Consumer Discretionary

Analyses on Chinese autos and Brazil are available below. Highlights The Fed’s aggressive monetization of public and some private debt has inspired investors to allocate cash to risk assets However, a number of cyclical indicators continue to flash red or amber, suggesting this rally is not about a cyclical economic recovery.  Continue underweighting EM equities and credit markets versus their DM counterparts. We will wait for a correction to assess whether to maintain or close our shorts on EM currencies. Feature Neither the ongoing plunge in corporate profits nor a great deal of uncertainty about the economic outlook justify this rally. It seems the sole driver of the rally from March’s lows has been the Federal Reserve’s enormous purchases of various securities. These unprecedented actions are crowding out investors into riskier parts of fixed-income markets and persuading them to purchase equities. Neither the ongoing plunge in corporate profits nor a great deal of uncertainty about the economic outlook justify this rally. It Has Not Been About Profits And Valuations In the past two months, the S&P 500 index has experienced not only the fastest and steepest crash on record, but also the speediest rebound (Chart I-1). Investors have had to make swift investment decisions amid extremely low economic visibility. Chart I-1The S&P 500: The Fastest Crash And Speediest Recovery The S&P 500: The Fastest Crash And Speediest Recovery The S&P 500: The Fastest Crash And Speediest Recovery Indeed, it is fair to say that during the mayhem and carnage many investors operated on a “sell now, think later” principle, and on the subsequent rebound with a “buy now, ask questions later” framework. Remarkably, the plunge and subsequent recovery in global share prices has been so rapid that even equity analysts’ forward earnings estimates cannot keep up. The top panel of Chart I-2 illustrates that the global forward EPS usually tracks the world equity index. When share prices rally, analysts upgrade their earning expectations; when equities sell off, analysts’ downgrade their earnings outlooks. In the past month, analysts have continued to slash forward EPS estimates despite the strong equity rebound. As a result, the 12-month forward P/E ratio for global stocks is back to its post-2008 highs (Chart I-2, bottom panel). Chart I-2Rising Share Prices Amid Collapsing Forward Earnings Rising Share Prices Amid Collapsing Forward Earnings Rising Share Prices Amid Collapsing Forward Earnings Chart I-3China: A Decoupling Between Economy And Equities China: A Decoupling Between Economy And Equities China: A Decoupling Between Economy And Equities Elsewhere, Chart I-3 illustrates China’s domestic orders for 5000 industrial enterprises historically correlated with the Shanghai Composite equity index. Since early this year, domestic orders have plummeted due to the country-wide lockdown. Yet equity prices in China have not fallen enough to reflect the downfall in economic activity and corporate profits. This underscores that investors’ purchases of global and Chinese stocks in the past month have been driven by factors other than the corporate profit outlook.   This leaves two rationales for justifying roaring equity purchases in recent weeks: (1) liquidity overflows due to central banks’ balance sheet expansion, and (2) valuations. We examine the first argument in this report and will revisit the topic of equity valuations in forthcoming publications. In a nutshell, although equity valuations may be cheap in EM, Europe and Japan, they are expensive in the US. Nevertheless, the US stock market has been substantially outperforming EM and DM ex-US equities. Further, the most expensive stocks in the US – FAANGM – have by far outperformed the rest. Chart I-4China: A Decoupling Between New And Old Economy Stocks China: A Decoupling Between New And Old Economy Stocks China: A Decoupling Between New And Old Economy Stocks In China, the ChiNext index – a Nasdaq proxy of the onshore market – has massively outperformed the Shanghai Composite index, which is dominated by “old” economy stocks (Chart I-4). The trailing P/E ratios on the ChiNext and Shanghai Composite indexes are 62 and 14, respectively. In short, the fact that most expensive equity segments/sectors have outperformed suggests that cheap valuation have not been the key driver of this rally. Bottom Line: Neither profits nor considerations of equity valuations have been the driving factor behind the recent equity rally.  The Sole Driver Of This Rally The Fed’s aggressive monetization of public and some private debt has inspired investors to allocate cash to risk assets. The US broad money supply is surging at a record pace, both in nominal and real terms (Chart I-5). Is there too much money relative to the size of financial assets? Chart I-5US Broad Money Supply Is Booming US Broad Money Supply Is Booming US Broad Money Supply Is Booming Today we explore how the level of US broad money supply (M2) relates to the market cap of all bonds and stocks denominated in US dollars. US broad money (M2) supply encompasses all deposits and cash of residents and non-residents in and outside the US. Chart I-6 exhibits the ratio of US broad money supply (M2) relative to the sum of: Chart I-6The US: Broad Money Supply Relative To Equity And Bond Market Capitalization The US: Broad Money Supply Relative To Equity And Bond Market Capitalization The US: Broad Money Supply Relative To Equity And Bond Market Capitalization the US equity market capitalisation (the Wilshire 5000); the market cap values of all US-dollar bonds, including government, corporate, mortgage-backed securities, asset-backed securities and commercial mortgage backed securities (the Bloomberg Barclays US Aggregate Index); the market cap value of US dollar-denominated bonds issued by EM governments and corporations; minus the Fed’s and US commercial banks’ holdings of all types of securities. The higher this ratio is, the more US dollar deposits (liquidity) is available per one dollar of outstanding securities – excluding those held by the Fed and US commercial banks. Based on the past 25 years, the US M2-to-market value of securities ratio is somewhat elevated. This means liquidity is relatively abundant. However, this may not preclude the ratio from drifting higher like it did in 2008. This scenario would be consistent with a renewed selloff in equity and credit markets. Interestingly, back in January, the ratio was almost at a 20-year low – i.e., money supply (liquidity) was tight relative to the market value of outstanding US dollar-denominated securities. This was contrary to the prevalent perception in the global investment community that in 2019 the advances in share prices and credit markets were liquidity-driven. We discussed what constitutes pertinent liquidity for financial assets in our January 16 report titled, A Primer On Liquidity. The key takeaways of the report were: Money supply – not central bank assets – is the ultimate liquidity available to economic agents to purchase goods and services as well as invest in both real and financial assets. Changes in the velocity of money are as important as those in money supply. Yet forecasting changes in the velocity of money is a near-impossible task, as it entails foreseeing the behavior of economic agents. A large and expanding stock of money in and of itself does not guarantee greater liquidity for asset markets. Gauging liquidity flows to asset markets boils down to predicting investor behavior. Liquidity flows into financial assets when “animal spirits” among investors improve, and vice versa. Bottom Line: Even though the US money supply is expanding at a record pace, the key to financial asset price fluctuations is willingness among investors to purchase those assets. In turn, willingness to allocate cash to securities is generally driven by (1) the potential income and cash flow generation by securities issuers; (2) uncertainty related to future income (the risk premium); and (3) the opportunity cost of holding cash. Presently, the opportunity cost of holding cash is the sole reason to buy risky securities. Cash flow/income generation is currently impaired for the majority of equities and credit instruments. Further, there is a great deal of uncertainty about issuers’ ability to generate cash/income for investors – i.e., the required risk premium should be very high. All of these circumstances make the risk-reward profile of this rally poor. Reasons To Fade This Rally There are several market-based indicators that do not corroborate a further run-up in EM and DM equity prices. Our Risk-On / Safe-Haven Currency Ratio has struggled to gain traction (Chart I-7, top panel). It is not confirming the rebound in EM share prices. It is essential to emphasize that this indicator is agnostic to the direction of the US dollar, as it is calculated as the ratio of cyclical commodities currencies (AUD, NZD, CAD, ZAR, BRL, MXN, CLP, RUB, and IDR) versus safe-haven currencies such as the Swiss franc and Japanese yen on a total-return basis – i.e., all exchange rates include the cost of carry. Chart I-7Various Reflation Indicators Have Been Slugish Various Reflation Indicators Have Been Slugish Various Reflation Indicators Have Been Slugish Our Reflation Confirming Indicator has not been sending a strong bullish reflation signal either (Chart I-7, bottom panel). This indicator is composed of an equally-weighted average of industrial metals, platinum and US lumber prices. The Global Cyclical-to-Defensive Equity Sectors Ratio has formed a classic head-and-shoulders pattern, and has broken down (Chart I-8, top panel). The latest rebound has not altered this pattern. Therefore, the path of least resistance for this ratio is still down, which entails underperformance of the global cyclical equity sector versus global defensives. The latter often occurs in selloffs. Similarly, the relative performance of Swedish versus Swiss non-financial stocks has failed to rebound, having experienced a major breakdown in March (Chart I-8, bottom panel). Swedish non-financial stocks are much more cyclical than Swiss ones. Finally, the global business cycle is experiencing its deepest recession in the post-World War II period, with the pace and nature of the recovery remaining highly uncertain. Chart I-9 portends global EPS in SDR, which is the proper measure given the greenback’s weight in SDR is 58%, the euro’s 39%, the yen’s 11%, and the yuan’s 1%. Chart I-8Global Cyclical Stocks Have Not Outperformed Global Cyclical Stocks Have Not Outperformed Global Cyclical Stocks Have Not Outperformed Chart I-9Global Corporate EPS In Perspective Global Corporate EPS In Perspective Global Corporate EPS In Perspective Global EPS shrank by 28% in 2001-2002 and by 40% in the 2008 recession. Given the current recession will be deeper, global EPS will likely shrink by about 50%. We do not think equity markets are discounting such a dire outcome after the recent rally. Bottom Line: A number of cyclical indicators continue to flash red or amber, suggesting this rally is not about a cyclical economic recovery.     Investment Strategy We closed our short position in EM equities on March 19, and on the March 26 report we argued that it was too late to sell but still too early to buy. Given the rally in global equities is overstretched from a short-term perspective, we will wait for a correction to assess whether to maintain or close our shorts on EM currencies. Chart I-10EM Currencies And S&P 500 EM Currencies And S&P 500 EM Currencies And S&P 500 That said, we maintained our underweights in both EM stocks and credit versus their DM peers. Also, we have continued to short EM currencies versus the US dollar. Chart I-10 demonstrates that EM currencies have failed to rally despite the strong rebound in the S&P 500.   