded For Healthy Balance Sheets Bottom Line: Weaker demand for C&I loans is a result of the recent global growth downturn and decline in investment spending. It is not a harbinger of the end of the credit cycle. Loan demand should improve as global growth rebounds this year. Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “How Are Inflation Expectations Adapting?”, dated February 11, 2020, available at usbs.bcaresearch.com 2 For further 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 https://projects.fivethirtyeight.com/2020-primary-forecast/?ex_cid=rrpromo Fixed Income Sector Performance Recommended Portfolio Specification

Highlights An analysis on Turkey is available on page 10. In the short term, EM share prices will likely continue searching for a direction as visibility is extremely low. Beyond the near term, an appropriate strategy for EM equity investors is buying breakouts and selling breakdowns. The forthcoming stimulus from China is not a surefire guarantee of an immediate cyclical recovery. Low and falling willingness to spend among Chinese consumers and enterprises could overwhelm the positive boost from the stimulus. Forecasting changes in willingness to spend is not straightforward. Elsewhere, we are recommending a new trade: Short Turkish banks / long Russian banks. Feature Chart I-1EM Vs DM Equities: The Path Of Least Resistance Is Down EM Vs DM Equities: The Path Of Least Resistance Is Down EM Vs DM Equities: The Path Of Least Resistance Is Down EM risk assets and currencies as well as China-related financial markets are facing higher than usual uncertainty. Not only are the magnitude and duration of the coronavirus shock to the mainland’s economy unknown, but also both the scale of China’s forthcoming stimulus and its multiplier are highly uncertain. How should investors navigate through such uncertainty? For EM equity investors, an appropriate strategy is buying breakouts and selling breakdowns. Presently, we maintain a neutral stance on the absolute performance of EM stocks. We initiated a long position on December 19 and closed it on January 30 to manage risks amid the coronavirus outbreak. For asset allocators, we continue to recommend underweighting EM within global equity and credit portfolios (Chart I-1). As to exchange rates, investors should stay short a basket of EM currencies versus the US dollar. The EM equity index and EM currencies have been in a trading range in the past 12 months (Chart I-2). In the short term, markets will likely continue searching for a direction as visibility is extremely low. Beyond the near term, however, EM share prices and currencies are unlikely to remain in a narrow trading range. They will either break out or break down. Which way the market swings is contingent on corporate profits and the business cycle. A Framework To Assess Shocks What framework should investors use to gauge economic and financial market outcomes? We recommend the following: When a system – in this case the Chinese economy – is hit by an external shock, its most likely trajectory depends on the duration and magnitude of the shock as well as the initial health of the system. If the system is balanced and robust, a moderate shock can certainly shake it, but will not knock it over. A V-shaped recovery is most likely in this case. By contrast, if the system is unbalanced and precarious, a measured tremor could produce an outsized negative impact. As a result, this economy is more likely to experience a U-shaped recovery. No one can gauge with any precision the impact of the coronavirus outbreak on China’s economy. The only thing we can assess is the health of the mainland economy prior to this exogenous shock. Beyond the near term, EM share prices and currencies are unlikely to remain in a narrow trading range. Which way the market swings is contingent on corporate profits and the business cycle. In this regard, we present the following analysis on both the economy’s cyclical condition and structural vitality: 1. Cyclically, China’s growth was ostensibly bottoming when the coronavirus outbreak occurred. The top panel of Chart I-3 illustrates that – at that time – the Chinese broad money impulse foreshadowed a revival in nominal industrial output from late 2019 until mid-2020. In the second half of this year, however, the same indicator projected renewed growth deterioration. Chart I-2EM Stocks And Currencies Are In A Trading Range: How Long Will It Last? EM Stocks And Currencies Are In A Trading Range: How Long Will It Last? EM Stocks And Currencies Are In A Trading Range: How Long Will It Last? Chart I-3Without The Coronavirus Outbreak, Chinese Recovery Would Have Been Muted And Short-Lived Without The Coronavirus Outbreak, Chinese Recovery Would Have Been Muted And Short-Lived Without The Coronavirus Outbreak, Chinese Recovery Would Have Been Muted And Short-Lived   Notably, the broad money impulse has often led the credit and fiscal spending impulse, and it currently signals a rollover in the latter sometime in the first half of 2020 (Chart I-3, bottom panel). Chart I-4EM Corporate Profits: Modest And Temporary Improvement EM Corporate Profits: Modest And Temporary Improvement EM Corporate Profits: Modest And Temporary Improvement Consistently, China’s narrow money growth had been projecting a muted and only temporary rebound in EM corporate profits – which are often driven by the Middle Kingdom’s business cycle – from late 2019 until the middle of 2020 (Chart I-4). Thereafter, EM profit growth was set to relapse anew. In short, even prior to the coronavirus outbreak, our indicators were signaling that any economic improvement on the back of the Chinese government’s 2018-19 stimulus would have been muted and short-lived from late 2019 until mid-2020. Hence, the negative shock from the public health emergency could end up nullifying the pending recovery. 