Consumer

Highlights US consumer spending will stall this summer in response to the rising number of Covid cases. Worries about the looming fiscal cliff could also dampen sentiment. Markets are likely to trade nervously over the coming days, but ultimately, stocks will resume their uptrend. The number of new cases already seems to be peaking in some southern US states, and there is no political will to rescind fiscal stimulus. Many institutional investors missed out on the equity rally and will be keen to “buy the dip” on any opportunity. The drop in government bond yields since the start of the year has more than offset the decline in earnings expectations. As odd as it sounds, the pandemic may have raised the fair value of equities. If one wants to challenge this conclusion, one needs to demonstrate that: 1) earnings estimates have not fallen enough; 2) government bond yields have been artificially suppressed; or 3) the post-pandemic world justifies a higher equity risk premium. While there is some truth to all three arguments, they are unlikely to hold much sway over the next 12 months, provided that global growth rebounds and governments and central banks maintain ultra-accommodative fiscal and monetary policies. Investors should remain overweight global equities, while tilting their exposure to beaten-down cyclically-geared stocks and non-US markets. The equity bull market will only end when central banks get panicky about rising inflation, which is unlikely to happen for the next three years. From ROMO To FOMO People often talk about FOMO (the Fear of Missing Out). But for many institutional investors, the past four months has been more about ROMO – the Reality of Missing Out. Chart 1Many Investors Are Bearish On Stocks Many investment professionals missed the rally that began in March, and not much has changed since then. The July BofA Merrill Lynch Survey of Fund managers revealed that fund managers are almost one standard deviation overweight cash and nearly one standard deviation underweight equities. In fact, cash allocations increased further since June. The latest sentiment survey conducted by the American Association of Individual Investors (AAII) tells a similar story. Bears exceeded bulls by 15 points in this week’s tally, one of the highest spreads on record (Chart 1). This is not what market tops look like.   Near-Term Worries Granted, risks abound. The Google Mobility Index has hooked lower, reflecting the worsening Covid outbreak in the sunbelt states and parts of the Midwest. This real time index tends to track economic activity quite well (Chart 2). At this point, it is reasonable to expect the recovery in US consumer spending to stall this summer. Chart 2Covid Outbreak Is Weighing On Spending Worries about the fiscal cliff could also dampen sentiment. Unemployment benefits for the average American worker are set to fall by more than 60% at the end of July. The funds in the Paycheck Protection Program for small businesses are also running out. To make matters worse, many state and local governments, which began their fiscal year in July, are facing a severe cash crunch due to evaporating tax revenues and rising social spending obligations. Meanwhile, the US elections are only four months away. If the Democrats win the White House and take control of the Senate, the Trump tax cuts will be in jeopardy. Joe Biden has pledged to lift corporate tax rates halfway back to their original levels. This would reduce S&P 500 EPS by about 6%. Risks In Perspective While the discussion above suggests that stocks could trade nervously over the coming days, we should keep things in perspective. The number of new Covid cases has been trending lower in Arizona over the past week and may be close to peaking in the other southern states (Chart 3). Positive news on the vaccine front could also buoy sentiment.  Chart 3A Snapshot Of The Number Of New Cases In The Most Afflicted US States With respect to the fiscal cliff, there is a very high probability that Congress will reach a deal on a new aid package worth around $2.5 trillion. Table 1 shows stimulus remains politically popular nationwide and, more importantly, in the swing states. Table 1There Is Much Public Support For Fiscal Stimulus If Democrats prevail in November and raise corporate taxes, most of the revenue gained will be plowed back into the economy. Given that empirical estimates suggest that the spending multiplier from the corporate tax cuts was quite small, the net effect will probably be stimulative.1 The risk of an all-out trade war with China would also decline under a Biden administration, which is something the stock market would welcome. Some might contend that stocks are already pricing in a very rosy outlook. However, as we argue below, it is far from clear that this is the case. Has All The Good News Been Priced In? An NPV Analysis The fair value of the stock market can be represented as the expected stream of cash flows that shareholders will receive, deflated by an appropriate discount rate. The discount rate, in turn, can be expressed as a risk-free rate plus an equity risk premium (ERP). The ERP compensates investors for holding riskier stocks compared to safer government bonds. At the start of the year, Wall Street analysts expected S&P 500 earnings to increase by 9% in 2020 and by 11% in both 2021 and 2022. Today, analysts expect earnings to shrink by 23% in 2020, but then rebound by 29% in 2021. This would essentially take earnings back to last year’s levels. Looking further out, analysts expect earning to recover a further 17% in 2022, which would put them on track to reach their pre-pandemic trend by 2024. In contrast, market participants see little scope for a recovery in bond yields (Chart 4). According to the forward curve, the US 10-year is poised to rise from 0.62% at present to just 1.3% in five years’ time. At the start of 2020, investors thought the 10-year yield would be 2.5% in 2025. Along the same vein, the 30-year bond yield is down 106 bps since the start of the year. The 30-year TIPS yield has fallen by 82 bps. Since stocks are a long duration asset, the TIPS yield is a good proxy for the inflation-adjusted, risk-free component of the discount rate. Chart 4After Nosediving, Bond Yields Aren’t Expected To Rise By Much Chart 5 shows that if we combine the change in analyst earnings expectations with the drop in the TIPS yield, the net present value (NPV) of S&P 500 earnings has risen by a staggering 16.2% since the start of the year. Chart 5The Present Value Of Earnings: A Scenario Analysis Really? It might seem preposterous to conclude  that the fair value of the S&P 500 may have increased at a time when the US and the rest of the world have plunged into the deepest recession since the 1930s. Yet, it naturally flows from the premise that the hit to earnings from the pandemic will be temporary, while the decline in bond yields will be much longer lasting. If one wants to challenge this conclusion, one needs to demonstrate that: 1) earnings estimates have not fallen enough; 2) government bond yields have been artificially suppressed; or 3) the post-pandemic world justifies a much higher equity risk premium. Let us examine all three arguments in turn. Are Earnings Estimates Too Optimistic? The short answer is yes. However, this does not say very much. As Chart 6 shows, analysts are usually too optimistic. They typically start every year with overinflated estimates, and subsequently have to scale them down. This happens even during economic expansions. Thus, if estimates end up being trimmed over the coming months, this will not necessarily prevent stocks from moving higher. Chart 6Earnings Estimates Tend To Be Revised Down Even In The Best Of Times Of course, magnitudes matter a lot. If analysts end up having to revise estimates down more than usual, this could hurt stocks. But will they? That is far from a foregone conclusion. Earnings usually follow the path of nominal GDP. The Congressional Budget Office (CBO) expects the level of nominal GDP to be just half a percentage point lower in 2021 than it was in 2019. In this light, the notion that earnings next year will be on par with last year’s levels does not seem that farfetched. Moreover, one should also note that health care and technology are highly overrepresented on Wall Street compared to Main Street. Together, they account for 42% of S&P 500 market capitalization. Outside these two sectors, S&P 500 earnings are expected to be 9% lower in 2021 relative to 2019. In any case, the conclusion that the pandemic has increased the fair value of equities would not change much if we were to assume that earnings recover more slowly than anticipated. The red colored bar in Chart 5 shows the impact on the NPV in a scenario where earnings only return to their pre-pandemic trend by 2030: the NPV still rises by 13.5%. Even if we assume that earnings permanently remain 5% below their pre-pandemic forecast, the NPV would still increase by 9.2% (blue colored bar). In order to push down the NPV by a considerable amount, one would need to assume that the pandemic will not only reduce the level of corporate earnings, but it will reduce the growth rate of earnings as well. For example, if the pandemic reduces earnings growth by one percentage point, this would cause the NPV to fall by 7.5% (gray colored bar). Is this a sensible assumption, however? We don’t think so. While the pandemic will reduce capital spending temporarily, it is unlikely to damage the long-term growth rate of either productivity or the labor force, the two key drivers of potential output. Chart 7 shows that even after the Great Depression, per capita income eventually returned to its long-term trend. Chart 7No Clear Evidence That The Great Depression Lowered Long-Term Trend Growth Are Bond Yields Distorted To The Downside? The notion that the pandemic may have increased the fair value of the stock market hinges critically on the view that the discount rate has fallen substantially this year. We will get to the question of what the appropriate level of the equity risk premium should be in a moment, but let us first examine the risk-free component of the discount rate. Many pundits argue that central bank bond purchases have pushed down yields below where they ought to be. That may be true, but it is not clear why that matters. If one is making present value calculations, one should look at the actual bond yield, not the yield that accords with one’s preconception of what is appropriate. Granted, if bond yields were to rise sharply in the future, the present value of future earnings would probably end up falling. However, this is unlikely to occur anytime soon. It will take a while for unemployment to return to pre-pandemic levels, during which time inflation will remain dormant. And even once inflation starts rising, central banks will likely refrain from hiking rates because they have been concerned about excessively low inflation for nearly two decades. Central banks could also face pressure from governments to keep rates low in order to suppress interest costs. As a result, real rates could fall initially, which would be supportive of stocks. The bull market in equities will only end when inflation reaches a level that makes markets nervous that central banks will have to raise rates. This is unlikely to happen for the next three years. The Equity Risk Premium Is More Likely To Fall Than Rise Chart 8Non-US Stocks Look Cheaper Than Their US Peers In Both Absolute Terms And In Relation To Bond Yields As noted above, there are many risks confronting investors. The key question is whether the stock market’s perception of these risks will subside or intensify. If it is the former, the equity risk premium will probably shrink, pushing stocks higher. If it is the latter, stocks will fall. Our bet is on the former. We have already learned a lot about the virus. We will learn even more over the coming months. This should reduce the cone of uncertainty investors are facing. On the economic side, central bank asset purchases, combined with large-scale fiscal stimulus, have reduced the tail risk of another market meltdown. If policy stays supportive for the next few years, as we expect, the equity risk premium will shrink. Starting points matter, too. Globally, the equity risk premium, which we calculate by subtracting the real bond yield from the cyclically-adjusted earnings yield, was quite high at the start of the year and is even higher now (Chart 8). This suggests that investors should favor stocks over bonds.   A Weaker Dollar Will Give Non-US Stocks An Edge The ERP is particularly elevated outside the US. Thus, valuations tend to favor non-US stocks. Of course, it helps to have factors other than valuations on your side when making investment decisions. In the case of regional and sector allocation, the outlook for the US dollar is critical. Chart 9 shows that cyclical stocks tend to outperform defensives when the dollar is weakening, while non-US stocks tend to do better than their US peers. There are five reasons to expect the US dollar to depreciate over the next 12 months. First, as a countercyclical currency, a revival in global growth should hurt the dollar (Chart 10). Second, the US has been harder hit by the virus over the past few months than most other economies. Thus, the spread between overseas growth and US growth is likely to widen more than usual (Chart 11). Chart 9Cyclical Sectors Should Outperform Defensives As Global Growth Recovers... And A Weaker Dollar Should Also Help Non-US Stocks Chart 10A Revival In Global Growth Should Hurt The Dollar Chart 11The Dollar Will Also Weaken On The Widening Gap Between Overseas Growth And US Growth Chart 12Interest Rate Differentials No Longer Favor The Dollar Third, interest rate differentials no longer favor the dollar, now that the Fed has brought rates down to zero (Chart 12). Fourth, momentum is not on the greenback’s side anymore (Chart 13). Fifth, the dollar is expensive based on measures such as purchasing power parity exchange rates (Chart 14). Chart 13Momentum Is Not On The Greenback’s Side   The right trade over the past few years was to be long the dollar and overweight US stocks. It is time to flip this trade and do the opposite. Peter Berezin Chief Global Strategist peterb@bcaresearch.com Chart 14USD Is Not Cheap Footnotes 1  An IMF analysis of the use of funds of listed companies found that only about one fifth of the increase in corporate cash since the adoption of the Tax Cuts and Jobs Act (TCJA) was used for capex and R&D. The rest was utilized for share buybacks, dividend payouts, and other activities. The same study also noted that actual GDP and business investment growth in 2018 fell short of the predicted impact of the TCJA based on empirical studies of postwar US tax changes. Please see Emanuel Kopp, Daniel Leigh, Susanna Mursula, and Suchanan Tambunlertchai, "U.S. Investment Since the Tax Cuts and Jobs Act of 2017," IMF Working Paper, May 31, 2019. Global Investment Strategy View Matrix Current MacroQuant Model Scores

Dear Client, US Investment Strategy will take the first of two summer breaks next week, so there will be no publication on July 13th. We will return on July 20th with the latest installment of our Big Bank Beige Book, reviewing the five largest banks’ second quarter earnings calls. Best regards, Doug Peta   Highlights Bottom-up S&P 500 earnings expectations for 2021 are probably high: I/B/E/S expectations incorporating periods six or seven quarters away are little more than extrapolations and investors shouldn’t get hung up on them. The higher corporate income tax rates that would follow a Democratic sweep are a bigger concern. Policymakers have decisively won the early rounds of their bout with the pandemic’s economic effects, … : Transfer payments pushed April and May personal income well above its February level, and households have accordingly stayed current on their rent and other financial obligations. … and they will win the fight provided Congress doesn’t tire, … : Volatility may rise amidst the back and forth of negotiations, but Republican Senators cannot risk allowing aid to elapse three months before the election. … but what’s good for the economy in the long run may come at the expense of active managers’ performance: Value investors can’t catch a break, and all stock pickers will have to contend with a policy backdrop that challenges their established modus operandi.   Feature We have not traveled any farther for work than the kitchen table in three and a half months. Renewing our expiring passport could take a year, and the clock is ticking on our ability to fly domestically on a driver’s license from the persona non grata state of New York. Unless the administration or the electorate has a change of heart, the REAL ID rules may prevent us from seeing a client in person until well into 2021. At least the construction at LaGuardia may be finished by then. Even if we’re not seeing clients face to face, however, communication continues. Several topics have come up repeatedly in virtual discussions and we devote this week’s report to examining them. Our overriding impression is that global investors have been surprised by risk assets’ resilience and are skeptical that it can be sustained. We share the surprise and some measure of the skepticism, though we are more constructive than most BCA clients because of our conviction that policymakers can bridge the economic gap created by the pandemic and the commercially restrictive measures undertaken to combat it. Yes, Estimates Are Too High (But It’s Mainly An Election Story) Q: Consensus S&P 500 earnings estimates for next year are in line with actual 2019 earnings, yet 2019 was the tenth full year of an expansion and we’re likely to begin 2021 with an unemployment rate close to 10%. Isn’t there something wrong with this picture? We agree that consensus estimates for 2021 S&P 500 earnings are too high. It seems unlikely on its face that 2021 earnings, currently estimated at $163, will match 2018 ($162) and 2019 ($163) when the public health and economic backdrops are so uncertain. An additional 14% of EPS growth in 2022 seems like a pipe dream. We put very little stock in consensus estimates more than two quarters into the future, however, because analysts put very little effort into producing them. They focus on the current quarter and the following quarter; estimates beyond that range are nothing more than simple extrapolation. Investors familiar with sell-side analysts’ processes presumably don’t look beyond near two-quarter estimates themselves. We therefore doubt that the equity market is hanging on stated 2021 estimates and will be at risk when they are eventually revised down. We simply conclude that the S&P 500’s forward four-quarter earnings multiple of 24 is somewhat more elevated than it appears to the naked eye. Stocks are not cheap, and investors have probably gotten somewhat complacent. Equities have little margin for safety now and are therefore vulnerable to a near-term decline. Valuation is a notoriously poor timing tool, however, and we are content to remain neutral on equities over the tactical zero-to-three-month timeframe. A much stronger case against the earnings outlook for 2021 and beyond comes from the president’s flagging re-election prospects. Our Geopolitical Strategy service continues to estimate Joe Biden’s probability of winning the election at 65%. The virtual betting market PredictIt places Biden’s odds at 62%, and has had him as the favorite since May 30th. It is too simplistic to say that a Democratic president, backed by majorities in both houses of Congress,1 would be bad for the economy, but a Biden victory would introduce two profit headwinds. First, reversing half of the decline in the top marginal corporate tax rate, as the Biden campaign has proposed, would directly strike at the earnings stream available to common shareholders. Precisely quantifying that drop is not easy. S&P 500 constituents’ effective tax rates vary widely, with only a small proportion paying the statutory rate, and they do not disclose the federal component of their tax bill. We make the simple back-of-the-envelope assumption that the maximum net earnings impact of the cut in the top marginal rate from 35% to 21%, beginning in 2018, was 21.5%, as .79 (1-.21) is 21.5% greater than .65 (1-.35). Similarly, the maximum net earnings impact of hiking the top marginal rate to 28% from 21%, beginning in 2021, would be -9%, as .72 (1-.28) is nearly 9% less than .79 (1-.21). Equities seem to be ignoring the negative profit margin consequences of an increasingly likely Democratic sweep. Chart 1The Tax Cut Materially Boosted Median S&P 500 Earnings The change in effective tax rates before and after the 2018 tax cuts was about half of our maximum ballpark estimate. In the two years before the rate cut, excluding 4Q17 and its myriad one-time adjustments, the median effective tax rate for S&P 500 constituents was around 28%; in the two subsequent years, excluding 1Q18, the median rate has hovered near 20% (Chart 1). The change suggests that the tax cuts have boosted median S&P 500 earnings by about 11%.2 In addition to raising taxes, a Biden administration would be considerably more friendly to labor than the Trump administration. A soft labor market in which full employment is at least a few years away argues against broad wage gains, but companies that have benefitted from a complaisant National Labor Relations Board for the last four years could face a rude awakening. If Biden wins, we wager that McDonald’s workers will be unionized before next summer,3 a scenario that McDonald’s stock clearly does not anticipate (Chart 2). Chart 2For McDonald's, A Biden Win Means An NLRB Reversal Bottom Line: A Democratic sweep would weigh on earnings via higher corporate income tax rates and revived advocacy for labor at executive branch departments like the NLRB. Considering these incremental drags, it is unlikely that S&P 500 earnings will match their 2019 levels in 2021. Policymakers Versus The Virus: The Fight So Far Chart 3D.C. Is Keeping Households Afloat ... Q: Your constructive cyclical take depends on policymakers’ ability to offset the pandemic’s economic consequences. How do the data say that’s going so far? The data say that it’s going swimmingly. Thanks to generous transfer payments from the federal government, personal income in April and May comfortably surpassed February’s pre-pandemic peak (Chart 3). Households have not spent much of their windfall (Chart 4), choosing instead to squirrel it away, driving the savings rate to 32% in April and 23% in May. The mountain of savings will make it easy for households to service their debt (Chart 5), which they have been paying down. Chart 4... And They're Saving The Money, ... Chart 5... Much To Their Creditors' Relief The apartment REITs will not likely disclose June rent collection data before their earnings calls, but the National Multifamily Housing Council rent tracker shows that June collections have built on May’s month-over-month improvement. Through June 27th, June collections are tracking ahead of April and May collections and are barely off of last year’s pace (Table 1). Table 1Apartment Tenants Are Paying Their Rent Table 2Consumer Borrowers Are Making Their Payments TransUnion’s monthly consumer loan delinquency data for May reinforce the conclusion that policymakers are achieving their goal of preventing a default spiral. Auto loan delinquencies rose sharply in May, but delinquencies in all other personal loan categories fell on a month-over-month basis (Table 2). Mortgage delinquencies are below their year-ago level, while credit cards and other personal loans have risen only slightly from a low base. Auto loan delinquencies are up appreciably from May 2019, but TransUnion’s data show that the true rot is concentrated in loans made by independent lenders. Their 60-day delinquencies rose to 7.2% in May from 4.5% in April, while bank (0.62%) and credit union delinquencies (0.51%) eased slightly in May. Bottom Line: Extremely generous income assistance has helped households amass formidable cash reserves. The aid has allowed households to pay their rent and service their debt, shielding landlords, banks and many specialty lenders from pressure. Policymakers Versus The Virus: Going The Distance Q: What might cause the Fed to waver in its resolution to help the economy battle the virus? Will the Senate block future stimulus efforts? Nothing will cause the Fed to waver in its resolution to shield the economy from the virus; investors can take Chair Powell’s pledge to do whatever it takes for as long as it takes to the bank. Capitol Hill’s commitment is much less certain and public posturing during Senate negotiations could stoke market volatility. Elected officials reliably respond to career incentives, however, and those incentives will keep recalcitrant Senate Republicans from blocking another round of fiscal largesse. Investors need not worry that Republicans in the Senate will pull the rug out from under the economy and markets – doing so would wreck their own political fortunes. The Republicans’ election prospects have been sliding for a month. Four months is an eternity in a campaign, and they have ample time to reverse their fortunes. But if Republican Senators were to obstruct the passage of the next aid bill, they would be signing their own death warrant. They simply cannot cut off ailing households’ lifeline, or strip municipalities of essential services, as the campaign enters the homestretch. Any individual Senator would be imperiling his/her own quest for influence, and the party’s majority status and relevance, if s/he were to cast one of the votes that blocked a new spending round, and it would be folly to do so over a minor matter like principle. Policymakers Versus Active Managers Q: If valuations no longer matter, how do we show our clients that we’re adding value? It chagrined us to acknowledge on a call last week that equity valuations have been greatly deemphasized in our base case scenario. That scenario calls for overweighting equities in balanced portfolios over a twelve-month timeframe on the view that the flood of emergency stimulus will linger in the system long after it’s needed, stoking aggregate demand and pushing up the prices of cyclically exposed assets. Provided that policymakers succeed in limiting defaults and bankruptcies, thus preventing a pernicious chain reaction from taking hold, we are willing to overlook elevated valuations. Massive accommodation makes active managers' jobs harder because there's no telling who's swimming naked when policymakers won't let the tide go out. Those valuations are supported arithmetically by discount rates which appear as if they will remain very low for an extended period as long as investors don’t become nervous and demand a higher equity risk premium, diluting the impact of nominally lower interest rates. Our base case is that they won’t, but there is no doubt that equity investors’ margin of safety is quite thin. We cannot use the term margin of safety without thinking of Benjamin Graham, and it gives us a pang to think that his disciples may face another few years of wandering in the wilderness. Value investing is predicated on making distinctions between individual companies, as is security analysis more generally. A rising tide lifts all boats, however, and the massive stimulus efforts that have been unleashed in all the major economies (Chart 6) have the effect of obliterating differences between companies. That potentially limits the value that skilled active managers can add to an investment portfolio via a focus on traditional bottom-up metrics. Chart 6All Together Now Our solution is to try to focus on the varying impact top-down factors will have on different companies and sub-industry groups. We are overweight the SIFI banks because we view them as the biggest beneficiary of policymakers’ attempt to suppress defaults and their rock-bottom valuations stand in sharp contrast with the rest of the market. We echo our fixed income strategists’ recommendations to buy the bonds the Fed is buying. We also think that positioning portfolios for regulatory changes that might ensue in 2021 and beyond could be a rich source of alpha if a blue wave really is poised to strike the US on the first Tuesday in November.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com     Footnotes 1 Our geopolitical team expects the Democrats to take the Senate if they win the White House. PredictIt markets imply that Democrats have a 61% probability of winning a Senate majority. 2After-tax earnings before the tax cut were 72 cents on the dollar (1-28%) = .72. After the tax cut, they rose to 80 cents (1-20%) = .80. 80 is 11.11% greater than 72. 3Please see the NLRB/McDonald’s discussion on pp.7-9 of the February 3, 2020 US Investment Strategy Special Report, “Labor Strikes Back, Part 3: The Public-Approval Contest,” available at usis.bcaresearch.com.