Given the rally in global equities is overstretched from a short-term perspective, we will wait for a correction to assess whether to maintain or close our shorts on EM currencies. For dedicated EM equity managers, our recommended overweights are Korea, Thailand, Vietnam, Russia, central Europe, Mexico and Peru. Our underweights are Brazil, South Africa, Turkey, Indonesia, India and the Philippines. We are neutral on other bourses. Last week we published two reports for fixed-income investors: EM: Foreign Currency Debt Strains and EM Domestic Bonds And Currencies. In the first report we assessed individual EM countries' vulnerabilities to foreign debt and discussed strategies for EM sovereign and corporate credits. In the second report, we upgraded our stance on EM local markets from underweight to neutral. Before upgrading to a bullish stance, we would first need to upgrade our stance on EM currencies.   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Chinese Auto Sales: Disappointments Ahead Chinese automobile sales plunged 42% year-on-year over the first quarter of this year, due to the Covid-19 lockdowns (Chart II-1). We still expect auto sales in China to be flat or very mildly negative year-on-year over the period of April-December of this year. First, official data shows the growth rate for nominal disposable income was falling toward zero, but realistically it was probably negative in the first quarter (Chart II-2, top panel). Very sluggish household income growth – in combination with the still-elevated uncertainty of the job market (Chart II-2, bottom panel) – will restrain Chinese auto demand. Chart II-1Auto Sales In China: A Rate Of Change Recovery Ahead Auto Sales In China: A Rate Of Change Recovery Ahead Auto Sales In China: A Rate Of Change Recovery Ahead Chart II-2Sluggish Household Income Growth Will Constrain Chinese Auto Demand Sluggish Household Income Growth Will Constrain Chinese Auto Demand Sluggish Household Income Growth Will Constrain Chinese Auto Demand While household income growth will recover from current level later this year, it will likely remain much lower than the previous years’ 8-9% growth. Second, Chinese households are already quite leveraged. Their debt levels reached over 94% of annual disposable income, almost as high as in the US (Chart II-3). Third, peer-to-peer lending – an important source of auto loans in recent years – has shrunk considerably and is unlikely to pick up this year (Chart II-4). Chart II-3Chinese Household Debt Burden Is High Chinese Household Debt Burden Is High Chinese Household Debt Burden Is High Chart II-4Auto Financing Has Become More Scarce Auto Financing Is Becoming More Scarce Auto Financing Is Becoming More Scarce Bank lending rates for household consumption loans and peer-to-peer lending rates are currently about 5% and 10%, respectively. Such borrowing costs are restrictive given the tame growth of household income. Finally, the stimulus packages intended to boost automobile demand this year are no greater than they were last year. This entails that the net stimulus is close to zero. The focus of this year’s stimulus remains on the demand for new energy vehicles (NEV), which is in line with the central government’s strategic goal. Given that NEVs account for only 5% of auto sales, any boost to NEV demand is unlikely to make a huge difference in aggregate auto sales.  Another boost to auto sales is the relaxation of license controls in the first-tier cities. The extent of these measures is so far considerably smaller than it was last year. About 60,0001 additional new license plates have so far been added, accounting for only 0.2% of Chinese auto sales. This number was 180,000 last year.2  This year local governments in 16 cities announced cash subsidies for auto buyers.3 Despite larger geographic coverage, the amount of cash subsidies is similar to what it was last year – at about 3% of the retail price. This is too small to make any meaningful impact on auto sales. Investment Implications The lack of considerable new stimulus for auto purchases and lower household income growth will make the recovery in passenger car sales halting and hesitant. The lack of considerable new stimulus for auto purchases and lower household income growth will make the recovery in passenger car sales halting and hesitant. Chinese auto stock prices in the domestic A-share market are breaking down (Chart II-5). Lingering demand contraction as well as possible price cuts will further curtail auto producers’ profits. Disappointing Chinese auto sales will lead to sluggish auto production and, consequently, to weak demand for metals like steel, aluminum and zinc. Chinese auto exports will outpace its imports (Chart II-6). As China accounts for about 30% of global auto sales and production, rising net exports of automobiles from China may diminish other global producers’ margins. Chart II-5Avoid Chinese Auto Stocks For Now Avoid Chinese Auto Stocks For Now Avoid Chinese Auto Stocks For Now Chart II-6Rising Chinese Auto Net Exports Are Negative To Other Global Auto Producers Rising Chinese Auto Net Exports Are Negative To Other Global Auto Producers Rising Chinese Auto Net Exports Are Negative To Other Global Auto Producers   Ellen JingYuan He Associate Vice President ellenj@bcaresearch.com   Brazil: Not Out Of The Woods Yet We believe risks to Brazilian assets remain to the downside. Political infighting among various branches of power and state institutions will depress consumer and business confidence, lengthening the recession. Chart III-1Brazil: Recurring Crises Brazil: Recurring Crises Brazil: Recurring Crises Political infighting among various branches of power and state institutions will depress consumer and business confidence, lengthening the recession (Chart III-1). Political turmoil also reduces the probability of structural reforms. This combined with a delayed economic recovery will further strain the already precarious public debt dynamics.  First, the country is in a full-blown political crisis. The Supreme Court's decision to reject Bolsonaro's nomination for Director of the Federal Police manifests broad-based political infighting among Brazilian institutions. Further, the Supreme Court has started an investigation into the President as calls for impeachment intensify among both the public and the Congress. The rift between President Bolsonaro and Congressional President Maia is especially worrisome. Given Maia’s future political ambitions, we do not expect a truce between the two. On the contrary, they will continue to stand off in order to assert control over the fragmented Congress. As a result, structural reforms such as the national tax program and privatizations will be delayed. Second, Bolsonaro’s popularity is also plunging due to his slow and controversial response to the COVID-19 outbreak. This week, Bolsonaro’s disapproval ratings jumped above those of former president Lula da Silva, and public support for impeachment is now over 54%. Third, Congress has allowed the government to go over the limit of fiscal spending this year, which has resulted in almost 1.2 trillion reais in emergency fiscal spending, or about 16% of GDP. This will push the gross public debt-to-GDP ratio to well above 100% by the end of 2020. Chart III-2This Large Gap Makes Public Debt Dynamics Untenable This Large Gap Makes Public Debt Dynamics Untenable This Large Gap Makes Public Debt Dynamics Untenable In order to stabilize its public debt-to-GDP ratio, a government’s borrowing costs should be below nominal GDP growth. Brazil fails to meet this condition. Local currency interest rates at 5.5% are well above nominal GDP growth, which will likely be negative in 2020 (Chart III-2). This assures unsustainable debt dynamics. Finally, in terms of monetary policy, the central bank’s policy rate cuts have not been efficiently transmitted to the real economy, as discussed in our March 31st Special Report. Borrowing costs for companies and households remain elevated relative to their nominal income growth. Overall, the sole feasible way for Brazil to stabilize its public debt-to-GDP ratio is to push nominal GDP growth above interest rates. Further, this is only possible with falling interest rates and further material currency depreciation. The continued currency devaluation represents a risk to foreign investors holding local assets. Investment Recommendations Continue to underweight Brazil within EM equity and credit portfolios. We reiterate our trade to short the BRL versus the US dollar. Even though the BRL is moderately cheap (Chart III-3), there is still considerable downward pressure on the currency. The BRL is tightly correlated with commodities prices (Chart III-4). Until these do not bottom out, the real will continue depreciating. Critically, the real needs to depreciate to lift nominal GDP growth above borrowing costs. The latter is essential to stabilize public debt dynamics. Chart III-3The BRL Is Only Modestly Cheap The BRL Is Only Modestly Cheap The BRL Is Only Modestly Cheap Chart III-4The BRL Correlates With Commodities Prices The BRL Correlates With Commodities Prices The BRL Correlates With Commodities Prices Finally, we are underweight both local currency and US$ denominated bonds in Brazil due to worrisome public debt dynamics and high foreign currency stress.   Juan Egaña Research Associate juane@bcaresearch.com Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com     Footnotes 1    Shanghai announced to add 40,000 new license plates this year while Hangzhou increased 20,000 new license plates. 2   There were 100,000 additional license plates approved by Guangzhou province and an additional 80,000 by Shenzhen in 2019. 3   The cash subsidies are about RMB1000-3000 for buying regular cars, RMB3000-5000 for car replacement (e.g., scrapping their autos with Emission Standard 3 and buying autos with new Emission Standard 6), and RMB5000-10,000 for NEV purchases. Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Overweight Home improvement retailers (HIR) were the first consumer discretionary stocks to sniff out the end of the Great Recession, troughing even prior to the China-sensitive materials and industrials equities. As such we believe these economically hyper-sensitive stocks will once again showcase their early cyclical status. We recommend augmenting exposure to above benchmark (please see the most recent Weekly Report for additional details). ZIRP along with the rising gap between house price inflation and mortgage refinancing rates are a tonic for home improvement retailers (fed funds rate shown inverted, top panel). While the residential real estate market will remain in the doldrums for a few months (we recently monetized impressive gains in our underweight stance in the S&P homebuilding index and lifted to neutral), mortgage holders that retain their jobs will be quick to benefit from lower refinancing rates, and boost their savings. Some of these savings will likely flow into home renovation activities courtesy of the recent quarantine rules. Bottom Line: Boost the S&P HIR index to overweight. The ticker symbols for the stocks in this index are: BLBG: S5HOMI – HD, LOW. Buy Home Improvemenent Retailers Buy Home Improvemenent Retailers    

Amazonification Amazonification Overweight In the most recent Weekly Report, we boosted the S&P consumer discretionary index to overweight via upgrading its heavy-weight internet retail sub-index to an above benchmark allocation. E-commerce has been garnering a rising market share of total retail sales uninterruptedly for over two decades. In fact, this juggernaut accelerates during recessions not only because overall retail sales level off, but also because internet sales prove resilient during downturns (see chart). AMZN dominates the internet retail space and by extension the broad consumer discretionary index, especially ever since the media complex migrated to the newly formed S&P communications services index in October 2018. Therefore, as AMZN goes, so goes the rest of the consumer discretionary sector. Time and again we have stressed that when growth is scarce investors flock to industries that exemplify growth. The inevitable rise in online retail sales as a percent of total due to the ongoing pandemic will underpin demand for e-commerce services. Bottom Line: Boost the S&P internet retail index to overweight. The ticker symbols for the stocks in this index are: BLBG: S5INRE - AMZN, BKNG, EBAY, EXPE.  