2. Structurally, as we have written extensively, China has enormous credit and money excesses. The economy has become addicted to rampant money and credit creation. This, along with the misallocation of capital and the resulting growth in the number of zombie companies, makes the system vulnerable, even to moderate shocks. It is reasonable to assume that there are some companies that enjoy great financial health, some zombies that are unable to service their debt at all, and a certain number of enterprises that generate just enough cash flow to service their debt. While the coronavirus-induced downtrend in the economy will not materially change the financial status of healthy or zombie businesses, it will likely alter the financial standings of debtors that were on the proverbial edge. Assuming the unavoidable drop in cash flows due to the country’s sudden shutdowns, these debtors will struggle to service their debt. This will likely alter their short-to-midterm decision making. For example, if they were planning to expand their operations and hire more employees, these plans are likely to be shelved for now. Low and falling willingness among households to consume and among enterprises to invest and hire could overwhelm the positive boost from the stimulus. In short, the coronavirus-induced shutdowns are cutting into cash flows, but they do not in any way reduce debt burdens. Chart I-5 illustrates that debt servicing costs as a share of income for companies and households in China are among the highest in the world. Chart I-5China Has A High Debt Service-To-Income Ratio China Has A High Debt Service-To-Income Ratio China Has A High Debt Service-To-Income Ratio Notably, this measure for China is relative to nominal GDP while for other countries it is relative to disposable income. Disposable income is smaller than GDP as it takes into account taxes paid. Therefore, on a comparable basis, this ratio for China will be meaningfully higher than the one shown on Chart I-5. Bottom Line: Provided the Chinese economy is highly leveraged, it is reasonable to conjecture that the recovery following the adverse shock from the coronavirus will be U- rather than V-shaped. Stimulus: Yes. Multiplier: Unknown. It is a given that the Chinese authorities will inject more fiscal and monetary stimulus into the system. Nevertheless, the ultimate size of stimulus is unknown. So far, the following has been announced: On the monetary and credit side: A RMB300 billion re-lending quota to supply special low-cost funds to assist national commercial banks and local banks to provide preferential interest rate loans to key enterprises for epidemic prevention and control; On February 3, open market operation rates were cut by 10 basis points, and the key 7-day repo rate fell by 45 basis points; The People’s Bank of China injected liquidity1 via open market operations; The People’s Bank of China encouraged banks to lower lending costs for small and medium enterprises by 10% in some provinces. Critically, the banking regulatory authority has indicated it will allow an extension of the transition period for the implementation of the New Asset Management Regulation beyond 2020. Chart I-6Marginal Propensity To Spend Varies From Cycle To Cycle Marginal Propensity To Spend Varies From Cycle To Cycle Marginal Propensity To Spend Varies From Cycle To Cycle On the fiscal side: Additional local government debt quotas of RMB848 billion have been approved, on top of the previously authorized quota of RMB1 trillion in November 2019; the front-loaded debt quota will offer local governments more flexibility with their budgets and support growth via public investment; Cumulatively about RMB66 billion in supplementary funds has been deployed to support local governments and businesses, according to the Ministry of Finance; The authorities have delayed or partially waived taxes, social security fees, and government-owned rents for affected businesses; The government has instituted refunds of unemployment insurance premiums to enterprises who retain most employees in some cities; The central government will provide temporary interest rate relief (equivalent to 50% of the re-lending policy rate) on loans to key enterprises involved in the fight against the epidemic. However, stimulus in and of itself is not a sufficient condition on which to bet on a V-shaped recovery. Stimulus (or in the opposite scenario, tightening) does not always immediately entail an economic recovery (or on the flip side, a downturn). For one, policy stimuli always work with a time lag. In addition, the size of stimulus is still unknown. What’s more, the multiplier of the stimulus varies from cycle to cycle. Chart I-7Chinese Households Are Indebted Chinese Households Are Indebted Chinese Households Are Indebted We gauge the magnitude of any stimulus in China by observing money, credit and fiscal spending impulses. The multiplier is in turn contingent on economic agents’ (households and enterprises) propensity to spend. The impact of a large amount of stimulus can be offset by a low/falling marginal willingness to spend (a lower multiplier). Before the coronavirus outbreak, the marginal propensity to spend in China had improved slightly for households and had barely stabilized in the case of companies (Chart I-6). It is plausible to assume that a negative shock to confidence will likely dent both households’ and companies’ marginal propensity to consume. This is especially true since both economic agents are highly leveraged, as discussed above (Chart I-7). Finally, the leads and lags between the measures of stimulus like money impulses or credit and fiscal spending impulses and EM stocks in general and Chinese share prices in particular are not constant, as illustrated in Chart I-8 and Chart I-9. Chart I-8China: Share Prices And Money Impulse China: Share Prices And Money Impulse China: Share Prices And Money Impulse Chart I-9EM Stock Prices And China Credit And Fiscal Impulse EM Stock Prices And China Credit And Fiscal Impulse EM Stock Prices And China Credit And Fiscal Impulse   Bottom Line: Forthcoming stimulus is not a surefire guarantee of an immediate cyclical rally – neither for EM risk assets and currencies, nor for other China-related plays. This does not mean that a rally will not occur. Rather, gauging the timing and potential drawdown that precede it are almost impossible. The basis is that low and falling willingness among households to consume and among enterprises to invest and hire could overwhelm the positive boost from the stimulus. Unfortunately, forecasting changes in willingness to spend is not straightforward. Investment Strategy Chart I-10An Inconclusive Message From This Reliable Indicator An Inconclusive Message From This Reliable Indicator An Inconclusive Message From This Reliable Indicator We are currently neutral on EM stocks in absolute terms. We will be watching for market-based indicators to signal a breakout or breakdown and will adjust our strategy accordingly. One of our favorite indicators – the Risk-On /Safe-Haven currency ratio – is presently inconclusive (Chart I-10). Relative to DM, EM share prices broke to new lows last week as illustrated in Chart I-1 on page 1. We continue recommending an underweight position in EM within a global equity portfolio. Consistently, we are reiterating our long-standing short EM / long S&P 500 strategy. The US dollar’s technical profile is bullish (Chart I-11), which entails that its bull market is not yet over. We continue shorting an equally-weighted basket of BRL, CLP, COP, ZAR, KRW, IDR and PHP against the US dollar. We