Highlights The cost of housing is the one item that has held up US inflation vis a vis European inflation in recent years. But as the cost of housing flips from being a strong tailwind to a strong headwind, US inflation is about to converge down to European levels and stay there. This means that US and European bond yields will also converge. If the US 30-year yield converges down to the UK 30-year yield, it would equate to a price appreciation of 15 percent. Underweight the dollar versus the most defensive European currency, the Swiss franc. Continue to favour long-duration defensive equities, technology and healthcare, whose net present values are most leveraged to a decline in the US T-bond yield. Fractal trade: long GBP/RUB. Feature Chart I-1Housing Cost Inflation Has Been Subdued In The UK... Chart I-2...But Running Hot In The US. What Happens Next? One of the biggest ongoing costs that we face is the cost of housing. Yet economists remain perplexed on how to measure this cost in a consumer price index. For people who rent their homes, the issue is straightforward – the rent paid every month captures the cost of the housing services that are consumed. But for owner occupiers, the biggest ongoing cost tends to be the mortgage interest payment. Therein lies a problem. Measuring Housing Costs Is A Challenge A consumer price index aims to measure the costs of consumption. But a mortgage interest payment measures the cost of borrowing money, rather than a cost of consumption. Therefore, capturing owner occupiers’ housing costs poses a challenge, and economists have developed several theoretical approaches to measure them (Box I-1). Box I-1The Different Methods Of Measuring Owner Occupiers’ Housing Costs This report focusses on the approach known as rental equivalence or ‘owners’ equivalent rent’. The reason is that rental equivalence is the approach used in the UK CPI including housing (CPIH) – though be aware that the Bank of England still targets inflation using the CPI excluding housing. Rental equivalence is also the approach used in the US CPI and PCE, and the Federal Reserve does target inflation including housing. The treatment of housing costs in inflation matters enormously. The UK versus US comparison reveals something odd. In the UK, owner occupiers’ housing inflation has been running well below overall inflation, whereas in the US it has been running hot (Chart I-1 and Chart I-2). In fact, remove the 25 percent weighting to owners’ equivalent rent from the US consumer price index – to make it comparable with Europe – and the US inflation rate would now be one of the lowest in the world at minus 1 percent! (Chart I-3). Hence, the treatment of housing costs in inflation matters enormously. Chart I-3Excluding Owners' Equivalent Rent, US Inflation Is Minus 1 Percent What Is Driving Housing Costs? A UK Versus US Comparison Rental equivalence uses the rent paid for an equivalent house as a proxy for the costs faced by an owner occupier. The approach answers the question: “how much rent would I have to pay to live in a home like mine?” In other words, the housing services are valued by looking at the cost of the next best alternative to owning the home, namely renting an identical or near-identical property. As rental equivalence aims to measure the cost of housing services rather than the asset value of the house, it should not be expected to move in line with house prices in the short-term. Indeed, the rent for a property is likely to be lower in relation to the house price when the monthly mortgage payment is lower. This is because a lower monthly mortgage payment makes it more affordable to own a house, pushing down the prices of rents and rental equivalence. Economists remain perplexed on how to measure housing costs in a consumer price index. In the UK, mortgages tend to have a variable interest rate linked to the Bank of England policy rate. Hence, the change in short-term mortgage rates explains the profile of housing cost inflation. For the past few years, UK owner occupiers’ housing inflation has been subdued because short-term mortgage rates have been drifting down (Chart I-4). Chart I-4UK Owner Occupiers' Housing Cost Inflation Tracks Changes In The Mortgage Rate But in the US, mortgages tend to have fixed rates resulting in a different explanation for the profile of housing cost inflation. US owners’ equivalent rent inflation moves in lockstep with actual rent inflation. In fact, the two series are almost indistinguishable (Chart I-5). Raising the question: what drives US rent inflation? Empirically, the most important driver is the (inverted) unemployment rate – which establishes the number of people who can rent a property. Chart I-5US Owners' Equivalent Rent Tracks Actual Rent Inflation This leads to a crucial finding. The last three times that the US unemployment rate moved into the high single digits – in the recessions of the early 1980s, early 1990s, and 2008 – rent inflation plus owners’ equivalent rent inflation flipped from being a strong tailwind to core inflation into a very strong headwind. Given the consistent relationship in each of the last three recessions, and with US unemployment rate now running in double digits, only a brave man would bet on it being any different in the 2020 recession (Chart I-6). Chart I-6Whenever US Unemployment Surges, Shelter Inflation Flips From An Inflation Tailwind To An Inflation Headwind The combination of rent plus owners’ equivalent rent – shelter – comprises 34 percent of the US consumer price index, 42 percent of the core CPI, as well as a hefty weighting in the core PCE. It is the one item that has held up US core inflation vis a vis European core inflation in recent years (Chart I-7). But as shelter inflation flips from being a strong tailwind to a strong headwind, US inflation is about to converge down to European levels and stay there. Chart I-7Shelter Has Propped Up US Core Inflation... But For How Much Longer? The Implications Of Converging Inflation As US inflation converges down to European levels, the last few years of divergence in US bond yields from European yields will prove to be a brief aberration. Before 2016, US and European yields were joined at the hip. It is highly likely that they will soon re-join at the hip (Chart I-8 and Chart I-9). Chart I-8The Last Few Years Of Divergence Between US And European Bond Yields... Chart I-9...Will Prove To Be A Brief ##br##Aberration All of which reinforces three of our existing investment recommendations: Stay overweight US T-bonds versus high-quality European government bonds. In fact, if the US 30-year yield converges down to the UK 30-year yield, it would equate to a price appreciation of 15 percent. Meaning that an absolute overweight to the US long bond will also reap rewards. Turning to currencies, yield convergence should be bearish for the dollar versus European currencies. That said, the dollar has the merit of being well bid during periods of economic and financial stress which might prove to be regular occurrences in the coming year. On this basis, the best strategy is to underweight the dollar versus the most defensive European currency, the Swiss franc. If the US 30-year yield converges down to the UK 30-year yield, it would equate to a price appreciation of 15 percent. Finally, in the equity markets, continue to favour long-duration growth defensives – whose net present values are most leveraged to a decline in the US T-bond yield. This means technology and healthcare. Fractal Trading System* The rally in the Russian rouble is technically stretched and susceptible to a countertrend reversal. Accordingly, this week’s recommended trade is long GBP/RUB. Set the profit target and symmetrical stop-loss at 3 percent. Chart I-10GBP/RUB In other trades, long Australia versus New Zealand closed at the end of its 65 day holding period flat. The rolling 1-year win ratio now stands at 59 percent. When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated  December 11, 2014, available at eis.bcaresearch.com.   Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading System   Cyclical Recommendations Structural Recommendations Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields   Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations  

Highlights Historically, when global growth picks up, the yen weakens. But this is less likely in an environment where global yields remain anchored at low levels. Meanwhile, there is rising risk that consumption in Japan will remain muted. This will limit any pickup in domestic inflation. A modest rise in real rates will lead to a self-reinforcing upward spiral for the yen. That said, cheap yen valuations will buffet Japanese exports. Go short USD/JPY with an initial target of 100. Feature Chart I-1Higher Volatility, Higher Yen The powerful bounce in global markets since the March lows is at risk of a bigger technical correction. As we enter the volatile summer months, it may only require a small shift in market sentiment to trigger this reversal. The yen has tended to strengthen when market volatility rises (Chart I-1). Should this happen, it will provide the necessary catalyst for established long yen positions. On the other hand, if risk sentiment stays ebullient, the yen will surely weaken on its crosses but can still strengthen vis-à-vis the dollar. This places short USD/JPY bets in an enviable “heads I win, tails I do not lose too much” position. Growth And Monetary Policy Like most other economies, Japan entered a recession in the first quarter of this year, with GDP contracting at a 2.2% annualized pace. For the private sector, this is the worst growth rate since the Fukushima crisis in 2011. This is particularly significant, since the structural growth rate of the economy has fallen below interest rates. Going back to Japan’s lost decades, where private sector GDP growth averaged well below nominal rates (due to the zero bound), it is particularly imperative that Japan exits this liquidity trap in fast order (Chart I-2). A strong yen back then, on the back of deficient domestic demand, led to a self-fulfilling deflationary spiral. Chart I-2The Story Of Japan In One Chart The Bank of Japan began to acknowledge this problem with the end of the Heisei era1  last year. For example, with the BoJ owning almost 50% of outstanding JGBs, the supply side puts a serious limitation on how much more stimulus the BoJ can provide. The yen has become extremely sensitive to shifts in the relative balance sheets between the Federal Reserve and the BoJ. If the BoJ continues to purchase securities at the current pace, then the rate of expansion in its balance sheet will severely lag behind the Fed, and could trigger a knee-jerk rally in the yen (Chart I-3). Chart I-3The Yen And QE Inflation And The 2% Target The US is a much more closed economy than Japan, and has not been able to maintain a 2% inflation rate since the Global Financial Crisis. This makes the BoJ’s target of 2% a pipe dream for any timeline in the near future. There are three key variables the authorities pay attention to for inflation: Core CPI, the GDP deflator and the output gap. All three indicators point towards deflationary pressures, with the recent slowdown in the global economy exacerbating the trend. In fact, since the financial crisis, prices in Japan have only been able to really rise during a tax hike (Chart I-4). Always forgotten is that the overarching theme for prices in Japan is a rapidly falling (and ageing) population, leading to deficient demand. The overarching theme for prices in Japan is a rapidly falling (and ageing) population, leading to deficient demand. More importantly, almost 50% of the Japanese consumption basket is in tradeable goods, meaning domestic inflation is as much driven by the influence of the BoJ as it is by globalization. Even for domestically-driven prices, an ageing demographic that has a strong preference for falling prices is a powerful conflicting force. For example, over the years, a strong voting lobby has been able to advocate for lower telecom prices, which makes it difficult for the BoJ to re-anchor inflation expectations upward (Chart I-5). Chart I-4Japan CPI At A Glance Chart I-5Strong Deflationary Pressures In Japan Meanwhile, the BoJ understands that it needs domestic banks to expand the credit intermediation process if any inflation is to take hold. Unfortunately, the yield curve control strategy and negative interest rates have been anathema for Japanese net interest margins and share prices (Chart I-6). This puts the BoJ in a precarious balance between trying to stimulate the economy further and biting the hand that will feed a pickup in inflation. Chart I-6Point Of No Return For Japanese Banks? Japanese Consumption And Fiscal Policy The consumption tax hike last year delivered a severe punch to aggregate demand in Japan. COVID-19 has dealt a fatal blow. In prior episodes of the tax hikes, it took around three to four quarters for growth to eventually bottom. This suggests that a protracted slowdown in Japanese consumption is a fait accompli (Chart I-7). Foreign and domestic machinery orders are slowing, employment growth has gone from over 2% to free fall and the availability of jobs relative to applicants has reversed a decade-long rising trend. The Abe government has passed an additional 117 trillion yen of fiscal stimulus. With overall fiscal announcements near 40% of GDP, could this fully plug the spending gap? Not quite. The consumption tax hike last year delivered a severe punch to aggregate demand in Japan.  First, as is usually the case with Japanese stimulus announcements, the timeframe is uncertain for when the funds will be deployed. It could be one year or ten years. Chart I-7A V-Shaped Recovery Might Stall Chart I-8More Jobs, More Savings Second, Japanese consumption has been quite weak for some time. Despite relatively robust economic conditions since the Fukushima disaster, Japanese consumption has trended downward. The reason is that government spending triggered a rise in private savings, because of expectations of higher taxes. In other words, the savings ratio for workers has surged. If consumers were not willing to spend prior to COVID-19 due to Ricardian equivalence,2  they are unlikely to do so with much higher fiscal deficits (Chart I-8). Some of the government’s outlays will certainly go a long way to boosting aggregate demand, since the fiscal multiplier tends to be much larger in a liquidity trap. This will especially be the case for increased social security spending such as child education, construction activity or the move towards promoting cashless transactions (with a tax rebate). However, there are important near-term offsets. In particular, the postponement of the Olympics will continue to be a drag on Japanese construction activity, and the labor (and income) dividend from immigration has practically vanished. The important tourism industry that faced sudden death will only recover slowly. This suggests a much more protracted recovery in many nuggets of Japanese activity. The Yen As A Safe Haven Real interest rates are already higher in Japan, well before any of the above factors began to meaningfully generate a deflationary impulse. As such, the starting point for yen long positions is already favorable (Chart I-9). Real interest rates are already higher in Japan, well before any of the above factors began to meaningfully generate a deflationary impulse. With global growth bottoming, a continued rise in global equity markets is a key risk to our scenario. However, if inflows into Japan accelerate on cheap equity valuations, the propensity of investors to hedge these purchases will be much less today, given how cheap the yen has become. This is especially important since in an era of rising budget deficits, balance of payments dynamics can resurface as the key driver of currencies. This suggests the negative yen/Nikkei correlation will continue to weaken, as has been the case in recent quarters. Chart I-9Real Rates And The Yen Chart I-10USD/JPY And DXY Are Positively Correlated As a low-beta currency, our contention is that the yen will surely weaken on its crosses, but could strengthen versus the dollar. The yen rises versus the dollar not only during recessions, but during most episodes of broad dollar weakness (Chart I-10). This places short USD/JPY trades in an envious “heads I win, tails I do not lose too much” position.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 The Heisei era refers to the period of Japanese history corresponding to the reign of Emperor Akihito from 8 January 8th, 1989 until his abdication on April 30th, 2019. 2 Ricardian equivalence suggests in simple terms that public sector dissaving will encourage private sector savings. Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the US have been robust: Nonfarm payrolls increased by 2.5 million in May after declining by a record 20.7 million in April. This was better than expectations of an 8 million job loss. The unemployment rate fell from 14.7% to 13.3%. The NFIB business optimism index increased from 90.9 to 94.4 in May. Headline consumer price inflation fell from 0.3% to 0.1% year-on-year in May. Core inflation fell from 1.4% to 1.2%. Initial jobless claims increased by 1542K for the week ended June 5th. The DXY index fell by 1.3% this week. On Wednesday, the Fed left interest rates unchanged, with a signal that rates might not be increased before the end of 2022. The Fed also stated that it will maintain the current pace of Treasuries and mortgage-backed securities purchases, at minimum. 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 Chart II-4EUR Technicals 2 Recent data in the euro area have been improving: The Sentix investor confidence index improved from -41.8 to -24.8 in June. Employment increased by 0.4% year-on-year in Q1. GDP contracted by 3.1% year-on-year in Q1. The euro appreciated by 1.2% against the US dollar this week. At an online seminar held this week, Isabel Schnabel, member of the executive board of the ECB, noted that "evidence is increasingly pointing towards a protracted impact of the crisis on both demand and supply conditions in the euro area and beyond" and that the current PEPP remains appropriate in de aling with the global recession. 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 Chart II-6JPY Technicals 2 Recent data in Japan have been negative: The coincident index fell from 88.8 to 81.5 in April. The leading economic index also decreased from 85.1 to 76.2. The current account surplus shrank from ¥1971 billion to ¥262.7 billion in April. Annualized GDP fell by 2.2% year-on-year in Q1. Machine tool orders plunged by 52.8% year-on-year in May, following a 48.3% decrease the previous month. The Japanese yen appreciated by 2.6% against the US dollar this week. According to a Bloomberg survey, the majority of economists believe that the BoJ has done enough to cushion the economy, and expect the BoJ to leave current monetary policy unchanged next week. We continue to recommend the yen as a safe-haven hedge, especially given a possible second wave of COVID-19. 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 Chart II-8GBP Technicals 2 Recent data in the UK have been positive: Halifax house prices increased by 2.6% year-on-year in May. Retail sales surged by 7.9% year-on-year in May, up from 5.7% the previous month. GfK consumer confidence was little changed at -36 in May. The British pound rose by 1% against the US dollar this week. On Wednesday, BoE governor Andrew Bailey noted that easing lockdown restrictions has been fueling a recovery in the UK, which could be faster than previously anticipated. Our long GBP/USD and short EUR/GBP positions are 4% and 0.2% in the money, respectively. 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 Chart II-10AUD Technicals 2 Recent data in Australia have been mixed: The NAB business confidence index increased from -45 to -20 in May. The business conditions index also ticked up from -34 to -24. The Westpac consumer confidence index increased from 88.1 to 93.7 in June. Home loans declined by 4.8% month-on-month in April, down from a 0.3% increase the previous month. That said, expectations were for a fall of 10%. AUD/USD was flat this week. While the RBA has other options in its policy toolkit to combat the global recession, negative interest rates is still on the table and hasn't been totally ruled out. We remain positive on the Australian dollar both against the US dollar and the New Zealand dollar due to cheap valuations and increasing Chinese stimulus. 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 Chart II-12NZD Technicals 2 Recent data in New Zealand have been mixed: Manufacturing sales declined by 1.7% quarter-on-quarter in Q1, down from a 2.8% increase the previous quarter. ANZ business confidence increased from -41.8 to -33 in June. The activity outlook index also ticked up from -38.7 to -29.1. The New Zealand dollar appreciated by 0.8% against the US dollar this week. RBNZ's Deputy Governor Geoff Bascand said that house prices in New Zealand could fall by 9-10% or even worse. Besides disrupting exports and imports for a trade-reliant country like New Zealand, the global health crisis is also likely to further reduce immigration to New Zealand, curbing housing demand. 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 Chart II-14CAD Technicals 2 Recent data in Canada have been positive: The unemployment rate ticked up from 13% to 13.7% in May, versus expectations of a rise to 15%, but this was due to a  rise in the participation rate from 59.8% to 61.4%. Average hourly wages increased by 10% year-on-year in May. Net employment increased by 289.6K, up from a 1994K job loss the previous month. Housing starts increased by 193.5K in May, up from 166.5K the previous month.  The Canadian dollar fell by 0.2% against the US dollar this week. The labor market has seen some recovery in May with the gradual easing of COVID-19 restrictions and re-opening of the economy. Employment rebounded and absences from work dropped. Notably, Quebec accounts for nearly 80% of overall employment gains in May. 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 Chart II-16CHF Technicals 2 There was scant data out of Switzerland this week: FX reserves increased from CHF 801 billion to CHF 816 billion in May.  