Highlights Stay tactically neutral to equities. The market may meet some short-term resistance, especially as a slew of poor earnings are released in the coming weeks. The long-term threat to equities comes from the pandemic’s lasting after-effects, such as financial and corporate distress, and/or a political backlash against the private sector. Long-term investors should prefer equities over bonds, with the caveat that the threat does not materialise. Long-term equity investors should avoid oil and gas and European banks at all costs… …but healthcare, European personal products, and European clothes and accessories should all form core long-term holdings. Fractal trade: long nickel / short copper. Feature Chart of the WeekSales Per Share Must 'Catch Down' With GDP, Just Like In 2008 Sales Per Share Must 'Catch Down' With GDP, Just Like In 2008 Sales Per Share Must 'Catch Down' With GDP, Just Like In 2008 The sharp snapback rally in stock markets has reached an important resistance point – the critical Fibonacci level of a 38.2 percent proportionate retracement of the sell-off.1 Technical analysts define the sell-off in terms of the most recent peak to trough. But we define it differently. We define it in terms of the longest time horizon of investors that capitulated at the sell-off. The market may meet some short-term resistance. The longest time horizon of investors that capitulated at the sell-off’s climax on March 18 was a seven-quarter horizon. Hence, we define the sell-off as the seven-quarter decline to March 18. On that basis, and using the DAX as our benchmark, we would expect the index to meet resistance at around a 21 percent retracement rally from the March 18 low. Which is pretty much where the DAX stands right now (Chart I-2).2 Chart I-22020 Low: A Seven-Quarter Capitulation Followed By A Fibonacci Retracement 2020 Low: A Seven-Quarter Capitulation Followed By A Fibonacci Retracement 2020 Low: A Seven-Quarter Capitulation Followed By A Fibonacci Retracement After A Sharp Snapback Rally What Happens Next? The maximum length of investment horizons that capitulated on March 18 was unusually long at seven quarters. This should comfort long-term investors because of an important investment identity: Financial markets have fully priced a downturn when the longest time horizon of investors that have capitulated = the length of the downturn. So, the good news is that the March 18 bottom should hold if the downturn does not last longer than seven quarters. In this regard, the main risk of a protracted downturn comes not from the pandemic itself. Even if the pandemic returns in second and third waves, any economic shutdowns, full or partial, should last considerably less than seven quarters. Instead, the main risk comes from lasting after-effects, such as financial and corporate distress, and/or a political backlash against the private sector. The long-term threat comes from the pandemic’s after-effects on economic and political systems. But a protracted downturn of what? As we are focussing on the stock market, the downturn is not of GDP per se but its stock market equivalent: sales per share. In the long run, sales per share and GDP advance at the same rate. But the sector compositions of the stock market and GDP are not the same, so over shorter periods sales per share can underperform or outperform GDP. In which case, sales per share must catch up or catch down (Chart of the Week). In 2008, sales per share had to catch down. As a result, world sales per share declined for seven quarters through 2008-10, considerably longer than the decline in GDP (Chart I-3). Hence, the stock market found its bottom in early March 2009 when the longest time horizon of investors that had capitulated had reached seven quarters (Chart I-4). Chart I-32008-10: Sales Per Share Fell For Seven Quarters 2008-10: Sales Per Share Fell For Seven Quarters 2008-10: Sales Per Share Fell For Seven Quarters Chart I-42009 Low: A Seven-Quarter Capitulation Followed By A Fibonacci Retracement 2009 Low: A Seven-Quarter Capitulation Followed By A Fibonacci Retracement 2009 Low: A Seven-Quarter Capitulation Followed By A Fibonacci Retracement From this March 2009 bottom, the Fibonacci retracement equated to a 35 percent advance, which the market achieved by early June 2009. Thereafter, stocks met short-term resistance and gave back some of the snapback rally. Fast forward to 2020. Having likewise reached the Fibonacci retracement, the market may meet some short-term resistance, especially as a slew of poor earnings are released in the coming weeks. Assuming no lasting after-effects from financial distress or political backlash, the next sustained advance will happen later this year. Valuations Flatter Equities, But They Still Beat Bonds Turning to long-term investors the three most important things are: valuation, valuation, and valuation. Our favourite valuation measure is price to sales, which has been a good predictor of 10-year prospective returns going back to at least the 1980s (Chart I-5). Chart I-5Price To Sales Might Over-Estimate Prospective Returns In 2020, Just Like In 2008 Price To Sales Might Over-Estimate Prospective Returns In 2020, Just Like In 2008 Price To Sales Might Over-Estimate Prospective Returns In 2020, Just Like In 2008 But the predictive power depends on a crucial underlying assumption – that the past is a good guide to the future. Specifically, today we must assume that the pandemic causes just a brief blip in the multi-decade uptrend in stock market sales and profits. To repeat, the main long-term threat to stock markets comes not from the pandemic itself. The long-term threat comes from the pandemic’s after-effects on economic and political systems – such as crippled banking systems or large-scale nationalisations of the private sector. Furthermore, price to sales will err in its prediction if sales per share have deviated from GDP – implying either a future catch up or catch down. In the 1990s sales per share had underperformed GDP, so future returns outperformed the valuation prediction. However, in 2008 sales per share had outperformed GDP, so future returns underperformed the prediction. Today, just as in 2008, sales per share have become overstretched relative to GDP, so there will be a catch down. Which will weigh down prospective returns relative to what valuations appear to imply. Still, even adjusting for this, equities are likely to produce annualised nominal returns in the mid-single digits, comfortably higher than the yields on long-term government bonds. Hence, with the caveat that the pandemic does not generate lasting after-effects for economic and political systems, long-term investors should prefer equities over bonds. What Not To Buy, And What To Buy If a stock, sector, or stock market maintains a structural uptrend in sales and profits, then a big drop in the share price provides an excellent buying opportunity for long-term investors. In this case, the lower share price is stretching the elastic between the price and the up-trending profits, resulting in an eventual snap upwards. However, if sales and profits are in terminal decline, then the sell-off is not a buying opportunity other than on a tactical basis. This is because the elastic will lose its tension as profits drift down towards the lower price. In fact, despite the sell-off, if the profit downtrend continues, the elastic may be forced to snap downwards! Do not buy sectors whose profits are in major downtrends. This leads to a somewhat counterintuitive conclusion for long-term investors. After a big drop in the stock market, do not buy everything that has dropped. And do not buy the stocks and sectors that have dropped the most if their profits are in major downtrends. Specifically, the profits of oil and gas and European banks are in major structural downtrends (Chart I-6 and Chart I-7). Long-term equity investors should avoid these sectors at all costs. Chart I-6Oil And Gas Profits In A Major ##br##Downtrend Oil And Gas Profits In A Major Downtrend Oil And Gas Profits In A Major Downtrend Chart I-7European Banks Profits In A Major Downtrend European Banks Profits In A Major Downtrend European Banks Profits In A Major Downtrend Conversely, the profits of healthcare, European personal products, and European clothes and accessories are all in major structural uptrends (Chart I-8 - Chart I-10). As such, all three sectors should be core holdings for all long-term equity investors. Chart I-8Healthcare Profits In A ##br##Major Uptrend Healthcare Profits In A Major Uptrend Healthcare Profits In A Major Uptrend Chart I-9European Personal Products Profits In A Major Uptrend European Personal Products Profits In A Major Uptrend European Personal Products Profits In A Major Uptrend Chart I-10European Clothing Profits In A Major Uptrend European Clothing Profits In A Major Uptrend European Clothing Profits In A Major Uptrend Fractal Trading System* Given the outsized moves in markets over the past month, all assets have become highly correlated making it more difficult to find candidates for trend reversals. Chart I-11Nickel Vs. Copper Nickel Vs. Copper Nickel Vs. Copper However, we find that some relative moves within the commodity complex have not correlated with risk on/off. Specifically, the underperformance of nickel versus copper is technically stretched, so this week’s recommended trade is long nickel / short copper, setting a profit target of 11 percent with a symmetrical stop-loss. The rolling 1-year win ratio now stands at 67 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 Footnotes 1 0.382 = 1- phi. Where phi is the Golden Ratio, defined as the ratio of successive Fibonacci numbers in the limit. Alternatively, phi =1 / (1 + phi). 2 The seven-quarter sell-off in the DAX (capital only) to March 18 2020 was 39.4 percent, so a full retracement rally equals 65.1 percent, and a 0.382 geometric retracement equals 21.1 percent. 