Bear/Bull Market

Highlights Chinese stocks are still in the “public participation phase” of a cyclical bull market and have not yet reached the “excess phase.” Economic fundamentals should provide support for more upside in Chinese stock prices in the next 6 to 12 months. Even if Chinese stocks evolve into a boom-bust cycle reminiscent of 2014-15, near-term technical price corrections should provide good buying opportunities. We remain overweight Chinese equities in both absolute and relative terms, and recommend investors increase their exposure to beaten-down cyclically-geared stocks, particularly in China’s domestic market.  Feature Chinese stocks rallied by 15% and 13% in the onshore and offshore markets, respectively, in the first 10 days of July. However, both markets gave up almost half of their gains in the third week of the month. The above-expectation Q2 GDP growth figure, which was released last Thursday, only exacerbated the market selloffs. This month’s rollercoaster ride in Chinese equities reminds investors of the boom-bust stock market cycle in 2014-2015, and raises the inevitable question: is it too late to buy or is it too early to sell Chinese stocks? We believe Chinese stocks are still at an early stage of a cyclical bull market.  While the recent near-vertical escalation in equity prices was clearly overdone, any near-term technical corrections will provide good buying opportunities. Three Phases Of A Bull Market Chinese bull markets typically last 2-2.5 years and involve three phases.1 The length and boundaries of each phase in a bull run are often blurred and are best identified in hindsight. However, this framework helps put the ongoing market rally in both A shares and investable stocks into perspective. In our view, the A share market is currently in the early stage of the “public participation phase”, whereas investable stocks seem to be halfway through (Chart 1A and 1B). Chart 1AA Shares In Early Stage Of The “Public Participation Phase (PPP)” A Shares In Early Stage Of The "Public Participation Phase (PPP)" A Shares In Early Stage Of The "Public Participation Phase (PPP)" Chart 1BChinese Investable Shares May Be Halfway Through PPP Chinese Investable Shares May Be Halfway Through PPP Chinese Investable Shares May Be Halfway Through PPP We think that the current bull market started in January 2019, following a bear market from 2016 to 2018. We upgraded Chinese stocks from neutral to cyclically overweight in April 2019, which was a couple of months into the “accumulation phase” of the bull market underway. The accumulation phase is the start of an uptrend, typically after a bear market, when smart money begins to buy stocks; fundamentals still look bleak and valuations are at exceptionally depressed levels. Chart 2China’s Economy Should Be On Track To A Cyclical Upturn Chinese Stocks: Stay Invested Chinese Stocks: Stay Invested The public participation phase typically exhibits a massive increase in trading volumes and explosive growth in new investor accounts. This phase begins when the market is already off the bottom and negative sentiment begins to wane on signs of economic improvement (Chart 2). As the bull trend is clearly established, technical and trend traders also begin to pile in, generating a self-feeding cycle. The market begins to feel overheated, making value investors uncomfortable, but valuations are not yet extreme (Chart 3). This phase tends to last longer than the other two stages in a bull market primary trend. The expansion of multiples remains the dominant driver for the broad market while earnings struggle (Chart 4). Chart 3Valuations In A Shares Are Not Too Extreme Valuations In A Shares Are Not Too Extreme Valuations In A Shares Are Not Too Extreme For investable shares, we believe that the bull market is probably more than halfway through the public participation phase (Chart 5). The market has decisively broken out of its key technical resistance and entered into expensive territory (Chart 6). Still, neither A-share nor investable markets seem to be in the “excess phase” as witnessed in 2015 (Table 1). Chart 4Market Returns Between Multiples And Earnings Growth: Chinese A Shares Market Returns Between Multiples And Earnings Growth: Chinese A Shares Market Returns Between Multiples And Earnings Growth: Chinese A Shares Chart 5Market Returns Between Multiples And Earnings Growth: Chinese Investable Shares Market Returns Between Multiples And Earnings Growth: Chinese Investable Shares Market Returns Between Multiples And Earnings Growth: Chinese Investable Shares Chart 6Valuations In Chinese Investable Shares Are Becoming Expensive, But Not Too Stretched Valuations In Chinese Investable Shares Are Becoming Expensive, But Not Too Stretched Valuations In Chinese Investable Shares Are Becoming Expensive, But Not Too Stretched Table 1Multiples In Chinese Stocks Are Not Yet In The “Excess Phase” Chinese Stocks: Stay Invested Chinese Stocks: Stay Invested China's short and volatile stock market history provides some classic examples of equity boom-bust cycles. The massive bull market in Chinese A shares between 2013 and 2016 fits the three phases perfectly: stock prices jumped by a whopping 93% in the three phases of the bull market between early 2013 and May 2015. The bull market eventually marched onto the excess phase in the first half of 2015 and reached the ultimate top in May 2015 with a trailing P/E of 25 and price-to-book of over 3. Bottom Line: Both the A-share and investable bourses still have room for upside in the ongoing bull market. Remain overweight on both investable and domestic shares, but domestic stocks have more latitude for rally as China’s economy and earnings continue to recover. Pullbacks Not Enough To Turn Bearish On July 1 we upgraded our tactical (0 to 3 months) call on Chinese stocks and initiated long Chinese domestic and investable stock trades relative to global benchmarks. While it is impossible to predict whether the current market will supercharge into a boom-bust cycle as seen in 2014-15, we intend to keep the trades given our conviction that cyclically there is still upside to Chinese stock prices. To turn cyclically bearish on Chinese shares, the following conditions need to develop: First, the broad market should reach an overvalued extreme, at which point gravity would set in. Some sectors and small-cap names, particularly in the ChiNext board, are currently stretched (Chart 7).  However, overall market valuations still appear reasonable, based on our composite valuation indicator. Historically, major peaks in the market occurred when the valuation indicator reached much higher levels. Further, cyclically-adjusted equity risk premiums (ERPs) in both Chinese onshore and offshore stocks are materially higher than their historical means (Chart 8). This suggests investors have already priced in extremely high uncertainties surrounding the Chinese economy. Perhaps overdone, in our view. As China's economy continues to recover, their ERPs should shrink, pushing stock prices higher. Chart 7A Structural Bull Run In Chinese Tech Stocks A Structural Bull Run In Chinese Tech Stocks A Structural Bull Run In Chinese Tech Stocks Chart 8Equity Risk Premium In Chinese Stocks Are Extremely High And Will Likely Shrink, Pushing Stock Prices Higher Equity Risk Premium In Chinese Stocks Are Extremely High And Will Likely Shrink, Pushing Stock Prices Higher Equity Risk Premium In Chinese Stocks Are Extremely High And Will Likely Shrink, Pushing Stock Prices Higher   Secondly, liquidity should tighten. An important liquidity source is margin lending, which has gone up exponentially since late June and invited regulatory attention (Chart 9). Instead of waiting for overleverage in the market to form a momentum like in the 2014 cycle, Chinese regulators seem to be more vigilant and restrictive this time. By acting early and removing some steam from recent market velocity, a healthier secular bull market can develop.   China’s overall monetary conditions are another important source of liquidity. If the policy stance turns from easing to tightening before the economy fully recovers, then it will lead to a compression in multiples in the equity market before stock prices can gain support from an earnings recovery. Historically, Chinese authorities tend to maintain an easing stance for at least three quarters following a nadir in the economy (Chart 10). The track record of Chinese policymakers suggests that the PBoC will likely keep monetary policy accommodative through the end of this year. Chart 9Chinese Authorities Have Been Cracking Down On Overleverage Early In This Bull Run Chinese Authorities Have Been Cracking Down On Overleverage Early In This Bull Run Chinese Authorities Have Been Cracking Down On Overleverage Early In This Bull Run Chart 10Easy Policy Should Sustain Through End Of 2020 Easy Policy Should Sustain Through End Of 2020 Easy Policy Should Sustain Through End Of 2020 Finally, the economy should weaken significantly, which would elevate the equity risk premium and threaten the earnings outlook. A second wave of COVID-19 would have to be severe enough to substantially impact China’s economic recovery, however, the pandemic situation in China seems to be contained and earnings recovery is on course (Chart 11, 12A, 12B, and 12C). Additionally, a major pandemic-triggered shock would only force Chinese authorities to up their ante on reflation and revive domestic demand, which could benefit stocks. Chart 11COVID-19 Virus Spread Has Been Largely Contained Within China COVID-19 Virus Spread Has Been Largely Contained Within China COVID-19 Virus Spread Has Been Largely Contained Within China Chart 12AA Share Prices Are Not Too Far Ahead Of Earnings Recovery A Share Prices Are Not Too Far Ahead Of Earnings Recovery A Share Prices Are Not Too Far Ahead Of Earnings Recovery Bottom Line: Chinese equities will likely experience technical corrections in the near term, but the downside risks are not enough to turn bearish.   Chart 12BChinese Investable Stock Prices Seem A Bit Ahead Of Its Own Historical Performance… Chinese Investable Stock Prices Seem A Bit Ahead Of Its Own Historical Performance... Chinese Investable Stock Prices Seem A Bit Ahead Of Its Own Historical Performance... Chart 12C…But Still Not Too Expensive Compared With Global Benchmarks ...But Still Not Too Expensive Compared With Global Benchmarks ...But Still Not Too Expensive Compared With Global Benchmarks Investment Conclusions Regardless of the direction of Chinese stocks in absolute terms, we recommend investors overweight equities within a global equity portfolio (Chart 13). Investors should also tilt their exposure to battered cyclicals, particularly in China’s domestic stock market (Chart 14). We favor consumer discretionary, materials and industrials in the next 6 to 12 months. Chart 13We Remain Overweight On Chinese Stocks We Remain Overweight On Chinese Stocks We Remain Overweight On Chinese Stocks Chart 14Cyclical Stocks Are Likely To Prevail Over Defensives Cyclical Stocks Are Likely To Prevail Over Defensives Cyclical Stocks Are Likely To Prevail Over Defensives Chinese equity prices have run ahead of economic fundamentals and setbacks will be likely in the near term. Still, these setbacks are buying opportunities and we recommend buying on the dip if Chinese equities, in either onshore or offshore markets, were to fall by 5% to 10% from current levels. However, consecutive selloffs accumulating to a 15% or greater fall in Chinese stock prices within a short period of time (e.g. 2 to 3 weeks) would prompt us to close our long Chinese equity trades. Historically, when the prices of Chinese equities fell by such a magnitude, the selloffs tended to trigger panic among China’s massive retail investors and, in turn, form a self-reinforcing downward spiral and push Chinese stocks into a prolonged bear market (Chart 15). Chart 15Oversized Selloffs Historically Tend To Push Chinese Stocks Into Prolonged Bear Markets Oversized Selloffs Historically Tend To Push Chinese Stocks Into Prolonged Bear Markets Oversized Selloffs Historically Tend To Push Chinese Stocks Into Prolonged Bear Markets   Jing Sima China Strategist jings@bcaresearch.com   Footnotes 1    Please see China Investment Strategy Weekly Report "Three Phases Of A Bull Market," dated April 22, 2015, available at cis.bcaresearch.com   Cyclical Investment Stance Equity Sector Recommendations

Highlights A clear U-turn in markets could make investors more conscious of losses, making them likely to sell. Hence, the fear-of-missing-out (FOMO) rally could turn into a fear-of-losing-out, or FOLO selloff. The P/E ratio is negatively correlated to the discount rate and the latter is the sum of the risk-free rate and the equity risk premium (ERP). Enormous lingering uncertainty warrants using an ERP that is at the upper end of its historical range.  By using the average equity risk premium in their equity valuation models, investors are underpricing risks that are presently exceptionally high. Several market-based indicators and technical configurations point to a relapse in the global equity rally and renewed US dollar strength. Feature For some time, we have been arguing that the global equity advance since late March can best be described as a fear-of-missing-out, or FOMO, rally. During a FOMO rally, investors are forced to chase share prices higher due to fear of missing out on gains. A clear U-turn in markets and falling share prices could make investors more conscious of losses, and they would likely resort to selling stocks. This will turn the FOMO rally into a fear-of-losing-out, or FOLO, selloff. Marginal investors trade with momentum during both FOMO and FOLO scenarios. This is why we argued in our June 18 note that current investment strategies should be placing more emphasis on momentum than would normally be the case. In a nutshell, if FOMO forces subside, investors – which are facing enormous uncertainty on several fronts – will likely require higher risk premiums to commit money to stocks. For now, the momentum of the equity rally has stalled, but it has not yet reversed (Chart I-1). Our momentum indicator for global share prices is struggling to break above the zero line. In the past, the indicator being above or below zero often differentiated bull versus bear markets, respectively (Chart I-1, bottom panel). Chart I-1Global Share Prices Are Facing An Important Resistance Global Share Prices Are Facing An Important Resistance Global Share Prices Are Facing An Important Resistance In this report, we examine the bullish narrative behind the rally and offer our interpretation of those arguments. Then, we present our assessment of the fundamentals. Finally, we highlight the signs we are looking for to confirm that a major selloff will soon occur. The Bull Case: Climbing A Wall Of Worries? The bull case rests on the thesis that risk assets are climbing a wall of worries, i.e., investors are correct to look through many apparent negatives. The following are the key bullish arguments that have supported the rally: Policymakers around the world will do whatever it takes. The US, China and Europe will continue to augment stimulus to prevent another relapse in economic activity. We have never doubted the willingness of policymakers around the world to provide stimulus to their economies amid the pandemic. Where we have had reservations and questions is in whether policymakers will be capable of limiting the bear market in stocks to only one month amid the pandemic and the worst global recession in decades. There is plenty of cash on the sidelines looking to be invested. We agree with the lots-of-cash-on-the-sidelines thesis. Our measure of US dollar cash that might be deployed in financial assets is illustrated in Chart I-2. It plots the ratio of the US broad money supply to the market value of all US dollar-denominated securities. The US broad money supply represents all US dollars in the world – in cash and in electronic bank deposits. The denominator is the market capitalization of US dollar-denominated stocks and all types of bonds held by non-bank investors. If the market shows resilience and the pandemic situation and corporate profits ameliorate, cash on the sidelines will leak into assets, lifting their prices. The counterargument is as follows: If and when the equity momentum reverses, FOMO will be followed by a FOLO phase. In such a case, investors will sell to avoid losses or protect profits, and cash on the sidelines might not matter for a period of time. The global economy reached a bottom in April-May. We agree that the worst of the contraction in economic activity globally was in April and May, when major economies were in lockdown. Nevertheless, it is also plausible that global share prices could relapse even if the bottom in economic output has already been reached. Interestingly, in the 2001-2002 recession, global stocks made a major new low in late 2002/early 2003 even though global growth bottomed in 2001 (Chart I-3). Chart I-2The US: Broad Money Supply Relative To US Equity And Bond Markets Capitalization The US: Broad Money Supply Relative To US Equity And Bond Markets Capitalization The US: Broad Money Supply Relative To US Equity And Bond Markets Capitalization Chart I-3Global Stocks And The Business Cycle In 2000-2003 Global Stocks And The Business Cycle In 2000-2003 Global Stocks And The Business Cycle In 2000-2003   This recession is different from the perspective of the magnitude of the drop in business activity. Many businesses are still operating below their breakeven points and will likely continue to do so for some time. As such, a marginal increase in the level of activity or slower annual contraction might not be sufficient to enable them to service their debt and resume hiring and business investment. Therefore, the recovery will be stumbling and hesitant and relapses are quite likely, especially in the context of the ongoing pandemic. Finally, one of the pervasive arguments dominating the current investment landscape is that equities are cheap given very low interest rates. Unlike some of our colleagues, we are not in accord with this valuation thesis on global stocks in general and US equities in particular. One consideration that is missing in this argument is the equity risk premium. The P/E ratio is negatively correlated to the discount rate.1 The discount rate is the sum of the risk-free rate and the equity risk premium (ERP). Presently, one should use an ERP that is materially higher than its historical mean (Chart I-4, top panel). Investors are currently facing record-high uncertainty related to the pandemic and the business cycle, as well as the structural trends in the economic, political and geopolitical spheres. This warrants using an ERP that is at the upper end of its historical range. Chart I-4Exceptionally High Uncertainty Warrants A Higher Equity Risk Premium Exceptionally High Uncertainty Warrants A Higher Equity Risk Premium Exceptionally High Uncertainty Warrants A Higher Equity Risk Premium Critically, the ERP is not a static variable. Yet many equity valuation models assume that the ERP is constant, and therefore compare equity multiples with risk-free rates. Such models are wrong-headed because a change in the ERP can in and of itself cause large fluctuations in share prices. The bottom panel of Chart I-4 plots the US ERP and the global policy uncertainty index. The latter is at an all-time high while US ERP is well below its highs. In a nutshell, if FOMO forces subside, investors – which are facing enormous uncertainty on several fronts – will likely require higher risk premiums to commit money to stocks. Bottom Line: By using the average ERP in their equity valuation models, investors are underpricing risks that are presently exceptionally high. Bear Markets (Like Pandemics) Occur In Waves The duration and magnitude of the rally from the late-March lows admittedly has taken us by surprise. Nevertheless, it is hard to believe that the bear market associated with the worst recession and pandemic in a century was confined to only one down leg (albeit a vicious one) and lasted just one month. Just as corrections are inherent parts of bull markets, bear market rallies are an integral part of bear markets. It would be unprecedented if this bear market did not have at least one bear market rally. We do not mean EM or DM share prices will drop to new lows. Our point is that global stocks and EM currencies will likely experience a setback large enough to make investors feel that the bear market is back. Like pandemics, bear markets occur in waves. The timing, duration and magnitude of the second wave of the equity selloff is as impossible to predict as that of the second wave of COVID-19. Just as corrections are inherent parts of bull markets, bear market rallies are an integral part of bear markets. Our fundamental case for a relapse in EM equities and currencies is as follows: First, a downturn in US equities will dampen EM risk assets. The former are vulnerable due to the second wave of the pandemic that is already underway in a considerable portion of the US. Even if the second COVID-19 wave does not produce simultaneous shutdowns across the entire country, rolling lockdowns in parts of the US and lingering general uncertainty will hinder business investment and hiring. This will delay the profit recovery that the market has priced in. Second, global equities have rallied too fast and too far, as evidenced by the unprecedented gap that has opened up between stock prices and forward EPS (Chart I-5). The 12-month forward P/E ratio is 19.5 for global equities, 22.5 for the US and 14 for EM. Rising share prices amid falling projected EPS levels has been one of the key reasons behind our argument that the equity advance of the past three months has been a FOMO rally.  