The unemployment rate increased from 3.1% to 3.4% in May, lower than the expected 3.7%. The Swiss franc appreciated by 2.3% against the US dollar this week, reflecting a flight back to safety amid concerns over political risks and a second wave of COVID-19. While the euro has been strong recently and EUR/CHF touched 1.09, the franc has lost most of those gains. We are lifting our limit buy on EUR/CHF to 1.055 on expectations we are in a run-of-the-mill correction.  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 Chart II-18NOK Technicals 2 Recent data in Norway have been mixed: Manufacturing output shrank by 1.6% month-on-month in April.  PPI fell by 17.5% year-on-year in May. Headline consumer prices increased by 1.3% year-on-year in May, up from 0.8% the previous month. Core inflation also increased from 2.8% to 3% in May. The Norwegian krone fell by 1.5% against the US dollar this week. The recent OPEC meeting over the weekend concluded that all members agreed to the extension to curb oil production. We believe that oil prices will continue to recover, and recommend to stay long the Norwegian krone. 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 Chart II-20SEK Technicals 2 Recent data in Sweden have been mixed: Household consumption plunged by 10% year-on-year in April. The current account surplus increased from SEK 43.2 billion to SEK 80.6 billion in Q1. Headline consumer prices recovered from a 0.4% year-on-year decline to flat in May. The Swedish krona increased by 0.6% against the US dollar this week. Sweden is benefitting economically from a less stringent Covid-19 agenda. With very cheap valuations, we remain short EUR/SEK and USD/SEK. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019 Balance Of Payments Across The G10 - February 15, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights If policymakers can neutralize default pressures arising from the lockdowns, the lasting impacts of this recession may not be so bad: As Jay Powell put it on 60 Minutes several weeks ago, policymakers just have to keep people and businesses out of insolvency until health professionals can gain the upper hand over the virus. Fiscal spending caused income and savings to spike, … : Generous transfer payments have left the majority of the unemployed better off than they were when they were working, and April household income and savings soared accordingly. … allowing consumers to meet nearly all of their obligations … : April’s income and savings gains showed up in reduced delinquencies across all categories of consumer loans and in solid April and May rent collections. May’s employment gains suggest that the private sector may not be too far away from taking the baton from Congress: The May employment report blew away expectations and sent risk assets surging, but the positive surprise may derail plans for further fiscal support. Feature Since March, investors have been presented with a simple choice: believe their eyes or believe in the government. They could either focus on horrendous economic data illustrating the crippling effects of widespread lockdowns, or they could trust in policymakers’ ability to shield most citizens and businesses from lasting damage. Our base case has been that policymakers would succeed, for the most part, provided they didn’t have to contend with acute COVID-19 pressures for more than six months. There are as many guesses about the virus’ future path as there are commentators, but it seems reasonably conservative to estimate that the most onerous restrictions will be eased by October. Chart 1DC To The Rescue In our view, preventing defaults is the key to mitigating the effects of the virus. If newly vulnerable debtors can be kept from defaulting until the economy can return to something resembling normal, a negatively self-reinforcing dynamic will not take hold, the infection will not spread to the financial system and creditworthy individuals’ and viable businesses’ temporary liquidity issues will not morph into solvency issues. Banking system data to confirm or disprove our thesis will not be available until August, however, as Fed and FDIC data are quarterly, and the shutdowns only began in late March. The unemployment safety net has turned into a trampoline; ... In this report, we have turned to a range of other sources for higher-frequency insights into what is happening in real time. We start with an academic paper showing that most laid-off workers are eligible for benefits comfortably exceeding their previous income, a conclusion reinforced by the April personal income data (Chart 1). We then look at April delinquency data from TransUnion, one of the major credit reporting agencies, and April and May rent-collection data from an apartment trade organization and large-cap publicly traded apartment REITs. We also review the Fed’s Survey of Consumer Finances to get a sense of household indebtedness across the income and wealth spectrums. For now, the data support the conclusion that policymakers have successfully defused credit distress pressures. What Comes In … Unemployment benefits typically fall far short of workers’ regular compensation, averaging about 40% of the median worker’s wage. To cushion the blow of unemployment from COVID-19, the CARES Act included a federal supplement to unemployment benefit payments distributed by the individual states. Added onto the average $400 weekly state benefit, the $600 federal supplement would make the average worker whole (mean earnings are a little less than $1,000 a week). As income inequality has intensified, the compensation distribution for all American workers has come to exhibit a pronounced rightward skew. That skew has pulled mean compensation (the average of all Americans’ earnings) well above median compensation (the earnings of the worker at the exact middle of the earnings distribution).1 By targeting mean compensation, the CARES Act opened the door for a lot of lower-income workers to make more money in unemployment than they did when they were working. According to a recent paper from three Chicago professors, 68% of unemployed workers are eligible to receive benefits that exceed their previous income, while 20% of unemployed workers are eligible for benefits that will at least double it. Overall, they calculate that the median worker is eligible to receive benefits amounting to 134% of his/her previous income.2 ... instead of keeping laid-off employees' incomes from falling below 40 cents on the dollar, it's launched them to $1.30. We offer no judgments about the policy merits of a 134% median replacement rate, but unusually generous benefits should help reduce the drag from unemployment that would otherwise ensue with a 40% replacement rate. Thanks to lower-income households’ higher marginal propensity to consume, consumption should rise at the margin (once activity resumes). Thanks to increased income, lower-income households should be better positioned to meet their financial obligations. We suspect the marginal consumption boost may be hard to see with the naked eye, but auto, credit card and mortgage delinquencies should be appreciably lower than any regression model not adjusted to reflect record replacement rates would predict. … And What Goes Out The Personal Income and Outlays data for April reflected the significant impact on household income of the up-to-$1,200 stimulus checks (economic impact payments) and the supplemental unemployment benefits. Despite an annualized $900 billion decline in employee compensation, personal income rose by nearly $2 trillion in April, thanks to a $3 trillion increase in transfer payments. De-annualizing the components, $250 billion in transfer payments offset a $75 billion decrease in compensation. At about $220 billion, the economic impact payments accounted for the bulk of the transfer payments, and they will fall sharply in May. The IRS did not disclose the amount of economic impact payments it had disbursed by April 30, but it appears that around 80% of the distributions have been made, leaving approximately $55 billion yet to be disbursed. Unemployment insurance receipts will rise in May on an extra week of benefits and an increase in the weekly sums of initial and continuing unemployment claims. We project that employee compensation rose about 3% in May, based on a 2% gain in employment and a 1% increase in average weekly earnings. Aggregating the February-to-May changes, it appears that May personal income ought to exceed February (Table 1). Absent another round of stimulus checks, however, personal income will slide below its pre-shutdown level beginning in June. Table 1May Personal Income Should Exceed Its Pre-Pandemic Level Income is not the sole driver of households’ capacity to service their debt, however. Assets matter, too, and even if the surge in cash flow was a one-off event, it left behind an elevated stock of cash as households slashed consumption in both March and April. Real personal consumption expenditures have fallen 19% from February’s all-time high and are now back to a level they breached in January 2012 (Chart 2). Households saved 33% of their April disposable income, and on a level basis, April savings were up nearly fivefold from their 2019 average. They were a whopping 20 times April interest payments, ex-mortgages (Chart 3). Chart 2Eight Years Of Spending Undone In Two Months Chart 3Consumers' Interest Coverage Ratios Have Soared Household Borrowers Are Staying Current … Table 2Consumer Borrowers Are Hanging In There It is possible to make too much of the April income and outlays data. We had been expecting another round of stimulus checks, but lawmakers’ comments even before the blockbuster employment report suggested one may not be forthcoming. Some of the savings activity was forced on homebound consumers, and some pent-up demand will surely be unleashed as the economy re-opens. Households amassed a mighty savings war chest across March and April, however, and it has left them better-positioned to service their debt obligations going forward. Despite an unemployment rate not seen since FDR, households made their scheduled payments in April. According to TransUnion, delinquency rates fell month-over-month across every major consumer loan category and delinquency rates for mortgages and unsecured personal loans declined on a year-over-year basis (Table 2). The TransUnion data comes from its inaugural Monthly Industry Snapshot, intended to provide a higher-frequency read on headline consumer credit metrics than its typical quarterly releases. In addition to crunching the delinquency numbers, the report noted that forbearance programs have helped ease consumer liquidity pressures, consumers have reduced their outstanding credit card balances and credit scores have slightly improved. None of the factors is decisive on its own, but they contribute to a marginally improved consumer credit outlook. … And Apartment Tenants Are Paying Their Rent It is more common for households in the lower half of the income and net worth distributions to rent their residence than own it. Just one in every five households in the bottom two quintiles of the income distribution (Chart 4, top panel), and one in four in the bottom half of the net worth distribution (Chart 4, bottom panel), have a mortgage. Rent is the single largest recurring expense for these households and the shutdowns made paying it a concern. Several newspaper stories have highlighted the plight of distressed renters while discussing grassroots rent-strike movements, but the National Multifamily Housing Council’s (NMHC) Rent Payment Tracker tells a different story.3 Chart 4Households In The Lower Half Of The Income And Wealth Distributions Rent Their Homes The Rent Payment Tracker distills the results of a national survey covering over 11 million professionally managed apartment units. Through May 27th, it reported that 93.3% of renters had made full or partial payments for the month of May. The share of paying tenants was down just 150 basis points year-over-year, and up 160 basis points month-over-month. The six apartment REITs in the S&P 500 reported April and May rent collections that were better than the NMHC data. By the end of May, the REITs had collected 94-99% of the April rent they were due, and 93-96% of their May rents (Table 3). (Equity Residential (EQR) reported its April collections through April 7th and did not provide an end-of-month update; on June 1st, it reported that its May collections through May 7th were in line with April’s.) Essex Property Trust (ESS), which owns a portfolio of apartments in southern California, the Bay Area and greater Seattle, provided a table showing how the economic impact payments and the supplemental unemployment benefit would affect the income of unemployed California and Washington state couples without children. Table 4 expands it to cover four income scenarios, illustrating just how far up the income distribution CARES Act relief stretches. Table 3Residential Tenants Are Paying Their Rent Table 4The CARES Act For Essex Property Trust Renters Who Borrows: Evidence From The Survey Of Consumer Finances Helping the households in the bottom half of the income distribution won’t materially limit credit distress across the economy if those households don’t have access to credit. The latest edition of the Fed’s triennial Survey of Consumer Finances, published in 2017, makes it clear that they do. Those households may be much less likely to carry mortgage debt (Chart 5), but they make up for it by borrowing via other channels. 64% of households in the bottom two quintiles have some debt, and the share grows to 70% when the middle quintile, which qualified for the full $1,200 economic impact payment, is included (Chart 6). Chart 5The Homeownership Income Divide Chart 6Households In The Lower Two Quintiles Have Debt To Service, Too Investment Implications The discussion above focused solely on the consumer, as we discussed the Fed’s efforts to assist lenders and business borrowers in a joint Special Report with our US Bond Strategy colleagues in April.4 Record corporate bond issuance in March and April – before the Fed bought a single corporate bond – testifies to the effectiveness of the Fed’s measures. Its corporate credit facilities bazooka was so large that it was able to soothe the roiled corporate issuance market without firing a single shot. Spreads have narrowed across the spread product spectrum and the primary and secondary markets are once again able to function normally. Too much economic improvement could be self-limiting, and the S&P 500 is trading at an ambitious multiple. We remain equal weight equities over the tactical three-month timeframe. The foregoing review of consumer performance reinforces our view that the SIFI banks should be overweighted relative to the S&P 500. The ongoing data indicate that the SIFI banks will not have to build up their reserves for loan losses as much as investors feared. Our conviction that the SIFI banks are unlikely to face material book value declines has only increased. It has become possible that second- and third-quarter reserve builds may be even less than our optimistic two-times-the-first-quarter view, but the virus will have the final say. The SIFI banks remain our favorite long idea. At the asset allocation level, we remain equal weight equities over the tactical three-month timeframe. We are encouraged by the green shoots visible in the employment report, but stocks are generously valued and the virus outlook is still unclear. The improvement on the ground could prove to be self-limiting if it kills the momentum for further fiscal assistance, or if it encourages officials and individuals to let their guard down regarding the social distancing measures that have been effective in lowering COVID-19 infection rates.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 According to the Census Department’s annual Current Population Survey, mean household income ($90,000) exceeded median household income ($63,000) by 42% in 2018. 2 Ganong, Peter, Noel, Pascal J., Vavra, Joseph S. "US Unemployment Insurance Replacement Rates During the Pandemic," NBER Working Paper No. 27216. 3https://www.nmhc.org/research-insight/nmhc-rent-payment-tracker/ Accessed June 1. 4 Please see the April 14, 2020 US Investment Strategy/US Bond Strategy Special Report, "Alphabet Soup: A Summary Of The Fed’s Anti-Virus Measures," available at usis.bcaresearch.com.

Dear Client, Next week we will be sending you a Special Report providing our insights on the much-anticipated China National People’s Congress. We think the messages sent from the conference will be highly relevant to both the global economy and financial markets. Please note: instead of Wednesday, the Special Report will be published on Thursday the 28th of May. Best regards, Jing Sima China Strategist Highlights Insert HiEarly signs suggest a renewed appetite among Chinese consumers for real assets and durable goods. China’s discretionary consumption will likely benefit greatly from pro-growth measures, and recover much faster than the aggregate consumption.   The unemployment rate has been rising and largely concentrated in lower-income workers. Elevated unemployment will be a drag on China’s overall consumption, but its impact on discretionary consumption is limited. We are initiating two trades: long investable consumer discretionary/short investable consumer staples and long domestic consumer discretionary/broad A-share market. Feature Chart 1Sectors Directly Benefiting From Stimulus Are Recovering Faster Economic data released last week showed that China’s economy continued to recover, particularly the infrastructure, construction and high-tech sectors (Chart 1). On the other hand, household consumption, which accounts for nearly 40% of the country’s economy, remained in a deep contraction in April. While we think the annual growth in China’s aggregate household demand will remain muted this year, the breakdown in April’s retail sales data suggests that the speed in consumer discretionary spending is already accelerating (Chart 2). During economic recoveries, consumer discretionary spending usually rebounds ahead of a recovery in overall consumption. Even though the current economic downturn is extra-ordinary, we believe that China’s discretionary consumption growth will pick up faster and stronger than the aggregate household consumption. Consumer discretionary stocks, an early cyclical sector in China’s equity market, troughed about 3 months ahead of a bottoming in Chinese investable and domestic stock prices in previous cycles. In line with our constructive view on Chinese stocks in the next 6 to 12 months, we recommend investors overweight Chinese consumer discretionary stocks relative to the benchmarks. In addition, we are initiating a long position in investable consumer discretionary versus investable consumer staples, and a long position in domestic consumer discretionary versus A-share market. Chart 2Discretionary Consumption Is Rebounding Faster Than Staples China’s Stimulus-Driven Consumption Cycles Chinese consumption cycles since 2008 have mostly reflected the effectiveness of China’s pro-consumption and stimulus policies. So far, the Chinese government’s stimulus measures have been concentrated in the corporate sector rather than households. Nevertheless, government pro-growth measures, flush liquidity in the market and global travel restrictions should provide a lift to domestic sales of durable and luxury goods. Chart 3 illustrates how, in contrast to the US, China’s retail sales have grown faster than nominal GDP during every economic downturn since 2008. A reason for this counter-cyclicality in China’s consumption is that the monthly retail sales data consists of household, government and business purchases.  Since the Chinese government tends to increase its expenditures during economic downturns, the increases in government purchases help to offset the declines in household and business consumption. Chart 3Retail Sales In China Have Become 'Countercyclical' Since 2008 Chart 4China's Post-GFC Consumption Cycles Largely Driven By Stimulus A more important contributor to the faster retail sales growth during economic down cycles is government stimulus. Direct pro-consumption policies, such as sales tax cuts and subsidies, helped to boost auto sales in every cycle since 2008, whereas stimulus measures to enhance home sales indirectly led to an upcycle in the sales of home appliances in 2015-2016 (Chart 4).  April’s retail sales data showed a sharp rebound in Chinese household consumption in autos, appliances and furniture (Chart 5). The strong comeback in durable goods purchases in April was driven by a release of pent-up demand and government pro-consumption measures. Since March, local governments have handed out subsidies, vouchers and tax reductions on consumer durable goods purchases and discretionary spending, such as travel and restaurant dining. By end-April, an estimate of 40 billion yuan worth of consumption vouchers were issued by provincial and city-level governments, with more than 90 percent of them targeted at discretionary goods and services. We think the government will announce further policies to support consumption at the May 22-23 National People’s Congress.  Chart 5A Strong Comeback In Durable Goods Sales Chinese consumers took on more medium- and long-term loans in March and April, indicating a renewed appetite for purchasing real assets and durable goods (Chart 6). This is partially because consumers want to take advantage of lower interest rates and easier monetary conditions. Moreover, Chinese households may also be seeking real assets to hedge future inflation and financial market uncertainties. Housing in China in the past two decades has been perceived as countercyclical and a low-risk asset that holds value. Early signs indicate a renewed Chinese consumers’ appetite for real assets and durable goods. Both land sales and real estate investment growth returned to positive territory in April, while the contraction in floor space started, completed, and sold all narrowed. The upward cycle in the property market should continue to support a recovery in household appliances and furniture (Chart 7).   