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Highlights Portfolio Strategy The Fed’s QE and ZIRP, the collapse in gasoline prices and extremely depressed breadth readings that are contrarily positive, all signal that it no longer pays to be bearish consumer discretionary stocks. A boost in demand for e-commerce, the high-growth profile of internet retailers along with neutral valuations and technicals, all compel us to trigger our upgrade alert and lift the S&P internet retail index to overweight. The rising gap between house price inflation and mortgage rates, the looming increase in residential investment’s contribution to GDP growth and firming industry operating metrics, all argue for an above benchmark allocation in the S&P home improvement retail index. Recent Changes Boost the S&P consumer discretionary sector to overweight today. Execute the upgrade alert and lift the S&P internet retail index to overweight today. Augment exposure to the S&P home improvement retail index to above benchmark today. Table 1 Fight Central Banks At Your Own Peril Fight Central Banks At Your Own Peril Feature The SPX oscillated violently last week, and a glimmer of good news on the coronavirus fight front, the Fed’s newly announced bazooka and a tick down in unemployment insurance claims all signaled that the bulls have the upper hand. We first showed the Google Trends’ worldwide searches for “coronavirus” series in our early-March Weekly Report,1 when stocks were unhinged and we were still bearish. Now, the most recent update of this indicator suggests that the recessionary lows are likely in for the SPX – this search term peaked a week prior to the overall stock market’s bottom (Google Trends shown inverted, Chart 1) – and we therefore reiterate our cyclically sanguine equity market view.2 Moreover, two weeks ago we highlighted that market internals were confirming the SPX recessionary lows.3 Not only did the SOX versus NDX and small caps versus large caps bottom in advance of the S&P 500, but also transports along with the Value Line Geometric and Arithmetic Indexes relative ratios all led the broad market’s trough.4 Chart 1Joined At The Hip Joined At The Hip Joined At The Hip Chart 2Dr. Copper... Fight Central Banks At Your Own Peril Fight Central Banks At Your Own Peril Importantly, Dr. Copper is also sending a bullish signal for the broad equity market. Economically sensitive copper tends to trough prior to the SPX especially in recessions. Copper collapsed below $2/lb recently leading the SPX by a few days (Chart 2). Similarly, in the recent late-2015/early-2016 manufacturing recession, the 2007/09 and 2001 recessions, copper sniffed out the bottom before the overall equity market troughed (Chart 3). Turning over to the macro backdrop, keep in mind that the Fed first cut rates this year on March 3, 2020, a mere nine trading days following the SPX peak when it fell just below the 10% correction mark. Then, on Sunday March 15, 2020 the Fed cut rates to zero, as the SPX had fallen another 10% into a bear market. Chart 3...Tends To Lead ...Tends To Lead ...Tends To Lead Just to put these moves into perspective, the last time the SPX fell roughly 20% from its peak was on Christmas Eve 2018, and it took the Fed seven months to cut interest rates. While a retest of the 2174 ES futures lows is possible, we would rather not fight the Fed. Instead, we continue to recommend investors deploy cyclically oriented capital in the broad equity market with a 9-12 month time horizon. Chart 4 shows that the Fed is on track to balloon its balance sheet over $11tn in the coming year, i.e. almost trebling it, and soaring to over 50% of GDP. Chart 4Follow The… Follow The… Follow The… Beyond the Fed’s QE5 liquidity injection and skyrocketing bank credit, in response to firms tapping existing credit lines, money seems to be growing on trees. M2 money supply growth spiked to 14.8% of late, the highest rate since WWII! This breakneck pace of M2 growth translates into $2tn created versus last year. In the past two weeks alone, M2 grew by $805bn. Deposits and money market funds’ assets are surging, driving the money supply to unprecedented levels. While we have sympathy to some investors’ view that very little of this money and credit will flow to the real economy, such flush liquidity is likely to spillover from the banking system. Asset prices will be the primary beneficiaries of that flood, albeit with a slight lag (Chart 5). Chart 5…Money Trail …Money Trail …Money Trail Meanwhile, we have heeded our research of how to prepare a portfolio from the SPX peak to the recessionary trough highlighted in the Special Report penned in May 2018, and we have been overweight health care and consumer staples (please refer to Table 5 in that Special Report).5 We are now building on the research from that report. Table 2 shows the (unweighted) average relative sector performance six, twelve and eighteen months out from the SPX recessionary troughs, using market cycles since the 1960s. Table 2Sector Winners From Recessionary Recoveries Fight Central Banks At Your Own Peril Fight Central Banks At Your Own Peril Early cyclicals financials and consumer discretionary along with tech are clear winners in all three periods we analyzed. This empirical evidence confirms the theoretical backdrop that early cyclicals are the first to sniff out a recovery during a recession. At the opposite end of the spectrum, defensive utilities, consumer staples and telecom services fare poorly in the three time frames we examined. Impressively, health care (we are overweight), which is the defensive sector with the largest market cap weight, manages to eke out modest relative gains. Charts 6 & 7 depict these time series profiles for the ten GICS1 sectors (we use telecom services instead of communication services due to lack of historical data). Chart 6Early Cyclicals Rise To The Occasion... Early Cyclicals Rise To The Occasion... Early Cyclicals Rise To The Occasion... Chart 7...But Defensives Lag ...But Defensives Lag ...But Defensives Lag We are already overweight financials, hence, this week we heed this empirical evidence and are upgrading the S&P consumer discretionary sector to overweight via executing the upgrade alert on the S&P internet retail index and also via augmenting the S&P home improvement retail (HIR) index to an above benchmark allocation. Boost Consumer Discretionary To Overweight… While we may be a bit early, we recommend investors augment exposure to the S&P consumer discretionary index to overweight, today. The Fed really cares about household net worth (HNW). It is a key pillar of consumer spending, which powers over 70% of the US economy. Greenspan in the late 1990s eloquently described this relationship between HNW and the economy. In Q1/2020 HNW will take a beating, but the Fed is making sure it recovers in Q2, and is doing everything in its power to keep the stock and residential real estate markets afloat (roughly 50% of HNW). Granted employment and income are also currently of paramount importance, and the Main Street Fed programs along with the massive fiscal easing package should partially cushion the blow from the looming surge in the unemployment rate. We are therefore comfortable with lifting consumer discretionary to an above benchmark allocation. Chart 8 highlights the inverse correlation between consumer discretionary relative performance and the fed funds rate dating back to the 1980s. Now that the Fed has returned to ZIRP and is on track to expand its balance sheet to over $11tn, the risk/reward tradeoff favors consumer discretionary stocks. Keep in mind household balance sheets have been repaired since the Great Recession with both debt/income and debt/GDP ratios plumbing multi-year lows as the GFC hit the consumer (and financial sector) hardest (bottom panel, Chart 8). Chart 8Buy Consumer Discretionary Stocks Buy Consumer Discretionary Stocks Buy Consumer Discretionary Stocks Our consumer drag indicator comprising interest rates and oil prices also signals that the path of least resistance for this early cyclical sector is higher (Chart 9). Not only will consumers eventually take advantage of ultra-low interest rates to buy big ticket items on credit, but also a wave of mortgage refinancing at lower rates translates into more cash in consumers’ wallets. Keep in mind that $20/bbl oil also saves US consumers money as retail gas at the pump has now plunged to $1.8/gallon from a recent high of $2.8/gallon. If we are correct and the US economy avoids a Great Depression/Recession, then the swift economic collapse will likely prove transitory as the authorities will have to slowly reopen the economy in early May, and the US consumer will come roaring back in the back half of the year. Finally, sentiment is bombed out toward consumer discretionary equities. Earnings breadth is as bad as it gets, technicals are washed out and a lot of damage has already been done to these interest rate-hypersensitive stocks (Chart 10). True, valuations are a bit extended, but were our thesis to pan out, these early cyclical stocks will grow into their expensive valuations. Chart 9Tailwinds Tailwinds Tailwinds Netting it all out, the Fed’s QE and ZIRP, the collapse in gasoline prices and extremely depressed breadth readings that are contrarily positive, all signal that it no longer pays to be bearish consumer discretionary stocks. Chart 10As Bad As It Gets As Bad As It Gets As Bad As It Gets Bottom Line: Boost the S&P consumer discretionary sector to overweight today from previously underweight, for a modest loss of 1.4% since inception. …Via Executing The Upgrade Alert On Internet Retail To Overweight… E-commerce has been garnering a rising market share of total retail sales uninterruptedly for over two decades. In fact, this juggernaut accelerates during recessions not only because overall retail sales level off, but also internet sales prove resilient during downturns. We are thus compelled to boost the bellwether S&P internet retail index to overweight by executing our upgrade alert to take advantage of the ongoing explosion of internet sales in the face of the coronavirus pandemic (Chart 11). AMZN dominates the internet retail space and by extension the broad consumer discretionary index, especially ever since the media complex migrated to the newly formed S&P communications services index in October 2018. Therefore, as AMZN goes so goes the rest of the consumer discretionary sector. Chart 11Market Share Gains As Far As The Eye Can See Market Share Gains As Far As The Eye Can See Market Share Gains As Far As The Eye Can See AMZN is a retail category killer and the “amazonification” of the economy is not something new as evidenced by the shopping mall evisceration and the dampening of retail sales price inflation. Nearly every segment AMZN has entered it has dominated. The Whole Foods acquisition has also positioned this internet retail behemoth to benefit from an online push for groceries. All of these forces were ongoing prior to the current recession. Now we deem they will accelerate and disproportionately benefit internet retailers at the expense of bricks and mortar retailers: the howling out of the latter is best evidenced by the recent double demotion of Macy’s from the big leagues to the S&P 600 small cap index. Related to the inevitable rise in demand for e-commerce owing to social distancing, growth is a highly sought after