Third, retail participation in this equity rally has been unprecedented. This has been true not only in North America but also in many Asian markets. Specifically, Chart I-6 demonstrates increased retail participation in equity markets in Korea, Thailand, and Malaysia. These are corroborated by numerous media articles such as: Amateur Traders Pile Into Asian Stocks, Making Pros Nervous Small India Investors Are Latest to Snag Beaten-Down Stocks Fear of Missing Historic Rally Has Koreans Borrowing to Invest Retail Investors Are Driving Record Turnover in Thai Stocks Singapore’s Retail Investors Load Up On What Institutions Dump Chart I-5The Global Forward P/E Ratio Is At Its Highest Since 2002 The Global Forward P/E Ratio Is At Its Highest Since 2002 The Global Forward P/E Ratio Is At Its Highest Since 2002 Chart I-6A Stampede By Asian Retail Investors Into Local Equities A Stampede By Asian Retail Investors Into Local Equities A Stampede By Asian Retail Investors Into Local Equities   Chart I-7Oil Inventories Are Rising In The US And OECD Oil Inventories Are Rising In The US And OECD Oil Inventories Are Rising In The US And OECD Retail investors chasing share prices higher is another fact leading us to term this advance as a FOMO rally. If share prices relapse meaningfully, retail investors may well turn from net buyers to net sellers – i.e. FOMO will turn into FOLO. Fourth, oil prices have had a nice run, despite crude inventories in the US and OECD countries continuing to mushroom (Chart I-7). Rising inventories signify that demand remains deficient relative to supply. Hence, the oil price rally can also be qualified as a FOMO rally, driven by investors rather than demand-supply dynamics. Interestingly, global energy stocks have a higher correlation with forward oil prices rather than the spot rate. Both share prices of oil producers and three-year forward oil prices have already rolled over (Chart I-8). Finally, geopolitical tensions between the US and China are set to escalate as President Trump attempts to save his re-election campaign by rallying the nation behind the flag against foreign adversaries. China would certainly respond. As part of China’s response, North Korea will likely be “allowed” by Beijing to test a strategic weapon, undermining President Trump’s foreign policy achievements. The resulting geopolitical uncertainty will further weigh on the confidence of investors in Asian markets. Critically, share prices in north Asia – China, Korea and Taiwan – that account for 60% of the MSCI EM equity benchmark will come under selling pressure. Excluding these three bourses, EM shares prices have already rolled over (Chart I-9). Chart I-8Global Oil Stock Prices Move With Forward Oil Prices Global Oil Stock Prices Move With Forward Oil Prices Global Oil Stock Prices Move With Forward Oil Prices Chart I-9Diverging Equity Performance: North Asia Versus The Rest Of EM Diverging Equity Performance: North Asia Versus The Rest Of EM Diverging Equity Performance: North Asia Versus The Rest Of EM   In short, the key risk to Chinese, Korean and Taiwanese stocks is geopolitics. The rest of the EM universe is suffering from the acute COVID-19 crisis and numerous economic challenges. Bottom Line: The overarching message from our fundamental analysis is that the rally in global and EM share prices has ignored many negatives and is at a risk of a meaningful relapse. Gauging The Second Selling Wave: Technical Observations Chart I-10The US Dollar And VIX Have Not Yet Broken Below Their Supports The US Dollar And VIX Have Not Yet Broken Below Their Supports The US Dollar And VIX Have Not Yet Broken Below Their Supports We constantly monitor numerous market indicators. We highlight below some of the most important ones that we feel are pointing to a second sell-off wave occurring sooner than later. The broad trade-weighted US dollar and the VIX index have not yet entered a bear market (Chart I-10). In fact, it seems they are finding support at their 200-day moving averages and respective horizontal lines - shown on Chart I-10. A rebound in both the trade-weighted dollar and VIX will coincide with an air pocket in global stocks. Our Risk-On/Safe-Haven Currency ratio has rolled over (Chart I-11). It correlates with EM shares prices, and points to a relapse in EM stocks. Chart I-11The Risk-On/Safe-Haven Currency Ratio Heralds A Pullback In EM Stocks The Risk-On/Safe-Haven Currency Ratio Heralds A Pullback In EM Stocks The Risk-On/Safe-Haven Currency Ratio Heralds A Pullback In EM Stocks Finally, credit spreads of riskier parts (CAA rated) of the US high-yield corporate bond universe have commenced widening versus the aggregate US high-yield benchmark. These relative spreads are shown inverted in Chart I-12. Chart I-12US Credit Markets Internals Point To A Relapse In US Small Cap Stocks US Credit Markets Internals Point To A Relapse In US Small Cap Stocks US Credit Markets Internals Point To A Relapse In US Small Cap Stocks Underperformance of riskier parts of the US corporate credit market often coincides with lower US small-cap share prices (Chart I-12). Bottom Line: Several critical market-based indicators and technical configurations point to a relapse in global equities and renewed US dollar strength. The odds of a selloff in EM share prices, currencies and credit markets are considerable. Investment Recommendations In our June 18 report, we contended that a breakout of global share prices and a breakdown in the trade-weighted US dollar would indicate that this rally might persist for a while. Conversely, a drawdown in global equities and a rebound in the greenback could be considerable. Since then, neither global stocks have broken out nor the US dollar broken down. Hence, the jury is still out. At the moment, the risk-reward profile of EM stocks remains unattractive. Within a global equity portfolio, we continue underweighting EM. Within a global credit portfolio, we are neutral on EM sovereign credit versus US corporate credit. The rationale is as follows: the low odds of public debt defaults among mainstream developing countries and the Federal Reserve’s purchases of US corporate bonds has channeled flows to EM credit, possibly precluding relative EM underperformance.  We continue shorting the following basket of EM currencies versus the US dollar: BRL, CLP, ZAR, TRY, IDR, PHP and KRW. Structurally, we are also short the RMB and SAR. Finally, we continue receiving rates in Mexico, Colombia, India, China, Malaysia, Korea, Russia, Ukraine, Pakistan and Egypt. Central banks in the majority of EM countries will continue cutting rates, but we find better value in these fixed-income markets.  Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Footnotes 1     The P/E ratio inversely correlates to the discount rate: P/E ratio = (Payout rate x (1 + Growth rate))/ (Discount rate – Growth rate) Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights Recommended Allocation Quarterly Portfolio Outlook: Cash Injections Versus COVID Infections Quarterly Portfolio Outlook: Cash Injections Versus COVID Infections The coronavirus pandemic is not over. Enormous fiscal and monetary stimulus will soften the blow to the global economy, but there remain significant risks to growth over the next 12 months. The P/E ratio for global equities is near a record high. This suggests that the market is pricing in a V-shaped recovery, and ignoring the risks. We can, therefore, recommend no more than a neutral position on global equities. But government bonds are even more expensive, with yields having largely hit their lower bound. Stay underweight government bonds, and hedge downside risk via cash. The US dollar is likely to depreciate further: It is expensive, US liquidity has risen faster than elsewhere, interest-rate differentials no longer favor it, and momentum has swung against it. A weakening dollar – plus accelerating Chinese credit growth – should help commodities. We raise the Materials equity sector to neutral, and put Emerging Market equities on watch to upgrade from neutral. Corporate credit selectively remains attractive where central banks are providing a backstop. We prefer A-, Baa-, and Ba-rated credits, especially in the Financials and Energy sectors. Defensive illiquid alternative assets, such as macro hedge funds, have done well this year. But investors should start to think about rotating into private equity and distressed debt, where allocations are best made mid-recession. Overview Cash Injections Vs. COVID Infections The key to where markets will move over the next six-to-nine months is (1) whether there will be a second wave of COVID-19 cases and how serious it will be, and (2) how much appetite there is among central banks and fiscal authorities to ramp up stimulus to offset the damage the global economy will suffer even without a new spike in cases. A new wave of COVID-19 in the northern hemisphere this fall and winter is probable. It is not surprising, after such a sudden stop in global activity between February and May, that economic data is beginning to return to some sort of normality. PMIs have generally recovered to around 50, and in some cases moved above it (Chart 1). Economic data has surprised enormously to the upside in the US, although it is lagging in the euro zone and Japan (Chart 2). Chart 1Data Is Rebounding Sharply Data Is Rebounding Sharply Data Is Rebounding Sharply Chart 2US Data Well Above Expectations US Data Well Above Expectations US Data Well Above Expectations     New COVID-19 cases continue to rise alarmingly in some emerging economies and in parts of the US, but in Europe and Asia the pandemic is largely over (for now) and lockdown regulations are being eased, allowing economic activity to resume (Chart 3). Nonetheless, consumers remain cautious. Even where economies have reopened, people remain reluctant to eat in restaurants, to go on vacation, or to visit shopping malls (Chart 4). While shopping and entertainment activities are now no longer 70-80% below their pre-pandemic levels, as they were in April and May, they remain down 20% or more (Chart 5). Chart 3Few COVID-19 Cases Now In Europe And Asia Few COVID-19 Cases Now In Europe And Asia Few COVID-19 Cases Now In Europe And Asia Chart 4Consumers Still Reluctant To Go Out Quarterly Portfolio Outlook: Cash Injections Versus COVID Infections Quarterly Portfolio Outlook: Cash Injections Versus COVID Infections Chart 5Spending Well Below Pre-Pandemic Levels Quarterly Portfolio Outlook: Cash Injections Versus COVID Infections Quarterly Portfolio Outlook: Cash Injections Versus COVID Infections So how big is the risk of further spikes in COVID-19 cases? Speaking on a recent BCA Research webcast, the conclusion of Professor Peter Doherty, a Nobel prize-winning immunologist connected to the University of Melbourne, was that, “It’s not unlikely we’ll see a second wave.”1 But experts can’t be sure. It seems that the virus spreads most easily when people group together indoors. That is why US states where it is hot at this time of the year, such as Arizona, have seen rising infections. This suggests that a new wave in the northern hemisphere this fall and winter is probable. Offsetting the economic damage caused by the coronavirus has been the staggering amount of liquidity injected by central banks, and huge extra fiscal spending. Major central bank balance-sheets have grown by around 5% of global GDP since March, causing a spike in broad money growth everywhere (Chart 6). Fiscal spending programs also add up to around 5% of global GDP (Chart 7), with a further 5% or so in the form of loans and guarantees. Chart 6Remarkable Growth In Money Supply... Remarkable Growth In Money Supply... Remarkable Growth In Money Supply... Chart 7...And Unprecedented Fiscal Spending Quarterly Portfolio Outlook: Cash Injections Versus COVID Infections Quarterly Portfolio Outlook: Cash Injections Versus COVID Infections   But is it enough? Considerable damage has been done by the collapse in activity. Bankruptcies are rising (Chart 8) and, with activity still down 20% in consuming-facing sectors, pressure on companies’ business models will not ease soon – particularly given evidence that banks are tightening lending conditions. Household income has been buoyed by government wage-replacement schemes, handout checks, and more generous unemployment benefits (Chart 9). But, when these run out, households will struggle if the programs are not topped up. Central banks are clearly willing to inject more liquidity if need be. But the US Congress is prevaricating on a second fiscal program, and the Merkel/Macron proposed EUR750 billion spending package in the EU is making little progress. It will probably take a wake-up call from a sinking stock market to push both to take action. Chart 8Companies Feeling The Pressure Quarterly Portfolio Outlook: Cash Injections Versus COVID Infections Quarterly Portfolio Outlook: Cash Injections Versus COVID Infections Considerable damage has been done by the collapse in activity. We lowered our recommendation for global equities to neutral from overweight in May. We are still comfortable with that position. Given the high degree of uncertainty, this is not a market in which to take bold positioning in a portfolio. When you have a high conviction, position your portfolio accordingly; but when you are unsure, stay close to benchmark. With stocks up by 36% since their bottom on March 23rd, the market is pricing in a V-shaped recovery and not, in our view, sufficiently taking into account the potential downside risks. P/E ratios for global stocks are at very stretched levels (Chart 10). Chart 9Households Dependent On Handouts More Stimulus Forthcoming? Households Dependent On Handouts More Stimulus Forthcoming? Households Dependent On Handouts Chart 10Global Equities Are Expensive... Global Equities Are Expensive... Global Equities Are Expensive...   Nonetheless, we would not bet against equities. Simply, there is no alternative. Most government bond yields are close to their effective lower bound. Gold looks overbought (in the absence of a significant spike in inflation which, while possible, is unlikely for at least 12 months). No sensible investor in, say, Germany would want to hold 10-year government bonds yielding -50 basis points. Assuming 1.5% average annual inflation over the next decade, that guarantees an 18% real loss over 10 years. The only investors who hold such positions have them because their regulators force them to. Chart 11...But They Are Cheap Against Bonds ...But They Are Cheap Against Bonds ...But They Are Cheap Against Bonds The Sharpe ratio on 10-year US Treasurys, which currently yield 70 BPs, will be 0.16 (assuming volatility of 4.5%) over the next 10 years. A simple calculation of the likely Sharpe ratio for US equities (earnings yield of 4.5% and volatility of 16%) comes to 0.28. One would need to assume a disastrous outlook for the global economy to believe that stocks will underperform bonds in the long run. Though equities are expensive, bonds are even more so. The equity risk premium in most markets is close to a record high (Chart 11). With such mathematics, it is hard for a long-term oriented investor to be underweight equities. Garry Evans, Senior Vice President Chief Global Asset Allocation Strategist garry@bcaresearch.com   What Our Clients Are Asking Chart 12Premature Opening Of The Economy Is Risky Quarterly Portfolio Outlook: Cash Injections Versus COVID Infections Quarterly Portfolio Outlook: Cash Injections Versus COVID Infections COVID-19: How Risky Is Reopening? Countries around the world are rushing to reopen their economies, claiming victory over the pandemic. It is hard to be sure whether a second wave of COVID-19 will hit. What is certain, however, is that a premature relaxation of measures is as risky as a tardy initial response. That was the lesson from our Special Report analyzing the Spanish Flu of 1918. The risk is certainly still there: Herd immunity will require around 70% of the population to get sick, and a drug or vaccine will (even in an optimistic scenario) not be available until early next year. China and South Korea, for example, after reporting only a handful of daily new cases in early May, were forced to impose new restrictions over the past few weeks as COVID-19 cases spiked again (Chart 12, panel 1). We await to see if other European countries, such as Italy, Spain, and France will be forced to follow. Some argue that even if a second wave hits, policy makers – to avoid a further hit to economic output – will favor the “Swedish model”: Relying on people’s awareness to limit the spread of the virus, without imposing additional lockdowns and restrictions. This logic, however, is risky since Sweden suffered a much higher number of infections and deaths than its neighboring countries (panel 2). The US faces a similar fate. States such as Florida, Arizona, and Texas are recording a sharp rise in new infections as lockdowns are eased. In panel 3, we show the daily number of new infections during the stay-at-home orders (the solid lines) and after they were lifted (dashed lines). To an extent, increases in infections are a function of mass testing. However, what is obvious is that the percentage of positive cases per tests conducted has started trending upwards as lockdown measures were eased (panel 4). Our base case remains that new clusters of infections will emerge. Eager citizens and