Chart 6Appetite For Real Asset Purchases May Be Returning Chart 7A Recovering Property Market Should Help Boost Home Appliance Sales In addition, global travel restrictions will likely remain in place through this year. This may prompt Chinese consumers to allocate a larger portion of their discretionary spending budgets to domestic, high-end consumer goods and services. Bottom Line: Early signs indicate a renewed consumer appetite for real assets and durable goods. The government’s pro-consumption and pro-growth measures should further boost discretionary spending. The Wealth Effect The consumption behavior of Chinese households will likely be driven by both the change in the value of their assets, and their expectations of the immediate or perceived future loss of employment and income. Housing is the largest part of Chinese households’ net worth.1 At the same time, financial assets account for a much lower share of Chinese households’ net worth versus their American peers.2 Home prices are much less volatile than stock prices, and we expect home prices in China to grow faster this year than in 2019. Hence the wealth effect of housing on Chinese consumers should remain positive. The unemployment rate has been elevated, but job losses so far are concentrated in the labor-intensive, lower-skilled manufacturing and service sectors (Chart 8). While lower-income workers account for more than half of China’s total population, their share of the country’s total household wealth and income is dismal compared with households in the top 10 percentile earnings3  (Chart 9). In fact, households in the bottom 40 percentile essentially have no discretionary spending capacity.4 Households in the top 40 group (middle- and upper middle-class urbanites) are the main driver of China’s discretionary and luxury goods market.5 Chart 8Job Losses So Far Concentrated In Lower-Skilled, Lower-Wage Manufacturing & Service Sectors Chart 9Higher-Income Chinese Households Will Drive Recovery In Discretionary Consumption Because poorer households tend to have a higher marginal propensity to consume than the richer ones, China’s high income inequality may reduce the aggregate demand and has the potential to structurally stagnate its household consumption growth. This is a topic we hope to provide insights on in our future research. Cyclically, however, accommodative monetary conditions and outsized stimulus during economic downturns often help augment richer households’ net worth as well as increase their discretionary purchasing power. Our constructive view on China’s discretionary consumption could change if a second wave of Covid-19 infections is virulent enough to trigger another round of global lockdowns. In this case unemployment may expand from lower-income to middle-class Chinese consumers and extend from temporary to permanent job losses.  Consumption will also be constrained by more widespread income declines and renewed physical lockdowns.  Bottom Line: Job losses are concentrated in the lower-income household group so far. While developments in the pandemic remain fluid, our baseline view suggests that the wealth effect will have a limited impact on Chinese middle-class consumers. Investment Conclusions The recovery is still in its early stages, but government stimulus is bearing fruit in discretionary consumption. Furthermore, the elevated unemployment rate should prompt the government to roll out more consumption and growth-supporting measures at this week’s NPC conference, which will help further boost Chinese consumers’ appetite for discretionary spending.  China’s investable consumer discretionary sector has consistently outperformed both the broad market and consumer staples during previous economic recoveries. China’s investable consumer discretionary sector has consistently outperformed both the broad market and consumer staples during previous economic recoveries (Chart 10). The overwhelming shares of China’s online tech titans in the investable market, such as Alibaba and JD, make a strong case to overweight the consumer discretionary sector given that both online platforms will continue to benefit from the Chinese government’s pro-consumption schemes. On the other hand, the behavior of consumer discretionary versus consumer staples in China’s A-share market has been atypical.  Chart 11 shows domestic consumer discretionary stocks have consistently underperformed consumer staples since 2015, even during the 2016/2017 upcycle in broad market stock prices. We think a few underlying factors may be at play: Chart 10The CD Sector Has Consistently Outperformed CS In Offshore Market Upcycles... Chart 11...It Is Not The Case In The Onshore Market Food and beverage companies in mainland China have one of the highest ROAs and the lowest financial leverages, which is preferred by Chinese domestic investors; Chinese liquor brands such as Kweichow Moutai and Wuliangye, which are listed on the A-share market and within the consumer staples group, have become collectable luxury goods. They have helped driving up the prices of consumer staple equities (Chart 12);  Soaring food prices since 2017 have helped to widen profit margins among food processing firms (Chart 13).   Chart 12Some 'Consumer Staples' Have Become Luxury Goods Chart 13Soaring Food Prices Also A Contributing Factor For investors with a time horizon longer than a 12 months, consumer discretionary sector is a winner. However, for investors with a time horizon longer than 12 months, average returns in consumer discretionary stocks still beat staples in the past three market recoveries (Table 1). This is true for both onshore and offshore markets. As such, we recommend investors go long on consumer discretionary versus consumer staples in the investable market, and also go long on domestic consumer discretionary versus the broad domestic market. We are initiating these two trades today. Table 1CD Sector Still A Winner On A 12-18 Month Horizon   Jing Sima China Strategist jings@bcaresearch.com   Footnotes 1 Housing accounts for 59.1% in Chinese households’ net worth, compared with 30% in the US. PBoC, “2019 Chinese Urban Households Assets And Liabilities Survey”. 220.4% of Chinese households’ total net worth is in financial assets. In the US, the share is 42.5%. PBoC, “2019 Chinese Urban Households Assets And Liabilities Survey”. 3China’s low-income households account for about 60% of China’s population as of 2015. “How well-off is China’s middle class?” Center For Strategy & International Studies. https://chinapower.csis.org/china-middle-class/ 4 “Can China Avoid the Middle Income Trap?” Damien Ma, Foreign Policy, March 2016 5China Consumer Report 2020, McKinsey & Company, December 2019 Cyclical Investment Stance Equity Sector Recommendations

Special Report

Highlights The duration of this crisis and the details of the plan to reopen the economy will determine whether the initial uptick in median home prices will prove to be transitory. Phase I provides room for construction to resume at least partially, while demand for homes is likely to recover more gradually. This temporary supply/demand imbalance is unlikely to result in a meaningful price contraction as significant mitigating factors are at play. Government actions to support households and the availability of credit as well as low mortgage rates should prop up the homeownership rate. Housing’s wealth effect has decreased and is unlikely to drive consumption in a pandemic-related recession. Construction employment was highly affected though resuming work in this sector is more likely to boost steel demand than have a significant impact on the unemployment rate. Feature A recession typically occurs amidst imbalances in the economy and the 2008 sub-prime episode arguably embodied the epitome of housing excesses. Housing’s contribution to GDP has significantly decreased over the past seventy years, and today’s well-balanced housing market is unlikely to be the center of attention, but home prices are cyclical and large fluctuations can have repercussions in other areas of the economy. Social distancing is leading supply to contract first, altering the typical recessionary chain of events. We examine the COVID-induced shock to housing and its potential ramifications. Under the working assumption that a vaccine and/or effective treatment will allow economic activity to fully resume within the next twelve months, we conclude that home prices are unlikely to contract meaningfully. The homeownership rate should remain well supported and consumption is more likely to be impacted by unemployment than housing wealth effects. Meanwhile, a tightening in lending standards at the margin should not get in the way of credit availability. A Sellers’ Market Chart 1COVID-19 Is Destroying More Supply Than Demand The latest housing data releases strikingly contrast with the employment data and GDP growth estimates. The median home price actually increased by 8% on a year-on-year basis while new home sales contracted by 10%, suggesting that supply has been decreasing at a faster pace than demand (Chart 1). In the typical recession sequence of events, home prices slip as falling employment dents demand which in turn leads homebuilders to defer new starts and reduce prices on the existing supply of new homes. This is not a typical recession, however, and the supply shock preceded the demand shock. Confinement measures prevented construction professionals from going to work, thereby immediately halting the production of new homes. Meanwhile, the fact that most job losses have been temporary thus far has led to a relatively slower pace of demand destruction. Moreover, real estate transactions take a couple of months to close and the latest data may simply reflect purchase decisions that were made before the US became an epicenter of the pandemic. Median home prices may also be holding firm because sellers are not compromising on their asking price when social distancing prevents in-person visits (Chart 2), or because sellers are waiting things out before re-listing their property for sale. The housing market is effectively in a time-out where a reduced number of transactions is preventing prices from adjusting in a timely fashion. Chart 2Prospective Buyers Taking Social Distancing To Heart Prices Subject To Mitigating Forces Chart 3A Well-Balanced Housing Market The duration of the COVID-19 crisis and the details of the phases of economic reopening will ultimately determine whether this initial uptick in median home prices proves to be transitory. The housing market can remain a sellers’ market for as long as the mortgage forbearance allowed under CARES Act protects mortgage owners from defaults. It currently allows applicants to postpone their mortgage payments for up to a year amid COVID-related economic hardships. These payments are then tacked on to the end of the forbearance period and paid back over time in a mortgage modification. The winds will change if a vaccine is not mass-produced by then and Congress does not provide new aid. A wave of defaults would lead to mass property listings by desperate sellers, exerting significant downward pressure on home prices. Local homebuilders’ associations are making their case to Washington to be considered essential. The current plans to reopen the economy would provide room for residential construction to resume at least partly under Phase I, as mandated social distancing measures can be implemented on an open-air construction site. The US Census Bureau estimates that the average length of time from start to completion ranges between 7 and 15 months depending on the type of construction. Even if no new project begins until the end of the recession, currently pending constructions will resume and add another 730,0001 new homes on the market by fall - a conservative estimate that excludes any potential existing homes that might go up for sale. Existing homes account for the lion’s share of total inventory. Meanwhile, it would take much longer for demand to recover even in the unlikely event that the virus miraculously disappeared and life returned to normal in a fortnight. It generally takes time for the unemployment rate to recover to pre-recession levels, as matching available workers with employers is time-consuming and feedback loops are at play whereby unemployment leads to less spending which in turn reduces the incentive for firms to hire. The temporary nature of the layoffs and the government financial support to households will be mitigating factors, but precautionary savings tend to rise after a recession and unemployed workers might have drawn down their bank accounts. All these factors should contribute to a slower pace of housing demand recovery. Even though demand might take longer to recover, a generally well-balanced market will support prices. This temporary supply/demand imbalance scenario is bearish for home prices. However, it is worth remembering2 that unlike the previous downturn, the housing market was well balanced before this crisis began, another important factor that should mitigate the magnitude of any potential price decline (Chart 3). Bottom Line: Under the working assumption that a vaccine will be available and mass-produced within twelve months, this atypical recession is unlikely to result in a severe home price contraction. Support For Credit Chart 4Loan Deferrals Exert Pressure On Banks... An increasing share of banks have tightened residential mortgage lending standards at the margin (Chart 4), an unsurprising outcome given that a recession has arrived and payment deferrals reduce the net present value of any given mortgage. Securitization may also become more difficult or costly as mortgage servicers’ resources are strained by delayed reimbursement from Fannie Mae and Freddie Mac for the interest payments they have to advance to holders of agency mortgage-backed securities. Three-quarters of residential mortgages are backed by federal agencies, and banks presumably have little appetite to tie up limited capital with new loans at the onset of what might be a brutal recession. They will presumably be eager to get loans off their balance sheets by selling them into securitization pools, but if servicers are wary in an environment when 7.5% of all mortgages are already in forbearance, they would be well-advised to underwrite them as if they were going to have to hold them. However, banks have exerted significant restraint since their pre-Great Financial Crisis frenzy.3 Their loan books - across all core lending categories, but most prominently in the real estate segment - have grown at a markedly slower pace in the past decade than they did in any other postwar expansion4 (Chart 5). Banks are also better capitalized than they used to be, strengthening their ability to sustain losses (Chart 6). Chart 5...But Their Restrained Behavior In The Late Expansion...   Chart 6...And Increased Equity Capital Strengthen Their Ability To Sustain Losses Bottom Line: Financing should remain available to prospective home buyers. There are no excesses in the overall banking system and regulators will not allow the mortgage securitization machinery to break down. Resilient Homeownership Rate Just as the pandemic is unlikely to result in a drastic decline in home prices, the homeownership rate is unlikely to deteriorate meaningfully. Chart 7Better Situated Households Taking Advantage Of Competitive Rates COVID-19 may have claimed a staggering 33 million jobs and counting, but CARES Act forbearance will shield the most vulnerable households for the next twelve months, propping up their current rate of homeownership. Meanwhile, low mortgage rates create opportunities for better-situated households. Data from Corelogic suggest that millennials have driven the bulk of the uptick in mortgage applications (Chart 7). They are also the cohort most inclined to transition from renting to owning and their increasing access to homeownership these past few years suggests that their financial situation is not as dire as widely believed (Chart 8). Chart 8Millennials' Transition From Renting To Owning Low mortgage rates have also increased homeownership’s competitiveness relative to renting (Chart 9). This trend is unlikely to reverse in the near term. Eviction protection programs and rent forbearance under the CARES Act will only temporarily cap rent growth. Meanwhile, mortgage rates are set to remain competitive beyond the timeframe of this recession. Chart 9Owning Is More Attractive Than Renting... Low mortgage rates and relatively easy lending standards have prevailed since 2013 but home price appreciation has outpaced wage growth, denting housing affordability (Chart 10). While the tendency to build smaller housing units would contribute to decreasing median home prices at the margin (Chart 11), income growth will take a while to catch up. The labor market will have to tighten anew before income growth can revive. Chart 10...Even Though Homes Have Become Less Affordable Chart 11Is Smaller Becoming Better? Still, declining affordability has not prevented the homeownership rate from recovering to its long-run average. It may stand at a lower level today than it did in 2007 when it reached 69%, but it reflects sounder lending behaviors. Bottom Line: The COVID-19 crisis does not pose an immediate risk to the currently healthy level of homeownership. Better-situated households can take advantage of low mortgage rates but decreasing housing affordability will prevent homeownership from grinding meaningfully higher. Fading Wealth Effect Amid COVID-19 Consumers tend to spend more when the value or perceived value of their assets rises. Housing accounts for a sizable portion of homeowners’ equity, but the wealth effect of housing may have become less significant than most investors believe. The contribution to spending from housing wealth mirrors the decrease in housing as a share of households’ aggregate net worth (Chart 12). The latter now stands at 15%, way off its 1980s and 2006 peaks, while pension entitlements and equity and mutual fund holdings have filled the void, each accounting for a quarter of homeowners’ net worth. Chart 12The Wealth Effect Of Housing Is Decreasing... The wealth effect of housing remains positive. However, fluctuations in home prices are not evident to consumers in real time (Chart 13) and COVID-19 has precipitated the swiftest recession on record. The immediate or perceived future loss of employment and income are much more likely to drive consumption than home prices. Chart 13...And Is Unlikely To Influence Spending In A Pandemic Bottom Line: In a pandemic-induced downturn, home prices alone are unlikely to have a meaningful effect on consumption patterns. A Marginal Impact On Employment Overall housing-related sectors of the economy account for a marginal share of total employment. Construction activity makes up a mere 5% while related sectors including the sale and manufacturing of furniture, appliances and wood products, amongst others, chip in another 4.5% (Chart 14). On a rate of change basis, however, housing has been at the forefront. While the airline and leisure and hospitality sectors have been the center of attention in the past couple of months, construction has also suffered markedly. Total construction employment contracted by a third in April alone, behind only leisure and hospitality (Chart 15). Chart 14Housing's Marginal Impact On Overall Employment Chart 15Construction Was Highly Affected By COVID-19 A Phase I economic reopening will make room for activity in housing and many other sectors to resume and restore at least a portion of the jobs temporarily destroyed. The leisure and hospitality sector, however, is most likely to be the real game changer. 40% of the job losses so far have been in this single sector. While restaurants will be able to resume partial activity under Phase I, traveling is unlikely to return to normal for some time, even after a vaccine is mass-produced. It took several years after 9/11 for individuals to feel safe traveling again and for air traffic to reach its pre-crisis levels. Bottom Line: Although housing employment has been highly affected by COVID-19, it accounts for a small share of nonfarm payrolls and a pickup in this sector is unlikely to have a meaningful impact on the overall unemployment rate. A Significant Source Of Global Steel Demand A revival in housing activity is more likely to significantly impact commodity prices than the overall unemployment rate. Homebuilders are a key driver of lumber demand and construction activity accounts for half of the demand for steel and copper (Chart 16). The US is the largest net importer, making it a heavy player in the steel market, but its influence on copper prices is dwarfed by the demand stemming from Asia. Chart 16A Revival In Construction Would Boost Demand For Commodities Putting It All Together Over the past seventy years, housing has accounted for a steadily decreasing share of the economy and homeowners’ net wealth. In the absence of excessive lending and overbuilding, its ramifications for employment, consumption and the rest of the economy should remain muted in this crisis. BCA researchers tend to leave the thorough bottom-up analysis to professional stock pickers and instead focus their attention on the fundamental 30,000-feet top-down macroeconomic perspective. Although we do not expect overall home prices to contract drastically, “location, location, location” has always been real estate’s modus operandi. We would note that home prices in cities like Las Vegas or Orlando with economic activity tied to tourism, arts and entertainment, restaurants and recreation might be disproportionally affected by COVID-related externalities. It is too early to assess whether the widespread social distancing measures will result in lasting structural changes on society, housing preferences and the way we conduct business. There is sound basis, however, to hypothesize that cooped-up city dwellers might find suburbs and satellite cities to be more attractive going forward, and that lasting work-from-home arrangements will enable them to make that life-style change.   Jennifer Lacombe Associate Editor jenniferl@bcaresearch.com Footnotes 1 The housing start data is seasonally adjusted. Starts averaged 1,466 million in 1Q20 and 1,443 million in 4Q19 meaning that a quarter of these projects actually started in 1Q20 and 4Q19 (367K and 361K starts, respectively). 2 Please see US Investment Strategy Special Report titled "Housing: Past, Present And (Near) Future", published November 19, 2018. Available at usis.bcaresearch.com. 3 Please see US Investment Strategy Special Report titled "How Vulnerable Are US Banks? Part 2: It’s Complicated", published April 6, 2020. Available at usis.bcaresearch.com. 4 Until the NBER makes the official designation, our working assumption is that the current recession began in March.