are also short the CNY versus the greenback on a structural basis. Within the EM currency space, we favor the MXN, RUB, CZK, THB and TWD. Finally, EM exchange rates hold the key to the performance of both EM local currency and US dollar bonds. Given our negative view on the currency, we are reluctant to chase the decline in domestic bond yields and narrowing spreads in the sovereign credit space (Chart I-12). Chart I-11The US Dollar Rally Is Intact The US Dollar Rally Is Intact The US Dollar Rally Is Intact Chart I-12EM: Local Bond Yields And Sovereign Spreads Are Too Low EM: Local Bond Yields And Sovereign Spreads Are Too Low EM: Local Bond Yields And Sovereign Spreads Are Too Low   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Turkey: Doubling Down On Unsound Policies Despite the steep drop in oil prices, Turkish stocks have failed to outperform the EM equity benchmark (Chart II-1). When a market fails to outperform amid a historically bullish backdrop, it is often a sign of trouble ahead. The basis for the decoupling between Turkey’s relative performance and oil prices is President Erdogan’s doubling down on populist and unorthodox macro policies. He is eager to boost growth at any cost. As a litmus test of aggressive expansionist policies, local currency broad money growth has already surged to 24% (Chart II-2). In brief, these overly expansionary policies will undermine the currency, lift inflation and lead to a further exodus of investors from the country’s financial markets. Chart II-1A Bearish Sign For Turkish Equities A Bearish Sign For Turkish Equities A Bearish Sign For Turkish Equities Chart II-2Turkey: Rampant Money Creation Turkey: Rampant Money Creation Turkey: Rampant Money Creation   Chart II-3Turkey: Booming Fiscal Spending Turkey: Booming Fiscal Spending Turkey: Booming Fiscal Spending First, the central bank has cut interest rates to below inflation. The outcome is negative policy rates in real terms. Moreover, the central bank has resumed plentiful liquidity provisioning to banks to prevent interbank rates from rising. Second, government expenditures are surging (Chart II-3). Ballooning government borrowing is largely being financed by commercial banks – i.e., the latter are involved in outright monetization of public debt (Chart II-4, top panel). Chart II-4Public Debt Monetization By Commercial Banks Public Debt Monetization By Commercial Banks Public Debt Monetization By Commercial Banks In the past two years, banks have purchased some TRY 250 billion of government bonds. This has boosted their share of holdings of government local currency bonds from 45% to 58% (Chart II-4, bottom panel). This has not only capped local bond yields, but also enormously expanded money supply. When a commercial bank purchases a bond from a non-bank entity, it creates a new deposit (broad money supply), as we discussed in November 29, 2018 report. The authorities have also announced tax cuts on various consumer goods in order to boost consumption. This is leading to a resurgence in consumer goods imports. In short, the trade balance is bound to widen again as domestic consumption resumes. Third, the government is forcing both state-owned and private banks to substantially boost credit flows to the economy. Last week, the AKP proposed a new banking bill that could force banks to fund large-scale projects. Further, the banking regulator is penalizing banks that fail to meet a “credit volume criteria’ by lowering the interest rate banks receive on their required reserves at the central bank. Crucially, the authorities are forcing banks to cut lending rates. Banks’ net interest rate margins have declined to all-time lows (Chart II-5). It will narrow further as they continue to cut lending rates, while holding deposit rates high to avoid flight from local currency deposits into US dollars. Banks, especially public ones, have dramatically accelerated their credit origination. This will lead to capital misallocation and potentially to non-performing loans (NPLs). On banks’ balance sheets, NPLs have been, and will remain, artificially suppressed. Neither banks nor regulators are incentivized to provision for potential loan losses.  Insolvent banks can operate indefinitely so long as their shareholders and regulators allow it, and the central bank provides sufficient liquidity. This will most certainly be the case in Turkey in the years to come. Constraints in such a scenario are surging inflation and currency devaluation. Turkish authorities have whole-heartedly opted for these lax fiscal, monetary and bank regulatory policies. This entails that inflation and currency devaluation are unavoidable. Overly expansionary policies will undermine the currency, lift inflation and lead to a further exodus of foreign investors from the country’s financial markets. Lastly, surging wages and unit labor costs corroborate that inflationary pressures are genuine and rampant (Chart II-6). The minimum wage is set to increase by another 15% this year. Chart II-5Banks' Net Interest Margins At All Time Lows Banks' Net Interest Margins At All Time Lows Banks' Net Interest Margins At All Time Lows Chart II-6Turkey: Wages Are Surging Turkey: Wages Are Surging Turkey: Wages Are Surging   The government has been trying to regulate prices in the consumer sector by putting administrative price caps in place. Yet inflation remains persistently high in both goods and services sectors. Investment Recommendation Chart II-7Excessive Stimulus Is Bearish For The Lira Excessive Stimulus Is Bearish For The Lira Excessive Stimulus Is Bearish For The Lira The Turkish lira is again on a precipice. Only government intervention can temporarily prevent a major down leg. We are reiterating our underweight call on Turkish stocks within an EM equity portfolio. As a new trade, we are recommending a short Turkish banks / long Russian banks position. In contrast to Turkey, Russia’s macro policies have been, and remain, extremely orthodox. The new Russian government is poised to boost fiscal stimulus and the economy will accelerate with low inflation. We will discuss Russia in next week’s report. Finally, a surging fiscal and credit impulse in Turkey often leads to higher inflation and downward pressure on the currency (Chart II-7). As such, local currency government yields offer little protection at these levels against a depreciating currency. Therefore, investors should underweight the Turkish currency, local fixed-income and sovereign credit relative to their respective EM benchmarks. Andrija Vesic Research Analyst andrijav@bcaresearch.com   Footnotes 1     We published A Primer On Liquidity on January 16, 2020 illustrating that the linkages from liquidity provisions by central banks and both increased spending in the real economy and higher asset prices are ambiguous. Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights The coronavirus is a real threat for the global economy and financial markets: We expect that the epidemic will be contained before it takes too much of a bite out of global output, but it has become the biggest market wild card. We are watching for a peak in new infections as a tell for when markets may move on from it. Earnings season was once again a ho-hum affair: S&P 500 earnings per share are on track to post 2% growth in 4Q19, about three percentage points above downwardly revised estimates. Profit margin contraction was in line with the previous three quarters. The biggest banks don’t see any immediate signs of credit problems, … : Net charge-off and non-performing loan ratios remain very low and the banks don’t see borrower performance worsening any time soon. … and think an uptick in business confidence is overdue: The banks’ calls occurred before the coronavirus broke out, but every management team saw the easing of trade tensions as a prelude to a pickup in corporate confidence. While We Were Out Chart 1Risk Off, Everywhere But Stocks Risk Off, Everywhere But Stocks Risk Off, Everywhere But Stocks We last published a Weekly Report on January 6th, and the ensuing five weeks have been anything but boring. The US assassinated Iran’s foremost military leader, escalating the two nations’ conflict; and the coronavirus burst forth in China’s ninth-largest city, sparking worldwide concerns. The VIX awakened, Treasury yields slid, crude oil swooned and the dollar surged, but the S&P 500 only declined 3% trough to peak, and now sits 2-3% above its January 6th close (Chart 1). The coronavirus is a significant threat to the global economy and global markets, and geopolitical tensions have escalated, but the underpinning of our market views has not changed. We continue to view monetary policy as the critical swing factor for financial markets and the macro cycles that influence them. Assuming the coronavirus or another exogenous event does not tip over the US economy, the next recession will not begin until monetary policy settings turn restrictive. Nothing that has happened since the beginning of year has changed our view that the Fed is almost certain not to hike rates before its November meeting, and we think it is unlikely that it will do so at all in 2020. As long as monetary policy remains accommodative, the economy will keep expanding, the equity bull market will roll on, and spread product will continue to generate excess returns over Treasuries and cash. When China Gets Locked Down It has long been said that when the US sneezes, the rest of the world catches a cold. Conversely, challenges in the rest of the world often fail to leave much of a mark on the US. Should US investors really be that concerned about a virus outbreak in China? The answer is yes, despite the S&P 500’s surge last week. There is no such thing as full-on decoupling, even for the US. The US may respond to global events with a longer lag than more export-oriented economies, but they eventually have an impact. Investors should bear in mind that the S&P 500 is considerably more attuned to global conditions than the domestic economy, given that more than a third of its revenues come from abroad. The coronavirus outbreak has turned into the main source of market uncertainty and is the largest risk to our bullish view on global growth and risk assets. For now, our base case is that the global growth recovery will be delayed, though we expect growth will pick up later this year, provided that the outbreak begins to recede by the end of March. That base case is heavily data-dependent, however, subject to the disease’s course and the Chinese government’s response. From a market perspective, tracking the number of new infections may provide a window on investor sentiment. In 2003, the bottom in equities coincided with the peak in the number of new SARS infections (Chart 2). However, a direct analogy between 2003 and 2020 may underplay the impact on growth. China exerts a lot more influence on the global economy than it did at the turn of the millennium (Table 1). A turn in investor sentiment may not be enough to support risk assets in the face of a significant growth headwind. Chart 2Infections Peak, Market Troughs Infections Peak, Market Troughs Infections Peak, Market Troughs Table 1China’s Importance Now And In 2003 Back To The Grind Back To The Grind Since it entered the World Trade Organization in 2001, China has grown from being the sixth-largest economy to the second, trailing only the US. It now accounts for 16% of global GDP in dollar terms. Its total imports of goods and services – the main growth transmission mechanism from China to the rest of the world – currently account for 13.5% of global trade, three times its 2002 share. The scale of the Chinese government response is also very different. While the SARS epidemic caused relatively mild disruptions to the travel and retail sectors, quarantines have put some areas in total lockdown, placing meaningful elements of the country’s overall production on indefinite hold. That’s bad enough from a domestic perspective, but it could swiftly lead to a sharp reduction in global manufacturing output if it derails global supply chains that depend on Chinese-produced components. Last week, Hyundai idled a production line in South Korea for lack of essential China-sourced parts, and Fiat Chrysler has warned that it might have to close a European factory in two to four weeks if critical Chinese suppliers are not able to operate. China exerts considerably more influence on the global economy today than it did in 2003.  