rushed policy decisions will fuel further contagion. If the Swedish model is implemented, lives lost are likely to be larger than during the first wave. Chart 13W Or U, Says The OECD Quarterly Portfolio Outlook: Cash Injections Versus COVID Infections Quarterly Portfolio Outlook: Cash Injections Versus COVID Infections What Shape Will The Recovery Be: U, V, W, Or Swoosh? The National Bureau of Economic Research (NBER) Business Cycle Dating Committee has already declared that the US recession began in March. The economists’ consensus is that Q2 US GDP shrank by 35% QoQ annualized. But, after such a momentous collapse and with a moderate move back towards normalcy, it is almost mathematically certain that Q3 GDP will show positive quarter-on-quarter growth. So does this mean that the recession lasted only one quarter, i.e. a sharp V-shape? And does this matter for risk assets? The latest OECD Economic Outlook has sensible forecasts, using two “equally probable” scenarios: One in which a second wave of coronavirus infections hits before year-end, requiring new lockdowns, and one in which another major outbreak is avoided.2 The second-wave scenario would trigger a renewed decline in activity around the turn of 2020-21: a W-shape. The second scenario looks more like a U-shape or swoosh, with an initial rebound but then only a slow drawn-out recovery, with OECD GDP not returning to its Q4 2019 level before the end of 2021 (Chart 13). Chart 14Unemployment Will Take A Long Time To Come Down Unemployment Will Take A Long Time To Come Down Unemployment Will Take A Long Time To Come Down Why is it likely that, in even the absence of a renewed outbreak of the pandemic, recovery would be faltering? After an initial period in which many furloughed workers return to their jobs, and pent-up demand is fulfilled, the damage from the sudden stop to the global economy would kick in. Typically, unemployment rises rapidly in a recession, but recovers only over many years back to its previous low (Chart 14). This time, many firms, especially in hospitality and travel, will have gone bust. Capex plans are also likely to be delayed. Chart 15Sub-Potential Output Can Be Good For Risk Assets Sub-Potential Output Can Be Good For Risk Assets Sub-Potential Output Can Be Good For Risk Assets However, a slow recovery is not necessarily bad for risk assets. Periods when the economy is recovering but remains well below potential (such as 2009-2015) are typically non-inflationary, which allows central banks to continue accommodation (Chart 15). Is This Sharp Equity Rebound A Retail Investor Frenzy? The answer to this question is both Yes and No. From a macro fundamental perspective, the answer is No, because coordinated global reflationary policies and medical developments to fight the coronavirus have been the key drivers underpinning this equity rebound. “COVID-on” and “COVID-off” have been the main determinants for equity rotations. Chart 16Active Retail Participation Lately Retail Investors Have Driven Up Trading Volumes Active Retail Participation Lately Retail Investors Have Driven Up Trading Volumes Active Retail Participation Lately But at the individual stock level, the answer is Yes. Some of the unusual action in beaten-down stocks over the past few weeks may have its origin in an upsurge of active retail participation (Chart 16). Retail investors on their own are not large enough to influence the market direction. Many online brokerages do not charge any commission for trades, but make money by selling order flows to hedge funds. As such, the momentum set in motion by retail investors may have been amplified by fast-money pools of capital. Retail participation in some beaten-down stocks has also provided an opportunity for institutions to exit. BCA’s US Investment Strategy examined the change in institutional ownership of 12 stocks in three stressed groups between February 23 and June 14, as shown in Table 1. In the case of these stocks, retail investors have served as liquidity providers to institutional sellers seeking to exit their holdings. The redeployment of capital by institutions into large-cap and quality names may have pushed up the overall equity index level. Table 1Individuals Have Replaced Institutions Quarterly Portfolio Outlook: Cash Injections Versus COVID Infections Quarterly Portfolio Outlook: Cash Injections Versus COVID Infections How Will Inflation Behave After COVID? Some clients have asked us about the behavior of inflation following the COVID epidemic. Over the very short term, inflation could have more downside. However, this trend is likely to reverse rapidly. Headline inflation is mainly driven by changes in the oil price and not by its level. Thus, even if oil prices were to stay at current low levels, the violent recovery of crude from its April lows could bring headline inflation near pre-COVID levels by the beginning of 2021 (Chart 17, top panel). This effect could become even larger if our Commodity strategist price target of 65$/barrel on average in 2021 comes to fruition. Chart 17Rising Oil Prices And Fiscal Stimulus Will Boost Inflation Rising Oil Prices And Fiscal Stimulus Will Boost Inflation Rising Oil Prices And Fiscal Stimulus Will Boost Inflation But will this change in inflation be transitory or will it prove to be sustainable? We believe it will be the latter. The COVID crisis may have dramatically accelerated the shift to the left in US fiscal policy. Specifically, programs such as universal basic income may now be within the Overton window3 of acceptable fiscal policy, thanks to the success of the CARES Act in propping up incomes amid Depression-like levels of unemployment (middle panel). Meanwhile there is evidence that this stimulus is helping demand to recover rapidly: Data on credit and debit card trends show that consumer spending in the US has staged a furious rally, particularly among low-income groups, where spending has almost completely recovered (bottom panel). With entire industries like travel, restaurants and lodging destroyed for the foreseeable future, the political will to unwind these programs completely is likely to be very low, given that most policymakers will be queasy about an economic relapse, even after the worst of the crisis has passed. Such aggressive fiscal stimulus, coupled with extremely easy monetary policy will likely keep inflation robust on a cyclical basis. Global Economy Overview: March-May 2020 will probably prove to be the worst period for the global economy since the 1930s, as a result of the sudden stop caused by the coronavirus pandemic and government-imposed restrictions on movement. As the world slowly emerges from the pandemic, data has started to improve. But there remain many risks, and global activity is unlikely to return to its end-2019 level for at least another two years. That means that further fiscal and monetary stimulus will be required. The speed of the recovery will be partly determined by how much more aggressively central banks can act, and by how much appetite there is among fiscal authorities to continue to bail out households and companies which have suffered a catastrophic loss of income. US: The economy has shown signs of a strong rebound from the coronavirus slump in March and April. Q2 GDP probably fell around 35% quarter-on-quarter annualized, but Q3 will almost certainly show positive growth. The Economic Surprise Index (Chart 18, panel 1) has bounced to a record high, after stronger-than expected May data, for example the 16% month-on-month growth in durable goods orders, and 18% in retail sales. But the next stage of the recovery will be harder: continuing unemployment claims in late June were still 19.5 million. Bankruptcies are rising, and banks are tightening lending conditions. One key will be whether Congress can pass a further fiscal program before the emergency spending runs out in July. Euro Area: Although pandemic lockdowns ended in Europe earlier than in the US, recovery has been somewhat slower. The euro zone PMI rebounded to close to 50 in June but, given that activity had collapsed in February-May, it is surprising (since the PMI measures month-on-month change) that it is not well above 50 (Chart 19, panel 1). Fiscal and monetary stimulus, while large, has not been as aggressive as in the US. The ECB remains circumscribed (as least psychologically) by the German constitutional court’s questioning the justification for previous QE. Germany and France have agreed a EUR750 billion additional package to help the periphery, but this has still to be finalized, due to the opposition of some smaller northern EU members. Chart 18Economic Data Has Started To Surprise To The Upside... Economic Data Has Started To Surprise To The Upside... Economic Data Has Started To Surprise To The Upside... Chart 19...But From Dramatically Low Levels ...But From Dramatically Low Levels ...But From Dramatically Low Levels   Japan: Although Japan escaped relatively easily from pandemic deaths and lockdowns, its economy remains notably weak. New machinery orders in April were still falling 18% YoY, and exports in May were down 28% YoY. The poor economic performance is due to its dependence on overseas demand, distrust in the government, the lingering effects of the ill-timed consumption tax rise last October, and limited room for manoeuvre by the Bank of Japan. The government has announced fiscal stimulus equal to a barely credible 40% of GDP, but much of this is double-counting, and less than half of the household and small-company income-replacement handouts announced in March have so far been paid out. Emerging Markets: India, Brazil, and other Latin American countries are now bearing the brunt of the coronavirus pandemic. Economies throughout Emerging Markets have weakened dramatically as a result. Two factors may come to their aid, though. China is again ramping up monetary stimulus, with a notable acceleration of credit growth over the past three months. Its economy has stabilized as a result, as PMIs show (panel 3). And the US dollar has begun to depreciate, which will take pressure off EM borrowers in foreign currencies, and boost commodities prices. The biggest risk is that many EM central banks have now resorted to printing money, which could result in currency weakness and inflation at a later stage. Interest Rates: Central banks in advanced economies have lowered policy rates to their effective lower bound. It is unlikely the Fed will cut into negative territory, having seen the nefarious effects of this on the banking systems in Japan and the euro zone, and particularly due to the large money-market fund industry in the US, which is unviable with negative rates. Reported inflation everywhere, both headline and core, has fallen sharply, but this is somewhat misleading since the price of items that households in lockdown have actually been buying has risen sharply. Markets have started to sniff out the possibility of inflation once the pandemic is over, and inflation expectations have begun to rise (panel 4). For now, deflation is likely to be the bigger worry and so we do not expect long-term rates to rise much this year. But a sharp pickup in inflation is a definite risk on the 18-24 month time horizon. Global Equities Chart 20Stretched Valuation Has Earnings Growth Bottomed? Has Earnings Growth Bottomed? Valuation Concern: Global equities staged an impressive rebound of 18% in Q2 after the violent selloff in Q1, thanks to the “whatever-it-takes” support from central banks, and massive fiscal stimulus packages around the globe. Within equities, our country allocation worked well, as the US outperformed both the euro Area and Japan. Our sector performance was mixed: The overweight in Info Tech and underweight in Utilities and Real Estate generated good profits, but the overweights in Industrials and Healthcare and the underweight in Materials suffered losses. As shown in Chart 20, even before the pandemic-induced profit contraction, forward earnings were already only flattish in 2019. The sharp selloff in Q1 brought the valuation multiple back down only to the same level as at the end of 2018. Currently, this valuation measure stands at the highest level since the Great Financial Crisis after a 37% increase in Q2 2020 alone. Such a rapid multiple expansion was one of the key reasons why we downgraded equities to Neutral in May at the asset-class level. Going forward, BCA’s house view is that easy monetary policies and stimulative fiscal policies globally will help to revive economic activity, and that a weakening US dollar will give an additional boost to the global economy, especially Emerging Markets. Consequently, we upgrade global Materials to neutral from underweight and put Emerging Market equities (currently neutral) on an upgrade watch (see next page). Warming To Reflation Plays Chart 21EM On Upgrade Watch EM On Upgrade Watch EM On Upgrade Watch Taking risk where risks will most likely be rewarded has been GAA’s philosophy in portfolio construction. As equity valuation reaches an extreme level, the natural thing to do is to rotate into less expensive areas within the equity portfolio. As shown in panel 2 of Chart 21, EM equities are trading at a 31% discount to DM equities based on forward P/E, which is 2 standard deviations below the average discount of past three years. Valuation is not a good timing tool in general, but when it reaches an extreme, it’s time to pay attention and check the fundamental and technical indicators. We are putting EM on upgrade watch (from our current neutral stance, and also closing the underweight in Materials given the close correlation of the two (Chart 21, panel 1). Three factors are on our radar screen: First, reflation efforts in China. The change in China’s total social financing as a % of GDP has been on the rise and BCA’s China Investment Strategy Team expects it to increase further. This bodes well for the momentum of the EM/DM performance, which is improving, albeit still in negative territory (panel 3). Second, a weakening USD is another key driver for EM/DM and the Materials sector relative performance as shown in panel 4. According to BCA’s Foreign Exchange Strategy, the US dollar is likely to churn on recent weakness before a cyclical bear market fully unfolds.4 Last but not least, the recent surge in the number of the coronavirus infections in EM economies, especially Brazil and India, has increased the likelihood of a second wave of lockdowns. Government Bonds Chart 22Bottoming Bond Yields Bottoming Bond Yields Bottoming Bond Yields Maintain Neutral Duration. Global bond yields barely moved in Q2 as the global economy rebounded from the COVID-induced recession low (Chart 22, panel 1). The upside surprise in economic data releases implies that global bond yields will likely go up in the near term (panel 2). For the next 9-12 months, however, the upside in global bond yields might be limited given the increasing likelihood of a new set of COVID-19 lockdowns due to the recent surge in new infections globally, especially in the US, Brazil, and India. As such, a neutral duration stance is still appropriate (Chart 22). Chart 23Inflation Expectations On The Rise Inflation Expectations On The Rise Inflation Expectations On The Rise Favor Linkers Vs. Nominal Bonds. To fight off the risk of an extended recession, policymakers around the world are determined to continue to use aggressive monetary and fiscal stimulus to boost the global economy. The combined effect of extremely accommodative policy settings and the rebound in global commodity prices, especially oil prices, will push up inflation expectations (Chart 23). Higher inflation expectations will no doubt push up nominal bond yields somewhat, but according to BCA’s Global Fixed Income Strategy (GFIS), positioning for wider inflation breakevens remains the “cleaner” way to profit for the initial impact of policy reflation.5 According to GFIS valuation models, inflation-linked bonds in Canada, Italy, Germany, Australia, France, and Japan should be favored over their respective nominal bonds. Corporate Bonds Chart 24Better Value In A-rated and Baa-rated Credit Better Value In A-rated and Baa-rated Credit Better Value In A-rated and Baa-rated Credit Investment-grade: Since we moved to overweight on investment-grade credit within the fixed-income category, it has produced 8.8% in excess returns over duration-matched government bonds. We remain overweight, given that the Federal Reserve has guaranteed to rollover debt for investment-grade issuers, essentially eliminating the left tail of returns. Moreover, the Fed has begun buying both ETFs and individual bond issues, in an effort to keep financial stress contained during the pandemic. However, there are some sectors within the investment-grade space that are more attractive than others. Specifically, our Global Fixed Income Strategy team has shown that A-rated and Baa-rated bonds are more attractive than higher-rated credits (Chart 24). Meanwhile, our fixed-income strategist are overweight Energy and Financials at the sector level.6 High-yield: High-yield bonds – where we have a neutral position - have delivered 11.5% of excess return since April. We are maintaining our neutral position. At current levels, spreads no longer offer enough value to justify an overweight position, specially if one considers that defaults in junk credits could be severe, since the Fed doesn’t offer the same level of support that it provides for investment-grade issuers. Within the high-yield space, we prefer Ba-rated credit. Fallen angels (i.e. bonds which fell to junk status) are particularly attractive given that most qualify for the Fed’s corporate buying program, since issuers which held at least a Baa3 rating as of March 22 are eligible for the Fed’s lending facilities.7  Commodities Chart 25Commodity Prices Will Rise As Growth Revives Commodity Prices Will Rise As Growth Revives Commodity Prices Will Rise As Growth Revives Energy (Overweight): A near-complete lack of storage led WTI prices to go into freefall and trade at -$40 in mid-April: The largest drawdown in oil prices over the past 30 years (Chart 25, panel 1). Since then, oil prices have picked up, reaching their pre-“sudden stop” levels, as the OPEC 2.0 coalition slashed production. Nevertheless, excess supply remains a key issue. Crude inventories have been on the rise as global crude demand weakens. Year-to-date inventories have increased by over 100 million barrels, and current inventories cover over 40 days of supply (panel 2). As long as the OPEC supply cuts hold and demand picks up over the coming quarters, the excess inventories are likely to be worked off. BCA’s oil strategists expect Brent crude to rise back above $60 by year-end. Industrial Metals (Neutral): Last quarter, we flagged that industrial metals face tailwinds as fiscal packages get rolled out globally – particularly in China where infrastructure spending is expected to increase by 10% in the latter half of the year. Major industrial metals have yet to recover to their pre-pandemic levels but, as lockdown measures are lifted and activity is restored, prices are likely to start to rise strongly (panel 3). Precious Metals (Neutral): The merits of holding gold were not obvious during the first phase of the equity sell-off in February and March. Gold prices tumbled as much as 13%, along with the decline in risk assets. Since the beginning of March, however, there have been as many positive return days as there has been negative (panel 4). However, given the uncertainty regarding a second wave of the pandemic, and the rise in geopolitical tensions between the US and China, as well