Special Report

Dear Client, With this weekly update on the Chinese economy, we are sending you a Special Report published by BCA Geopolitical Strategy team and authored by my colleague Matt Gertken. Lately we have been getting numerous questions from our clients, on the risk of a significant re-escalation in the US-China conflict. Matt’s report provides timely insights on the topic, and we trust you will find the report very helpful. Best regards, Jing Sima, China Strategist Feature An Update On The Chinese Economy Since mid-April, the speed of resumption in China’s domestic business activity has accelerated. Industrial enterprises appear to be operating at 87% of normal activity levels as of May 11, up from 81.8% one month ago. Small to medium-sized enterprise (SMEs) are estimated to now operate at 87.3% of their normal activity, a vast improvement from 82.3% just two weeks ago. Chart 1Pickup In M1 Still Modest The material easing in monetary conditions and strong flows of local government special-purpose bond issuance in the past two months helped jump start a recovery in the construction sector. But at this early stage of a domestic economic rebound and in the middle of a deep global economy recession, China’s corporate marginal propensity to invest remains muted (Chart 1). Household consumption showed some resilience during last week’s “Golden Week” holiday. The strength in big-ticket item purchases, however, was highly concentrated among consumers in China’s wealthiest urban areas (Chart 2). The COVID-19 pandemic has created a situation resembling a combination of SARS and the global financial crisis. Now the physical constraints on consumption have largely been lifted, consumers’ willingness to spend, after a brief period of compensatory spending, will be suppressed if their expectations of the medium-term job and income security remain pessimistic (Chart 3). Chart 2A Compensatory Rebound In Big-Ticket Item Sales Chart 3The Average Chinese Consumer Remains Cautious Next week we will publish a report, focusing on China’s consumption in a post-pandemic environment. Looking forward, we maintain the view that China’s business activity will pick up momentum in H2, when the massive monetary and fiscal stimuli continue working its way into the economy.  Downside risks to employment and income loom large, which makes it highly unlikely that the authorities will tighten their policy stance any time soon. As such, while we maintain our defensive tactical positioning due to near-term economic and geopolitical uncertainties, our view remains constructive on both the economy and Chinese financial asset prices in the next 6 to 12 months.  (Chart 4). Chart 4Recovery To Gain Traction In H2   Jing Sima China Strategist jings@bcaresearch.com     #WWIII The phrase “World War III” or #WWIII went viral earlier this year in response to a skirmish between the US and Iran (Chart 1). Only four months later, the US and China are escalating a strategic rivalry that makes the Iran conflict look paltry by comparison (Chart 2). Chart 1US-Iran Tensions Were Just A Warm-Up Chart 2The Thucydides Trap Fortunately, the two great powers are constrained by the same mutually assured destruction that constrained the US and the Soviet Union during the Cold War. They are also constrained by the desire to prevent their economies from collapsing further. Unfortunately, the intensity of their rivalry can escalate dramatically before reaching anything truly analogous to the Berlin Airlift or Cuban Missile Crisis – and these kinds of scenarios are not out of the question. Safe haven assets will catch a bid and the recovery in US and global risk assets since the COVID selloff will be halted. We maintain our defensive tactical positioning and will close two strategic trades to book profits and manage risk. In the wake of the pandemic and recession, geopolitics is the next shoe to drop. The War President Over the past 24 hours the White House has taken several steps indicating that President Trump is adopting the “war president” posture in the run-up to the US election: Export controls: Trump has gone forward with new export controls on “dual-purpose” technologies – those that have military as well as civilian applications, in a delayed reaction to China’s policy of civil-military technological fusion. The Commerce Department has wide leeway in whether to grant export licenses under the rule – but it is a consequential rule and would be disruptive if enforced strictly. Supply chain de-risking: Trump is also going forward with new restrictions on the import of foreign parts for US power plants and electricity grid. The purpose is to remove risks from critical US infrastructure. COVID investigation: Trump has hinted that the novel coronavirus that causes the COVID-19 disease may have originated in the Wuhan Institute of Virology. The Director of National Intelligence issued a statement indicating that the Intelligence Community does not view the virus as man-made (not a bio-weapon), but is investigating the potential that the virus transferred to humans at the institute. The State Department had flagged the institute for risky practices long before COVID. Trump avoided the bio-weapon conspiracy theory and is focused on the hypothesis that the laboratory’s investigations into rare coronaviruses led to the outbreak. New tariffs instead of reparations: Director of the National Economic Council Larry Kudlow denied that the US would stop making interest and principal payments on some Chinese holdings of US treasuries. He said that the “full faith and credit of the United States’ debt obligation is sacrosanct. Absolutely sacrosanct.” Trump denied that this form of reparations, first floated by Republican Senator Marsha Blackburn of Tennessee, was under consideration. Instead he suggested that new tariffs would be much more effective, raising the threat for the first time since the Phase One trade deal was agreed in principle in December. Strategic disputes: Tensions have flared up in specific, concrete ways across the range of US-Chinese relations – in the cyber-realm, psychological warfare, Korean peninsula, Taiwan Strait, and South China Sea. These could lead to sanctions. The war president posture is one in which President Trump recognizes that reelection is extremely unlikely in an environment of worse than -4.8% economic growth and likely 16% unemployment. Therefore he shifts the basis of his reelection to an ongoing crisis and appeals to Americans’ patriotism and desire for continuity amid crisis. Bottom Line: Protectionism is not guaranteed to work, and therefore it was not ultimately the path Trump took last year when he still believed a short-term trade deal could boost the economy. Now the bar to protectionism has been lowered. The Decline Of US-China Relations President Trump may still be bluffing, China may take a conciliatory posture, and a massive cold war-style escalation may be avoided. However, it is imprudent to buy risk assets on these reasons today, when the S&P 500’s forward price-to-earnings ratio stands at 20.15. It is more prudent to prepare for a historic escalation of tensions first, buy insurance, then reassess. Why? Because the trajectory of US-China relations is empirically worsening over time. US household deleveraging and the Chinese shift away from export-manufacturing (Chart 3) broke the basis of strong relations during the US’s distractions in Iraq and Afghanistan and China’s “peaceful rise” in the early 2000s. US consumers grew thriftier while Chinese wages rose. Not only has China sought economic self-sufficiency as a strategic objective since General Secretary Xi Jinping took power in 2012, but the Great Recession, Trump trade war, and global pandemic have accelerated the process of decoupling between the two economies. Decoupling is an empirical phenomenon, and it has momentum, however debatable its ultimate destination (Chart 4). Obviously policy at the moment is accelerating decoupling. Chart 3The Great Economic Divorce Chart 4Decoupling Is Empirical The US threat to cease payments on some of China’s Treasury holdings is an inversion of the fear that prevailed in the wake of 2008, that China would sell its treasuries to diversify away from dependence on the US and the greenback. China did end up selling its treasuries, but the US was not punished with higher interest rates because other buyers appeared. The US remains the world’s preponderant power and ultimate safe haven (Chart 5). By the same token, Trump and Kudlow naturally poured water on the threat of arbitrarily stopping payments because that would jeopardize America’s position. Instead Trump is threatening a new round of trade tariffs. Since the US runs a large trade deficit with China, and China is more exposed to trade generally, the US has the upper hand on this front. But it is important to notice that US tariff collections as a share of imports bottomed under President Obama (Chart 6). Chart 5Treasuries Can't Be Weaponized By Either Side... Chart 6... But Tariffs Can And Will Be   The US shift away from free trade toward protectionism occurred in the wake of the 2008 financial crisis. President Trump then popularized and accelerated this policy option in an aggressive and unorthodox way. Trade tariffs are a tool of American statecraft, not the whim of a single person, who may exit the White House in January 2021 anyway. The retreat from globalization is not a passing fancy. Today’s recession also marks the official conclusion of China’s historic 44 year economic boom – and hence a concrete blow to the legitimacy of the ruling Communist Party (Chart 7). The more insular, autarkic shift in the Communist Party’s thinking is not irreversible, but there are no clear signs that Xi Jinping is pivoting toward liberalism after eight years in power. Chart 7Recession Destabilizes The 'G2' Powers China’s unemployment rate has been estimated as high as 20.5% by Zhongtai Securities, which then retracted the estimate (!). It is at least at 10%. Moreover 51 million migrant workers vanished from the job rolls in the first quarter of the year. Maximum employment is the imperative of East Asian governments, especially the Communist Party, which has not dealt with joblessness since the late 1990s. The threat to social and political stability is obvious. The party will take extraordinary measures to maintain stability – not only massive stimulus but also social repression and foreign policy distraction to ensure that people rally around the flag. Xi Jinping has tried to shift the legitimacy of the party from economic growth to nationalism and consumerism, the “China Dream.” But the transition to consumer growth was supposed to be smooth. Financial turmoil, the trade war, and now pandemic and recession have forced the Communist Party off the training wheels well before it intended. Xi’s communist ideology, economic mercantilism, and assertive foreign policy have created an international backlash. The US is obviously indulging in nationalism as well. A stark increase in inequality and political polarization exploded in President Trump’s surprise election on a nationalist and protectionist platform in 2016 (Chart 8). All candidates bashed China on the campaign trail, but Trump was an anti-establishment leader who disrupted corporate interests and followed through with his tariff threats. The result is that the share of Americans who see China’s power and influence as a “major threat” to the United States has grown from around 50% during the halcyon days of cooperation to over 60% today. Those who see it as a minor threat have shrunk to about a quarter of the population (Chart 9). Chart 8A Measure Of Inequality In The US Chart 9US Nationalism On The Rise Chart 10Broad-Based Anti-China Sentiment In US As with US tariff policy, the bipartisan nature of US anger toward China is significant. More than 60% of Democrats and more than 50% of young people have an unfavorable view of China. College graduates have a more negative opinion than the much-discussed non-college-educated populace (Chart 10). Already it is clear, in Joe Biden’s attack ads against Trump, that this election is about who can sound tougher on China. The debate is over who has the better policy to put “America first,” not whether to put America first. Biden will try to steal back the protectionist thunder that enabled Trump to break the blue wall in the electorally pivotal Rust Belt in 2016 (Map 1). Biden will have to win over these voters by convincing them that he understands and empathizes with their Trumpian outlook on jobs, outsourcing, and China’s threats to national security. He will emphasize other crimes – carbon emissions, cyber attacks, human rights violations – but they will still be China’s crimes. He will return to the “Pivot to Asia” foreign policy of his most popular supporter, former President Barack Obama. Map 1US Election: Civil War Lite Bottom Line: Economic slowdown and autocracy in China, unprecedented since the Cultural Revolution, is clashing with the United States. Broad social restlessness in the US that is resolving into bipartisan nationalism against a peer competitor, unprecedented since the struggle with the Soviets in the 1960s, is clashing with China. Now is not the time to assume global stability. Constraints Still Operate, But Buy Insurance The story outlined above is by this time pretty well known. But the “Phase One” trade deal allowed global investors to set aside this secular story at the beginning of the year. Now, as Trump threatens tariffs again, the question is whether he will resort to sweeping, concrete, punitive measures against China that will take on global significance – i.e. that will drive the financial markets this year. Trump is still attempting to restore his bull market and magnificent economy. As long as this is the case, a constraint on conflict operates this year. It is just not as firm or predictable. Therefore we are looking for three things. First, will President Trump’s approval rating benefit so much from his pressure tactics on China that he finds himself driven into greater pressure tactics? This raises the risk of policy mistakes. Second, will Trump’s approval rating fall into the doldrums, stuck beneath 43%, as the toll of the recession wears on him and popular support during the health crisis fades? “Lame duck” status would essentially condemn him to electoral loss and incentivize him to turn the tables by escalating the conflict with China. Chart 11Trump May Seek A Crisis ‘Bounce’ To Popularity Presidents are not very popular these days, but a comparison with Trump’s two predecessors shows that while he can hardly obtain the popularity boost that Obama received just before the 2012 election, he could hope for something at least comparable to what George W. Bush received amid the invasion of Iraq (Chart 11). (Trump has generally been capped at 46% approval, the same as his share of the popular vote in 2016.) The reason this is a real risk, not a Shakespearean play, is outlined above: however cynical Trump’s political calculus, he would be reasserting US grand strategy in the face of a great power that is attempting to set up a regional empire from which, eventually, to mount a global challenge. Thus if he is convinced he cannot win the election anyway, this risk becomes material. Investors should take seriously any credible reports suggesting that Trump is growing increasingly frustrated with his trailing Biden in head-to-head polls in the swing states. Third, will China, under historic internal stress, react in a hostile way that drives Trump down the path of confrontation? China has so far resorted to propaganda, aircraft carrier drills around the island of Taiwan, and maritime encroachments in the South China Sea – none of which is intolerably provocative to Trump. A depreciation of the renminbi, a substantial change to the status quo in the East or South China Seas, or an attempt to vitiate US security guarantees regarding US allies in the region, could trigger a major geopolitical incident. A fourth Taiwan Strait crisis is fully within the realm of possibility, especially given that Taiwan’s “Silicon Shield” is fundamentally at stake. While we dismissed rumors of Kim Jong Un’s death in North Korea, any power vacuum or struggle for influence there is of great consequence in today’s geopolitical context. Aggressive use of tariffs always threatened to disrupt global trade and financial markets, but tariffs function differently in the context of a global economic expansion and bull market, as in 2018-19, than they do in the context of a deep and possibly protracted recession. Trump has a clear political incentive to be tough on China, but an equally clear financial and economic incentive to limit sweeping punitive measures and avoid devastating the stock market and economy. If events lower the economic hurdle, then the political incentive will prevail and financial markets will sell. Bottom Line: However small the risk of Trump enacting sweeping tariffs, the downside is larger than in the 2018-19 period. The stock market might fall by 40%-50% rather than 20% in an all-out trade war this year. Investment Takeaways Go tactically long US 10-year treasuries. Book a 9.7% profit on our long 30-year US TIPS trade. Close long global equities (relative to US) for a loss of 3.8%.   Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com   Footnotes Cyclical Investment Stance Equity Sector Recommendations

Special Report

Highlights COVID-19 & The Economy: Australia is now in its first recession in 30 years, thanks to lockdown measures to contain the spread of COVID-19. Yet the nation’s rates of infection and death from the virus are relatively low, which should allow for a faster reopening of the domestic economy. Policy Responses: The RBA has taken extraordinary measures to cushion the blow from the lockdowns, like cutting policy rates to near-0% and capping shorter maturity bond yields through quantitative easing. The Australian government has also been aggressive in providing fiscal stimulus. These measures give the economy a better chance of seeing a “v”-shaped recovery as the lockdown restrictions are eased. Fixed Income Strategy: Downgrade Australian government bonds to neutral within global fixed income portfolios: the RBA has little room to cut rates, inflation expectations are too low and the structural convergence to global yields is largely complete. Favor inflation-linked bonds and investment grade corporate debt over government debt, as both now offer better value. Feature Chart 1The Australian Bond Yield Convergence Story Is Over Australia has a well-deserved reputation as a wonderful place to live, regularly sitting near the top of annual “world’s most livable countries” lists. A big reason for that is the stability of the economy, which has famously not suffered a recession since 1991. The COVID-19 pandemic has changed that happy economic story, with Australia now in the midst of a deep recession. Yet even during this uncertain time, Australia is living up to its reputation as a livable country, with one of the lowest rates of COVID-19 infection among the major economies. This potentially sets up Australia as an economy that can recover from the pandemic – and the growth-crushing measures used to contain its spread - more quickly than harder-hit countries like the US and Italy. For global fixed income investors, Australia has also been a very pleasant place to spend some time. The local bond market has enjoyed a stellar bull run since the 2008 Global Financial Crisis, with policy rates and yields converging to much lower global levels (Chart 1). We have steadfastly maintained a structural overweight recommendation on Australian government bonds since December 2017. Over that time, the benchmark yield on the Bloomberg Barclays Australia government bond index declined -168bps, delivering a total return of +17.6% (in local currency terms). That soundly outperformed the global government benchmark index by 5.7 percentage points (in USD-hedged terms). However, just like the nation’s recession-free streak, Australia’s status as a secular bond outperformer is coming to an end. Just like the nation’s recession-free streak, Australia’s status as a secular bond outperformer is coming to an end. In this Special Report, we take a closer look at the Australian economy and fixed income landscape after the shock of the global pandemic. Our main conclusion is that most of the juice has been squeezed out of the Australian government bond yield global convergence trade. There are, however, some interesting opportunities still available in other parts of the Australian fixed income universe, like corporates and inflation-linked bonds. Yes, Recessions Can Actually Happen In Australia Chart 2A V-Shaped Recovery Is Widely Expected During the record streak of recession-free growth in Australia, the annual growth of real GDP has never dipped below 1.1%. The fact that a recession was avoided in 2009, given the degree of the shock from the Global Financial Crisis, is a testament to the balance within the Australian economy; consumer spending is 55% of GDP, business investment is 12%, government spending is 24% and exports are 25%. This stands out in contrast to more imbalanced economies like the US (where consumer spending is 70% of GDP) and Germany (where exports are 47% of GDP). Yet the unique nature of the COVID-19 pandemic, which has forced shutdowns across the entire economy, has nullified that advantage for Australia. There is no part of the economy that can avoid a major slowdown to help prevent a full-blown recession in 2020. Yet while expectations have adjusted to this new short-term reality, there appears to be a broad consensus that this Australian recession will be a short-lived “V” rather than an extended “U”. That can be seen in the forecasts of the Bloomberg Consensus survey and the Reserve Bank of Australia (RBA), both of which are calling for a year-over-year decline in real GDP growth of at least -7% in Q2/2020. That will represent the low point of the recession, with growth expected to steadily recover over the subsequent year, with annual real GDP growth reaching +7% by the second quarter of 2021 (Chart 2). The Westpac-Melbourne Institute consumer sentiment index suffered the single greatest monthly decline in the 47-year history of the series in April. Yet there was only a modest decline in the longer-run expectations component of that survey, which remains above recent cyclical lows (bottom panel) This is a message consistent with the RBA and Bloomberg consensus forecasts, where economic resiliency is expected. One reason for that relative optimism among Australian consumers is that COVID-19 has not hit the country as hard as other nations. A recent survey of Australian consumers conducted by McKinsey in April showed that 65% of respondents named “the Australian economy” as their biggest COVID-19 related concern. At the same time, only 33% of those surveyed cited “not being able to make ends meet” as their main worry related to the virus (Chart 3). Other responses to the survey showed a similar divide, with greater concern shown for the state of the overall Australian nation compared to worries about one’s own economic or health outlook. Chart 3Australians Worrying More About The Nation Than Their Own Situation For an economy that has not seen a recession in over a generation, a relative lack of concern over one’s own financial health – even in a global pandemic that has paralyzed the world economy – may not be that surprising. Another reason for that relative optimism is that Australia has, so far, escaped relatively unscathed from the spread of COVID-19 compared to other nations. Australia has, so far, escaped relatively unscathed from the spread of COVID-19 compared to other nations. The number of new daily COVID-19 cases is now only 1 per million people, according to the Johns Hopkins University data on the virus. This is down from the peak of 20 per million people reached on March 28, and substantially below the numbers seen in countries more severely struck by the virus like the US and Italy (Chart 4). Australia has also seen a relatively low fatality rate from the virus, with only 1.4% of confirmed cases resulting in deaths (Chart 5). Chart 4The COVID-19 Wave Has Crested Down Under Chart 5Australia Has Weathered The Pandemic Much Better Than Others Given these low rates of infection and death, it is likely that Australia will be able to reopen its economy faster than other nations. The Australian government has already announced an easing of the COVID-19 lockdown measures, which will include the opening of restaurants (with limited seating) and schools (on a staggered schedule). There is even talk of creating a “trans-Tasman travel bubble” with neighboring New Zealand, which has similarly low rates of COVID-19 infection. Yet even when Australians can begin resuming a more “normal” life, the backdrop for consumer spending will be constrained by relatively low income growth and high consumer debt levels (Chart 6). Real consumer spending has struggled to grow faster than 2-3% over the past decade and, with household debt now up to a staggering 190% of disposable income, a faster pace of spending is unlikely even as the economy reopens. Chart 6Weak Consumer Fundamentals Chart 7Australian Businesses Are Retrenching Among the other parts of the Australian economy, the near-term outlook is gloomy, but there are potential areas where the damage to growth could be more limited. Capital Spending Business fixed investment has been flat in real terms over the past year. With corporate profit growth already slowing rapidly and likely to contract because of the recession, firms will look to cut back on capital spending to preserve cash, leading to a bigger drag on overall growth from investment (Chart 7). According to the latest National Australia Bank business survey conducted in March, confidence has collapsed to lower levels than seen during the Global Financial Crisis, while capital spending and employment expectations have also declined sharply – trends that had already started before the COVID-19 breakout. Chart 8No Rebound In Housing Housing The housing market has long been a source of both strength and vulnerability for the Australian economy. While the days of double-digit growth in house prices are in the past, thanks to greater restrictions on banks for mortgage lending and worsening affordability, Australian housing was showing signs of life before the COVID-19 outbreak. National house prices were up +2.8% on a year-over-year basis in Q4/2019, while building approvals were stabilizing (Chart 8). That nascent housing rebound was choked off by the virus, with the Westpac-Melbourne Institute “good time to buy a home” survey plunging 30 points in April to the lowest level since February 2008. While the RBA’s interest rate cuts over the past decade have helped lower borrowing costs in Australia, the gap between the RBA cash rate and variable mortgage rates has been steadily widening (bottom panel). This suggests a worsening transmission from monetary policy into the most interest-sensitive parts of the economy like housing. Australian banks have been