Extended quarantines will have a readily observable impact. Chart 3Services Now Account For A Majority Of Chinese Output Services Now Account For A Majority Of Chinese Output Services Now Account For A Majority Of Chinese Output Moreover, this time around the outbreak coincided with the Lunar New Year celebration, when spending on services is usually elevated. Services engender less pent-up demand than durable goods; while demand for durables may merely be deferred until the epidemic is contained, demand for services is much more likely to be destroyed. Nonmanufacturing sectors’ increasing importance in the Chinese economy (Chart 3) implies that relative to 2003, less "lost" spending will be made up later. Using SARS’ impact on Chinese GDP to support a back-of-the-envelope estimate, our Global Investment Strategy colleagues judge that the coronavirus could zero out Chinese growth in the first quarter. Our Global Fixed Income Strategy service estimates that major country sovereign bonds are pricing in two months of lost Chinese growth. The prospect of a stagnant two to three months could well force policymakers to focus exclusively on encouraging growth. They have already signaled they will pull forward some scheduled infrastructure investments, and our China strategists note that 2020 is policymakers’ deadline for meeting their target to double GDP over the decade. Bottom Line: The coronavirus outbreak is a serious threat to the global economy and financial markets, but we do not expect that it will induce a US recession or S&P 500 bear market. The Same Old Earnings Song-And-Dance Chart 4A Typical Quarter Back To The Grind Back To The Grind With 305 of the companies in the S&P 500 having reported earnings through last Thursday’s open, the fourth quarter appears to be nearly exactly like the first three quarters. Earnings growth was nothing to write home about, but it’s tracking to be a few percentage points better than expected when the big banks kicked off reporting season (Chart 4). Revenue growth continues to be in step with nominal global GDP growth, but profit margins are contracting at about the same rate that they did in the first three quarters (Chart 5). The source of the margin contraction remains a mystery, and unraveling it is near the top of our research to-do list. Chart 5The Incredible Shrinking Profit Margin Back To The Grind Back To The Grind Earnings don't matter much in the near term, but they've been good enough to allay the undercurrent of worry that was a prominent feature of the equity market all of last year. We have previously written about earnings’ limited effect on equity prices.1 In the near term, moves in the S&P 500 exhibit little to no correlation with either earnings growth or the magnitude of earnings beats. Earnings do matter in the long term, and the uneventful 4Q19 reports at least suggest that stocks give no indication of falling off their currently projected path. As has been the case throughout 2019, the bears’ worst fears failed to come to pass in the fourth quarter. Once the coronavirus is contained, accommodative monetary conditions should help keep them at bay in 2020, as well. Follow The Money The big banks reported their fourth quarter earnings in mid-January, and the market reaction suggested their torrid fourth quarter run has fully played out, at least until long yields perk up again. Our review of their earnings calls is not meant to tell us anything about bank stocks, however. We review the calls to gain some insight into the lending market and where it might be headed, seeking color on banks’ willingness to lend, consumers’ and businesses’ appetite for credit, borrower performance, and the banks’ bottom-up perspective on the economy. This time around, we also wanted to hear if the brand-new CECL (Current Expected Credit Loss) loan-loss provisioning standard could constrain lending. 4Q19 Big Bank Beige Book As a group, the banks were constructive on the economy.2 They agree that the consumer is in fine fettle, and they see signs that corporate confidence is returning as trade tensions recede. Overall loan growth has dipped to 4% on a year-over-year basis (Chart 6), while corporate and industrial (C&I) loan growth has contracted on a thirteen-week basis (Chart 7). The C&I contraction is not a sign that corporations are circling the wagons, however, it’s simply that they’ve turned to the corporate bond market instead (Chart 8). Businesses seeking credit generally have access to all they want at tight spreads, given the paucity of yield in the ZIRP/NIRP era. Chart 6Overall Bank Lending Is Decelerating, ... Overall Bank Lending Is Decelerating, ... Overall Bank Lending Is Decelerating, ... Chart 7... And C&I Lending Is Contracting, ... ... And C&I Lending Is Contracting, ... ... And C&I Lending Is Contracting, ... Chart 8... But The Bond Market Is Capable Of Picking Up The Slack ... But The Bond Market Is Capable Of Picking Up The Slack ... But The Bond Market Is Capable Of Picking Up The Slack Positive operating leverage was a mantra that all of the management teams recited. Branch footprints are being rationalized, and the biggest banks are successfully automating manual tasks and driving mundane activity to websites and apps and away from branches and ATMs. Shrinking branch counts could intensify the pressure at the margin for retail landlords, and automation could squeeze bank head counts. Every bank grew deposits faster than loans, furnishing them with dry powder for future lending, and padding their holdings of Treasury and agency securities in the meantime. Households And Businesses [S]entiment on the corporate side appears to be looking better. We’re going to be signing [the Phase I] trade agreement with China today, … and the US-Mexico-Canada agreement is well on its way. So I think that some of that uncertainty that might have been impacting discretionary spend on the commercial side of the equation has been alleviated. [W]e feel pretty good. (Dolan, USB CFO) Every bank cited trade tensions as a drag on corporate confidence last year, and pointed to USMCA and the Phase 1 agreement with China as a sign that it will rebound. [T]he US consumer remains in very strong shape, … from a credit perspective, sentiment, [and] spending, [and] obviously [the] labor market is very strong[.] [C]apital spending is still a bit soft, but sentiment is … certainly better than it was six months ago. [B]roadly speaking, [we have a] constructive outlook as we’re heading into 2020[.] (Piepszak, JPM CFO) [T]hroughout the year, we saw … a lot of things out there that [were] driving uncertainty, be it the lack of the China trade deal, USMCA, Brexit, Hong Kong and … now … the horizon looks like some of those things may clear[,] … and we [may] get a bit more action out of the C-suite. [T]he [capital markets] backlog looks pretty good[,] … [a]nd the forward calendar [does, too]. (Corbat, C CEO) [C]ustomers [in our consumer business] are coming off a strong [spending] finish in 2019. In addition, there’s good loan demand, … result[ing] from good employment levels and growing wages. We saw solid loan demand in our commercial client base throughout the year, [though it] moderated in the second half of the year as worries about global economic uncertainty … dragged on. Today we see some resolution of those issues and that combined with continued consumer strength leads us to expect to see businesses continue their solid activity and we’re hearing more optimism. All this provides a great backdrop[.] (Moynihan, BAC CEO) Borrower Performance Overall credit quality indicators in our commercial portfolio remained strong with our fourth quarter internal credit grades at their strongest levels in two years. Non-accrual loans … in the fourth quarter [were at] their lowest level in over ten years. (Shrewsberry, WFC CFO) [Credit quality metrics] show … that asset quality remained strong in [consumer and commercial] categories. (Donofrio, BAC CFO) [C]redit quality was stable in the fourth quarter. … The ratio of non-performing assets … improved linked quarter and year-over-year. (Dolan, USB) [CLO is] still an asset class that we feel comfortable with the risk/reward … in spite of where we are in the cycle[.] (Shrewsberry, WFC) [There’s nothing] we’re overly concerned about [in our own loan portfolio], given how [conservatively] we manage [lending], but we’re certainly paying attention to leveraged lending. We’re certainly paying attention to energy with respect to natural gas prices, we’re certainly looking at retail … malls. (Donofrio, BAC) CECL Impacts We would expect provisions to be a little higher than net charge-offs in 2020 due to CECL. … All else equal, [the new increased provision] would lower our Common Equity Tier 1 capital ratio by roughly 20 basis points[, but we have a sizable capital buffer, and the capital charge] is phased in … evenly through 2023. (Donofrio, BAC CFO) [I]t’s fair to say, under CECL, [that] you could have incremental volatility [of provisioning expenses]. [But] incremental volatility would [not] be material for us. … It’s just timing [of expense recognition, not any increase in expenses.] (Piepszak, JPM) [A]t this point, it’s not likely that [CECL would] change our appetite for longer-duration consumer loans[.] … [I]t hasn’t caused anything to drop below a hurdle level that says to us, we need to either meaningfully reprice it or … [consider] whether [we want to be] in the business. (Shrewsberry, WFC) Investment Implications Chart 9US Data Have Also Weighed On Yields US Data Have Also Weighed On Yields US Data Have Also Weighed On Yields The coronavirus outbreak is a serious threat, but its very seriousness is likely to provoke Chinese policy responses that may better ensure a turnaround once it can be brought under control. Our view is subject to the real-time course of events on the ground, but our base case is that the business cycle and the bull markets in risk assets remain intact, even if they may sputter here and there until the epidemic is brought to heel. While we acknowledge that economic data have been spotty, and the decline in Treasury yields has not solely been a function of coronavirus fears (Chart 9), we think that yields are near the bottom of their likely 2020 range and have more scope to rise than fall from current levels. We continue to recommend below-benchmark duration positioning. We also continue to recommend that investors remain at least equal weight equities in balanced portfolios and at least equal weight spread product within bond portfolios. We would relish the chance to buy an S&P 500 dip to 3,000 if it were to occur when the coronavirus threat appeared to be manageable.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Jennifer Lacombe Senior Analyst JenniferL@bcaresearch.com Footnotes 1 Please see the November 11, 2019 US Investment Strategy Weekly Report, "Why Bother With Earnings?" available at usis.bcaresearch.com. 2 The calls were all held before the coronavirus outbreak.

Highlights Malaysian businesses and households have been deleveraging and the economy risks entering a debt deflation spiral. This macro-backdrop is bond bullish. EM fixed income-dedicated investors should keep an overweight position in both local currency and US dollar government bonds. In Peru, the central bank does not want its currency to depreciate rapidly; it will therefore defend the sol at the cost of slower economic growth. The outperformance of the Peruvian sol heralds an overweight stance in domestic and US dollar government bonds versus EM peers. Malaysia: In Deleveraging Mode Malaysian businesses and households have been deleveraging. The top panel of Chart I-1 illustrates that commercial banks’ domestic claims on the private sector – both companies and households – relative to nominal GDP have been flat to down in recent years. This measure is produced by the central bank and includes both bank loans as well as securities held by banks (Chart I-1, bottom panel). It does not include borrowing from non-banks or external borrowing. Other measures of indebtedness from the Bank of International Settlements (BIS) – which includes non-bank credit as well as foreign currency borrowing – portend similar dynamics: Household and corporate debt seem to have topped out as a share of GDP (Chart I-2). Chart I-1Malaysian Banks' Claims On The Private Sector Have Rolled Over Malaysian Banks' Claims On The Private Sector Have Rolled Over Malaysian Banks' Claims On The Private Sector Have Rolled Over Chart I-2Malaysia's Business And Household Total Leverage Has Peaked Malaysia's Business And Household Total Leverage Has Peaked Malaysia's Business And Household Total Leverage Has Peaked   Chart I-3Malaysia: The GDP Deflator Is About To Turn Negative Malaysia: The GDP Deflator Is About To Turn Negative Malaysia: The GDP Deflator Is About To Turn Negative The message is that after years of an unrelenting credit boom, households’ and companies’ appetite for new borrowing has diminished, and at the same time, creditors have become less willing to finance them.  At 136% of GDP, the combined total of household and company debt is non-trivial. If deleveraging among debtors intensifies, the economy risks entering a debt deflation spiral. To prevent such an ominous outcome, aggressive central bank rate cuts, sizable fiscal stimulus, some currency devaluation or a combination of all of the above is required. Not only is real growth very sluggish in Malaysia, but deflationary pressures are intensifying. Chart I-3 shows the GDP deflator is flirting with contraction. Moreover, headline and core consumer price inflation are both weak, while trimmed-mean inflation is at 1.1% (Chart I-4). Last year's spike in consumer inflation was due to low base effects from the abolishment of the country’s goods and services tax back in June 2018. Going forward, these base effects will dissipate, making deflation in consumer prices a likely threat. If prices or wages begin deflating, the highly-indebted Malaysian economy will fall into debt deflation. The latter is a phenomenon that occurs when falling level of prices and wages cause the real value of debt to rise. In such a case, demand for credit will plummet and banks could become unwilling to lend. A vicious cycle of further falling prices, income and credit retrenchment could grip the economy. Household and corporate debt seem to have topped out as a share of GDP. Nominal GDP growth has already dropped slightly below average