attribute that this index enjoys. Time and again we have stressed that when growth is scarce investors flock to industries that exemplify growth (Chart 12). AMZN’s cloud business, AWS, represents another aspect of significant growth, that will remain on an exponential trajectory as more and more businesses move to the SaaS model catalyzed by the current recession. While at first sight this index appears expensive, versus its own history it has worked off previously extreme valuation readings. In more detail, our relative Valuation Indicator has fallen from three standard deviations above the mean back to the historical average. Similarly, despite the recent run-up in prices, relative technicals are only back up to the neutral zone (Chart 13). Chart 12Seek Out Growth… Seek Out Growth… Seek Out Growth… Chart 13...At A Reasonable Price ...At A Reasonable Price ...At A Reasonable Price Adding it all up, a boost in demand for e-commerce, the high-growth profile of internet retailers along with neutral valuations and technicals, all compel us to trigger our upgrade alert and lift the S&P internet retail index to overweight. Bottom Line: Execute the upgrade alert and boost the S&P internet retail index to overweight, today. The ticker symbols for the stocks in this index are: BLBG: S5INRE - AMZN, BKNG, EBAY, EXPE. …And Upgrading Home Improvement Retailers To Overweight Home improvement retailers (HIR) were the first consumer discretionary stocks to sniff out the end of the Great Recession, troughing even prior to the China-sensitive materials and industrials equities (Chart 14). As such we believe these economically hyper-sensitive stocks will once again showcase their early cyclical status, and we recommend augmenting exposure to above benchmark. ZIRP along with the rising gap between house price inflation and mortgage refinancing rates are a tonic for home improvement retailers (fed funds rate shown inverted, Chart 14). While the residential real estate market will remain in the doldrums for a few months (we recently monetized impressive gains in our underweight stance in the S&P homebuilding index and lifted to neutral), mortgage holders that retain their jobs will be quick to benefit from lower refinancing rates, and boost their savings. Some of these savings will likely flow into home improvement activities courtesy of the recent quarantine rules. One big assumption is that these retailers remain open during the coronavirus induced lockdown. Chart 14Overweight Home Improvement Retailers… Overweight Home Improvement Retailers… Overweight Home Improvement Retailers… If our thesis pans out, then given the looming drubbing in Q2 GDP, residential investment/GDP should jump and provide a relative boost to the S&P HIR index (second panel, Chart 15). None of this positive news is priced in relative forward sales or profits that are flirting with the zero line (third panel, Chart 15). Importantly, relative valuations have dropped below par and are 30% below the historical mean, offering a compelling entry point for fresh capital with a 12-18 month time horizon (bottom panel, Chart 15). Turning over to industry operating metrics, there is a budding recovery in a number of the indicators we track. Chart 15...As A Play On A Relative Rise In Fixed Residential Investment ...As A Play On A Relative Rise In Fixed Residential Investment ...As A Play On A Relative Rise In Fixed Residential Investment Chart 16Firming Operating Metrics Firming Operating Metrics Firming Operating Metrics While it is not very visible in Chart 16, lumber prices have bounced from $275/tbf to over $338/tbf of late, signaling gains for industry relative profits. As a reminder, HIR make a set margin on lumber sales, thus earnings tend to move with the ebb and flow of lumber prices. Moreover, the Fed is resolute to keep the residential real estate market afloat, as we aforementioned, owing to the HNW effect and all these new and old Fed QE policies should underpin the US residential market and by extension lumber prices (Chart 16). Meanwhile, the HIR price deflator has made an effort to exit deflation recently and should also contribute to the sector’s profitability in the coming quarters (Chart 16). Tack on the V-shaped recovery in the HIR sales-to-inventories ratio, albeit from depressed levels, and factors are falling into place for an earnings-led rebound in relative share prices (Chart 16). In sum, the Fed’s ZIRP and QE5, the rising gap between house price inflation and mortgage rates, the looming increase in residential investment’s contribution to GDP growth and firming industry operating metrics, all argue for an above benchmark allocation in the S&P home improvement retail index. Bottom Line: Lift the S&P HIR index to overweight, today. The ticker symbols for the stocks in this index are: BLBG: S5HOMI – HD, LOW.   Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com   Footnotes 1     Please see BCA US Equity Strategy Weekly Report, “From "Stairway To Heaven" To "Highway To Hell"?” dated March 2, 2020, available at uses.bcaresearch.com. 2     Please see BCA US Equity Strategy Weekly Report, ““The Darkest Hour Is Just Before The Dawn”” dated March 23, 2020, available at uses.bcaresearch.com. 3    Please see BCA US Equity Strategy Weekly Report, “What Is Priced In?” dated March 30, 2020, available at uses.bcaresearch.com. 4    Please see BCA US Equity Strategy Daily Report, “Watch The Value Line Geometric Index” dated April 1, 2020, available at uses.bcaresearch.com. 5    Please see BCA US Equity Strategy Special Report, “Portfolio Positioning For A Late Cycle Surge” dated May 22, 2018, available at uses.bcaresearch.com. Current Recommendations Current Trades Strategic (10-Year) Trade Recommendations Fight Central Banks At Your Own Peril Fight Central Banks At Your Own Peril Size And Style Views June 3, 2019 Stay neutral cyclicals over defensives (downgrade alert)  January 22, 2018 Favor value over growth May 10, 2018 Favor large over small caps (Stop 10%) June 11, 2018 Long the BCA  Millennial basket  The ticker symbols are: (AAPL, AMZN, UBER, HD, LEN, MSFT, NFLX, SPOT, TSLA, V).

Highlights Chinese stocks have outperformed global benchmarks by a wide margin. We are taking profits on our overweight position, and downgrading our tactical call on Chinese stocks to neutral. In absolute terms, Chinese stocks have failed to buck the trend in a global selloff of risk assets. This suggests Chinese stocks are not immune to worldwide panics. Investors should wait for a peak in the global pandemic before going long on Chinese equities. Chinese stocks have become less cheap relative to global benchmarks. The size of Chinese stimulus is also less impressive compared with other major economies such as the US. Therefore, in order to maintain an overweight stance on Chinese risk assets in a global portfolio, Chinese stocks need to either offer a better price entry point, or a more upside potential in earnings outlook relative to their global peers. Feature Chart I-1Chinese Stocks Have Significantly Outperformed Global Benchmarks... Chinese Stocks Have Significantly Outperformed Global Benchmarks... Chinese Stocks Have Significantly Outperformed Global Benchmarks... In the current pandemic environment, economic fundamentals mean little to panicked investors who have mostly ignored the unprecedented degree of monetary and fiscal stimulus pouring into the global economy. Investors are looking for clear signs that the COVID-19 crisis can be brought under control, but medical experts have been unable to predict the timing of a peak in the pandemic. Policymakers around the world are beginning to address investors’ concerns that substantial and timely fiscal policy supports are needed to offset the knock-on effects on businesses and individuals.1 However, until the number of new infections in major economies peaks, the erratic trading behavior among global investors will persist. Given the lack of near-term certainty, we are downgrading our tactical stance on Chinese stocks from overweight to neutral. Chart 1 highlights since we upgraded our tactical call to overweight in end-2019, Chinese stocks have significantly outperformed global stocks. This outperformance has been passive in nature; Chinese stocks are down about 10% year-to-date in US$ terms, versus a 23% decline in global stocks. We are also closing 7 of our 10 high-conviction investment calls from our trade book, for reasons cited here and then detailed in the next sections. Of the 10 active trades in our book, 7 have generated a positive return since their inceptions, including 3 that have recorded double-digit gains.2 Investors should wait for clarity on the peak of the global pandemic before going long on risk assets. Investors should wait for more signs of an upside potential in earnings and/or a better price entry point to go long on Chinese stocks. China Is Not Immune To A Global Pandemic Chart I-2...But Their Prices Have Also Plunged In Absolute Terms ...But Their Prices Have Also Plunged In Absolute Terms ...But Their Prices Have Also Plunged In Absolute Terms Chinese equities have not been immune from the gyrations in the global financial markets, which have not responded to monetary and fiscal stimulus measures in either a customary or predictive manner. Unlike the 2008 global recession triggered by a financial crisis, public health crises damage the economy by reducing human activity and, therefore, erode both supply and demand. A return to normalcy depends almost entirely on whether the pandemic can be contained. Even though Chinese business activities are gradually resuming, Chinese stocks failed to buck the worldwide trend of a liquidation in risk assets. While Chinese stocks have outperformed global benchmarks by a wide margin, the relative gains have mostly been passive since early March. In absolute terms, Chinese domestic stocks have lost all their gains from February and investable stock prices have fallen back to their November 2018 level (Chart 2). Chart I-3Number Of Imported Cases Now On The Rise Investing During A Global Pandemic Investing During A Global Pandemic China is not immune to a second COVID-19 wave. China has been reporting zero-to-low single-digit numbers of locally transmitted cases since mid-March, but it is now experiencing an increase in imported cases from overseas travelers (Chart 3). The mounting numbers have led the Chinese government to shut its borders to non-Chinese citizens.3 This indicates that it is still too early to claim a victory in China’s virus containment efforts.  Given that China’s domestic businesses are open, the trajectory of new cases also remains unknown. These lingering doubts will slow the pace in the resumption of Chinese production (Chart 4).   