more stringent on mortgage lending standards over the past couple of years, which likely explains some of the widening gap between the RBA cash rate and mortgage rates. However, Australian banks have also seen an increase in their funding costs over that same period, both for onshore measures like the Bank Bill Swap Rate and offshore indicators like cross-currency basis swaps (Chart 9). Those funding costs have plunged in recent weeks, in response to the RBA’s aggressive monetary policy easing measures to help mitigate the hit to growth from COVID-19. The US Federal Reserve’s decision to activate a $60 billion currency swap line with the RBA back in March also helped reduce offshore funding costs for Australian banks. It is possible that the easing of funding costs could make banks more willing to make consumer and mortgage loans in the coming months, at lower interest rates, as the lockdown restrictions ease. This could help improve the transmission from easy RBA monetary policy to economic activity. Exports Demand for Australian exports was already starting to soften in the first few months of 2020. The year-over-year growth in total exports fell to 9.7% in March from a peak of 18.7% in July 2019. Exports to China, Australia’s largest trade partner, have held up better than non-Chinese exports (Chart 10). This was largely due to increased Chinese demand for Australian iron ore earlier in the year. Chart 9Bank Funding Pressures Have Diminished Iron ore prices have been declining more recently, but remain surprisingly elevated given the sharp contraction in global economic activity since March. This may be a sign that China’s reawakening from its own COVID-19 lockdowns, combined with more monetary and fiscal stimulus measures from Chinese policymakers, is putting a floor under the demand for Australian exports to China. Chart 10Australian Exports Will Not Rebound Anytime Soon Summing it all up, a major near-term economic contraction in Australia is unavoidable, but a relatively quick rebound could happen as domestic quarantine measures are lifted – especially given the significant amount of monetary and fiscal stimulus put in place by the RBA and the Australian government. Bottom Line: Australia is now in its first recession in 30 years, thanks to lockdown measures to contain the spread of COVID-19. Yet the nation’s rates of infection and death from the virus are relatively low, which should allow for a faster reopening of the domestic economy. A Powerful Policy Response To The Recession Almost every government and central bank in the world has introduced fiscal stimulus or monetary easing measures in response to the COVID-19 economic downturn. Australia’s policymakers have been particularly aggressive, both on the monetary and (especially) fiscal side. Monetary Policy The RBA has announced a variety of measures since late March to ease financial conditions and provide more liquidity to the economy, including: cutting the cash rate by 50bps to 0.25% the introduction of quantitative easing for the first time, buying government bonds in enough quantity in secondary markets to keep the yield on 3-year Australian government debt around 0.25% introducing a Term Funding Facility for the banking system under which authorized deposit-taking institutions can get funding from the RBA for three years at a rate of 0.25%, with additional funding available to increase lending to small and medium-sized businesses an increase in the amount and maturity of daily reverse repurchase (repo) operations, to support liquidity in the financial system setting up the currency swap line with the US Fed, providing US dollar liquidity to market participants in Australia. The RBA’s decisions on cutting the cash rate the 0.25%, and capping 3-year bond yields at the same level, sent a strong message to the markets that monetary policy must be highly accommodative until the threat of COVID-19 has passed. Fixed income markets have taken notice, with the yield on the benchmark 10-year Australian government bond falling from 1.30% just before the RBA announced the easing measures on March 19th to a low of 0.68% on April 1st. The yield has since rebounded to 0.95%, but this remains well below the level prevailing before the RBA eased. Those low interest rates have also helped to keep monetary conditions easy by dampening the attractiveness, and value, of the Australian dollar. The currency has historically been driven by three factors – interest rate differentials, commodity prices and global investor risk-aversion. With the RBA’s relentless rate cuts over the past decade, capped off by the measures introduced two months ago, the dominant factor on the currency has become interest rate differentials between Australia and other countries (Chart 11). The Aussie dollar has enjoyed a bounce as global equity markets have rebounded since the collapse in March, but remains well below levels implied by the RBA Commodity Price Index. The implication is that the upside in the currency will be capped by the RBA’s interest rate stance, which has taken all the formerly attractive carry out of the Aussie dollar. The RBA will need to maintain an accommodative stance for some time, as inflation – and inflation expectations – are likely to remain well below the central bank’s 2-3% target range. The RBA will need to maintain an accommodative stance for some time, as inflation – and inflation expectations – are likely to remain well below the central bank’s 2-3% target range. The new baseline forecast by the RBA calls for the Australian unemployment rate to double from 5.2% in Q1/2020 to 10% in Q2/2020, before drifting back down to 8.5% by Q2/2021 (Chart 12). The central bank sees the jobless rate returning to 6.5% in Q2/2022, but that will still not be enough to push headline or core CPI inflation back above 2% (middle panel). Chart 11Interest Rates Are The Main Driver Of The AUD Now Chart 12Inflation Is Dormant Down Under Inflation expectations have discounted a similar outcome. The Union Officials’ and Market Economists’ surveys of 2-year-ahead inflation expectations are both now under 2%. Market-based measures like the 2-year CPI swap rate are even more pessimistic, priced at a mere 0.12%! The recent plunge in oil prices is clearly playing a role in that extreme CPI swap pricing, but until there is some recover in market-based inflation expectations, the RBA will be unable to move away from its current emergency policy easing measures. Fiscal Policy The Australian government has been very aggressive in its economic support measures, including1: a so-called “JobKeeper Payment” to allow businesses to cover employee wages direct income support payments to individuals and households allowing temporary withdrawals from superannuation (retirement savings) plans direct financial support to businesses to “boost cash flow” temporary changes to bankruptcy laws to make it more difficult for creditors to demand payment increased financial incentives for new investment providing loan guarantees to small and medium-sized businesses temporarily easily regulatory standards (like capital ratios) for Australian banks, to free up more funds for lending The size of these combined measures is estimated to be 12.5% of GDP, according to calculations from the IMF (Chart 13). This puts Australia in the upper tier of G20 countries in terms of the size of the total government support measures, according to an analysis of fiscal policy responses to COVID-19 from our colleagues at BCA Research Global Investment Strategy.2 When looking at purely the fiscal policy response through tax changes and direct spending, and removing liquidity support and loan guarantees that may not be fully utilized, the Australian government’s stimulus response is 10.6% of GDP - the largest in the G20 (Chart 14). Chart 13Australian Policymakers Have Responded Aggressively To COVID-19 Chart 14Australia’s Planned Deficit Increase Is The Largest In The G20 Chart 15Australia Has The Fiscal Space To Be Aggressive The Australian government can deliver such a large response because it has the fiscal space to do it, with a debt/GDP ratio that was only 41.9% prior to the COVID-19 outbreak (Chart 15). This compares favorably to other countries that have delivered major stimulus packages but from a starting point of much higher levels of government debt. The Australian government can deliver such a large response because it has the fiscal space to do it. We do not see any downgrade risk for Australia’s sovereign AAA credit rating from the fiscal stimulus measures, despite the recent decision by S&P to put the nation on negative outlook. Australia will still have one of the lowest government debt/GDP ratios among the G20, even after adding in the expected increases in deficits for all the countries in 2020 (Chart 16). Chart 16Australia’s AAA Credit Rating Is Safe Net-net, the monetary and fiscal stimulus measures undertaken by Australian policymakers appear large enough to offset the immediate hit to the economy from the COVID-19 recession. This has important investment implications for Australian bond markets. The monetary and fiscal stimulus measures undertaken by Australian policymakers appear large enough to offset the immediate hit to the economy from the COVID-19 recession. Bottom Line: The RBA has taken extraordinary measures to cushion the blow from the lockdowns, like cutting policy rates to near-0% and capping shorter maturity bond yields through quantitative easing. The Australian government has also been aggressive in providing fiscal stimulus. These measures give the economy a better chance of seeing a “v”-shaped recovery as the lockdown restrictions are eased. Investment Conclusions We started this report by discussing the consistent outperformance of Australian government bonds versus other developed market debt over the past decade. After going through a careful analysis of the economy, inflation, monetary policy and fiscal policy, we now view the period of Australian bond outperformance as essentially complete. This leads us to make the following investment conclusions on a strategic (6-12 months) investment horizon. Duration: We recommend only a neutral duration stance for dedicated Australian fixed income portfolios; the RBA has little room to cut policy rates further; inflation expectations are too low; the nation is poised to rapidly emerge from COVID-19 lockdowns; and fiscal stimulus will be more than enough to offset the hit to domestic incomes from the recession. Country Allocation: Within global bond portfolios, we recommend downgrading Australia to neutral from overweight. The multi-year interest rate convergence story is largely complete, both in terms of central bank policy rates and longer-term bond yields. Our most reliable indicator for the future relative performance of Australian government bonds versus the global benchmark – the ratio of the OECD’s leading economic indicator for Australia to the overall OECD leading indicator – is increasing because of a greater decline in the non-Australian measure (Chart 17, second panel). This fits with the idea of the relative economic growth story turning into a headwind for Australian bonds after being a tailwind for the past few years. Within global bond portfolios, we recommend downgrading Australia to neutral from overweight.  Yield Curve: We recommend positioning for a steeper Australian government bond yield curve. The RBA is anchoring the short-end of the curve as part of its quantitative easing program, leaving the slope of the curve to be driven more by longer-term inflation expectations that are too depressed (third panel). Inflation-linked Bonds: We recommend overweighting Australian inflation-linked bonds versus nominal government debt. As we discussed in a recent report, breakevens on Australian inflation-linked bonds are far too low on our fair value models, which include the sharp decline in global oil prices (fourth panel).3 Chart 17Move To Neutral Duration Exposure In Australia, While Favoring Inflation-Linked Bonds Chart 18Australian Corporate Bonds Look More Attractive Now   Corporate Credit: We recommend going overweight Australian investment grade corporate debt versus government bonds. The recent spread widening has restored some value - especially when compared to the more modest increase seen in credit default spreads - while Australian equity market volatility, which correlates with spreads, has peaked (Chart 18). Also, the RBA has just announced that they will now accept investment grade corporates as collateral for its domestic repo market operations, which should increase the demand for corporates on the margin.4   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 The full details of the Australian government economic response to COVID-19 can be found here: https://treasury.gov.au/sites/default/files/2020-03/Overview-Economic_Response_to_the_Coronavirus_2.pdf 2 Please see BCA Research Global Investment Strategy Special Report, “The Global COVID-19 Fiscal Response: Is It Enough?”, dated April 30, 2020, available at gis.bcaresearch.com. 3 Please see BCA Research Global Fixed Income Strategy Weekly Report, "Global Inflation Expectations Are Now Too Low", dated April 28, 2020, available at gfis.bcaresearch.com. 4https://www.rba.gov.au/mkt-operations/announcements/broadening-eligibility-of-corporate-debt-securities.html Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index

Highlights The global economy will contract at its fastest pace since the early 1930s, but will not slump into a depression. Easy monetary conditions, an extremely expansive fiscal policy, and solid bank and household balance sheets are crucial to the economic outlook. Risk assets remain attractive. The dollar and bonds will soon move from bull to bear markets. The credit market offers some attractive opportunities. Stocks are vulnerable to short-term profit-taking, but the cyclical outlook remains bright. Favor energy and consumer discretionary equities. Feature What a difference a month makes. US and global equities have rallied by 31.4% and 28.3% from their March lows, respectively. Last month we recommended investors shift the weighting of their portfolios to stocks over bonds. April’s dramatic turnaround has not altered our positive view of equities on a 12- to 24-month basis, especially relative to government bonds. However, the probability of near-term profit taking is significant. The spectacular dislocation in the oil market also has grabbed headlines. This was a capitulation event. Hence, assets linked to oil are now cyclically attractive, even if they remain volatile in the coming weeks. It is time to buy energy equities, especially firms with solid balance sheets and proven dividend records. Under the IMF’s base case, the resulting output loss will total $9 trillion. Finally, the Federal Reserve’s large liquidity injections have dulled the dollar’s strength. While the USD still has some upside risk in the near term, investors should continue to transfer capital into foreign currencies. A weaker dollar will be the catalyst to lift Treasury yields and will contribute to the outperformance of energy stocks. Dismal Growth Versus Vigorous Policy Responses Chart I-1Consumer Spending Is In Freefall The economic lockdowns and the collapse in consumer confidence continue to take their toll on the US and global economies (Chart I-1). The eventual end of the shelter-at-home orders and the progressive re-opening of the economy will halt this trend. The rapid monetary and fiscal easing worldwide will allow growth to recover smartly in the second half of the year, but only after authorities loosen extreme social distancing measures. The Economy Is In Freefall… First-quarter US growth is already as weak as it was at the depth of the recession that followed the Great Financial Crisis. The second quarter will be even more anemic. Our Live-Trackers for both the US and global economies either continue to collapse or have flat-lined at rock-bottom levels (Chart I-2). US industrial production is falling at a 21% quarterly annualized rate and the weakness in the PMI manufacturing survey warns that the worst is yet to come. In March, retail sales contracted by 8.7% compared with February, which was the poorest reading on record, and year-on-year comparisons will only deteriorate further. Annual GDP growth could fall below -11% next quarter with both the industrial and consumer sectors in shock, according to the New York Fed Weekly Economic Index (Chart I-3). Chart I-2No Hope From The Live Trackers Chart I-3Real GDP Growth Is Melting The IMF expects the recession to eclipse the post GFC-slump, in both advanced and emerging economies. Its most recent World Economic Outlook describes base-case 2020 growth of -5.9%, -7.5%, and -1.0% in the US, Eurozone and emerging markets, respectively. This compares with -2.5%, -4.5% and 2.8% each in 2009. If a second wave of infections forces renewed lockdowns in the fall, then 2020 growth could be 5.12% and 4.49% lower than baseline in developed markets and emerging markets, respectively. Under the IMF’s base case, the resulting output loss will total $9 trillion in the coming 3 years (Chart I-4). Chart I-4An Enormous Output Gap Is Forming Chart I-5Disinflation Build-Up An output gap of the magnitude depicted by the IMF will dampen inflation for the next 12 to 24 months. In addition to the shortfall in aggregate demand, imploding economic confidence and the lag effect of the Fed’s monetary tightening in 2018 will pull down the velocity of money even further. This combination will reduce US inflation to 1.5% or lower (Chart I-5, top panel). The Price Paid component of both the Philly Fed and Empire State Manufacturing Surveys already captures this impact. The return of producer price deflation in China guarantees that weak US import prices will add to domestic deflationary pressures (Chart I-5 third panel). The recent strength in the dollar will only amplify imported deflation (Chart I-5, bottom panel). A deflationary shock is an immediate problem for businesses and creates a huge risk for household incomes because it exacerbates the already violent contraction in aggregate demand. In the coming months, the weakest nominal GDP growth since the Great Depression will depress profits. BCA Research’s US Equity Strategy team expects S&P 500 operating earnings per share to drop from $162 in 2019 to no further than $104 in 2020.1 The profits of small businesses will suffer even more. Cash flow shortfalls will also cause corporate defaults to spike because many firms will not be able to service their debt (Chart I-6). Currently, 86% of the job losses since the onset of the COVID-19 crisis are temporary. However, if corporate bankruptcies spike too fast and too high, then these job losses will become permanent and household incomes will not recover quickly. A sharp but brief recession would turn into a long depression. Chart I-6Defaults Can Only Rise …But The Liquidity Crisis Will Not Morph Into A Solvency Crisis… In response to the aggregate demand shock caused by COVID-19, global central banks are supporting lending. These policies are an essential ingredient to flatten the default curve and minimize the permanent hit to employment and household income. The US Fed is acting as the central banker to the world. The US Fed is acting as the central banker to the world. Its new quantitative easing program has already added $1.36 trillion in excess reserves this quarter. Moreover, the Fed’s decision to loosen supplementary liquidity ratios and capital adequacy ratios allows the interbank and offshore markets to normalize. Meanwhile, the Fed’s swap lines with global central banks have surged by $432 billion since the crisis began. Its FIMA facility also permits central banks to pledge Treasurys as collateral to receive US dollars. These two programs let global central banks provide dollar funding to the private sector outside the US. Chart I-7Easing Liquidity Stress The Fed is also supporting the credit market directly. The $250 billion Secondary Market Corporate Facility, the $500 billion Primary Market Corporate Facility and the $600 billion Main Street New Loan and Expanded Loan Facilities, all mean that firms with a credit rating above Baa or a debt-to-EBITDA ratio below 4x can still get funding. Together with the $100 billion Term-Asset-backed Securities Loan Facility, these measures will prevent a liquidity crisis from morphing into a solvency crisis in which healthier borrowers cannot roll over their debt. Such a crisis would magnify the inevitable increase in defaults manyfold.  The market is already reflecting the impact of the Fed’s programs. Corporate spreads for credit tiers affected by the Fed’s support are narrowing (Chart I-7). Spreads reflective of liquidity conditions, such as the FRA-OIS gap, the Commercial paper-OIS spread and cross-currency basis-swap spreads, have also begun to normalize. The narrowing of bank CDS spreads demonstrates that unlike the GFC, the current crisis does not threaten the viability of major commercial banks (Chart I-7, bottom panel). Other central banks are doing their share. The Bank of Canada is buying provincial debt to ensure that the authorities directly tasked with managing the pandemic have the ability to do so. The European Central Bank has enacted a QE program of at least EUR1.1 trillion and enlarged the TLTRO facility while decreasing its interest rate, which cheapens the cost of financing for commercial banks. Moreover, the ECB has also eased liquidity and capital adequacy ratios for commercial banks. Last week, it announced that it would also accept junk bonds as collateral, as long as these bonds were rated as investment grade prior to April 7, 2020. …And Governments Are Pulling Levers… Chart I-8Record Fiscal Easing Governments, too, are ensuring that private-sector default rates do not spike uncontrollably and doom the economy to a repeat of the 1930s. Policymakers in the G-10 and China have announced larger stimulus packages than the programs implemented in the wake of the GFC (Chart I-8). The US’s programs already total $2.89 trillion or 13% of 2020 GDP. Germany is abandoning fiscal discipline and has declared stimulus measures totaling 12% of GDP. Italy’s package is more modest at 3% of GDP. Even powerhouse China is not taking chances. In addition to a larger fiscal package than in 2008, the reserve requirement ratio stands at 9.5%, the lowest level in 13 years, and the People’s Bank of China cut the rate of interest on excess reserves by 37 basis points to 0.35% (Chart I-9). The last cut to the IOER was in November 2008 and was of 27 basis points. This interest rate easing preceded a CNY4 trillion increase in the stock of credit, which played a major role in the global recovery that began in 2009. Hence, the recent IOER reduction, in light of the decline in loan prime rates and MLF rates, suggests that China is getting ready to boost its economy by as much as in 2008. Chart I-9China Is Pressing On The Gas Pedal Among the advanced economies, loan guarantees supplement growing deficits. So far, this protection totals at least $1.3 trillion. While guarantees do not directly boost the income and spending of the private sector, they address the risk of an uncontrolled spike in defaults. Therefore, they minimize the odds that rocketing temporary layoffs will morph into permanent unemployment. Section II, written by BCA’s Jonathan Laberge, addresses the question of fiscal policy and whether the packages announced so far are large enough to fill the hole created by COVID-19. While a deep recession is unavoidable, governments will provide more stimulus if activity does not soon stabilize. … While Banks And Household Balance Sheets Compare Favorably To 2008 Banks and the household sector, the largest agent in the private sector, entered 2020 on stronger footing than prior to the GFC. Otherwise, all the fiscal and monetary easing in the world would do little to support the global economy. If banks were as weak as when they entered the GFC, then monetary stimulus would have remained trapped in the banking system in the form of excess reserves. Both in the US and in the euro area, banks now possess higher capital adequacy ratios than in 2008 (Chart I-10). Moreover, as BCA Research’s US Investment Strategy service has demonstrated, the large cash holdings and low loan-to-deposit ratio of the US banking system reinforces its strength (Chart I-11).2  Thus, banks are unlikely to tighten credit standards for as long as they did after the GFC. Broad money expansion should outpace the post-GFC experience, as the surge in US M2 growth to a post-war record of 16% indicates. Chart I-10Banks Have More Capital Than In 2008… Chart I-11...And Have More Cash And Secure Funding     Consumers are also in better shape than in 2008. Last December, US household debt stood at 99.7% of disposable income compared with a peak of 136% in 2008. More importantly, financial obligations represented only 15.1% of disposable income, a near-record low. Limited financial obligations suggest that consumer bankruptcies should remain manageable as long as governments help households weather the current period of temporary unemployment (Chart I-12). Meanwhile, household indebtedness in Spain and Ireland has collapsed from 137% to 94% and from 183% to 85% of disposable income, respectively. Italy, despite its structural economic weakness, always sported a low private-sector debt load. A precautionary rise in the savings rate is unavoidable, but it will not match the magnitude of the increase that followed the GFC. The economy will recover quicker than it did following the GFC. The deep recession engulfing the world should not evolve into a prolonged depression because banks and household balance sheets are in a better state than in 2008. While the recovery will be chaotic, the velocity of money will not remain as depressed for as long as it stayed after 2008, which will allow nominal GDP to recover faster than after the GFC. Banks and households will be quicker to lend and borrow from each other than they were after the GFC. Consequently, the collapse in the consumption of durable goods (e.g. cars) has created pent-up demand, but not a permanent downshift in the demand curve (Chart I-13). Chart I-12Robust Household Finances Chart I-13Households' Pent-Up Demand   Bottom Line: The global economy is on track to suffer its worst contraction since the 1930s. However, the combination of aggressive monetary and fiscal stimulus will prevent a rising wave of defaults from swelling to a crippling tsunami that permanently curtails household income. Given that banks and households have stronger balance sheets than in 2008, when governments ease lockdowns, the economy will recover quicker than it did following the GFC. The evolution of any second wave of infection is the crucial risk to this view. The IMF’s forecast indicates that growth will suffer substantial downside relative to its baseline scenario if the second wave is strong and forces renewed lockdowns. In this scenario, the current package of stimulus must be augmented to avoid a depression-like outcome. A big problem for forecasters, is that we do not have a good sense of how the second wave of infections will evolve. Moreover, the ability to test the population and engage in contact tracing will determine how aggressive lockdowns will be. Therefore, we currently have very little visibility to handicap the odds of each path. Investment Implications Low inflation for the next 18 months will allow monetary conditions to stay extremely accommodative. Growth will recover in the second half of 2020, so the window to own risk assets remains fully open as long as we can avoid a second wave of complete lockdowns. The Dollar’s Last Hurrah The US dollar has become dangerously expensive. According to a simple model, the dollar trades at a premium to its purchasing-parity equilibrium against major currencies, which is comparable to 1985 or 2002 when it attained its most recent cyclical tops (Chart I-14). The dollar may not trade as richly against our Behavioral Effective Exchange Rate model, but this fair value estimate has rolled over (Chart I-14, bottom panel). A peak in global policy uncertainty may be the key to timing the start of the dollar’s decline. Policy will prompt downside risk created by the dollar’s overvaluation. The US twin deficit, which is the sum of the fiscal and current account deficits, is set to explode because Washington will expand the fiscal gap by 15~20% of GDP while the private sector will not increase its savings rate at the same pace. If US real interest rates are high and rising, then foreign investors will snap up US liabilities and finance the twin deficit. If real rates are low and falling, then foreigners will demand a much cheapened dollar (which would embed higher long-term expected returns) to buy US liabilities (Chart I-15). Chart I-14The Dollar Is Pricey Chart I-15Bulging Twin Deficits Are A Worry   Real interest rates probably will not climb, hence the twin deficit will become an insurmountable burden for the dollar. The Fed has not hit its symmetric 2% inflation target since the GFC and will not do so in the next one to two years. As a result, the Fed will not lift nominal interest rates until inflation expectations, currently at 1.14%, return to the 2.3% to 2.5% zone consistent with investors believing that the Fed is achieving its mandate. Thus, real interest rates will decline, which will drag down the USD. Relative money supply trends also point to a weaker dollar in the coming 12 months (Chart I-16). The Fed is easing policy more aggressively than other central banks and US banks are better capitalized than European or Japanese ones. Therefore, US money supply growth should continue to outpace foreign money supply. The inevitable slippage of dollars out of the US economy, especially if the current account deficit widens, will boost the supply of dollars globally relative to other currencies. Without any real interest rate advantage, the USD will lose value against other currencies. China’s policy easing is also negative for the dollar. China’s large-scale stimulus will allow the global industrial cycle to recover smartly in the second half of 2020, especially if the increase in pent-up demand fuels realized demand in the fall. The US economy’s closed nature and low exposure to both trade and manufacturing will weigh on US internal rates of return relative to the rest of the world, and invite outflows (Chart I-17). This selling will accentuate downward pressure created by the aforementioned balance of payments and policy dynamics.  