as between India and China, we continue to recommend holding gold as a hedge against tail risks. Currencies Chart 26Momentum For The Dollar Has Turned Negative Momentum For The Dollar Has Turned Negative Momentum For The Dollar Has Turned Negative US Dollar: The DXY has depreciated by almost 3% since the beginning of April. Currently, there are multiple forces pushing the dollar lower: first, interest-rate differentials no longer favor the dollar Second, liquidity conditions have improved substantially thanks to the unprecedented fiscal and monetary stimulus, as well as coordinated swap lines between the Fed and other central banks to keep USD funding costs contained. Third, momentum in the DXY – one of the most reliable indicators for the dollar – has turned negative (Chart 26– top & middle panel). Taking all these factors into account, we are downgrading the USD from neutral to underweight. Euro: The euro should benefit in an environment where the dollar weakens, and global growth starts to rebound. Moreover, outperformance by cyclical sectors as well as concerns about over-valuation in US markets should bring portfolio flows to the Euro area. Therefore, we are upgrading the euro from neutral to overweight. Australian dollar: Last quarter we upgraded the Australian dollar to overweight due to its attractive valuations, as well as the effect of the monetary stimulus coming out of China. This proved to be the correct approach: AUD/USD has appreciated by a staggering 13% since our upgrade – the best performance of any G10 currency versus the dollar this quarter (bottom panel). Overall, while we believe that Chinese stimulus should continue to prop up the Aussie dollar, valuations are no longer attractive with AUD/USD hovering around PPP fair value. This means that the risk-reward profile of this currency no longer warrants an overweight position. Thus, we are downgrading the AUD to neutral. Alternatives Chart 27Opportunities Will Emerge In Private Equity Opportunities Will Emerge In Private Equity Opportunities Will Emerge In Private Equity Return Enhancers: Over the past year, we have flagged that hedge funds, particularly macro funds, will outperform other risk assets during recessions and periods of high market stress. This played out as we expected: macro hedge funds’ drawdown from January to March 2020 was a mere 1.4%, whereas other hedge funds’ drawdown ranged between 9% and 19% and global equities fell as much as 35% from their February 2020 peak. (Chart 27, panel 1). However, unlike other recessions, the unprecedented sum of stimulus should place a floor under global growth. Given the time it takes to move allocations in the illiquid space, investors should prepare for new opportunities within private equity as global growth bottoms in the latter half of this year. In an earlier Special Report, we stressed that funds raised in late-cycle bull markets tend to underperform given their high entry valuations. If previous recessions are to provide any guidance, funds raised during recession years had a higher median net IRR than those raised in the latter year of the preceding bull market (panel 2). Inflation Hedges: Over the past few quarters, we have been highlighting commodity futures as a better inflation hedge relative to other assets (e.g. real estate). Within the asset class, assuming a moderate rise in inflation over the next 12-18 months as we expect, energy-related commodities should fare best (panel 3). This corroborates with our overweight stance on oil over the next 12 months (see commodities section). Volatility Dampeners: We have been favoring farmland and timberland since Q1 2016. While both have an excel track record of reducing volatility, farmland’s inelastic demand during slowdowns will be more beneficial. Investors should therefore allocate more to farmland over timberland (panel 4). Risks To Our View The risks are skewed to the downside. After such a big economic shock, damage could appear in unexpected places. Banking systems in Europe, Japan, and the Emerging Markets (but probably not the US) remain fragile. Defaults are growing in sub-investment grade debt; mortgage-backed securities are experiencing rising delinquencies; student debt and auto loans are at risk. Emerging Market borrowers, with $4 trn of foreign-currency debt, are particularly vulnerable. The length and depth of recessions and bear markets are determined by how serious are the second-round effects of a cyclical slowdown. If the current recession really lasted only from March to July, and the bear market from February to March, this will be very unusual by historical standards (Chart 28). Chart 28Can The Recession And Bear Market Really Be All Over Already? Can It Really Be Over Already? Can It Really Be Over Already? Upside surprises are not impossible. A vaccine could be developed earlier than the mid-2021 that most specialists predict. But this is unlikely since the US Food and Drug Administration will not fast-track approval given the need for proper safety testing. If economies continue to improve and newsflow generally remains positive over the coming months, more conservative investors could be sucked into the rally. Evidence suggests that the rebound in stocks since March was propelled largely by hedge funds and individual day-traders. More conservative institutions and most retail investors remain pessimistic and have so far missed the run-up (Chart 29). One key, as so often, is the direction of US dollar. Further weakness in the currency would be a positive indicator for risk assets, particularly Emerging Market equities and commodities. In this Quarterly, we have moved to bearish from neutral on the dollar (see Currency section for details). Momentum has turned negative, and both valuation and relative interest rates suggest further downside. But it should be remembered that the dollar is a safe-haven, counter-cyclical currency (Chart 30). Any rebound in the currency would not only signal that markets are entering a risk-off period, but would cause problems for Emerging Market borrowers that need to service debt in an appreciating currency. Chart 29Many Investors Are Still Pessimistic Many Investors Are Still Pessimistic Many Investors Are Still Pessimistic Chart 30Dollar Direction Is Key Dollar Direction Is Key Dollar Direction Is Key     Footnotes 1  Please see BCA Webcast, "The Way Ahead For COVID-19: An Expert's Views," available at bcaresearch.com. 2  OECD Economic Outlook, June 2020, available at https://www.oecd-ilibrary.org/economics/oecd-economic-outlook/volume-2020/issue-1_0d1d1e2e-en 3  The Overton window, named after Joseph P. Overton, is the range of policies politically acceptable to the mainstream population at a given time. It frames the range of policies that a politician can espouse without appearing extreme. 4  Please see Foreign Exchange Strategy Weekly Report, “DXY: False Breakdown Or Cyclical Bear Market?” dated June 5, 2020 available at fes.bcaresearch.com 5  Please see Global Fixed Income Strategy Weekly Report, “How To Play The Revival Of Global Inflation Expectations” dated June 23, 2020 available at gfis.bcaresearch.com 6 Please see Global Fixed Income Strategy, "Hunting For Alpha In The Global Corporate Bond Jungle," dated May 27, 2020, available at gfis.bcaresearch.com. 7  Fallen angels also outperform during economic recoveries. Please see Global Asset Allocation Special Report, "Even Fallen Angels Have A Place In Heaven," dated November 15, 2020, available at gaa.bcaresearch.com.   GAA Asset Allocation

Highlights Should the DXY fail to breach below 92 in the coming months, momentum will be a risk to our short dollar positions. Another risk is valuation. The trade-weighted dollar is expensive, but not overly so. It is not especially expensive versus the euro and some commodity currencies. A post-COVID-19 world in which global economies become more closed could also hurt short dollar positions. Maintain a barbell strategy, being long a basket of the cheapest currencies (SEK and NOK) together with some safe havens (JPY). This should insulate portfolios over what could become a more volatile summer. Feature Chart I-1The Dollar And Markets The Dollar And Markets The Dollar And Markets The breakdown in the dollar since March is still facing some skepticism, even internally at BCA. As a reserve currency, the dollar tends to do well during periods of heightened uncertainty. With a clear risk of a second COVID-19 infection wave, and with equity markets up strongly from their lows, odds are that volatility could rise in the near term. Renewed geopolitical tensions between China and the US as well as the upcoming US presidential election are also sources of risk. Historically, the dollar has tended to rise with both increasing equity and geopolitical risk premia (Chart I-1). The key question is whether any near-term bounce in the dollar is technical in nature, or represents the resumption of the bull market. While the dollar is a countercyclical currency, it has also been in a bull market since 2011, notwithstanding the growth upcycles that took place during that period. Through a series of technical, valuation, and macroeconomic charts, we will explore the key risks to our dollar-bearish view as well as potential signposts to see if we are spot on in our thinking. The Long-Term Technical Profile Is Bullish Chart I-2The Dollar And Cycles The Dollar And Cycles The Dollar And Cycles The dollar is a momentum currency, and so tends to move in long cycles. Moreover, in recent history, these cycles have tended to last around eight to 10 years, coinciding with the NBER definition of business cycles. The dollar bear market of the 1980s entered its capitulation phase with the 1990s recession. Similarly, the dollar bull market of the late ‘90s ended with the 2001 recession. The Great Recession in 2008 and subsequently cascading crises from the Eurozone to Japan in 2010-2011 ended the bear market run in the dollar from 2001. If the past is prologue, then the pandemic recession of 2020 may also be signaling an end to the dollar’s decade-long bull run. There is also an economic reason for the decade-long run in dollar cycles. This is the time it usually takes to build and subsequently unwind imbalances in the US economy. In a closed economy, savings must equal investment. However, in open economies, investors usually require a cheaper exchange rate (or higher interest rates) to fund rising deficits, just as they require a higher IRR to fund projects with risky cash flows. This has been the story for the US dollar since the 1980s (Chart I-2). Of course, dollar transition phases can be quite volatile, and the risk to this view is that the dollar bear story could be one for 2022 rather than 2020. However, it is also noteworthy that dollar tops are generally V-shaped, while bottoms are more saucer-shaped. The reason is that the Federal Reserve is usually at the center of a dollar peak, in its decisiveness to ease monetary conditions quite aggressively. At bottoms, the dollar is typically already sufficiently cheap that it does not pose headwinds to the US economy. The pandemic recession of 2020 may also be signaling an end to the dollar’s decade-long bull run. If the DXY can easily break through  the 92-94 zone, this will technically end the bull market in place since 2011, as the powerful upward-sloping channel, in place since then, will be breached (Chart I-3). On the sentiment side of things, conditions remain bullish, which is positive from a contrarian perspective. Professional forecasters often tend to be  adaptive, with a Bloomberg survey expecting the DXY to be flat by year end, but hitting 92 only in 2022 (Chart I-4). More importantly, they tend to miss important turning points in the greenback. Chart I-3A Technical Profile For DXY A Technical Profile For DXY A Technical Profile For DXY Chart I-4The Dollar And Forecasters The Dollar And Forecasters The Dollar And Forecasters The Dollar Is Not Overly Expensive The valuation picture for the dollar is more nuanced, and is our biggest source of risk. The dollar is clearly expensive versus currencies such as the Swedish krona and Norwegian krone, but on a trade-weighted basis, the dollar is only one standard deviation above our fair-value model. This still makes the dollar pricey, but not to the extent of previous peaks, that have tended to occur around two standard deviations above fair value (Chart I-5). Our long-term fair value model has two critical inputs – the productivity gap between the US and its trading partners as well as real bond yield differentials. Rising productivity ensures a country can pursue non-inflationary growth. This lifts the neutral rate of interest in the country, raising the long-term fair value of its exchange rate. The Bloomberg survey expects the DXY to be flat by year end, but hitting 92 only in 2022. Since 2010, the productivity gap between the US and its trading partners has been flat, but there is reason to believe this gap will start to roll over. For one, fiscal largesse could crowd out private investment. But more importantly, as my colleague Ellen JingYuan He of BCA’s Emerging Market Strategy reckons, productivity gains in countries like China could start to pick up as it becomes a world leader in innovation (Chart I-6). This will allow real bond yields outside the US to remain high. Chart I-5The Dollar Is Expensive The Dollar Is Expensive The Dollar Is Expensive Chart I-6US Relative Productivity May Decline US Relative Productivity May Decline US Relative Productivity May Decline The key point is that valuation alone is not a sufficient catalyst for dollar short positions, which is a risk to the view. This is especially the case versus commodity currencies and the euro. That said, there are still some currencies trading below or near two standard deviations from their mean relative to the US dollar. This includes the NOK, SEK, and to a certain extent the GBP (Chart I-7). We remain long these currencies in our portfolio. Chart I-7ASome G10 Currencies Are Very Cheap Some G10 Currencies Are Very Cheap Some G10 Currencies Are Very Cheap Chart I-7BSome G10 Currencies Are Very Cheap Some G10 Currencies Are Very Cheap Some G10 Currencies Are Very Cheap   Post COVID-19 Behavior Could Be Dollar Bullish A post COVID-19 world in which global economies become more closed could hurt the bearish dollar view. This is because when global growth is rebounding, more cyclical economies benefit from this growth dividend, and as such capital tends to gravitate to their respective economies. This is aptly illustrated with consumption being a much larger share of GDP in the US compared to exports (Chart I-8). A move towards more domestic production will hurt the capital flows that have tended to dictate the dollar’s countercyclical nature. A post COVID-19 world in which global economies become more closed could hurt the bearish dollar view.  Chart I-9 shows that dollar strength throughout most of March can be partly  explained by the relative resilience of the US economy, in part driven by a late start to state-wide shutdowns. With economies outside the US now reopening, PMIs abroad have recovered at a faster pace. Once the initial snapback phase has been established, differentiation among economies will then begin Chart I-8The US Economy Will Benefit From De-Globalization The US Economy Will Benefit From De-Globalization The US Economy Will Benefit From De-Globalization Chart I-9Relative Growth And ##br##The Dollar Relative Growth And The Dollar Relative Growth And The Dollar More importantly, in a post COVID-19 world, “platform” companies that can virtually leverage their technology and expertise across borders are replacing “brick and mortar” businesses that need both shipping lanes and ports to remain open. For example, will demand for autos ever recover to pre-crisis levels, when one can video conference rather than drive for two hours to the office? In general terms, if deep value stocks cannot find a way to improve their return on capital, flows into these markets (heavily represented outside the US), will dwindle. This will be a key risk to the dollar bearish view (Chart I-10).   Chart I-10Deep Value And The Dollar Deep Value And The Dollar Deep Value And The Dollar That said, manufacturing renaissances do happen. Asia, for example, remains at the core of both robotic and semiconductor manufacturing, which are redefining the production landscape. And over the long term, valuations do matter – and the starting point for US equities is unfavorable. Strategy And Housekeeping We continue to recommend a barbell strategy. Hold a basket of the cheapest currencies such as the NOK, SEK, and the GBP, along with some safe havens. Our list of trades is printed on page 9. We were stopped out of our short gold/silver position and are reinstating that trade today. While gold does better than silver during market riots, the ratio is 100:1, which is the most overvalued it has been in over a century. Once retail participation gains hold of cheap silver prices, which usually occurs during latter parts of precious metal bull markets, the move could be explosive. We remain long the pound, but are respecting our stop on our short EUR/GBP position that was triggered last week. Valuation supports the pound but politics will increase near-term volatility. We are raising our limit sell to 0.92, which has provided tremendous resistance since the referendum in 2016. Finally, the correction in energy prices is providing an interesting entry point for both the NOK/SEK cross and petrocurrencies. We remain oil bulls on the back of a pickup in global demand. This should lead to the outperformance of energy stocks, benefiting inflows into the CAD, NOK, RUB, MXN, and COP.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 Recent data in the US have been mostly positive: The Markit manufacturing PMI rebounded to 49.6 from 39.8 in June. The services PMI and composite PMI both increased to 46.7 and 46.8, respectively. The Chicago Fed National Activity index increased from -17.89 to 2.61 in May. Existing home sales fell by 9.7% month-on-month in May. However, new home sales surged by 16.6% month-on-month. Initial jobless claims increased by 1480K for the week ended June 19th, higher than the expected 1300K. The DXY index increased by 0.34% this week. Recent data have shown some improvement in the economy, supported by the reopening and Fed’s unprecedented relief measures. We remain cautiously bearish on the US dollar. Please refer to our front section this week for a checklist of risks to the bearish dollar view. Report Links: DXY: False Breakdown Or Cyclical Bear Market? - June 5, 2020 Cycles And The US Dollar - May 15, 2020 Capitulation? - April 3, 2020 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Recent data in the euro area have been mostly positive: The Markit manufacturing PMI increased from 39.4 to 46.9 in June. The services PMI increased to 47.3 from 30.5 and the composite PMI ticked up from 31.9 to 47.5. The current account surplus shrank from €27.4 billion to €14.4 billion in April. Consumer confidence slightly improved from -18.8 to -14.7 in June. The euro fell by 0.5% against the US dollar this week. The ECB decided to offer euro loans against collateral to central banks outside the euro area during the pandemic. Besides, the Eurosystem repo facility for central banks (EUREP) will remain available until the end of June 2021. Report Links: On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 On Money Velocity, EUR/USD And Silver - October 11, 2019 Japanese Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data in Japan have been negative: The manufacturing PMI fell from 38.4 to 37.8 in June. The coincident index fell from 81.5 to 80.1 in April, while the leading economic index ticked up from 76.2 to 77.7. The All Industry Activity Index fell by 6.4% month-on-month in April. The Japanese yen depreciated by 0.5% against the US dollar this week. The BoJ Summary of Opinions released this week pointed out that Japan’s economy has been in an extremely severe downturn and the recovery is likely to be longer and slower. Moreover, the BoJ has expressed concerns that Japan might slip back into deflation. We are long the yen as portfolio insurance. Report Links: The Near-Term Bull Case For The Dollar - February 28, 2020 Building A Protector Currency Portfolio - February 7, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data in the UK have been positive: The Markit manufacturing PMI increased from 40.7 to 50.1 in June. The services PMI also soared from 29 to 47. Retail sales fell by 13.1% year-on-year in May. However, it increased by 12% compared to the previous month.  