Chart I-4Chinese Companies Operating At 80% Capacity Investing During A Global Pandemic Investing During A Global Pandemic Moreover, China is not immune to qualms about the depth and duration of a global recession. China has the political will and policy room to stimulate its economy, and the country’s dominant domestic demand makes the economy relatively insulated from a global recession. However, when more than 40% of China’s trading partners (including Europe and the US) remain under lockdown, a collapse of external demand will weigh on China’s economic and corporate profit recovery in the next quarter or two. Therefore, short-term risks on Chinese stocks are tilted to the downside. Bottom Line: Chinese stocks have failed to buck the trend in the global pandemic and the tsunami selloff in risk assets. Investors should wait for a peak in the outbreak before going long on Chinese equities. Chinese Stocks Have Become Less Cheap Relative To Global Benchmarks Chart I-5Outperformance In Chinese Stocks Seems Quite Extended Outperformance In Chinese Stocks Seems Quite Extended Outperformance In Chinese Stocks Seems Quite Extended Chinese stocks, particularly in the domestic market, are no longer priced at deep discounts compared with global equities (Chart 5). The recent outperformance of Chinese stocks has brought the relative performance trend in both investable and domestic stocks back close to late-2017/early-2018 levels. That was before the US-China trade war began, and at a point where China’s economy was close to peak strength for the cycle. Although a passive outperformance does not automatically warrant an underweight stance on Chinese stocks, investors will demand a higher upside potential in Chinese corporate earnings to justify an overweight position in Chinese equities. Therefore, we will watch for the following signs before buying Chinese stocks: a strengthening in China’s economy and corporate profits outpacing recoveries in other major economies, and/or a near-term drop in Chinese stock prices outsizing the decline in global stock prices. Given the exceedingly strong policy responses from G20 economies (particularly the US), China’s stimulus will need to be amplified so that investors are confident that the rate of Chinese corporate profit recovery will surpass their global counterparts.4 In a recent Politburo meeting, Chinese policymakers signaled their willingness to expand stimulus, including much larger fiscal deficits and local-government special bond issuance quotas in 2020, along with further interest rate cuts.5 An escalation in policy support will probably bring China’s stimulus in line with that extended in the 2008-2009 global financial crisis. However, the size of the stimulus package will be determined at the National People’s Congress (NPC) meeting, which is delayed to end-April or early May. In the near term, the selloff in Chinese stocks will likely persist as financial markets continue to price in bad news in the global economy. Chinese investable stock prices continue to be priced at a discount relative to global benchmarks, although the discount is much smaller than it was three months ago. In absolute terms, Chinese investable stock prices have not reached their technical support levels.  The offshore market historically rebounds when prices approach a major defense line, measured by a 12-year moving average. This technical support for the MSCI China Index is currently 65, still about 13% below the March 30 close (Chart 6). Chart I-6Investable Stock Prices Not Yet At Their Long-Term Support Investable Stock Prices Not Yet At Their Long-Term Support Investable Stock Prices Not Yet At Their Long-Term Support The prices in Chinese domestic stocks have reached their 12-year moving average, although A-share prices are not decisively in a structural “cheap” territory yet (Chart 7).  Investors should wait on the sidelines for now, since the full effects of any enhanced stimulus in China will be felt in the real economy with a time lag. China’s production supply side is only operating at about 80% of normal capacity, and demand has yet to catch up (Chart 4 and Chart 8).  This suggests the rebound in economic activities in Q2 will likely be gradual, and corporate profits are likely to remain depressed. Chart I-7Domestic Stock Prices Approaching A Structural "Cheap" Territory Domestic Stock Prices Approaching A Structural "Cheap" Territory Domestic Stock Prices Approaching A Structural "Cheap" Territory Chart I-8Demand In Manufacturing Remains Sluggish Demand In Manufacturing Remains Sluggish Demand In Manufacturing Remains Sluggish Bottom Line: Chinese stocks have become less cheap against the backdrop of a massive liquidation of global equities. Chinese existing stimulus also appears moderate compared with other major economies. Therefore, in order for investors to overweight Chinese risk assets in a global portfolio, Chinese stocks either will have to offer a better entry price point or more upside corporate earnings potential. Both are currently missing. Investment Conclusions Investors should stay neutral on Chinese stocks in the next 3 months, and we are closing 7 out of the 10 active positions in our trade book. These trades are especially vulnerable to a protracted global recession and more selloffs in the domestic stock market. We will look for opportunities to incrementally add new trades to our book in the coming months. Here are our reasons for retaining or closing some of our positions: Long China Onshore Corporate Bonds (Maintain): The trade has yielded a handsome return of 16% since its inception in June 2017, (Chart 9). Although the spread in Chinese onshore corporate bond yields has widened sharply in the past few weeks, it has been the result of an indiscriminate global selloff of financial assets rather than the market pricing in any China-centric credit risks (Chart 10). In the next 6 to 12 months, corporate credit spreads should normalize as we expect monetary policies in major economies to remain ultra-loose, the global economy to recover and investors’ risk sentiment to improve. Chinese onshore corporate bonds will likely continue to offer a better risk-reward profile relative to other economies, with a higher risk premium and relatively stable default rate. Chart I-9Chinese Onshore Corporate Bonds Remain Attractive Chinese Onshore Corporate Bonds Remain Attractive Chinese Onshore Corporate Bonds Remain Attractive Chart I-10Corporate Credit Spreads Should Narrow Over A 12-Month Horizon Corporate Credit Spreads Should Narrow Over A 12-Month Horizon Corporate Credit Spreads Should Narrow Over A 12-Month Horizon     Long MSCI China Energy Stocks (Close): This trade has had the worst performance among our positions due to consistently falling oil prices since October 2018 (Chart 11). Although BCA’s commodity strategists expect Brent prices to average $36/barrel in 2020, $3 higher than the average oil prices in March, it is still at a 50% discount from the $70 price tag just 3 months ago. Such a minor improvement in the price outlook does not offer enough upside potentials to offset downside risks in earnings in the next 9 months. Therefore, we would rather cut the losses. Long China Domestic Consumer Discretionary Equities Versus Benchmark and Long China Domestic Consumer Discretionary Equities/Short China Domestic Consumer Staples Equities (Close): As explained in the previous sections, we think there will be better entry price points for Chinese stocks as well as cyclical stocks. Besides, discretionary consumption in China has yet to show signs of a meaningful rebound. In the near term, we will also look for opportunities to go long position in domestic consumer staple stocks because we think that food and beverage price inflation will persist well into the second half of this year (Chart 12).  Chart I-11Depressed Oil Prices Lead To Significant Underperformance In Energy Stocks Depressed Oil Prices Lead To Significant Underperformance In Energy Stocks Depressed Oil Prices Lead To Significant Underperformance In Energy Stocks Chart I-12Consumer Staple Stocks Should Benefit From Stubbornly High Food Prices Consumer Staple Stocks Should Benefit From Stubbornly High Food Prices Consumer Staple Stocks Should Benefit From Stubbornly High Food Prices   Long MSCI China Index, Long MSCI China Onshore Index, Long MSCI China Growth Index/ Short MSCI All Country World (Close): We will need to see more stable sentiment in the global financial markets, a better entry price point for Chinese stocks and a sure sign of outsized Chinese stimulus before reinitiating a long position on Chinese stocks. Jing Sima China Strategist jings@bcaresearch.com   Appendix Table 1Massive Stimulus In Response To Pandemic Investing During A Global Pandemic Investing During A Global Pandemic Footnotes 1  Please see Table 1 in the Appendix. 2  Please see the trade table at the end of the report. 3  https://www.bloomberg.com/news/articles/2020-03-26/china-to-suspend-foreigners-entry-starting-saturday?mc_cid=1bdcd29ddd&mc_eid=9da16a4859 4  The stimulus package announced in the US amounts to 9% of the country’s 2019 GDP, whereas China’s stimulus would be about 3% of its 2019 GDP. 5  http://www.xinhuanet.com/politics/leaders/2020-03/27/c_1125778940.htm Cyclical Investment Stance Equity Sector Recommendations

Housekeeping Housekeeping Frenetic trading continued unabated in the US equity markets with some bizarre moves now a daily phenomenon. One such occurrence is the positive correlation of the VIX with the SPX, which we had flagged as a negative omen in mid-February.1 Thus, risk management portfolio metrics are of the utmost importance when trading goes haywire. Following up from closing all our high-conviction trades last Friday, we are obeying all recently instituted rolling stops in our cyclical portfolio positions in order to protect profits. Our underweight position in homebuilders, and overweight positions in hypermarkets and household products have been all stopped out this week for a profit of 41%, 26% and 5%, respectively. As such, all three positions have reverted back to neutral. Bottom Line: Erratic trading patterns and heightened volatility compel us to obey our rolling stops. Book gains and move to neutral in the cyclically underweight S&P homebuilders, overweight in S&P hypermarkets and overweight in S&P household products positions for a profit of 41%, 26% and 5%, respectively. Stay tuned.   Footnotes 1    Please see BCA Research US Equity Strategy Weekly Report, “Will The Fed Save The Day, Again?”, dated February 18, 2020, available at uses.bcareseach.com.