Chart I-16Money Supply Trends Will Hurt The Dollar Chart I-17The Dollar Is A Countercyclical Currency   The dollar is also vulnerable from a technical perspective. A record share of currencies is more than one-standard deviation oversold against the USD (Chart I-18). According to the Institute of International Finance (IIF), outflows from EM economies have already eclipsed their 2008 records, and the underperformance of DM assets suggests that portfolio managers have aggressively abandoned non-USD assets. These developments imply that investors who wanted to move money back into the US have already done so. Chart I-18The Dollar Is Becoming Overbought Chart I-19The Dollar Is A Momentum Currency Investors should move funds out of the dollar, but not aggressively. The outlook for the dollar in the next year or two is poor, but the USD’s most important tailwind is intact: the global economy will recover, but for the time being, it remains in freefall. Moreover, among the G-10 currencies, the dollar responds most positively to the momentum factor (Chart I-19), which remains another tailwind. The greenback will remain volatile in the coming weeks. EM currencies offer a particularly tricky dilemma. They have cheapened to levels where historically they offer very compelling long-term returns (Chart I-20). However, EM firms have large amounts of dollar-denominated debt. The fall in EM FX and collapse in domestic cash flows will likely cause some large-scale bankruptcies. If a large, famous EM company defaults, then the headline risk would probably trigger a broad-based selling of EM currencies. For now, our Emerging Market Strategy service recommends that, within the EM FX space, investors favor the currencies with the lowest funding needs, such as the RUB, KRW and THB.3 Chart I-20EM FX Is Decisively Cheap For tactical investors, a peak in global policy uncertainty may be the key to timing the start of the dollar’s decline (Chart I-21). This implies that if a second wave of infections force severe lockdowns, the dollar rally may not be done. Chart I-21Uncertainty Must Recede For The Dollar To Weaken Fixed Income Government bonds have not yet depreciated and the exact timing of a price decline remains uncertain. However, Treasurys and Bunds offer an increasingly poor cyclical risk-reward ratio. Bond valuations continue to deteriorate. Our time-tested BCA Bond Valuation model shows that G-10 bonds, in general, and US Treasurys, in particular, are at their most expensive levels since December 2008 and March 1985, two periods that preceded major increases in yields (Chart I-22). Buy inflation-protected securities at the expense of nominal bonds. Liquidity conditions also represent a threat for safe-haven bonds. The wave of liquidity unleashed by global central banks is meeting record fiscal thrust. Thus, not only is the supply of government bonds increasing, but a larger proportion of the money injected by central banks will actually make its way into the real economy than after 2008. Record-low yields are vulnerable because the increase in the global money supply should prevent nominal GDP growth from slumping permanently as in the 1930s and after the GFC. Additionally, the sharp escalation in liquid assets on the balance sheets of commercial banks also creates an additional risk for bond prices (Chart I-23). Chart I-22Bonds Are Furiously Expensive Chart I-23Liquidity Injections Point To Higher Yields   QE also threatens government fixed income. After the GFC, real interest rates fell because investors understood that US short rates would remain at zero for a long time. Yet, 10-year Treasury yields rose sharply in 2009 as inflation breakevens increased more than the decline in TIPS yields. This pattern repeated itself following each QE wave (Chart I-24). In essence, if the Fed provides enough liquidity to allow markets to function well, then the chance of cyclical deflation decreases, which warrants higher inflation expectations. A lower dollar will be fundamental to the rise in inflation breakeven and yields. A soft dollar will confirm that the Fed is providing enough liquidity to satiate dollar demand and it will favor risk-taking around the world. Moreover, it will boost commodity prices and help realize inflation increases down the line. Chart I-24QE Lifts Breakevens And Yields Technical considerations also point to the end of the bond bull market, at least for the next 12 to 18 months. Investors remain bullish toward bonds, which is a contrarian signal. Our Composite Momentum Indicator has reached levels last achieved at the end of 2008, which suggested at that time that bond-buying was long in the tooth. Chart I-25Inflation Will Drive US/German Spreads In this context, investors with a cyclical investment horizon should consider bringing duration below benchmark. In the short term, this position still carries significant risks because the outlook for yields depends on the dollar. Another dollar spike caused by renewed lockdowns would also pin yields near current levels for longer. A lower-risk version of this bet would be to buy inflation-protected securities at the expense of nominal bonds, a position recommended by our US Bond Strategy service.4  Investors should be careful when betting that US yields will further converge toward German ones. The 10-year yield spread between US Treasurys and German Bunds has quickly narrowed, falling by 170 basis points from a high of 279 basis points in November 2018. Despite this sharp contraction, the spread remains elevated by historical standards. So far, the declining yield gap reflects the fall in policy rates in the US relative to Europe. Given that both the Fed and the ECB are at the lower bounds of their policy rates, short-rate differentials are unlikely to compress further. Instead, inflation differentials between the US and Europe must decline (Chart I-25). The inflation gap between the US and Europe probably will not narrow significantly this year. The IMF forecasts that Europe’s economy will underperform the US. Therefore, slack in Europe will expand faster than in the US. Moreover, monetary and fiscal support in the US is more aggressive than in Europe. Consequently, a weaker dollar, which will increase US inflation expectations relative to Europe, will put upward pressure on the US/German 10-year spread. However, if the European fiscal policy response starts to match the size of the US stimulus, then the spread between the US and Germany would narrow further. Ample liquidity also continues to underpin equity prices. Finally, for credit investors, our US Bond Strategy service recommends buying securities with abnormally large spreads and which the various Fed programs target. These include agency CMBS, consumer ABS, municipal bonds, and corporates rated Ba and above.5 Equities Chart I-26Investors Are Not Exuberant About Stocks Despite some short-term risks, we continue to favor equities on a 12- to 18-month investment horizon in an environment where a second wave of lockdowns can be avoided. Stock valuations have deteriorated, but they remain broadly attractive (see page 2 of Section III). While multiples are not particularly cheap, the equity risk premium remains very high. Alternatively, the expected growth rate of long-term earnings embedded in stock prices continues to hover at the bottom of its post-war distribution (Chart I-26). In other words, stocks are attractive because bond yields are low. Ample liquidity also continues to underpin equity prices. Our US Financial Liquidity Index points to rising S&P 500 returns in the coming months (Chart I-27). The Fed’s surging liquidity injections, which foreign central banks are mimicking, will only accentuate this backdrop. Moreover, in times of crisis, inflation expectations correlate positively with stock prices because “bad deflation” represents an existential threat to profitability.6 QE lifts inflation expectations, therefore, its bearish impact on bond prices should not translate into a fall in stock prices. Chart I-27Ample Liquidity For The S&P 500 Chart I-28Valuation And Monetary Condition Offset COVID-19 The combined valuation and liquidity backdrop are accommodative enough for stocks to persevere higher, despite the immense economic shock generated by COVID-19. The readings of our BCA Valuation and Monetary Indicator are even more accommodative for stocks than they were in Q1 2009, which marked the beginning of a 340% bull market (Chart I-28). Moreover, trend growth may have been less negatively affected by COVID-19 than it was by the GFC. Consequently, our US Equity Strategy service uses the historical pattern of profit rebounds subsequent to recessions to anticipate 2021 S&P 500 earnings per share of $162.1 Technicals remain supportive for stocks on a cyclical basis. Sentiment and momentum continue to be depressed, which could explain the resilience of stocks. Indeed, our Composite Momentum Indicator based on both the 13-week rate of change of the S&P 500 and traders’ sentiment lingers at the bottom of its historical distribution (Chart I-29). Moreover, the percentage of stocks above their 30-week moving average or at 52-week highs suggests that the average stock is still oversold (Chart I-30). Chart I-29Cyclical Momentum Is Not A Risk Yet Chart I-30The Median Stock Remains Oversold The problem for equity indices is that some sectors, such as tech, are very overbought on a near-term basis, which could invite profit-taking among the names that account for a disproportionate share of the index. If these sectors correct meaningfully, then the whole index would fall even if the median stocks barely vacillate. Nonetheless, all the forces listed in Section I suggest that the correction will not develop into a new down leg for the market. Energy stocks offer an attractive opportunity for investors, a view shared by our US Equity Strategy colleagues.1 The energy sector trades at its largest discount to the broad market on record and a weaker dollar normally lifts its relative performance (Chart I-31). Moreover, energy stocks have modestly outperformed the market since its March 23 bottom, despite the abyss into which oil prices tumbled. A pair trade is also available to investors. Healthcare and tech stocks have rallied in parabolic fashion relative to energy stocks. Oil may have capitulated on April 20 when the WTI May contract hit $-40/bbl. Storage capacity is essentially maxed out, but the Kingdom of Saudi Arabia is set to restrict production from 12.3 million b/d to 8.5 million b/d, which will contribute generously to the 10 million bpd cut agreed by OPEC+. Countries such as Canada are also curtailing output, a move repeated among many oil producers. US shale firms, which have become marginal producers of oil, are also paring down their production. Shale producers are not done cutting, judging by both the decline in horizontal rig counts and WTI trading below most marginal costs (Chart I-32). The oil market will move away from its surplus position when the global economy restarts. Chart I-31An Opportunity In Energy Chart I-32Shale Production Will Fall Much Further   The slope of the oil curve confirms that the outlook for energy stocks is improving. On April 20, Brent and WTI hit their deepest contango on record, a development accentuated by the reflexive relationship between major oil ETFs and the price of the commodity itself. The structure of those ETFs was amended on April 21st, allowing a break in this reflexive relationship. The oil curve is again steepening, which after such a large contango often results in higher crude prices (Chart I-33). Meanwhile, net earnings revisions for the energy sector have become very depressed. Relative to the broad market, revisions are also weak but turning up. In this context, rising oil prices can easily lift energy stocks relative to the broad market. Chart I-33A Decreasing Contango Would Boost Oil Stocks Chart I-34Parabolic Moves Are Rarely Durable   A pair trade is also available to investors. Healthcare and tech stocks have rallied in parabolic fashion relative to energy stocks (Chart I-34). We constructed a global sector ranking based on the bottom-up valuation scores from BCA Research’s Equity Trading Strategy service. Based on this metric, energy stocks are attractively valued, while tech and healthcare are not (Chart I-35). A rebound in oil prices should prompt some portfolio rebalancing in favor of the energy sector.   Chart I-35A Bottom-Up Ranking For Sectors Valuations Finally, our US Equity Sector Strategy service also recommends investors overweight consumer discretionary stocks. This sector will benefit because robust household balance sheets will allow consumers to take advantage of low interest rates when the global economy recovers.7 Mathieu Savary Vice President The Bank Credit Analyst April 30, 2020 Next Report: May 28, 2020   II. The Global COVID-19 Fiscal Response: Is It Enough? In this Special Report we explore in detail the fiscal response amongst advanced economies, with the goal of judging whether the response is large enough to prevent an “L-shaped” recession. The crisis remains in its early days and new information about the size and character of the response, as well as the magnitude of the economic shock, continues to emerge on a near-daily basis. As such, our conclusions may change over the coming weeks in line with incoming data. Even when narrowly-defined, the announced (or likely) fiscal response of the US, China, and Germany is quite large and appears to be adequate to prevent the direct and indirect effects of the lockdowns from causing an “L-shaped” event. This is not the case, however, in other euro area economies (France, Italy, and Spain), or in emerging markets. Our analysis also suggests that the global fiscal response will need to increase if the global economy faces a W-shaped shock caused by another round of aggressive containment measures later this year. This underscores the importance of ensuring that the “Great Lockdown” succeeds at reducing the spread of the disease to a point that does not necessitate widespread renewed restrictions on economic activity. The global economic expansion that began in 2009 has come to an abrupt end due to the COVID-19 pandemic. Aggressive containment measures necessary to control the spread of the disease and prevent the collapse in health care systems around the world have caused a large and sudden stop in global economic activity, which has prompted unprecedented responses from governments around the world. In this Special Report we explore in detail the fiscal response amongst advanced economies, with the goal of judging whether the response is large enough to prevent an “L-shaped” recession (characterized by a very prolonged return to trend growth). The crisis remains in its early days and new information about the size and character of the response, as well as the magnitude of the economic shock, continues to emerge on a near-daily basis. As such, our conclusions may change over the coming weeks in line with incoming data. But for now, we (tentatively) conclude that the fiscal response appears to be adequate to prevent the direct and indirect effects of the lockdowns from causing an “L-shaped” event. However, there are two important caveats. First, while Germany has provided among the strongest fiscal responses globally, measures in France, Italy, and Spain are still lacking and must be stepped up. Second, the announced fiscal measures will not be sufficient if the global economy faces a W-shaped shock caused by another round of aggressive containment measures later this year – more will have to be done. For policymakers, this underscores the importance of ensuring that the “Great Lockdown” succeeds at reducing the spread of the disease to a point that does not necessitate widespread renewed restrictions on economic activity. In this regard, the gradual re-opening of several US states by early-May, while positive for economic activity in the short-run, is a non-trivial risk to the US and global economic outlooks over the coming 6-12 months. This risk must be closely watched by investors. The Global Fiscal Response: Comparing Across Countries And Across Measures The flurry of policy announcements from national governments over the past six weeks has led to a great degree of confusion about the size and disposition of the global COVID-19 fiscal response. Our analysis is based heavily on the IMF’s tracking of these measures, albeit with a few adjustments. We also rely on analysis from Bruegel, a prominent European macroeconomic think-tank, as well as our own Geopolitical Strategy team and a variety of news reports. Chart II-1 presents the IMF’s estimate of the total fiscal response to the crisis across major countries, as of April 23rd, broken down into “above-the-line” and “below-the-line” measures. Above-the-line measures are those that directly impact government budget balances (direct fiscal spending and revenue measures, usually tax deferrals), whereas below-the-line measures typically involve balance sheet measures to backstop businesses through capital injections and loan guarantees. Chart II-1The Global Fiscal Response Is Huge When Including All Measures Chart II-1 makes it clear that the fiscal response of advanced economies is enormous when including both above- and below-the-line measures. By this metric, the response of most developed economies is on the order of 10% of GDP, and well above 30% in the case of Italy and Germany. However, using the sum of above- and below-the-line measures to gauge the fiscal response of any country may not be the ideal approach, given that below-the-line measures are contingent either on the triggering of certain conditions or on the provision of credit to households and firms from the financial system. Below-the-line measures also likely increase the liability position of the private sector, thus raising the odds of negative second-round effects. Instead, Chart II-2 compares the countries shown in Chart 1 based only on the IMF’s estimate of above-the-line measures, and with a 4% downward adjustment to Japan’s reported spending to account for previously announced measures.8 The chart shows that countries fall into roughly three categories in terms of the magnitude of their above-the-line response: in excess of 4% of GDP (Australia, the US, Japan, Canada, and Germany), 2-3% (the UK, Brazil, and China), and sub-2% (all other countries shown in the chart, including Spain, Italy, and France). Chart II-2The Picture Changes When Excluding Below-The-Line Measures Analysis by Bruegel provides somewhat different estimates of the global COVID-19 fiscal response for select European countries as well as the US (Table II-1). Bruegel breaks down discretionary fiscal measures that have been announced into three categories: those involving an immediate fiscal impulse (new spending and foregone revenues), those related to deferred payments, and other liquidity provisions and guarantees. Bruegel distinguishes between the first and second categories because of their differing impact on government budget balances. Deferrals improve the liquidity positions of individuals and companies but do not cancel their obligations, meaning that they result only in a temporary deterioration in budget balances. Table II-1The Type Of Fiscal Response Varies Significantly Across Countries Table II-1 highlights that Bruegel’s estimates of the sum of above- and below-the-line measures are similar to the IMF’s estimates for the US, the UK, and Spain, but are smaller for Italy and larger for France and Germany (particularly the latter). These differences underscore the extreme uncertainty facing investors, who have to contend not only with varying estimates of the magnitude of government policies but also a torrent of news concerning the evolution of the pandemic itself. Chart II-3 presents our best current estimate of the above-the-line fiscal response of several countries (the measure we deem to be most likely to result in an immediate fiscal impulse), by excluding loans, guarantees, and non-specified revenue deferrals to the best of our ability.9 Chart II-3 is based on a combination of data from the IMF, Bruegel analysis, and BCA estimates and news analysis. Chart II-3When Narrowly Defined, Several Countries Are Responding Forcefully, But Many Countries Are Not Overall, investors can draw the following conclusions from Charts II-1 – II-3 and Table II-1: When measured as the total of above- and below-the-line measures, nearly all large developed market countries have responded with sizeable measures. Emerging market economies are the clear laggards. Excluding below-the-line measures and using our approach, Australia, the US, China, Germany, Japan, and Canada appear to be spending the most relative to the size of their economies. While Japan’s “headline” fiscal number was inflated by including previously-announced spending, it is still decently-sized after adjustment. Outside of Germany, the rest of Europe appears to be providing a middling or poor above-the-line fiscal response. The UK appears to be providing between 4-5% of GDP as a fiscal impulse, whereas the fiscal response in Italy, Spain, and France looks more like that of emerging markets than of advanced economies. Measuring The Stimulus Against The Shock Despite the substantial amount of new information over the past six weeks concerning the evolution of the pandemic and the attendant policy response, it remains extremely difficult to judge what the balance between shock and stimulus will be and what that means for the profile of growth. Nonetheless, below we present a framework that investors can use to approach the question, and that can be updated as new information emerges concerning the impact of the shutdowns and the extent of the response. Our approach involves analyzing four specific questions: What is the size of the initial shock? What are the likely second-round effects on growth? What is the likely multiplier on fiscal spending? Will the composition of fiscal spending alter its effectiveness? The Size Of The Initial Shock Chart II-4 presents the OECD’s estimates of the initial impact of partial or complete shutdowns on economic activity in several countries. The OECD first used a sectoral approach to estimating the impact on activity while lockdowns are in effect, assuming a 100% shutdown for manufacturing of transportation equipment and other personal services, a 50% decline in activity for construction and professional services, and a 75% decline for retail trade, wholesale trade, hotels, restaurants, and air travel. Chart II-4 illustrates the total impact of this approach for key developed and emerging economies. Chart II-4Annual GDP Will Be 1.5%-2.5% Lower For Each Month Lockdowns Are In Effect The OECD’s approach provides a credible estimate of the impact of aggressive containment policies, and implies that annual real GDP is likely to be 1.5-2.5% lower for major countries for each month that lockdown policies are in effect. This implies that output in major economies is likely to fall 3.5% - 6% for the year from the initial shock alone, assuming an aggressive 10-week lockdown followed by a complete return to normal. Estimating Potential Second Round Effects Chart II-5 presents projections from the Bank for International Settlements on the spillover and spillback potential of a 5% initial shock to the level of global GDP from the COVID-19 pandemic (equivalent to a 20% impact on an annualized basis). Chart II-5Additional Lockdown Events Are A Greater Risk Than First Wave After-Effects The chart shows that the cumulative impact of the initial shock rises to 7-8% by the end of this year for the US, euro area, and emerging markets, and 6% for other advanced economies. These estimates account for both domestic second round effects of the