The British pound fell by 0.7% this week. Last week, the MPC voted unanimously to keep the current rate unchanged at 0.1%. The Committee also voted by a majority of 8-1 for the Bank to increase government bond purchases by another £100 billion, bringing the total purchases to £745 billion. However, governor Andrew Bailey also indicated in a Bloomberg Opinion article on Monday that the Bank might take measures to reduce the BoE’s swollen balance sheet, indicating the £100 billion might be the last should conditions improve. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 A Few Trade Ideas - Sept. 27, 2019 United Kingdom: Cyclical Slowdown Or Structural Malaise? - Sept. 20, 2019 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Recent data in Australia have been positive: The manufacturing PMI increased from 44 to 49.8 in June. The services PMI soared from 26.9 to 53.2, bringing the composite PMI up to 52.6 in June. The Australian dollar initially rose against the US dollar, then fell, returning flat this week. During an online panel discussion this week, the RBA Governor Lowe warned about the long-lasting impact of the COVID-19. More importantly, he said that at the current level close to 0.7, the Australian dollar is not overvalued against the US dollar, even though a lower currency would support exports and push the inflation back to target. Report Links: On AUD And CNY - January 17, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 A Contrarian View On The Australian Dollar - May 24, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 Recent data in New Zealand have been negative: Exports declined by 6.1% year-on-year to NZ$5.4 billion in May, mainly due to lower sales in logs, fish, machinery and equipment. In contrast, exports of dairy products increased by 4.5% year-on-year. Imports slumped by 25.6% year-on-year, led by lower purchases of vehicles and petroleum products. The trade surplus fell to NZ$ 1.25 billion in May from NZ$ 1.34 billion in April. However, this compares favorably with a trade deficit of NZ$ 175 million in the same month last year. The New Zealand dollar fell by 0.6% against the US dollar this week. On Wednesday, the RBNZ held its interest rate unchanged at 0.25% as widely expected and maintained its current pace of QE. However, the Bank sounded quite dovish and indicted that it is ready to further ease policy whenever needed. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Place A Limit Sell On DXY At 100 - November 15, 2019 USD/CNY And Market Turbulence - August 9, 2019 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Recent data in Canada have been positive: Preliminary data shows that retail sales rebounded by 19.1% month-on-month in May, following a 26.4% decrease the previous month. The Canadian dollar depreciated by 0.7% against the US dollar this week. In his first speech as Bank of Canada Governor this week, Tiff Macklem warned that the recovery might be longer than expected, and indicated that the Bank needs a quick response and targeted containment to fight possible future waves of COVID-19 and another round of a broad-based shutdown. Report Links: More On Competitive Devaluations, The CAD And The SEK - May 1, 2020 A New Paradigm For Petrocurrencies - April 10, 2020 The Loonie: Upside Versus The Dollar, But Downside At The Crosses Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Recent data in Switzerland have been positive: The ZEW expectations index rose from 31.3 to 48.7 in June. Money supply (M3) surged by 2.5% year-on-year in May. Total sight deposits increased to CHF 680.1 billion from CHF 679.5 billion for the week ended June 19th. The Swiss franc appreciated by 0.2% against the US dollar this week. The SNB Quarterly Bulletin in Q2 was released this week and it showed that while government loans have been helpful to support the economy, the declines in profit margins were exceptionally severe. Moreover, a further appreciation of the Swiss franc remains a downside risk for a small open economy like Switzerland. Report Links: On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 Portfolio Tweaks Before The Chinese New Year - January 24, 2020 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Recent data in Norway have been negative: The unemployment rate increased to 4.2% in April from 3.6% the previous month. The Norwegian krone fell by 1% against the US dollar this week, along with lower oil prices. Last week, the Norges Bank left its interest rate unchanged at 0% and signaled that the rates are set to remain at current levels over the next few years. Report Links: A New Paradigm For Petrocurrencies - April 10, 2020 Building A Protector Currency Portfolio - February 7, 2020 On Oil, Growth And The Dollar - January 10, 2020 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Recent data in Sweden have been positive: Consumer confidence increased from 77.7 to 84 in June. The Swedish krona appreciated by 1.2% against the US dollar this week. As one of the few countries without strict lockdown measures, Sweden’s business sectors are showing budding signs of recovery in May and June, according to a company survey by the central bank. However, most companies believe that the recovery would take at least 9 months or longer. On another note, the Riksbank has been testing its digital currency e-krona and might be the first central bank to implement the wide use of digital currency. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019 Balance Of Payments Across The G10 - February 15, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

US Dollar Bear Market... US Dollar Bear Market... In this Monday’s Special Report, we examined which S&P 500 GICS1 sectors have historically benefited from a falling greenback. Currently, piling evidence suggests that the path of least resistance will be lower for the US dollar. Looking at structural (five years+) dynamics, swelling twin deficits emit a bearish USD signal. In more detail, prior to COVID-19 outbreak, the US twin deficits were estimated to gradually rise towards the 7.5% mark (top panel), but now the US Congressional Budget Office (CBO) estimates that the US fiscal deficit alone will be approximately 11% of nominal GDP for 2020 if not higher. In other words, the recent pandemic has exacerbated already structurally bearish dynamics for the US dollar. Switching gears from a structural to a medium term horizon (2-3 years), BCA’s four-factor macro model, is sending an unambiguous bearish message regarding the greenback’s fate (middle panel). Finally, on a short-term time horizon, the USD is lagging the money multiplier by approximately 3 months. The COVID-19 catalyzed recession and resulting money printing will likely exert extreme downward pressure on the US dollar (bottom panel).  

Highlights The dollar is likely to churn on recent weakness before a cyclical bear market fully unfolds. The reason is that the economic landscape remains fraught with uncertainty, both politically and economically. We continue to recommend a barbell strategy. Hold a basket of the cheapest currencies such as the NOK, SEK, and GBP along with some safe havens. Watch the performance of cyclicals versus defensives and non-US markets versus the S&P 500 as important barometers for dollar downside. The EUR/USD could touch 1.16, while still staying in the confines of a structural bear market. Our FX model is more aggressive, and is recommending shorting the DXY for the month of June. Feature Chart I-1The Dollar Tries To Break Down DXY: False Breakdown Or Cyclical Bear Market? DXY: False Breakdown Or Cyclical Bear Market? The DXY index is punching below key support levels in an attempt to reverse the cyclical bull market in place since 2011. Our technical roadmap has been the upward-sloping channel, in place since 2018 (Chart I-1). At 96.77, the DXY index is already several ticks below the lower bound of this channel. As the breakdown becomes more broad based, especially vis-à-vis the euro, this will cement the transition from easing financial conditions to improving global growth. Cyclical currencies such as the Australian dollar and the Norwegian krone have already bounced powerfully from their March lows and have now entered the technical definition of a bull market (Chart I-2). For example, from a low of 55 cents, the Aussie is now trading at 69 cents, up 25%. As long-term dollar bears, our portfolio has benefited tremendously from this shift in market sentiment.1  Chart I-2A Report Card On Currency Performance DXY: False Breakdown Or Cyclical Bear Market? DXY: False Breakdown Or Cyclical Bear Market? The key question for new investors is whether the move in the dollar represents a false breakdown or the beginning of a cyclical bear market. To answer this, we are reviewing key charts and indicators to explain dollar weakness and help gauge whether it pays to enter new short positions. Explaining Dollar Weakness US dollar weakness has been driven by three interrelated factors: Non-US economies that were initially hit by COVID-19 are reopening faster. As a result, economic momentum is higher outside the US. The rise in economic momentum is supporting money velocity outside the US. In other words, animal spirits are being rekindled at a faster pace abroad. In the classical equation MV=PQ,2 a rise in both M and V can be explosive for nominal output. Higher money velocity outside the US has started to attract capital inflows. This is beginning to show up in the outperformance of non-US markets. With economies outside the US now reopening, PMIs abroad have recovered at a faster pace.  Chart I-3 shows that dollar strength throughout most of March can be partly explained by the relative resilience of the US economy, in part driven by a late start to state-wide shutdowns. This was exacerbated by a dollar liquidity shortage, as demand for US dollars abroad surged. With economies outside the US now reopening, PMIs abroad have recovered at a faster pace. As Chart I-2 illustrates, developed market currencies have fared in pecking order of the easing in lockdown measures, with the AUD outperforming the CAD, and the SEK outperforming the EUR. Prior to the onset of COVID-19, there was a pretty tight correlation between global services relative to manufacturing activity and the dollar (Chart I-4). As a relatively closed economy, the US tended to benefit when services output had the upper hand. This time around, the service sector has been hit much harder due to social distancing measures in place, but it is also likely to have a more drawn-out recovery. For example, visits to theme parks or restaurants are unlikely to retrace back to their pre-crisis peaks anytime soon. However, construction activity, especially geared towards infrastructure or residential housing, may bounce back sooner. Chart I-3A Strong Recovery Outside The US A Strong Recovery Outside The US A Strong Recovery Outside The US Chart I-4USD And Manufacturing Vs Services USD And Manufacturing Vs Services USD And Manufacturing Vs Services The key message is that global manufacturing activity so far is holding up better than services, and activity is picking up faster abroad. This has historically been good news for procyclical currencies. Money Velocity And The Dollar There is increasing evidence that money velocity is being supported outside the US. For global manufacturing activity to recover, it requires a rise in animal spirits to begin to capitalize on very generous financing conditions. In this respect, there is increasing evidence that money velocity is being supported outside the US. In the euro area, the velocity of money in Germany has stopped falling relative to the US. This is a marked change from anything we have seen since the European debt crisis. More importantly, the ebb and flow of ‘V’ in Germany relative to the US has mirrored the relative path of interest rates (Chart I-5). Global industrial activity remains quite subdued, but it appears that sentiment among German investors is very upbeat for the post-COVID recovery. This has usually been a good barometer for the improvement in PMIs (Chart I-6). Granted, the improvement in relative V has been driven mostly by the collapse in US money velocity. But what matters for currencies are relative trends. Once economic activity enters a full-fledged recovery, we expect US output to be hampered by the rise in the dollar over the past 18 months, while cyclical economies will be buffeted by much-cheapened currencies. This raises the prospect of much more pronounced economic vigor outside the US. Chart I-5Money Velocity Support In Europe Money Velocity Support In Europe Money Velocity Support In Europe Chart I-6Euro Area Sentiment Is Improving Euro Area Sentiment Is Improving Euro Area Sentiment Is Improving The ratio of the velocity of money between the US and China has tended to track the gold/silver ratio (GSR) with a tight fit (Chart I-7). A falling ratio signifies that the number of times money is changing hands in China outpaces the number in the US. This also tends to coincide with a pickup in manufacturing activity, for the simple reason that silver has more industrial uses than gold. Therefore, the recent collapse in the GSR is prescient.   Soft data confirms this trend. Both the Caixin and NBS manufacturing PMI are outperforming that in the US, and are likely to keep doing so in the coming months (Chart I-8). Chart I-7Money Velocity Support In China? Money Velocity Support In China? Money Velocity Support In China? Chart I-8Wide Gap Between Chinese And US Output Wide Gap Between Chinese And US Output Wide Gap Between Chinese And US Output It is important to note that while there has been some disconnect between the performance of the economy and stock prices, no such dichotomy exists in currency markets. The ratio of cyclical currencies relative to defensive ones tends to track the global PMI directionally. While this ratio is below its 2008 lows, the global PMI has bottomed at higher levels (Chart I-9). The difference can probably be explained by the fact that either domestic investors (especially retail) have been the dominant buyers of equities, and/or institutional investors have been hedging currency risk. It is true that the bounce in AUD/CHF (or other procyclical pairs) from the lows has brought it closer to technically stretched levels, and some measure of indigestion is overdue. That said, this mainly reflects mean reversion from deeply oversold levels (Chart I-10). If manufacturing activity can keep improving, and the velocity of money outside the US can pick up, this will revive capital flows into these markets, which will lead to more pronounced breakouts. Given the huge uncertainty surrounding these forecasts, we believe the risk to the greenback is currently balanced. Chart I-9Equity And Currency Markets Have Diverged Equity And Currency Markets Have Diverged Equity And Currency Markets Have Diverged Chart I-10Still Oversold Still Oversold Still Oversold Capital Flows As An Indicator The nascent upturn in a few growth indicators is also coinciding with a positive signal from equity markets. Global cyclical stocks have started to outperform defensives in recent weeks, as flows into more cyclical ETF markets are accelerating (Chart I-11). Chart I-11Inflows Into Cyclical ETFs Inflows Into Cyclical ETFs Inflows Into Cyclical ETFs Chart I-12Inflows Into US Assets Are Picking Up Inflows Into US Assets Are Picking Up Inflows Into US Assets Are Picking Up The S&P 500 has been the best performing market for a few years now, so a crucial part of the dollar call lies in international equity markets outperforming the US. Indeed, the latest data show that as recent as March, net foreign inflows into US equity markets were quite strong (Chart I-12). This might explain why the S&P 500 continued to outperform during the March drawdown. In a nutshell, the outperformance of more cyclical currencies will require confirmation of a breakout in their relative equity market performance. This applies to the euro area, commodity-producing countries, and other emerging and developed market currencies (Charts I-13A and I-13B). The catalyst will have to be rising relative returns on capital outside the US, but the starting point is also extremely attractive valuations. Chart I-13ANascent Bounce In Cyclicals Versus Defensives Nascent Bounce In Cyclicals Versus Defensives Nascent Bounce In Cyclicals Versus Defensives Chart I-13BNascent Bounce In Cyclicals Versus Defensives Nascent Bounce In Cyclicals Versus Defensives Nascent Bounce In Cyclicals Versus Defensives We recently penned a report titled “Cycles And The US Dollar,” which showed empirically that US valuations have more than fully capitalized future earning streams, especially vis-à-vis their G10 peers. That said, before a cyclical bear market can fully unfold, we are watching two key indicators for dollar downside: As the Fed continues to dilute existing bond shareholders, the ratio of the US bond ETF (TLT) to gold (GLD) will be an important proxy for investor sentiment. One of the functions of money is as a store of value, and gold remains a viable threat to the dollar (and Treasurys) in this regard. A falling ratio will suggest private investors are dumping their bond holdings in exchange for harder assets such as precious metals. Recent inflows into the GLD ETF may be signaling such a shift (Chart I-14), but it will take a clean break in this ratio below 0.95 to solidify the trend. As geopolitical tensions between US and China mount, the USD/CNY exchange rate will become the key arbiter between two dollars: one versus emerging markets and the other versus developed markets. So far, USD/CNY is holding close to cyclical highs, but a break above will put Asian currencies at risk. This will have negative implications for developed-market commodity currencies (Chart I-15). Chart I-14Gold And USD Inflows Diverge Gold And USD Inflows Diverge Gold And USD Inflows Diverge Chart I-15Tied To The Hip Tied To The Hip Tied To The Hip EUR, GBP And Housekeeping We continue to recommend a barbell strategy. Hold a basket of the cheapest currencies such as the NOK, SEK, and the GBP along with some safe havens. Being short the gold/silver ratio is also a good way to play an eventual economic recovery, with the benefit of a tremendous valuation cushion. The market certainly applauded the European Central Bank’s addition of €600 billion in bond purchases, given the fall in peripheral bond spreads. The euro also bounced on the back of two factors: Chart I-16QE And EUR/USD QE And EUR/USD QE And EUR/USD Even with additional stimulus, the balance sheet impulse of the Fed is still larger than that of the ECB (Chart I-16). Historically, this has favored long EUR/USD positions. The compression in peripheral spreads should boost European growth as it lowers the cost of capital for countries such as Spain and Italy. This improves debt dynamics and encourages the productive deployment of capital. Technically, the EUR/USD can rally towards 1.16 while remaining within the confines of a structural bear market (Chart I-17). Beyond this point, it will be imperative for European growth dynamics to take over the baton to support a much higher exchange rate. As we mentioned earlier, the velocity of money in Germany has stopped falling relative to the US, but relative improvement is not yet enough to warrant structural positions in EUR/USD. Our FX model is more aggressive, and is recommending shorting the DXY for the month of June. Our FX model is more aggressive, and is recommending shorting the DXY for the month of June. Since the 1980s, this three-factor model has outperformed the DXY index by a significant margin (Chart I-18). Chart I-17EUR/USD Could Touch 1.16 EUR/USD Could Touch 1.16 EUR/USD Could Touch 1.16 Chart I-18The Model Is Short DXY In June The Model Is Short DXY In June The Model Is Short DXY In June Finally, our limit-sell on EUR/GBP was triggered at 0.90 last week. While valuation favors a short position, the ramp-up in Brexit tensions is a key risk to this trade. As such, we are placing tight stops at 0.905.