lending rates (Chart I-5). When such a phenomenon occurs amid elevated debt levels, it can produce a lethal cocktail – namely, the debt-servicing ability of borrowers deteriorates, causing both demand for credit to evaporate and non-performing loans (NPLs) to rise. Chart I-4Malaysia: Consumer Price Inflation Is Very Low Malaysia: Consumer Price Inflation Is Very Low Malaysia: Consumer Price Inflation Is Very Low Chart I-5Malaysia: Nominal GDP Growth Dipped Below Lending Rates Malaysia: Nominal GDP Growth Dipped Below Lending Rates Malaysia: Nominal GDP Growth Dipped Below Lending Rates   Critically, falling inflation has caused real borrowing costs to rise. Lending rates in real terms are elevated, from a historical perspective (Chart I-6, top panel).1 Not surprisingly, loan growth has been decelerating sharply, posting a 13-year low (Chart I-6, bottom panel). Even though government expenditure growth has been accelerating over the past year or so and the central bank has cut interest rates twice in the past 8 months, economic conditions remain extremely feeble: Consumer spending has been teetering. Chart I-7 shows that retail sales are dwindling in nominal terms and have plummeted in volume terms. Chart I-6Malaysia: Real Lending Rates Have Risen & Credit Has Slowed Malaysia: Real Lending Rates Have Risen & Credit Has Slowed Malaysia: Real Lending Rates Have Risen & Credit Has Slowed Chart I-7Malaysia: Consumer Spending Is Teetering Malaysia: Consumer Spending Is Teetering Malaysia: Consumer Spending Is Teetering   Malaysian exports – which account for a 67% share of the economy – are still contracting 2.5% from a year ago, adding an additional unwelcome layer of deflation to the Malaysian economy. After years of travails, the property sector is not yet out of the woods. Residential property unit sales remain sluggish (Chart I-8, top panel). In turn, the number of unsold residential properties remains elevated and residential construction approvals are rolling over at lower levels (Chart I-8, second & third panels). As a result, residential property prices are beginning to deflate across various segments in nominal terms (Chart I-8, bottom panel). Listed companies’ earnings-per-share (EPS) in local currency terms are contracting (Chart I-9, top panel). Chart I-8Malaysia's Residential Property Market Is Struggling Malaysia's Residential Property Market Is Struggling Malaysia's Residential Property Market Is Struggling Chart I-9Malaysia: Capital Spending Is Contracting Malaysia: Capital Spending Is Contracting Malaysia: Capital Spending Is Contracting Chart I-10Malaysia: Weak Employment Outlook Malaysia: Weak Employment Outlook Malaysia: Weak Employment Outlook All of these ominous trends have induced Malaysian businesses to cut capital spending. The bottom three panels of Chart I-9 illustrate that real gross capital goods formation, capital goods imports and commercial vehicles units sales are all contracting. Equally important, the business sector slowdown is weighing on the employment outlook (Chart I-10). This will trigger a negative feedback loop of falling household income and spending. Bottom Line: Only by bringing borrowing costs down considerably for households and businesses and introducing large fiscal stimulus measures, can the Malaysian authorities prevent the economy from slipping into a vicious debt deflation spiral. On the fiscal front, the Malaysian government is committed to reducing its overall fiscal deficit from 3.4% to 3.2% of GDP this year, further consolidating it to 2.8% of GDP by 2021. Importantly, the government is also adamant about lowering its total public debt-to-GDP ratio from 77% to below 50% in the medium term by ridding itself of the outstanding legacy liabilities and guarantees incurred by the previous government. This leaves monetary policy and some currency depreciation as the likely levers to reflate the economy. Investment Recommendations We continue to recommend EM fixed -income dedicated investors keep an overweight position in local currency bonds within an EM local currency bonds portfolio. Malaysia’s macro-backdrop is bond bullish, and the central bank will cut its policy rate further. Consumer spending has been teetering. Consistent with further rate cut expectations, we also recommend continuing to receive 2-year swap rates. We initiated this trade on October 31, 2019, and it has so far produced a profit of 29 basis points. Furthermore, fiscal discipline and the government’s resolve to reduce public debt and government liabilities as a share of GDP will help Malaysian sovereign credit – US dollar-denominated government bonds – outperform their EM peers. Chart I-11The Malaysian Ringgit Is Cheap The Malaysian Ringgit Is Cheap The Malaysian Ringgit Is Cheap We recommend keeping a neutral allocation to Malaysian equities within an EM equity dedicated portfolio. In terms of the outlook for the currency, ongoing deflationary pressures are bearish for the MYR in the short-term. The basis is that the Malaysian economy needs a cheaper ringgit in order to help reflate the economy and boost exports. However, the Malaysian currency will sell off less than other EM currencies: First, foreign ownership of local bonds has declined from 36% in 2016-17 to 23% today. Likewise, foreign equity portfolios own about 31% of the stock market, which is less than in many other EMs. This has occurred because foreigners have been major net sellers of Malaysian equities. Overall, low foreign ownership of Malaysian financial assets reduces the risk of sudden portfolio outflows in case EM investors pull out en masse. Second, the current account balance is in surplus and will provide support for the Malaysian ringgit. Malaysia has become less reliant on commodities exports and more of a semiconductor exporter. We are less negative on the latter sector than on resources prices. Third, the currency is cheap, according to the real effective exchange rate, making further downside limited (Chart I-11). Finally, the ongoing purge in the Malaysian economy – deleveraging and deflation – is ultimately long-term bullish for the currency. Deflation brings down the cost structure of the economy and precludes the need for chronic currency depreciation in order to keep the economy competitive. All things considered, the risk-reward profile for shorting the MYR is no longer appealing. We are therefore closing this trade as of today. It has produced a 4% loss since its initiation on July 20, 2016.   