Dear Client, In addition to this week’s report, BCA Research will hold webcasts over the coming days to discuss the economic and financial outlook amid the myriad of uncertainties gripping global markets. I will take part in a roundtable discussion alongside my fellow BCA Strategists Arthur Budaghyan, Mathieu Savary, and Caroline Miller for a live webcast on Friday, March 13 at 8:00 AM EDT (12:00 PM GMT, 1:00 PM CET, 8:00 PM HKT). In addition, I will hold a webcast on Monday, March 16 at 12:00 PM EDT (4:00 PM GMT). Best regards, Peter Berezin, Chief Global Strategist Highlights A global recession is now a fait accompli. The only question is whether there will be a technical recession lasting a couple of quarters, or a more prolonged downturn that produces a sizeable increase in unemployment rates. We lean towards the former outcome. Unlike during most recessions, the decrease in labor demand will be mitigated by a decline in labor supply, as potentially millions of workers are confined to their homes. This will limit the rise in unemployment, at least initially. The pandemic is likely to prompt firms to increase inventory levels for fear of further disruptions to their supply chains. This should provide a short-term boost to output. While it is possible that spending will remain broadly depressed even after the panic subsides, this seems unlikely. Private-sector finances were reasonably strong going into the crisis, while ultra-low government bond yields will incentivize increased fiscal outlays. Spending on leisure travel and public entertainment will remain subdued well into 2021, but much of this demand will be redirected to other categories of discretionary consumer purchases, particularly in the online realm. Health care expenditures will also increase. The collapse in oil prices following the breakdown of OPEC 2.0 represents a positive supply shock for the global economy, albeit one that will have negative consequences for oil-extraction sectors. We tactically upgraded stocks on the morning of Friday, February 28. That was obviously a major mistake: While global equities did rally 7% higher after our upgrade, they have since given up all their gains (and then some). For now, we are maintaining a modest overweight recommendation to equities. However, this is a low-conviction view, and we would not dissuade more conservative investors from reducing risk exposure. We would only consider upgrading stocks to a high-conviction overweight if the S&P 500 dropped to 2250, or the number of new infections outside of China peaked. In the meantime, we are downgrading high-yield credit tactically, as the odds of earnings weakness prompting a near-term rise in default expectations warrant caution. What A Way To Start The Decade So far, the 2020s may not be roaring, but they are certainly not boring. At the outset of the crisis, there were three scenarios for the COVID-19 outbreak: 1) A regional epidemic largely confined to China; 2) a series of global outbreaks, successfully short-circuited by a combination of government intervention and voluntary “personal distancing” measures; 3) A full-blown pandemic that exposes a significant proportion of the planet to the virus. Unfortunately, the first scenario has been ruled out. Policymakers are now trying to achieve the second scenario. Successful containment would “flatten the curve” of new infections, while allowing the sick to receive better treatment than they would otherwise. It would also buy precious time to develop a vaccine and increase the output of face masks, hand sanitizers, and other products that could slow the spread of the disease. Health Versus Growth Ironically, while the second scenario is clearly preferable to a full-blown pandemic from a health perspective, it may be more damaging from the very narrow, technical perspective of GDP accounting. It all depends on how severe the measures to quash each outbreak need to be. If simple hygiene measures and social distancing turn out to be enough, the economic fallout will be minimal. If ongoing mass quarantines and business closures are necessary, the damage will be severe. History suggests that containment efforts can work. During the Spanish flu, US cities such as St. Louis, which took early action to slow the spread of the disease, ended up with far fewer deaths than cities such as Philadelphia which did not (Chart 1). Western Samoa did not impose any travel restrictions and lost a quarter of its population. American Samoa closed its border and suffered no deaths. Chart 1Containment Efforts Can Be Effective: The Case Of The Spanish Flu Contagion Contagion Recent experience suggests that COVID-19 can be stopped, even after community contagion has set in. The number of new Chinese cases has fallen from 3,892 on February 5 to 31 on March 11. South Korea seems to be getting the virus under control. The number of new cases there has declined from 813 on February 29 to 242 (Chart 2). Japan and Singapore also appear to be succeeding in preventing the virus from spreading rapidly. Chart 2Coronavirus: The Authorities In East Asia Seem To Be In Control Of The Situation Contagion Contagion What remains unclear is whether other countries can replicate East Asia’s experience. A recent Chinese study estimated that R-naught – the average number of people someone with the virus ends up infecting – fell from 3.86 at the outset of the outbreak to 0.32 following interventions (Chart 3).1 In other words, China was able to lower R-naught to one-third of what was necessary to stabilize the number of new infections. If one wanted to be optimistic, one could argue that other countries could get away with less heavy-handed measures, even if it is at the expense of a somewhat slower decline in the infection rate. Chart 3Severe Containment Measures Have Changed The Course Of The Wuhan Outbreak Contagion Contagion Unfortunately, given how contagious the virus appears to be, it is unlikely that simple measures such as regularly washing one’s hands, avoiding large gatherings, and wearing a face mask in public when sick will suffice. Trade-offs will have to be made between growth and health. Moreover, if the virus becomes endemic in a few countries that do not have the institutional capacity to contain it, this could create a viral reservoir that produces repeated outbreaks in the wider world. The result could feel like a ghastly game of whack-a-mole. The Fatality Rate The degree to which countries pursue costly containment measures depends on how deadly the virus turns out to be. On the one hand, there is some evidence that the fatality rate from COVID-19 is lower than the 2%-to-3% that has been widely reported once mild or asymptomatic cases, which often go undetected, are taken into account. This may explain why South Korea, which has arguably done a better job of testing suspected patients than any other country, has reported a fatality rate of only 0.7%. Like the seasonal flu, the death rate from COVID-19 appears to be heavily tilted towards the elderly. In Italy, 89% of COVID-19 deaths have occurred among those who are 70 and older. On the ill-fated Diamond Princess cruise liner, not a single person under the age of 70 has died. The fatality rate for passengers on the ship older than 70 is 2.4%. The seasonal flu kills about 1% of those it infects over the age of 70. Based on this simple calculation, COVID-19 is more lethal, but not light-years more lethal, than the typical flu (and possibly less lethal than the flu is for young children). Unfortunately, these optimistic estimates assume that patients with COVID-19 can continue to receive appropriate care. As we saw in Wuhan, where the official death rate stands at 4.5% compared to 0.9% in the rest of China, and as we are now seeing in Italy, once the health care system becomes overwhelmed, death rates can rise sharply. Bottom Line: Containing the virus will be economically costly, but given the potentially large death toll from a full-blown pandemic, most countries will be willing to pay the price. A Global Recession Even before the virus became endemic outside China, we estimated that global growth would fall to zero on a quarter-over-quarter basis in Q1. As we cautioned back then, the risk to our forecast was tilted to the downside, and that has proven to be the case. We now expect the global economy to shrink not just in the first quarter but in the second quarter as well, as country after country experiences a surge in new infections. Two consecutive quarters of negative growth constitute a technical recession. Despite the drop in new cases in China over the past two weeks, most high-frequency measures of economic activity such as property sales, railway-loaded coal volumes, and traffic congestion have yet to return anywhere close to normal levels (Chart 4). In the US, hotel occupancy rates, movie ticket sales, and attendance at sporting events were all close to normal levels as of last week. However, that is changing quickly. Already, automobile traffic in Seattle, one of the cities most hard-hit by the virus, has fallen sharply (Chart 5). Chart 4China: It Will Take Time For Life To Return To Normal Contagion Contagion Chart 5US: Staying Home More In Seattle Due To The Virus? Contagion Contagion Qualitatively Different While a recession in the first half of 2020 is now unavoidable, the nature of this recession is likely to be quite different than in the past. To understand why, it is useful to review what causes most recessions. A typical recession involves a prolonged loss of aggregate demand. Such a loss of demand can result from either financial market overheating or economic overheating. Financial market overheating can occur if a credit-fueled asset bubble bursts, leaving people with less wealth struggling to pay off debt. For example, US residential investment fell from 6.6% of GDP in 2005 to 2.5% of 2010. Thus, even after the credit markets thawed, there was still a large hole in aggregate demand that needed to be filled. A similar, though less severe, loss of demand occurred when the bursting of the dotcom bubble led to severe cutbacks in IT spending. Economic overheating occurs when a lack of spare capacity puts upward pressure on inflation. Wary of accelerating prices, central banks slam on the brakes, raising interest rates into restrictive territory. This often results in a recession. In both types of recessions, there are usually second-round effects that can swamp the initial shock to aggregate demand. As spending falls, firms start to lay off workers. The resulting loss in household income leads to less spending. Even those who retain their jobs are apt to feel less confident, leading to an increase in precautionary savings. For their part, businesses tend to cut production as inventory levels swell. Things only return to normal once enough pent-up demand has accumulated and/or policy has become sufficiently stimulative to revive spending. Framed in this way, one can see that the current downturn differs from past downturns in at least three important respects. First, unlike during most recessions, the decrease in labor demand this time around will be partly mitigated by a decline in labor supply, as potentially millions of workers are confined to their homes. While this will not prevent many workers from temporarily losing income, it will limit the increase in unemployment, at least initially. We have already seen this in China, where GDP growth collapsed but companies are complaining about a shortage of migrant labor. Second, rather than falling, inventory levels may actually rise. Since companies will have to deal