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Currencies US Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 Recent data in the US have been negative: Headline PCE fell from 1.3% to 0.5% year-on-year in April. Core PCE also declined from 1.7% to 1%. Personal income surged by 10.5% month-on-month in April, while personal spending decreased by 13.6%, implying a higher savings rate. Total vehicle sales increased from 8.6 million to 11 million in May. Factory orders fell by 13% month-on-month in April. The trade deficit widened from $42.3 billion to $49.4 billion in April. Initial jobless claims increased by 1877K for the week ended May 29th. The DXY index fell by 1.1% this week, reflecting cautiously positive sentiment as many countries started to ease lockdown measures.   Report Links: Cycles And The US Dollar - May 15, 2020 Capitulation? - April 3, 2020 The Dollar Funding Crisis - March 19, 2020   The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Recent data in the euro area have been negative: Headline inflation fell from 0.3% to 0.1% year-on-year in May, while core inflation was unchanged at 0.9%. The unemployment rate increased from 7.1% to 7.3% in April. The Markit manufacturing PMI slightly fell from 39.5 to 39.4 in May, while the services PMI increased from 28.7 to 30.5. Retail sales plunged by 19.6% year-on-year in April, following an 8.8% decline the previous month. EUR/USD appreciated by 1.4% this week. On Thursday, the ECB kept key interest rates unchanged, while announcing a further 600 billion euros increase of its PEPP facility, taking the total to 1.35 trillion euros. There was also an extension of the program till June 2021.   Report Links: On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 On Money Velocity, EUR/USD And Silver - October 11, 2019   The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data in Japan have been mostly negative: Construction orders plunged by 14.3% year-on-year in April. Housing starts fell by 12.9% year-on-year in April. Capital spending increased by 4.3% quarter-on-quarter in Q1. The monetary base surged by 3.9% year-on-year in May. The manufacturing PMI was unchanged at 38.4 in May, while the services PMI increased from 21.5 to 26.5. The Japanese yen fell by 1.3% against the US dollar this week. Japan lifted its nationwide state of emergency last week, however, the economy is still in deep recession as COVID-19 continues to disrupt global supply chains.   Report Links: The Near-Term Bull Case For The Dollar - February 28, 2020 Building A Protector Currency Portfolio - February 7, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020   British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data in the UK have been mixed: The Markit manufacturing PMI slightly increased from 40.6 to 40.7 in May. The services PMI also ticked up from 27.8 to 29. Nationwide housing prices fell by 1.7% month-on-month in May. Money supply (M4) surged by 9.5% year-on-year in April. Mortgage approvals increased by 15.8K in April, down from 56K the previous month. GBP/USD increased by 1.7% this week. The Bank of England urged banks to step up no-deal Brexit plans this week, implying that there might have been a shift in the BoE’s assumptions about the outcome of ongoing talks between the UK and the European Union. That being said, we remain bullish on the pound from a valuation perspective, but are tightening our stop loss this week.   Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 A Few Trade Ideas - Sept. 27, 2019 United Kingdom: Cyclical Slowdown Or Structural Malaise? - Sept. 20, 2019   Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Recent data in Australia have been mixed: The manufacturing index increased from 35.8 to 41.6 in May. The current account surplus increased from A$1 billion to A$8.4 billion in Q1. However, more recent trade data was less encouraging. Imports plunged by 9.8% month on month in April while exports slumped by 11.3%. The trade surplus narrowed from A$10.6 billion to A$8.8 billion. GDP grew by 1.4% year-on-year in Q1. On a quarterly basis, it fell by 0.3% compared with the last quarter in 2019.  Building permits increased by 5.7% year-on-year in April. AUD/USD appreciated remarkably by 4.5% this week. On Tuesday, the RBA kept its interest rate unchanged at 0.25%. Moreover, the RBA sounds cautiously positive in its rate statement, saying that “it is possible that the depth of the downturn will be less than earlier expected.”   Report Links: On AUD And CNY - January 17, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 A Contrarian View On The Australian Dollar - May 24, 2019   New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 Recent data in New Zealand have been negative: Terms of trade fell by 0.7% quarter-on-quarter in Q1, down from a 2.8% increase the previous quarter. It is the first fall since Q4 2018. Building permits fell by 6.5% month-on-month in April, following a 21.7% monthly decrease in March. NZD/USD increased by 4% this week. The fall in terms of trade was led by the decline in meat prices, including lamb and beef, from record levels at the end of 2019. Forestry product prices also fell by 3.4% quarterly in Q1. On a positive note, New Zealand is prepared to ease lockdown measures as there has been no new cases reported for nearly two weeks.   Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Place A Limit Sell On DXY At 100 - November 15, 2019 USD/CNY And Market Turbulence - August 9, 2019   Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Recent data in Canada have been negative: GDP plunged by 8.2% quarter-on-quarter in Q1. The Markit manufacturing PMI increased from 33 to 40.6 in May. Labor productivity increased by 3.4% quarterly in Q1. Imports fell from C$48 billion to C$36 billion in April. Exports also declined from C$46 billion to C$33 billion. The trade deficit widened from C$1.5 billion to C$3.3 billion.  The Canadian dollar rose by 2.2% this week, alongside oil prices. On Wednesday, the BoC kept interest rates unchanged at 0.25%. It also decided to scale back the frequency of some market operations as financing conditions have improved.   Report Links: More On Competitive Devaluations, The CAD And The SEK - May 1, 2020 A New Paradigm For Petrocurrencies - April 10, 2020 The Loonie: Upside Versus The Dollar, But Downside At The Crosses   Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Recent data in Switzerland have been negative: KOF leading indicator fell from 59.7 to 53.2 in May. Real retail sales plunged by 20% year-on-year in April, following a 5.8% decrease the previous month. The manufacturing PMI increased from 40.7 to 42.1 in May. GDP declined by 1.3% year-on-year in Q1. On a quarter-on-quarter basis, GDP fell by 2.6% compared with Q4 2019.  Headline consumer prices kept falling by 1.3% year-on-year in May. The Swiss franc rose by 0.5% against the US dollar this week. The 2.6% quarterly decline in Switzerland’s GDP has been the most severe since 1980, mostly led by hotels and restaurants which suffered a 23.4% fall. In addition, the consistent decline in consumer prices might lead the SNB to further step up FX intervention.   Report Links: On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 Portfolio Tweaks Before The Chinese New Year - January 24, 2020   Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 There has been scant data from Norway this week: The current account surplus increased from NOK 25 billion to NOK 66 billion in Q1. The Norwegian krone appreciated by 3.5% against the US dollar this week. Statistics Norway’s recent balance of payments report shows that the balance of goods and services surged to NOK 27 billion in Q1. Balance of income and current transfers also increased from NOK 1.9 billion to NOK 38.9 billion. Our Nordic basket against the euro and the US dollar is now 10% in the money.   Report Links: A New Paradigm For Petrocurrencies - April 10, 2020 Building A Protector Currency Portfolio - February 7, 2020 On Oil, Growth And The Dollar - January 10, 2020   Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Recent data in Sweden have been negative: GDP increased by 0.4% year-on-year in Q1, down from 0.5% the previous quarter. The trade surplus increased from SEK 5.2 billion to SEK 7.6 billion in April. The manufacturing PMI increased from 36.4 to 39.2 in May. Industrial production plunged by 16.6% year-on-year in April. Manufacturing new orders also declined by 20.7% year-on-year. The Swedish krona increased by 2.5% against the US dollar this week. Sweden’s GDP grew modestly in Q1, which is better than most of its European counterparts, following its decision not to impose a full lockdown to contain the virus.   Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019 Balance Of Payments Across The G10 - February 15, 2019   Footnotes 1Please see our table of trades below. 2Where M = money supply, V = velocity of money, P = price level and Q = output.   Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights Please note that we are publishing an analysis on Vietnam below. The unprecedented depth of this recession entails that many businesses will likely be operating below their break-evens for a while, even after the confinement measures are eased. Consequently, the process of bottoming in this bear market will be drawn out, and share prices will gyrate substantially in the interim. Elevated foreign currency debt levels among some EM corporations, plunging revenues and local currency depreciation combine for a perfect storm in EM corporate credit. Continue underweighting EM stocks and credit within global equity and credit portfolios, respectively. Take profits on the long EM currency volatility trade. Feature If history is any guide, the speed of the rebound in global equities is more consistent with a bear market rally than the beginning of a new bull market. Typically, for a new durable bull market to emerge after a vicious bear market, a consolidation period or a base-building phase is needed. As of now, share prices have not formed such a base. Playing bear market rallies is all about timing, in which fundamental analysis is not useful. Rebounds die as abruptly as they begin. Hence, it is all about chasing momentum on either side. The unprecedented depth of this recession heralds that many businesses will likely be operating below their break-evens for a while, even after the confinement measures are eased. We closed our absolute short position in EM equities on March 19 but we have continued shorting EM currencies versus the US dollar. Even though EM share prices have become cheap based on their cyclically-adjusted P/E ratio (Chart I-1), valuation is not a good timing tool. This is especially true for this structural valuation indicator. Chart I-1EM Equities Are As Cheap As In Previous Bottoms EM Equities Are As Cheap As In Previous Bottoms EM Equities Are Cheap According To The Cyclically-Adjusted P/E Ratio EM Equities Are As Cheap As In Previous Bottoms EM Equities Are Cheap According To The Cyclically-Adjusted P/E Ratio Why The Rebound? After the massive selloff, investor sentiment on risk assets in general, and cyclicals specifically, has become very depressed. In particular: Sentiment of traders and investment advisors on US stocks has plummeted (Chart I-2). That said, net long positions in US equity futures are still above their 2016 and 2011 lows, as we noted last week. Traders’ sentiment on cyclical currencies such as the CAD and AUD as well as on copper and oil has dropped to their previous lows (Chart I-3).  Chart I-2Investor Sentiment On US Equities Is Poor Investor Sentiment On US Equities Is Poor Investor Sentiment On US Equities Is Poor Chart I-3Investor Sentiment On Copper And Oil Is Depressed Investor Sentiment On Copper And Oil Are Depressed Investor Sentiment On Copper And Oil Are Depressed   Consistently, net long positions of investors in both copper and oil have been trimmed substantially (Chart I-4A and I-4B). Chart I-4AInvestors’ Net Long Positions In Copper... Investors Net Long Positions In Copper... Investors Net Long Positions In Copper... Chart I-4B…And Oil ...And Oil ...And Oil   On the whole, it should not be surprising that after having become very oversold, risk assets rebounded in the past two weeks. Nevertheless, depressed investor sentiment is a necessary but not sufficient condition for a major bear market bottom. As illustrated in Chart I-3, sentiment on oil and copper was extremely depressed in late 2014. Yet with the exception of brief rebounds, both oil and copper prices continued to plunge for about a year before bottoming in January 2016. The necessary and sufficient condition for a durable bottom in global cyclical assets is an improvement in global demand. Chart I-5The S&P 500 And VIX In The Last Two Bear Markets The S&P 500 And VIX In The Last Two Bear Markets The S&P 500 And VIX In The Last Two Bear Markets Given the US and Europe are still in strict confinement and the Chinese economy remains quite weak (please see our more detailed discussion on this below), the global recession is still deepening. Further, while the enormous amounts of stimulus injected by policymakers is certainly positive, it is not yet clear whether these efforts are sufficient to entirely offset the collapse in the level of economic activity and its second round effects. Nevertheless, the Federal Reserve and the European Central Bank have probably contained the acute phase of the financial market crisis by buying financial assets and providing credit to the real economy. Odds are that the VIX and other volatility measures will not retest their recent highs. However, this does not mean that risk assets cannot retest their lows or make fresh ones. For example, in the previous 2001-2002 and 2008 bear markets, the S&P 500 re-tested its low in early 2003 and made a deeper trough in early 2009 even though the VIX drifted lower (Chart I-5). Finally, as we discuss below, a unique feature of this recession makes it unlikely that a definite equity market bottom has been established so quickly. How This Recession Is Distinct From an investor viewpoint, this global recession stands out from others in a particularly distinct way: In an average recession, nominal output levels do not contract. In the US, since 1960 it was only during 2008 that the level of nominal GDP contracted (Chart I-6). Presently, we are experiencing the gravest collapse in nominal output/sales since the 1930s – much worse than what transpired in 2008. Chart I-6US Nominal GDP And Corporate Profits Growth US Nominal GDP And Corporate Profits Growth US Nominal GDP And Corporate Profits Growth When a company’s sales shrink, a critical threshold for sustainability is the level of its revenues relative to its break-even point. The latter is the level of sales where total revenue is equal to total cost – i.e., where profits are nil. Break-even points have ramifications for share prices and the shape of a potential recovery. In an average recession, break-even points for the majority of companies are not breached – i.e., they remain profitable. As a result, a moderate and sequential revival in sales boosts profits, often exponentially. Share prices react positively to even modest sequential growth. Besides, when profits are expanding, managers and owners of these businesses are often quick to augment their capital spending and hiring. A marginal and sequential recovery from this very low point is not sufficient to produce a durable bull market for stocks or corporate credit. When a company’s sales drop below its break-even level, a moderate sequential recovery in sales could be insufficient to make the company profitable. In such a case, the share price may not rally vigorously unless they had priced in a much worse outcome – i.e., a bankruptcy. Crucially, a moderate sequential revival in activity may not lead to more capital spending and hiring. Given US and global nominal GDP are presently contracting at an unprecedented double-digit pace, the revenue of a majority of companies has fallen below costs – i.e., they are presently operating below their break-evens (experiencing losses). This makes this recession distinct from others. On the whole, the loosening of confinement measures and the resumption of business operations may not be sufficient reasons to turn bullish on equities. So long as a company operates below its break-even, its share price may not rally much in response to marginal sequential growth. In short, the pace of recovery will be crucial. Yet, there is considerable uncertainty with respect to these dynamics. Such uncertainty also warrants a high equity risk premium. A U-shaped recovery is most likely, but the latter assumes that many companies will be operating with losses for some time. Consequently, odds are that the process of bottoming in this bear market will be drawn out, and share prices will gyrate substantially in the interim. Taking Pulse Of The Global Economy In our March 19 report, we argued that this global recession is much worse than the one in 2008. High-frequency data are confirming our view: The weekly US economic index from the New York Fed has plunged more than it did in 2008 (Chart I-7). Capital spending plans have been shelved around the world. Odds are many businesses will be operating below their break-evens even after confinement measures are eased. Therefore, they will not rush to invest in new capacity and equipment, or rush to hire. China is a case in point. Commodities prices on the mainland remain in a downtrend, despite the resumption of business activity (Chart I-8). This is a sign of lingering weakness in construction/capital spending. Chart I-7An Unprecedented Plunge In Economic Activity An Unprecedented Plunge In Economic Activity An Unprecedented Plunge In Economic Activity Chart I-8Commodities Prices In China Are Drifting Lower Commodities Prices In China Are Drifting Lower Commodities Prices In China Are Drifting Lower   The world’s oil consumption is presently probably down by more than 35%.  