Ayman Kawtharani Editor/Strategist ayman@bcaresearch.com Peru: A Pending Policy Dilemma Investors in Peruvian financial markets are presently facing three challenging macro issues: Will the currency appreciate or depreciate? If it depreciates, will the central bank cut or hike interest rates? If policy rates drop or rise, will bank stocks rally or sell off? Chart II-1Peru: Slow Money Growth Heralds Lower Inflation Peru: Slow Money Growth Heralds Lower Inflation Peru: Slow Money Growth Heralds Lower Inflation Looking forward, the central bank (also known as the BCRP) is facing a dilemma. On one hand, inflation is low and will likely drop toward the lower end of the central bank’s target band, as portrayed by narrow money (M1) growth (Chart II-1). Weak domestic demand and low and falling inflation – combined – justify additional rate cuts. On the other hand, the Peruvian currency – like most EM currencies – will likely depreciate versus the US dollar in the coming months, if our baseline view – that foreign capital will flow out of EM and industrial metals prices will drop further for a few months – transpires. In such a case, will the BCRP cut rates – i.e., will the monetary authorities choose to target the exchange rate, or inflation? If the Peruvian central bank follows its own historical footsteps, it will not cut rates, despite economic weakness and falling inflation. On the contrary, the BCRP will likely prioritize defending the nuevo sol by selling foreign currency reserves, as it has done in the past. This in turn will shrink banking system local currency liquidity and lift interbank rates (Chart II-2). Higher interbank rates will hurt the real economy as well as bank share prices. Chart II-2Peru: Selling BCRP FX Reserves Will Shrink Banking System Liquidity Peruvian Local Rates Have Risen Peru: Selling BCRP FX Reserves Will Shrink Banking System Liquidity Peruvian Local Rates Have Risen Peru: Selling BCRP FX Reserves Will Shrink Banking System Liquidity Is Peru more leveraged to precious or industrial metals? Precious and industrial metals account for 17% and 40% of Peruvian exports, respectively. Hence, falling industrial metals prices will be sufficient to exert meaningful depreciation on the sol, despite high precious metals prices. Foreign investors own about 50% of both Peruvian stocks and local currency bonds. Even if a fraction of these foreign holdings flees, the exchange rate will come under significant downward pressure.  Granted that Peru’s central bank does not want its currency to depreciate rapidly, it will defend the currency at the cost of the economy. All in all, the Impossible Trinity thesis is alive and well in Peru: In an economy with an open capital account, the central bank cannot target both interest rates and the exchange rate simultaneously. If the BCRP intends to achieve exchange rate stability, it needs to tolerate interest rate fluctuations. Specifically, interbank rates and other market-determined interest rates could diverge from policy rates. From a real economy perspective, it is optimal to target interest rates and allow the exchange rate to fluctuate. However, the Peruvian economy is still dollarized, albeit much less than before. Dollarization has been a motive to sustain exchange rate stability. If the Peruvian central bank follows its own historical footsteps, it will not cut rates, despite economic weakness and falling inflation. On the whole, Peru’s monetary authorities remain very mindful of exchange rate volatility. Odds are that they will sacrifice growth to avoid sharp currency fluctuations. This has ramifications for financial markets. The Peruvian sol will depreciate much less than other EM and Latin American currencies. This is why it is not in our basket of currency shorts. The central bank will not cut rates in the near term, even though the economy is weak and inflation is low. This is negative for the cyclical economic outlook. Growth will stumble further and non-performing loans (NPLs) in the banking system will rise. NPL growth (inverted) correlates with bank share prices (Chart II-3). Notably, the business cycle is already weak, as illustrated in Chart II-4. Higher interest rates and lower industrial metals prices will weigh further on the economy. Chart II-3Peru: Rising NPLs Will Depress Banks Share Prices Peru: Rising NPLs Will Depress Banks Share Prices Peru: Rising NPLs Will Depress Banks Share Prices Chart II-4Peru: The Economy Is Weak Peru: The Economy Is Weak Peru: The Economy Is Weak   Remarkably, local currency private sector loan growth has moderated, despite the 140 basis points decline in interbank rates over the past 12 months (Chart II-5). This indicates that either interest rates are too high, or banks are reluctant to originate more loans – or a combination of both. Whatever the reason, bank loan growth will decelerate further if interest rates do not drop. Investment Recommendations The Peruvian stock market has underperformed the aggregate EM index over the past five months (Chart II-6, top panel). This underperformance has not only been due to this bourse’s large weight in mining stocks but also because of banks’ underperformance (Chart II-6, bottom panel). Chart II-5Peru: Higher Rates Will Hinder Credit Growth Peru: Higher Rates Will Hinder Credit Growth Peru: Higher Rates Will Hinder Credit Growth Chart II-6Peruvian Equities Have Been Underperforming Peruvian Equities Have Been Underperforming Peruvian Equities Have Been Underperforming   Remarkably, bank shares have languished in absolute terms, even though their funding costs – interbank rates – have dropped significantly (Chart II-7). This is a definitive departure from their past relationship. Chart II-7Peruvian Bank Stocks Stagnated Despite Falling Interest Rates Peruvian Bank Stocks Stagnated Despite Falling Interest Rates Peruvian Bank Stocks Stagnated Despite Falling Interest Rates As interbank rates rise marginally, bank share prices will be at risk of selling off. This in tandem with lower industrial metals prices warrants a cautious stance on this bourse’s absolute performance. Relative to the EM benchmark, we remain neutral on Peruvian equities. The Peruvian sol will depreciate less than many other EM currencies, which will help the stock market’s relative performance versus the EM benchmark. Currency outperformance heralds an overweight stance in domestic bonds within the EM local currency bond portfolio. Dedicated EM credit portfolios should overweight Peruvian sovereign and corporate credit as well. The key attraction is that Peru’s debt levels are low, which will make its credit market a low-beta defensive one in the event of a sell off.   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Juan Egaña Research Associate juane@bcaresearch.com Footnotes 1 Deflated by the average of (1) the GDP deflator, (2) core consumer price inflation, and (3) 25% trimmed-mean consumer price inflation.   Equities Recommendations Currencies, Credit And Fixed-Income Recommendations