initial shock, as well as the reverberating impact of the shock on global trade. Chart II-5 also shows the devastating effect that a second wave of COVID-19 emerging in the second half of the year would have after including spillover and spillback effects, assuming that only partial lockdowns would be required. In this scenario, the level of GDP would be 10-12% lower at the end of the year depending on the region, suggesting that investors should be more concerned about the possibility of additional lockdown events than they should be about the after-effects of the first wave of infections (more on this below). Will Fiscal Multipliers Be High Or Low? When examining the academic literature on fiscal multipliers, the first impression is that multipliers are likely to be extremely large in the current environment. Tables II-2 and II-3 present a range of academic multiplier estimates aggregated by the IMF, categorized by the stage of the business cycle and whether the zero lower bound is in effect. Table II-2Fiscal Multipliers Are Much Larger During Recessions Than Expansions Table II-3Models Suggest The Multiplier Is Quite High At The Zero Lower Bound The tables tell a clear story: multipliers are typically meaningfully larger during recessions than during expansions, and extremely large when the zero lower bound (ZLB) is in effect. However, there are at least two reasons to expect that the fiscal multiplier during this crisis will not be as large as Tables II-2 and II-3 suggest. First, it is obviously the case that the multiplier will be low while full or even partial lockdowns are in effect, as consumers will not have the ability to fully act in response to stimulative measures. This will be partially offset by a burst of spending once lockdowns are removed, but the empirical multiplier estimates during recessions shown in Table II-2 have not been measured during a period when constraints to spending have been in effect, and we suspect that this will have at least somewhat of a dampening effect on the efficacy of fiscal spending relative to previous recessions (even once regulations concerning store closures are removed). Second, Table II-3 likely overestimates the multiplier at the ZLB. These estimates have been based on models rather than empirical analysis, and appear to be in reference to the prevention of large subsequent declines in output following an initial shock. The modeled finding of a large multiplier at the ZLB occurs because increased deficit spending will not lead to higher policy rates in a scenario where the neutral rate has fallen below zero. But it seems difficult to believe that the fiscal multiplier during ZLB episodes, defined as the impact of fiscal spending on the path of output relative to the initial shock (not relative to a counterfactual additional shock), is larger than the highest empirical estimates of the multiplier during recessions. The only circumstance in which we can envision this being the case is an environment where long-term bond yields are capped and remain at zero, alongside short-term interest rates, as the economy improves. The IMF has provided a simple rule of thumb approach to estimating the fiscal multiplier for a given country. The IMF’s approach involves first estimating the multiplier under normal circumstances based on a series of key structural characteristics that have been shown to influence the economy’s response to fiscal shocks. Then, the “normal” multiplier is adjusted higher or lower depending on the stage of the business cycle, and whether monetary policy is constrained by the ZLB. For the US, the IMF’s approach suggests that a multiplier range of 1.1 – 1.6 is reasonable, assuming the highest cyclical adjustment but no ZLB adjustment (see Box II-1 for a description of the calculation). Given the unprecedented nature of this crisis, we are inclined to use the low end of this range (1.1) as a conservative assumption when judging whether fiscal responses to the crisis are sufficient. For investors, this means that governments should be aiming, at a minimum, for fiscal packages that are roughly 90% of the size of the expected shock of their economies, using our US fiscal multiplier assumption as a guide. Box II-1 The “Bucket” Approach To Estimating Fiscal Multipliers The IMF “bucket” approach to estimating fiscal multiplier involves determining the multiplier that is likely to apply to a given country during “normal” circumstances, based on a set of structural characteristics associated with larger multipliers. This “normal” multiplier is then adjusted based on the following formula: M = MNT * (1+Cycle) * (1+Mon) Where M is the final multiplier estimate, MNT is the “normal times” multiplier derived from structural characteristics, Cycle is the cyclical factor ranging from −0.4 to +0.6, and Mon is the monetary policy stance factor ranging from 0 to 0.3. The Cycle factor is higher the more a country’s output gap is negative, and the Mon factor is higher the closer the economy is to the zero lower bound. Table II-B1 applies the IMF’s approach to the US, using the same structural score as the IMF presented in the note that described the approach. The table highlights that the approach suggests a US fiscal multiplier range of 1.1 – 1.6 given the maximum cycle adjustment proscribed by the rule, which we feel is reasonable given the unprecedented rise in US unemployment. We make no adjustment to the range for the zero lower bound. Table II-B1A Multiplier Estimate Of 1.1 – 1.6 Seems Reasonable For The US The Composition Of The Response: Helping Or Hurting? The last of our four questions deals with the issue of composition and whether the form of a country’s fiscal response is likely to alter its effectiveness. We implicitly addressed the first element of composition, whether measures are above-the-line or below-the-line, by comparing Charts II-1 - II-3 on pages 28-31. Our view is that above-the-line measures are far more important than below-the-line measures, as the former provides direct income and liquidity support. Below-the-line measures are also important, as they are likely to help reduce business failure and household bankruptcies. The fiscal multiplier on these measures has to be above zero, but it is likely to be much lower than that of an above-the-line response. The second element of composition concerns the appropriate distribution of aid among households, businesses, and local governments. On this particular question, it remains extremely challenging to analyze the issue on a global basis, owing to a frequent lack of an explicit breakdown of fiscal measures by recipient. Chart II-6Much Of The US Fiscal Response Is Going To Households And Small Businesses For now, we limit our distributional analysis to the US, and hope to expand our approach to other countries in future research. Chart II-6 presents a breakdown of the US fiscal response by recipient, which informs the following observations. Households: Chart II-6 highlights that US households will receive approximately $600 billion as part of the CARES Act, roughly half of which will occur through direct payments (i.e. “stimulus checks”) and another 40% from expanded unemployment benefits. In cases where the federal household response has been criticized by members of the public as inadequate, it has often been compared to income support programs of other countries. The Canada Emergency Response Benefit (“CERB”) is a good example of a program that seems, at first blush, to be superior: it provides $2,000 CAD in direct payments to individuals for a 4 week period, for up to 16 weeks (i.e. a maximum of $8,000 CAD), which seems better than a $1,200 USD stimulus check. However, Table II-4 highlights that this comparison is mostly spurious. First, the CERB is not universal, in that it is only available to those who have stopped or will stop working due to COVID-19. At a projected cost of $35 billion CAD, the CERB program represents 1.5% of Canadian GDP. By comparison, $600 billion USD in overall household support represents 2.75% of US GDP; this number drops to 1.75% when only considering support to those who have lost their jobs, but this is still higher as a share of the economy than in Canada. Moreover, there is little question that Congress is prepared to pass more stimulus for additional weeks of required assistance. The discrepancy between the perception and reality of US household sector support appears to be rooted in the speed of payments. Speed is the one area where Canada’s household sector response appears to have legitimately outperformed the US; CERB payments are received by applicants within three business days for those registered for electronic payment, and in some cases they are received the following day. By contrast, it has taken some time for US States to start paying out the additional $600 USD per week in expanded unemployment benefits, but as of the middle of last week nearly all states had started making these payments. Table II-4US Household Relief Is Just As Generous As Seemingly Better Programs Firms: On April 16th the Small Business Administration announced that the Paycheck Protection Program (“PPP”) had expended its initial budget of $350 billion. While additional funds of $320 billion have subsequently been approved (plus $60 billion in small business emergency loans and grants), the run on PPP funds was, to some investors, an implicit sign that the CARES Act was inadequately structured. However, the fact that the initial funds ran out in mid-April simply reflects the reality that social distancing measures had been in place for 3-4 weeks by the time that the program began taking applications. Table II-5 highlights that $350 billion was large enough to replace nearly 90% of lost small business income for one month, assuming that overall small business revenue has fallen by 50% and that small businesses account for 44% of total GDP. The Table also shows that a combined total of $730 billion is enough to replace almost 80% of lost small business income for 10 weeks, given these assumptions. With loan forgiveness at least partially tied to small businesses retaining employees on payroll for an 8-week period, the PPP is also essentially an indirect form of household income support. Table II-5Help For Small Businesses Will Replace A Significant Amount Of Lost Income Chart II-7Persistent State & Local Austerity Must Be Avoided This Time State & Local Governments: The magnitude of support for state & local (S&L) governments appears to be the least-well designed element of the US fiscal response. The CARES Act provides for $170 billion in support to S&L, which at first blush seems large as it is approximately 25% of S&L current receipts in Q4 2019 (i.e. it stands to cover a 25% loss in revenue for one quarter). However, this does not account for the significant reported increase in S&L costs to combat the pandemic, nor does it provide S&L governments with any revenue certainty beyond June 30th when most of the assistance from CARES must be spent. Unlike households or firms, who also face significant uncertainty, nearly all US states are subject to balanced budget requirements, which prevent them from spending more than they collect in revenue. When faced even with projected revenue losses in the second half of this year and into 2021, states are likely to aggressively and immediately cut costs in order to avoid budgetary shortfalls. Chart II-7 highlights that S&L austerity was a significant element of the persistent drag on real GDP growth from overall government expenditure and investment in the first 3-4 years of the post-GFC economic expansion. A repeat of this episode would significantly raise the odds of an “L-type” recession (and thus should certainly be avoided). This is why Congress is moving to pass larger state and local aid. Our Geopolitical Strategy team argues that neither President Trump nor Senate Majority Leader Mitch McConnell will prevent the additional financial assistance that US states will require, despite their rhetoric about states going bankrupt.10 A near-term, temporary standoff may occur, but Washington will almost certainly act to provide at least additional short-term funding if state employment starts to fall due to budget pressure. So while we recognize that the state & local component of the US fiscal response is currently lacking, it does not seem likely to represent a serious threat to an eventual economic recovery in the US. Putting It All Together: Will It Be Enough? Chart II-8 reproduces Chart II-3 with an assumed fiscal multiplier of 1.1, and with shaded regions denoting the likely initial and total impact on GDP from aggressive containment measures (based on the OECD and BIS’ estimates). Based on our analysis of the US fiscal response, we make no adjustments for the composition of the measures beyond defining the fiscal response on a narrow basis (i.e. excluding loans, guarantees, and non-specified revenue deferrals). The chart highlights that the narrowly-defined fiscal response of three key economies driving global demand, the US, China, and Germany, is either at the upper end or above the total impact range. Thus, for now, we tentatively conclude that the fiscal response that has or will happen appears to be adequate to prevent the direct and indirect effects of the lockdowns from causing an “L-shaped” event, especially since Chart II-8 explicitly excludes below-the-line measures. However, there are two important caveats to this conclusion. First, Chart II-8 makes it clear that measures in France, Italy, and Spain are still lacking and must be stepped up. Italy and France have provided a substantial below-the-line response, but it is far from clear that a debt-based response or one that only temporarily improves access to cash for households and businesses will be enough to prevent a prolonged fallout from the sudden stop in economic activity and income. Chart II-8Several Important Countries Seem To Be Doing Enough, But More Is Needed In Europe Ex-Germany Second, our analysis suggests that the announced fiscal measures will not be sufficient if the global economy faces a W-shaped shock caused by another round of aggressive containment measures later this year or if these measures remain in place at half-strength for many months. This underscores how sensitive the adequacy of announced fiscal measures are to the amount of time economies remain under full or partial lockdown. As such, it is crucial for investors to have some sense of when advanced economies may be able to sustainably end aggressive containment measures. When Can The Lockdowns Sustainably End? Several countries and US states have already announced some reductions in their restrictions, but the question of how comprehensive these measures can be without risking a second period of prolonged stay-at-home orders looms large. Table II-6 presents two different methods of estimating sustainable lockdown end dates for several advanced economies. First, we use the “70-day rule” that appears to have succeeded in ending the outbreak in Wuhan, calculated from the first day that either school or work closures took effect in each country.11 Second, using a linear trend from the peak 5-day moving average of confirmed cases and fatalities, we calculate when confirmed cases and fatalities may reach zero. Table II-6By Re-Opening Soon, The US May Be Risking A Damaging Second Wave The table highlights that these methods generally prescribe a reopening date of May 31st or earlier, with a few exceptions. The UK’s confirmed case count and fatality trends are still too shallow to suggest an end of May re-opening, as is the case in Canada. In the case of Sweden, no projections can truly be made based on the 70-day rule because closures never formally occurred. But the most problematic point highlighted in Table II-6 is that US newly confirmed cases are only currently projected to fall to zero as of February 2021. Chart II-9 highlights that while new cases per capita in New York state are much higher than in the rest of the country, they are declining whereas they have yet to clearly peak elsewhere. Cross-country case comparisons can be problematic due to differences in testing, but with several US states having already begun the gradual re-opening process, this underscores that US policymakers may be allowing a dangerous rise in the odds of a secondary infection wave. Chart II-9No Clear Downtrend Yet Outside Of New York State Investment Conclusions Our core conclusion that an “L-shaped” global recession is likely to be avoided is generally bullish for equities on a 12-month horizon. However, uncertainty remains extremely elevated, and the recent rise in stock prices in the US (and globally) has been at least partially based on the expectation that lockdowns will sustainably end soon, which at least in the case of the US appears to be a premature conclusion given the current lack of large-scale virus testing capacity. As such, we are less optimistic towards risky assets tactically, and would recommend a neutral stance over a 0-3 month horizon. As noted above, our cross-country comparison of narrowly-defined fiscal measures suggested that euro area countries (excluding Germany) will likely have to do more in order to prevent a long period of below-trend growth. In the case of highly-indebted countries like Italy, this raises the additional question of whether a significantly increased debt-to-GDP ratio stemming from an aggressive fiscal impulse will cause another euro area sovereign debt crisis similar to what occurred from 2010-2014. Chart II-10Italy's Debt Sustainability Hurdle Is Lower Than It Used To Be Government debts are sustainable as long as interest rates remain below economic growth, and from this vantage point Italy should spend as much as needed in order to ensure that nominal growth remains above current long-term government bond yields. Chart II-10 highlights that, despite a widening spread versus German bunds, Italian 10-year yields are much lower today than they were during the worst of the euro area crisis, meaning that the debt sustainability hurdle is technically lower. However, we have also noted in previous reports that high-debt countries often face multiple government debt equilibria; if global investors become fearful that that high-debt countries may not be able to repay their obligations without defaulting or devaluing, then a self-fulfilling prophecy will occur via sharply higher interest rates (Chart II-11). Chart II-11Multiple Equilibria In Debt Markets Are Possible Without A Lender Of Last Resort Chart II-12Italy's Structural Budget Balance Has Improved For now, we view the risk of a renewed Italian debt crisis from significantly increased spending related to COVID-19 as minimal, and it is certainly lower than the status quo as the latter risks causing a sharp gap between nominal growth and bond yields like what occurred from 2010 – 2014. First, Chart II-12 highlights that Italy has succeeded in somewhat reducing its structural balance, which averaged -4% for many years prior to the euro area crisis. Assuming an adequate global response to the crisis and that economic recovery ensues, it is not clear why global bond investors would be concerned that Italian structural deficits would persistently widen. Second, the ECB is purchasing Italian government bonds as part of its new Pandemic Emergency Purchase Program, which will help cap the level of Italian yields. Chart II-13Italy's Debt Service Ratio Won't Go Up Much, If Yields Are Unchanged Third, Chart II-13 shows what will occur to Italy’s government debt service ratio (general government net interest payments as a percent of GDP) in a scenario where Italy’s gross debt to GDP rises a full 20 percentage points and the ratio of net interest payments to debt remains unchanged. The chart shows that while debt service will rise, it will still be lower than at any point prior to 2015. So not only should Italy spend significantly more to combat the severely damaging nature of the pandemic, we would expect that Italian spreads would fall, not rise, in such an outcome. Jonathan LaBerge, CFA Vice President Special Reports III. Indicators And Reference Charts Last month, we took a more positive stance on equities as both our valuation and monetary indicators had moved decisively into accommodative territory. While the global economy was set to weaken violently, the easing in our indicators suggested that stocks offered an adequate risk/reward ratio to take some risk. This judgment was correct. On a cyclical basis, the same factors that made us willing buyers of stocks remain broadly in place. Stocks are not as cheap as they were in late March, but monetary conditions have only eased further. Moreover, we are starting to get more clarity as to the re-opening of most Western economies because new reported cases of COVID-19 are peaking. Finally, the VIX has declined substantially but is nowhere near levels warning of an imminent risk to stocks and sentiment is still subdued. Tactically, equities are becoming somewhat overbought. However, this impression is mostly driven by the rebound in tech stocks and the strong performance posted by the healthcare sector. The median stock remains quite oversold. In this context, if the S&P 500 were to correct, we would not anticipate this correction to morph into a new down leg in the bear market that would result in new lows below the levels reached on March 23. For now, the most attractive strategy to take advantage of the supportive backdrop for stocks is to buy equities relative to bonds. In contrast to global bourses, government bonds are still massively overbought and trading at their largest premium to fair value since Q4 2008 and late 1985. Additionally, the vast sums of both monetary and fiscal stimulus injected in the economy should lift inflation expectations and thus, bond yields. Real yields will likely remain at very low levels for an extended period of time as short rates are unlikely to rise anytime soon. The yield curve is therefore slated to steepen further. The dollar has stabilized since we last published but it has not meaningfully depreciated. On the one hand, the threat of an exploding twin deficit and a Fed working hard to address the dollar shortage and keep real rates in negative territory are very bearish for the dollar. But on the other hand, free-falling global growth and spiking policy uncertainty are highly bullish for the Greenback. A stalemate was thus the most likely outcome. However, we are getting closer to a rebound in growth in Q3, which means that the balance of forces will become an increasingly potent headwind for the expensive dollar. Thus, it remains appropriate to use rallies in the dollar to offload this currency. Finally, commodities continue to linger near their lows, creating a mirror image to the dollar. They are still very oversold and sentiment has greatly deteriorated, except for gold. Thus, if as we expect, the dollar will soon begin to soften, then commodities will appreciate in tandem. The move in oil prices was particularly dramatic this month. The oil curve is in deep contango and oil producers from Saudi Arabia to the US shale patch have begun cutting output. Therefore, oil is set to rally meaningfully as the global economy re-opens for business. The large balance sheet expansion by the Fed and other global central banks will only fuel that fire. EQUITIES: Chart III-1US Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3US Equity Sentiment Indicators   Chart III-4Revealed Preference Indicator Chart III-5US Stock Market Valuation Chart III-6US Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance   FIXED INCOME: Chart III-9US Treasurys And Valuations Chart III-10Yield Curve Slopes Chart III-11Selected US Bond Yields Chart III-1210-Year Treasury Yield ComponentsChart III-13US Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets   CURRENCIES: Chart III-16US Dollar And PPP Chart III-17US Dollar And Indicator Chart III-18US Dollar Fundamentals Chart III-19Japanese Yen Technicals Chart III-20Euro Technicals Chart III-21Euro/Yen Technicals Chart III-22Euro/Pound Technicals   COMMODITIES: Chart III-23Broad Commodity Indicators Chart III-24Commodity Prices Chart III-25Commodity Prices Chart III-26Commodity Sentiment Chart III-27Speculative Positioning   ECONOMY: Chart III-28US And Global Macro Backdrop Chart III-29US Macro Snapshot Chart III-30US Growth Outlook Chart III-31US Cyclical Spending Chart III-32US Labor Market Chart III-33US Consumption Chart III-34US Housing Chart III-35US Debt And Deleveraging   Chart III-36US Financial Conditions Chart III-37Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China   Mathieu Savary Vice President The Bank Credit Analyst Footnotes 1  Please see US Equity Strategy Weekly Report "Gauging Fair Value," dated April 27, 2020, available at uses.bcaresearch.com 2  Please see US Investment Strategy Special Report "How Vulnerable Are US Banks? Part 1: A 50-Year Bottom-Up Case Study," dated March 30, 2020 and US Investment Strategy Special Report "How Vulnerable Are US Banks? Part 2: It’s Complicated," dated April 6, 2020 available at usis.bcaresearch.com 3 Please see Emerging Markets Strategy Weekly Report "EM Domestic Bonds And Currencies," dated April 23, 2020, available at ems.bcaresearch.com 4  Please see US Bond Strategy Weekly Report "Buying Opportunities & Worst-Case Scenarios," dated March 17, 2020 and US Bond Strategy Weekly Report "Life At The Zero Bound," dated March 24, 2020 available at usbs.bcaresearch.com 5  Please see US Bond Strategy Weekly Report "Is The Bottom Already In?" dated April 21, 2020 and US Bond Strategy Special Report "Alphabet Soup: A Summary Of The Fed's Anti-Virus Measures," dated April 14, 2020 available at usbs.bcaresearch.com 6 “Bad deflation” reflects poor demand, which constrains corporate pricing power. “Good deflation” reflects productivity growth. Good deflation?? does not automatically extend to declining real profits and it is not linked with falling stock prices. The Roaring Twenties are an example of when “good deflation” resulted in a surging stock market. 7  Please see US Equity Strategy Weekly Report "Fight Central Banks At Your Own Peril," dated April 14, 2020, available at uses.bcaresearch.com 8  Skeptical economists call Japan’s largest-ever stimulus package ‘puffed-up’, Keita Nakamura, The Japan Times, April 8, 2020. 9  Please note that Chart II-3 differs somewhat from a chart that has been frequently shown by our Geopolitical Strategy service. Both charts are accurate; they simply employ different definitions of the fiscal response to the pandemic. 10 Indeed, McConnell has already walked back his comments that states should consider bankruptcy. President Trump is constrained by the election, as are Senate Republicans, and the House Democrats control the purse strings. Hence more state and local funding is forthcoming. At best for the Republicans, there may be provisions to ensure it goes to the COVID-19 crisis rather than states’ unfunded pension obligations. See Geopolitical Strategy, “Drowning In Oil (GeoRisk Update),” April 24, 2020, www.bcaresearch.com. 11 School and work closure dates have been sources from the Oxford COVID-19 Government Response Tracker.