According to INRIX, US car traffic last week was 47% below its level in late February before the confinement measures were introduced. Plus, airline travel has literally ground to a halt worldwide. In China’s major cities, traffic during rush hour is re-approaching its pre-pandemic levels. However, automobile congestion data from TomTom shows that in the afternoons and evenings, traffic remains well below where it was before the lockdown. This reveals that people go to work, spend most of their time at the office, and then quickly return home. They do not go out during lunch time or in the evenings. Hence, we infer that China’s service sector remains in recession.  Chart I-9EM ex-China, Korea And Taiwan: Nominal Growth Was Very Weak Before The Pandemic EM ex-China, Korea And Taiwan: Nominal Growth Was Very Weak Before The Pandemic EM ex-China, Korea And Taiwan: Nominal Growth Was Very Weak Before The Pandemic  The Chinese manufacturing and service PMI indexes registered 51 and 47 respectively in March, revealing that their economic recoveries are very subdued. As per our discussion above, we suspect revenues for many businesses in February dropped below break-even levels. The fact that only about a half of both manufacturing and service sector companies said their March activity improved from February is rather underwhelming. EM ex-China, Korea and Taiwan nominal GDP and core consumer price inflation were at very low levels before the pandemic (Chart I-9). The ongoing plunge in economic activity will produce the worst nominal output recession for many developing economies. Consequently, corporate profits of companies exposed to domestic demand will crash in local currency terms. Bottom Line: The unprecedented depth of this recession heralds that many businesses will likely be operating below their break-evens for a while, even after the confinement measures are eased. Thus, a marginal and sequential recovery from this very low point is not sufficient to produce a durable bull market for stocks or corporate credit. Credit Markets Hold The Key Solvency concerns for companies become acute and doubt about their debt sustainability persist when their revenues drop below their break-evens. Thus, a marginal improvement in revenue – as lockdowns worldwide are relaxed – may not suffice to produce a material tightening in EM corporate credit spreads. Playing bear market rallies is all about timing, in which fundamental analysis is not useful. Rebounds die as abruptly as they begin. Interestingly, equity markets often take their cues from credit markets. Chart I-10 demonstrates that EM US dollar corporate bond yields (inverted on the chart) correlate with equity prices. This chart unambiguously expounds that what matters for EM share prices is not US Treasurys yields but rather their own borrowing costs in US dollars. Chart I-10EM US Dollar Corporate Bond Yields And Stock Prices EM US Dollar Corporate Bond Yields And Stock Prices EM US Dollar Corporate Bond Yields And Stock Prices Presently, there are no substantive signs that US dollar borrowing costs for EM companies or sovereigns are declining. Chart I-11 illustrates that investment and high-yield corporate bond yields for aggregate EM and emerging Asia remain elevated. Remarkably, bank bond yields in overall EM and emerging Asia have not eased much (Chart I-12). The latter is crucial as banks’ external high borrowing costs will dampen their appetite to originate credit domestically. Chart I-11EM US Dollar Corporate Bond Yields EM US Dollar Corporate Bond Yields EM US Dollar Corporate Bond Yields Chart I-12EM Banks US Dollar Bond Yields EM Banks US Dollar Bond Yields EM Banks US Dollar Bond Yields Chart I-13EM Credit Spreads, Currencies And Commodities EM Credit Spreads, Currencies And Commodities EM Credit Spreads, Currencies And Commodities In turn, the direction of EM corporate and sovereign credit spreads is contingent on EM exchange rates and commodities prices, as demonstrated in Chart I-13. Credit spreads are shown inverted in both panels of this chart. We remain negative on both EM currencies and commodities prices, and argue for a cautious approach to EM credit markets.  Bottom Line: Elevated foreign currency debt levels among some EM corporations, plunging revenues and local currency depreciation combine for a perfect storm in EM corporate credit. To make matters worse, this asset class as well as EM sovereign credit were extremely overbought before this selloff. Therefore, there could be more outflows from these markets as adverse fundamentals persist.  Investment Strategy And Positions We continue to recommend underweighting EM stocks and credit versus their DM counterparts. Importantly, the EM equity index has been underperforming the global equity benchmark in the recent rebound (Chart I-14). Aggressive policy stimulus in the US and Europe have improved investor sentiment towards their credit and equity markets. Yet, the Chinese stimulus has so far been less aggressive than in the past. This will weigh on the growth outlook for emerging Asia and Latin America. The outlook for oil prices is currently a coin toss. Price volatility will remain enormous and it is not worth betting on either the long or short side of crude. Apart from oil, industrial metal prices remain at risk due to subdued demand from China. In general, this is consistent with lower EM currencies (Chart I-15).   Chart I-14Continue Underweighting EM Stocks Versus The Global Benchmark Continue Underweighting EM Stocks Versus The Global Benchmark Continue Underweighting EM Stocks Versus The Global Benchmark Chart I-15EM Currencies Correlate With Industrial Metals Prices EM Currencies Correlate With Industrial Metals Prices EM Currencies Correlate With Industrial Metals Prices Chart I-16Book Profits On Long EM Currency Volatility Trade Book Profits On Long EM Currency Volatility Trade Book Profits On Long EM Currency Volatility Trade In accordance with our discussion above that the most acute phase of this crisis might be over, we are booking profits on our long EM currency volatility trade. We recommended this trade on January 23, 2020 and the JP Morgan EM currency implied volatility measure has risen from 6% to 12% (Chart I-16). While EM currencies could still sell off, we doubt this volatility measure will make a new high. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Vietnamese Stocks: Stay Overweight Like many EM bourses, Vietnamese stocks have plunged 35% over the past two months in US dollar terms. How should investors now position themselves with regard to Vietnamese equities, in both absolute and relative terms? In absolute terms, there are near-term risks to Vietnamese equities: Vietnam’s economy is highly dependent on exports, which amount to more than 100% of the country’s GDP. The deepening global recession entails that overseas demand for Vietnamese exports will be decimated. Chart II-1 illustrates how share prices often swing along with export cycles. Customers from the US and EU, which together account for 40% of Vietnamese exports, have been cancelling their orders. In addition, the number of visitor arrivals has already dropped significantly, and tourism revenue – which amounts to about 14% of GDP – will continue to contract (Chart II-2). Chart II-1Vietnamese Stocks: Risks Are External Vietnamese Stocks: Risks Are External Vietnamese Stocks: Risks Are External Chart II-2Tourism Has Crashed Tourism Has Crashed Tourism Has Crashed   Nevertheless, we expect Vietnamese stocks to outperform the EM benchmark, in USD terms, both cyclically and structurally. First, Vietnam has solid macro fundamentals. The country’s annualized trade surplus has ballooned, reaching $12 billion in March (Chart II-3). Even as exports contract, the current account balance is unlikely to turn negative. Notably, Vietnam imports many of the materials required to produce its exported goods. As such, its imports will shrink along with its exports, which will support its current account balance. Meanwhile, the year-on-year growth of domestic nominal retail sales of goods has slowed down, but remains at 8% as of March, which is quite remarkable (Chart II-4). Chart II-3Vietnam Has Large Trade Surplus Vietnam Has Large Trade Surplus Vietnam Has Large Trade Surplus Chart II-4Consumer Spending To Slow But Not Contract Consumer Spending To Slow But Not Contract Consumer Spending To Slow But Not Contract   Second, the government has announced a sizable policy stimulus package. On March 16, the State Bank of Vietnam cut its policy rate by 50bps, from 4% to 3.5%, and its refinancing rate by 100bps, from 6% to 5%. On April 3, Vietnam's Ministry of Finance passed a fiscal stimulus package worth VND180 trillion (equal to US$7.64 billion, or 2.9% of its GDP). Third, Vietnam has contained the COVID-19 outbreak better than many other countries. With aggressive testing and isolation, the country has so far limited the infection rate to only three out of one million citizens, and reported zero deaths. This reduces the probability that Vietnam will be forced to adopt severe confinement measures that would derail its economy. This nation’s success also contrasts with the difficulties that many emerging and frontier economies are having in their struggle with COVID-19 containment.  We continue to overweight Vietnamese stocks relative to EM due to healthy fundamentals, attractive valuations, a large current account balance and a successful economic and health response to the COVID-19 outbreak. Fourth, the country remains quite competitive in global trade. For some time, multinational companies have been moving their supply chains to Vietnam in order to take advantage of its cheap and productive labor, inexpensive land and supportive government policies. As a result, Vietnamese exports have been outpacing those of China across many industries (Chart II-5). Given the geopolitical confrontation between the US and China is likely to persist over many years, more manufacturing will shift from China to Vietnam. Investment Recommendations In absolute terms, we believe Vietnamese stocks are still at risk. Stock prices falling to their 2016 low is possible over the coming weeks and months, which corresponds to a 10-15% downslide from current levels (Chart II-6, top panel). Chart II-5Vietnam Continues Gaining Export Market Share Vietnam Continues Gaining Export Market Share Vietnam Continues Gaining Export Market Share Chart II-6Vietnamese Stocks: Absolute & Relative Performance Vietnamese Stocks: Absolute & Relative Performance Vietnamese Stocks: Absolute & Relative Performance   Relative to the EM equity benchmark, however, we continue overweighting Vietnam equities, both cyclically and structurally. Technically, this bourse’s relative performance has declined to a major support line and it could be bottoming at current levels (Chart II-6, bottom panel). Ellen JingYuan He Associate Vice President ellenj@bcaresearch.com     Footnotes   Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Feature “People have been asking me whether this is the time to buy. My answer is more nuanced: it’s probably a time to buy.” Howard Marks, Oaktree Capital, Monthly Memo March 2020   Markets have moved dramatically since we published our Monthly Portfolio Update on March 2. Global stocks have fallen by 27% since then. The 10-year US Treasury yield fell from 1.2% to 0.4% before rebounding to 0.8%. And there have been some strange market moves: the US dollar fell then rebounded, and the classic safe haven, gold, has fallen by 7%. Investors are struggling with how to think about this environment, and how to position. Chart 1Risk Assets Should Bottom When New Ex-China Cases Peak Risk Assets Should Bottom When New Ex-China Cases Peak Risk Assets Should Bottom When New Ex-China Cases Peak Table 1US Healthcare Is Top Quality A Time To Buy, Or A Time To Panic? A Time To Buy, Or A Time To Panic? Our view has not greatly changed. We still believe that risk assets will bottom around the time when global COVID-19 cases peak. They showed signs of a rebound when cases in China peaked on February 13. And they started their recent crash when ex-China cases began to accelerate dramatically (Chart 1). It is likely – and well anticipated – that there will be a sharp rises in cases in the US (and probably the UK and Canada too) over the coming two or three weeks. It is wrong to think, though, that the US is particularly badly prepared for this. The US has a high standard of healthcare, with many more intensive-care beds per person than other developed countries (Table 1) – though it is worrying that some 20% of the US population is uninsured. We see two possibilities for how the pandemic will pan out in coming weeks: The US is the last big cluster and new cases peak there in early April. This causes a two-quarter recession. But if COVID-19 turns out to be seasonal (it has not spread much in hot countries such as Singapore, or in the southern hemisphere where it is now summer – Chart 2) and by April and May it peters out. US consumers stop going out for a while (the professional hockey, basketball, and soccer seasons have been put on hold) and so demand falls. Typically, stocks fall by 25-30% in a recession of this type (Table 2) – and so this is already close to being discounted. There are no longer-term impacts, and soon the world economy is getting back close to normal. Chart 2Will Hot Weather End The Pandemic? A Time To Buy, Or A Time To Panic? A Time To Buy, Or A Time To Panic? Table 2Peak-To-Trough Falls In Equities In Bear Markets A Time To Buy, Or A Time To Panic? A Time To Buy, Or A Time To Panic? The pandemic continues for months. Governments are able to slow contagion via social distancing in order to spread out the pressure on their health services over a longer period. But ultimately one-half to two-thirds of the world’s population gets the disease and the death rate among those people is 0.7% (the rate in Korea, which extensively tested for the virus and has a good medical system). This means worldwide deaths of about 20 million, disproportionately concentrated among the over-70-year-olds and those with chronic illnesses (Chart 3). The disease could spread to poor countries, such as India and Africa, where healthcare services would not be able to cope. The global economy would slow significantly, causing a severe recession. There would be second-round effects: for example, a blow-up in the US corporate credit markets, where debt is already high as a percentage of GDP (Chart 4), which could cause banks to drastically tighten lending conditions. This could cause problems with foreign-currency EM borrowers. It could trigger another euro zone crisis, as banks in southern Europe prove unable to cope with rising defaults. In this scenario, the peak-to-trough decline in global equities could be 40-50%. Chart 3COVID-19 Mostly Kills Old And Sick People A Time To Buy, Or A Time To Panic? A Time To Buy, Or A Time To Panic? Chart 4US Corporate Debt Is A Vulnerability US Corporate Debt Is A Vulnerability US Corporate Debt Is A Vulnerability   In our last Monthly, we talked about the usefulness of a Bayesian approach in this sort of uncertain environment. We ascribed a “prior” probability of 10-20% for the latter scenario. The probability has now risen, to perhaps 25%. Chart 5Close To Capitulation Close To Capitulation Close To Capitulation But the potential upside from Scenario 1) is considerable. Central banks around the world are throwing everything at the problem. Countries from the UK and Italy, to Japan and Australia have rolled out big fiscal packages this week. The key now is what will the US do. How positively would markets react if the US in coming days scripted a coordinated announcement, with the Fed cutting rates to zero, and the White House and Congress agreeing an $800 billion fiscal package. The Fed is likely to do this – indeed the market is pricing in the Fed Funds Rate at zero by the next FOMC meeting on March 18. The dynamics of fiscal stimulus are more complicated – the Democrats don’t want to give President Trump a boost that will help his election prospects, but they don’t want to be seen to be obstructive in a time of emergency either.1 So what should investors do? We have been tempted in recent days to lower our Overweight recommendation on equities, which has evidently proved wrong, to Neutral. But we fear it is too late to do this, particularly with equities having fallen by 15% over the past two days. There is probably still some downside. We would now look for signs of a bottoming-out, most notably the peak in new COVID-19 cases outside China, but also evidence of capitulation by investors (Chart 5). Moreover, we would pay attention to potential upside surprises (in addition to a Fed/White House/Congress joint package, maybe a making-up between Russia and Saudi Arabia on oil production cuts). In the meantime, when markets move as violently as they have, often the baby gets thrown out with the bathwater. There are many individual securities, in both debt and equity markets, that look very attractively valued now. For example, we see a lot of attraction in high-dividend-yield stocks, which might appeal to investors who no longer see the point of investing in government bonds, where the upside – even in a severe recession – is likely to be very limited. Table 3 shows a screening of large-cap stocks in developed markets with a dividend yield of more than 10%, taken from BCA Research’s ETS quants screening service. While many of these are in the Energy sector (where the price/book ratio is now below the lows of 2008 and 2015 – Chart 6), quality names among European Financials and Asia Industrials are also prominent. Table 3Stocks With Dividend Yield Above 10% A Time To Buy, Or A Time To Panic? A Time To Buy, Or A Time To Panic? Chart 6Energy Sector Valuation At Record Low Energy Sector Valuation At Record Low Energy Sector Valuation At Record Low For investors who want to remain risk-off, we would not recommend government bonds as a hedge. It is notable that the Swiss 10-year government bond yield has not fallen in the recent melt-down. They are simply at their theoretical lower bound. German Bunds must be close. The Fed has been clear that it will not cut policy rates below zero, which means that the lower limit for US Treasurys is probably around 0% too. Even in the severest recession, therefore, the upside for Treasurys is limited to 9% (Table 4). This means returns are likely to be very asymmetrical since, in a rebound in risk appetite, yields could rise sharply. Table 4Little Upside From Government Bonds A Time To Buy, Or A Time To Panic? A Time To Buy, Or A Time To Panic? We prefer cash as a hedge. This gives investors dry powder for use when they do want to reenter risk assets. We have been recommending gold, and it will probably continue to serve as a safe haven in the event of our most pessimistic scenario happening. But it looks very overbought in the short term (Chart 7) – as demonstrated by the way that it has recently been correcting even on days when equities fall. TIPS offer a better hedge than nominal bonds, given how low inflation expectations have fallen – the 5-year/5-year forwards now point to CPI inflation in 2025-2030 averaging 1.5% (Chart 8). This implies – highly unrealistically – that the Fed will miss its 2% PCE inflation target by 1 percentage point a year over that period. Chart 7Gold Is Overbought Gold Is Overbought Gold Is Overbought Chart 8Inflation Expectations Unrealistically Low Inflation Expectations Unrealistically Low Inflation Expectations Unrealistically Low Garry Evans, Senior Vice President Chief Global Asset Allocation Strategist garry@bcaresearch.com   Footnotes 1 Please see Geopolitical Strategy, Weekly Report, "GeoRisk Update: Leap Year, Or Steep Year?" available at gps.bcaresearch.com.  

Highlights We spent last week meeting with clients in South Africa, who maintained their equanimity despite the spread of the coronavirus: Maybe it was because there were not yet any reported cases close to home, but investors discussed the global outbreak dispassionately. We repeated our view that a US recession is not imminent, ex-a significantly adverse exogenous event: Tight monetary policy is a necessary precondition of a recession, and there’s no reason to expect that the Fed will make any move to remove accommodation in 2020. Investors were open to our view that the US economy is subject to upward inflation pressures, even if the time is not yet ripe for them to manifest themselves: Excess global capacity is still thwarting goods inflation, but it appears to be on its way to being absorbed. In the meantime, the Fed is deliberately encouraging the economy to run hot. Inflation just might surprise investors who have been lulled to sleep by its post-crisis absence. The presidential election is a hot topic in South Africa, too: The Democratic nomination appears to be Bernie Sanders’ to lose, and he has more of a chance in the general election than investors might expect. Feature We spent last week meeting with clients in South Africa. They expressed considerably more optimism about financial markets and the global economy than they did on our previous visit in January 2019, though we all conceded that the coronavirus outcome was unknowable. We discussed a wide range of topics, with COVID-19, recession prospects, the inflation outlook, and November’s election coming up in nearly every meeting. A summary of our discussions, organized by topic, follows below. Coronavirus Impressions We discussed the coronavirus at the beginning of every meeting, albeit after acknowledging that no one can know for sure how it will unfold. We discussed the virus’ potential outcomes, our base-case expectation, and the news and data we’re monitoring to track its course. Everyone is familiar by now with the best- and worst-case scenarios, and the continuum of possibilities in between, so we will not rehash them here. The main variables we have been watching – infection, mortality and recovery rates – are also surely familiar. From a review of those metrics within China – the daily rate of new incidences inside and outside of Hubei province (Chart 1), mortality (Chart 2) and recovery rates (Chart 3) within and without Hubei – there is good reason to conclude that China is gaining the upper hand, having sharply limited the virus’ spread beyond Hubei, and steadily slowing its spread in the epicenter. Chart 1Stringent Quarantine Measures Seem To Have Gotten Some Traction Road Trip Road Trip Chart 2Mortality Rates Are Inconclusive, ... Road Trip Road Trip Chart 3... But Recovery Rates Are Encouraging Road Trip Road Trip Unfortunately, however, other countries cannot perfectly replicate China’s template for corralling the virus, as their governments have considerably less ability to limit their citizens’ movements. It is a lot easier to impose and enforce a quarantine or other emergency restrictions in China than it is in any other major country. It is important, then, to consider not just the number of countries to which the virus spreads, but the characteristics of the countries themselves. In this sense, Italy and Iran may offer some insight. The Italians reacted swiftly and decisively when the first cluster emerged in northern Italy. They drew a circle with a large radius around the cluster, restricted movement in and out of that circle, and sharply limited activities within it. Carnival celebrations in Venice were called off, and Sunday’s slate of matches in Italy’s Serie A professional soccer league were cancelled (subsequent matches are being played in empty stadiums). Although the number of reported infections in Italy has been rising, and infections have begun to pop up in western and central Europe, Italian officials appear to have both the ability and the will to contain it. The Iranian experience contrasts with Italy’s. In Iran, the mortality rate (deaths divided by confirmed cases) is roughly five times greater than it has been everywhere else the virus has erupted. That seems improbably high, and our best guess is that the infections denominator is being undercounted. A country that cannot provide a reliable count (or a reasonably accurate estimate) of infections presumably lacks the public health infrastructure to contain the virus. We conclude that it matters where the infections occur – the wealthy countries of western Europe, North America, Asia and Oceania likely have a better chance of bringing the virus to heel than developing countries. Our interactions in South Africa, among the wealthiest countries in the developing world, may further reinforce the point. In several meetings, clients asked what entering the country was like. I told them that when I arrived at the Johannesburg airport on the morning of Sunday the 23rd, all passengers from international destinations had to pass by a screener who pointed a clunky object shaped like a radar gun in the vicinity of their nose and forehead. Several planes had landed just before mine and the passport control line wound around three or four times, affording repeated opportunities to look over the radar-gun employee’s shoulder at the images on her screen. They appeared to be simple black-and-white video of the arriving passengers without any color imagery to indicate body temperature ranges. The clients uniformly laughed at that detail, exclaiming that of course the screening was ineffectual. They then soberly conceded that Africa is especially vulnerable to an outbreak. If the coronavirus or another severe adverse exogenous event doesn't do it, it will take restrictive monetary policy to induce a recession. Infections outside of China are rising with no end yet in sight (Chart 4), but the news isn’t all bad. There are some promising treatment developments that may yield effective therapies, either from the conventional drug that worked wonders on an infected patient in Washington State and is now being tested on infected groups in China, or from antibody-based therapies of the type that were successfully deployed against Ebola. Our own views are conditional upon COVID-19’s evolution, but our current base case is that it is more likely to produce a soft patch within the context of a global expansion, and a correction within the context of a continuing equity bull market, than it is to trigger a recession or a bear market. Chart 4Now It's The Rest Of The World's Turn Road Trip Road Trip Recession Prospects Chart 5Necessary, If Not Sufficient Necessary, If Not Sufficient Necessary, If Not Sufficient Nearly every client asked us about the prospects for a US recession. We discussed how the negative term premium had made the yield curve more prone to invert, thereby diluting its predictive value, and asserted our view that restrictive monetary conditions are a necessary precondition of recessions (Chart 5). We touched on the rest of the points covered in last week’s report, which argued that a strong near-term outlook for consumption, dependable government spending and a post-trade-tensions recovery in investment would keep the US out of recession over a 12-month horizon. But we spent the most time outlining what we see as the most likely route to the next recession. Expansions don’t die of old age, they die because the Fed murders them, and we told our clients that we expect that maxim will be especially apropos in this cycle. Investors should therefore focus on the factors that will prod the Fed to embark on a tightening cycle with the express intent of reining in an overheating economy. We see two main catalysts: concern that inflation may get away from the Fed on the upside (discussed in the following section), and/or concern that there are unsustainable excesses in either the economy or financial markets. Chart 6The Real Economy Isn't Close To Overheating The Real Economy Isn't Close To Overheating The Real Economy Isn't Close To Overheating We contend that there are currently no signs of excesses in the real economy. Its most cyclical elements, which have driven overheating in the past, have not gotten back to their mean level, much less the red-line levels that have been associated with previous business cycle peaks (Chart 6, top panel). Proportional spending on consumer durables remains around the bottom of its 60-year range (Chart 6, second panel), investment in non-residential structures is quite low relative to history and comfortably in the middle of its post-1990-91-recession range (Chart 6, fourth panel), and residential investment is sitting at the level that previously marked business-cycle troughs (Chart 6, bottom panel). The only cyclical activity that looks a little frisky is equipment and software spending (Chart 6, third panel), which has the best chance of enhancing productivity and thereby yielding ongoing dividends. Financial market excesses are in the eye of the beholder, and reasonable people can disagree about their existence. The promiscuous application of the word “bubble” to anything and everything market related, however, has become as familiar and tiresome as rappers’ boasts of their prowess. The S&P 500’s steady climb higher doesn’t begin to approach the manic paths of prior decades’ hot assets (Chart 7). The key takeaway is that the economic or financial overheating likely to trigger the expansion’s ultimate denouement is yet to arrive. Until it does, the Fed will have no reason to intervene to stop it. Chart 7Which One Of These Is Not Like The Others? Which One Of These Is Not Like The Others? Which One Of These Is Not Like The Others? Inflation Prospects Many clients asked about inflation prospects before we could bring up the subject, a notable turnabout from our last visit thirteen months ago, when our arguments for accelerating wage gains met mostly with indifference. We were happy to oblige, as inflation occupies an essential place in our base-case cyclical scenario. Tight monetary policy is a necessary precondition for an endogenously occurring recession. Ex-a severe exogenous shock, like a global pandemic, the expansion cannot end without tight monetary conditions, and the Fed won’t knowingly impose them unless it is concerned that inflation is getting away from it on the upside. Q: Why has there been no whiff of US inflation in the last eleven years? A: Because the negative US output gap rendered it impossible until 2018. We are not daunted by inflation’s post-crisis hibernation. Meaningful price increases at the level of the entire economy cannot occur when an economy has a negative output gap (aggregate demand persistently falls short of economic capacity) unless its currency is sliding and it imports a lot of goods and services. From that perspective, inflation has only been possible in the US since 2018, because it didn’t close its output gap until 2017, according to estimates from both the IMF and the CBO. 2018 was the year that the US embarked on an unprecedented macroeconomic experiment (Chart 8), injecting fiscal stimulus amounting to one half of the economy’s long-run capacity (about 100 basis points) at a time when it was already operating at full capacity (2-2.25%). If corporations and other businesses viewed the surge in aggregate demand as a one-off event that couldn’t be replicated in the future, they would likely choose not to invest in additional capacity to meet it. The net result was demand in excess of supply in 2018 and in 2019, when an additional 50 basis points of stimulus was deployed. Inflation did not break out in either year, but negative output gaps in the rest of the developed world provided the US with the convenient out of importing other countries’ excess capacity. Chart 82018's Unprecedented Macroeconomic Experiment May Yet Produce Inflation 2018's Unprecedented Macroeconomic Experiment May Yet Produce Inflation 2018's Unprecedented Macroeconomic Experiment May Yet Produce Inflation The Bank of Canada estimated that Canada closed its output gap in 2018, and the IMF estimates that Europe’s output gap has now closed (Chart 9, top panel), and while even Japan has made a lot of progress on narrowing its output gap (Chart 9, bottom panel). Goods inflation is largely globally determined, and with excess capacity being absorbed around the world, it’s possible that the conditions that would allow for higher goods prices could soon lock into place. Services inflation, a predominantly domestic phenomenon, is poised to rise thanks to the tight-as-a-drum labor market. Just when inflation will rear its ugly head is uncertain, however, as it is a lagging indicator that often doesn’t peak, until a recession has nearly ended, or trough for nearly three years after a recession begins (Chart 10). Chart 9The Slack Is Being Absorbed The Slack Is Being Absorbed The Slack Is Being Absorbed Chart 10It May Take A Long Time For 2018's Seeds To Germinate Road Trip Road Trip We find supply and demand arguments compelling, and the excess-supply constraint on global goods inflation has quietly been easing. The bottom line is that we think the US economy harbors upward inflation pressures, though it is highly unlikely that they will manifest themselves this year. That will give the Fed free rein to allow the economy to run hot across all of 2020, in service of its primary goal of pushing inflation expectations higher, and the labor market as well, in service of its secondary goal of spreading the benefits of easy policy more evenly across the economy. The upshot is that the longer inflation remains outwardly dormant, the harder it will be to root it out once it eventually does begin to bloom. The World Is Watching American Voters As an indication of the anticipation surrounding November’s election, South African investors, who recognized Bernie Sanders’ name, asked about it in every meeting. We laid out our geopolitical strategists’ views, augmented in places by our own, on the key issues as follows: Presidential elections are referendums on the incumbent party. An incumbent president running for re-election has a sizable built-in advantage. In the postwar era, only major economic, social or international shifts have been sufficient to erode that advantage. Incumbents lose when a recession occurs near an election, but the president has to be considered a favorite if the expansion continues. The president may be an especially poor front-runner. Donald Trump personifies variability. That’s a great trait to have as an underdog, because a wide dispersion of individual outcomes broadens the range of possible competitive outcomes, but it’s a vulnerability for a favorite. It is nearly impossible for a golfer with a two-stroke lead ahead of the final par-four eighteenth hole to lose if s/he conservatively plays for par. It seems to us that the president is not wired to play conservatively, and our geopolitical strategists currently give him just a 55% chance of re-election. Bernie Sanders is not unelectable. Our geopolitical strategists note that the median voter is moving to the left, and that Sanders is many Biden supporters’ second choice. He may not be anathema to the broader public in the general election, and his leveling platform may play well in the Rust Belt states that are poised to decide the election once again. A Sanders administration would not transform America into France, but it would chip away at corporate profits. Our personal view is that a President Sanders would not mark the end of the US as a beacon of free enterprise. The Constitution was designed to obstruct dramatic changes, and his ability to pass major legislative initiatives is likely exaggerated. We think he could make his influence felt much more directly in the bureaucratic and regulatory spheres, where a president can act virtually unimpeded. A Sanders administration would be a devoted and presumably activist friend of labor, and a tenacious foe of corporate concentration. An administration that energetically champions organized labor and vigorously enforces anti-trust statutes would exert downward pressure on corporate profit margins. Bullish Or Bearish Borrowing a line from longtime Street economist and strategist Ed Yardeni, our mandate is bullish or bearish, not good or bad. We are charged with making objective decisions about what is most likely to occur in markets, not to daydream about what we would most like to happen. Our base-case scenario turns on our expectation that accommodative monetary policy will remain in place until well into 2021, and will continue to be effective in forestalling defaults and inflating asset valuations. It may not be the most comforting basis for being long risk assets, and we make no implied endorsement of its quality, but if we think it’s going to continue to work beyond the edge of the visible horizon, then we have to reiterate our recommendation that investors should remain at least equal weight equities in multi-asset portfolios, and at least equal weight credit in fixed income portfolios. Austrian adherents and self-styled monetary policy experts can howl about moral hazard and manipulation all they want, but we have to invest in the backdrop that we have, not the backdrop that we want. We do not yet see the approach of a catalyst that will prevent life insurers, pension funds, endowments and other investors who need yield from continuing to go further out the risk curve in search of it. And we don’t yet see the approach of a catalyst that will prevent equity investors from continuing to bid multiples higher. We remain constructive over the cyclical twelve-month timeframe.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com