with pervasive supply shocks of unknown frequency, duration, and magnitude, their natural inclination will be to increase inventory levels for fear that they will not be able to access their supply chains when they need them. If recent reports of hoarding of toilet paper and bottled water are any guide, the same sort of behavior will show up among consumers. Again, in the short term, this additional demand will help to keep unemployment from rising as much as it would otherwise. Third, and perhaps most importantly, the ongoing crisis is the result of an exogenous shock rather than an endogenous slowdown. In fact, a variety of economic indicators such as US payrolls, the Chinese PMI, and German factory orders were all pointing to an acceleration in global growth before the crisis began. This suggests that growth could recover quickly once the panic subsides. While it is impossible to say with any degree of certainty how long it will take for the panic to end, it may not last as long as many fear. Investors should particularly pay attention to the situation in Italy. If the number of new cases peaks there, it could create a sense that other western countries will be able to get the virus under control. Second-Round Effects? Although it is possible that economies will remain depressed even after the panic subsides, this seems unlikely. Private-sector finances were reasonably strong going into the crisis. The private-sector financial balance – the difference between what companies and households earn and spend – is in surplus in most countries, including China (Chart 6). Chart 6The Private Sector Spends Less Than It Earns In Most Economies Contagion Contagion Chart 7Lower Oil Prices Eventually Lead To Higher Growth Lower Oil Prices Eventually Lead To Higher Growth Lower Oil Prices Eventually Lead To Higher Growth Granted, not all sectors are likely to prove equally resilient. Spending on leisure travel and public entertainment will remain subdued well into 2021. The collapse in oil prices following the breakdown of OPEC 2.0 will also wreak havoc on oil producers. In both cases, however, there will be offsetting benefits. Much of the demand for travel and entertainment will be redirected to other categories of discretionary consumer purchases, particularly in the online realm. And while lower oil prices will hurt producers, they represent a boon for consumers and companies that use petroleum as an input. In general, as Chart 7 illustrates, global growth usually accelerates following declines in oil prices. Fiscal Policy Will Turn More Stimulative Even before the crisis began, we argued that most governments should permanently increase fiscal deficits in order to raise the neutral rate of interest. At the current juncture, with a recession upon us and government bond yields at ultra-low levels, the failure to enact meaningful fiscal stimulus would be economic malpractice of the highest order. In addition to easing measures being rolled out by central bankers, our sense is that we will get a lot of fiscal stimulus, sooner rather than later. During most recessions, there is always a chorus of voices from people whose own jobs are secure about how a downturn is necessary to cleanse the system. This time around, it is obvious that the victims are not to blame. Politicians will not endear themselves to voters by denying the need for fiscal support to households struggling with medical bills and lost time from work and businesses facing bankruptcy. President Trump’s pledge this week to cut payroll taxes and increase transfers to those affected by the virus is just a taste of what’s to come. Investment Conclusions Chart 8Stock-To-Bond Ratio: A Lot Of The Bad News Has Already Been Priced In Stock-To-Bond Ratio: A Lot Of The Bad News Has Already Been Priced In Stock-To-Bond Ratio: A Lot Of The Bad News Has Already Been Priced In We tactically upgraded stocks on the morning of Friday, February 28. That was obviously a major mistake: While global equities did rally 7% higher after our upgrade, they have since given up all their gains (and then some). In retrospect, we should have paid more attention to our own analysis in our report “Markets Too Complacent About The Coronavirus.” For now, we are maintaining a modest overweight recommendation to equities. The total return ratio between stocks and bonds has fallen by a similar magnitude as in the run-up to prior recessions, suggesting that much of the bad news has already been priced in (Chart 8). Nevertheless, significant downside risks remain, which is why we would characterize our equity overweight as a fairly low-conviction view. We would not dissuade more conservative investors from reducing risk exposure. As discussed above, containing the virus could lead to significant economic disruptions. We would only consider upgrading stocks to a high-conviction overweight if the S&P 500 dropped to 2250, or the number of new infections outside of China peaked. In the meantime, we are downgrading high-yield credit tactically, as the odds of earnings weakness prompting a near-term rise in default expectations warrant caution. Safe-haven government bond yields will probably not rise much from current levels, at least in the near term. The Fed cut rates by 50 basis points last week and will cut rates by another 50 basis points next week. Looking further out, however, bonds are massively overvalued and will suffer mightily as life returns to normal.   Peter Berezin Chief Global Strategist peterb@bcaresearch.com   Footnotes 1Chaolong Wang, Li Liu, Xingjie Hao, Huan Guo, Qi Wang, Jiao Huang, Na He, Hongjie Yu, Xihong Lin, Sheng Wei, and Tangchun Wu, “Evolving Epidemiology and Impact of Non-pharmaceutical Interventions on the Outbreak of Coronavirus Disease 2019 in Wuhan, China,”medrxiv.org, March 6, 2020. Global Investment Strategy View Matrix Contagion Contagion MacroQuant Model And Current Subjective Scores Contagion Contagion Strategic Recommendations Closed Trades

Highlights Supply constraints and unstoppable demand growth – the result of stricter regulations requiring higher loadings in autocatalysts to treat toxic pollution in automobile-engine emissions – will continue to push palladium’s price higher, despite a near-vertical move higher that began in 2H19. South Africa’s power grid is in a state of near-collapse, which will add volatility to mining operations focused on platinum-group metals – chiefly palladium, platinum and rhodium. South Africa accounts for 36% of global palladium production and 73% of platinum production, which makes it difficult to make the case that platinum could be substituted for palladium as its price rises. Palladium stocks are at risk of being further depleted globally as demand from automobile manufacturers in China, the US and Europe remains robust. This will keep palladium forward curves backwardated for the foreseeable future. While pressure to find alternatives for palladium will grow as prices rise, in absolute terms the additional cost resulting from higher prices for the metal – ~ $400 per vehicle – is not yet enough to draw significant investment to this effort. Feature Palladium markets are fundamentally tight and unresponsive to macroeconomic uncertainty. Table 1Top 5 Best Performing Commodities Epic Palladium Rally Likely Continues Epic Palladium Rally Likely Continues In 2019, for the third year in a row, palladium prices outperformed other major commodities, returning an impressive 54% over the year (Table 1). This is the result of a massive 13% increase in demand for the metal – powered by strong autocatalyst demand for gasoline-powered cars in China and Europe, even as collapsing auto production globally and elevated trade uncertainty continue to dog automobile sales (Chart 1). This apparent contradiction is explained by stricter vehicle emissions regulations in major consuming markets – chiefly the Euro 6d, China 6 and US Tier 3 regimes – and power shortages in South Africa, which are introducing considerable volatility on the supply side in the second-largest producing country for the metal. Chart of the WeekSurging Autocatalyst Palladium Demand Epic Palladium Rally Likely Continues Epic Palladium Rally Likely Continues  Again this year, palladium markets are fundamentally tight and unresponsive to macroeconomic uncertainty. Palladium prices soared 39% YTD, its fastest 40-day increase since 2010. Unlike other commodity markets, palladium is completely disregarding the COVID-19 outbreak that originated in China late last year. Favorable supply-side fundamentals continue to drive the palladium rally: The metal’s decade-long physical supply deficit intensified in 2019 and we expect it to widen this year (Chart 2, panel 1). On the demand side, Chinese consumption is at risk. China is the world’s largest auto manufacturing market. Hubei Province – COVID-19’s epicenter – is a large car manufacturing hub, accounting for ~ 10% of the country’s annual automobile output. In the wake of COVID-19, the country’s car production is expected to fall 10% in 1Q20. In addition, the virus had infected more than 80,000 people globally, and has spread rapidly outside Hubei into Asia, Europe, the Middle East, Africa, and North America, raising the odds of a pandemic. Interestingly, speculative positioning and ETF investment demand is subdued, and is not inflating prices (Chart 2, panel 2). Chart 2Palladium Deficit To Widen This Year Epic Palladium Rally Likely Continues Epic Palladium Rally Likely Continues Palladium Demand Soars As Auto Production Collapses Strong global automobile catalyst demand drove the rally in palladium prices last year. This occurred as car production fell by 9%, 8%, and 15% in US, China, and India – an unusual divergence in fundamentals. The culprit: Technical changes to autocatalysts from stricter emissions regulations. In China, the latest phase of car emissions regulations – China 6 – was gradually introduced in high-population centers, which also suffer from high levels of pollution. These centers accounted for ~ 60% of annual Chinese car sales in 2019. China 6 represents a major shift in emissions regulations and will make the Chinese auto fleet compliant with Europe’s best practices. As a result, palladium loadings in conforming light-duty gasoline vehicles reportedly increased by ~20% in 2019. This pushed China’s autocatalyst consumption up by 570k oz despite the drop in annual car sales, which created the rare dislocation between the country’s car production and palladium prices (Chart 3). We expect this trend to continue this year: China 6 is on track to be enforced countrywide – i.e., the remaining 40% of car sales – by mid-year, providing an additional ~ 10% boost in loadings of the metal. Chart 3Stricter Regulations Support Prices Amid Falling Car Production Epic Palladium Rally Likely Continues Epic Palladium Rally Likely Continues In Europe, the introduction of Euro 6c legislation in September 2018 and the extension to all new vehicles of Euro 6d-TEMP regulations in September 2019 – mainly the real driving emissions (RDE) testing procedure adopted in the wake of the Volkswagen “dieselgate” scandal in 2015 – pushed palladium loading in autocatalysts up by ~ 25% from 2017 to 2019.1 The regulations became stricter in January 2020, putting additional stress on manufacturers to comply with the new standards, which will continue to support higher palladium loadings. We expect the COVID-19 outbreak to delay the recovery in global gasoline-powered vehicle production and consumption to 2H20. Lastly, in the US – which remains an important market for autocatalyst palladium demand (Chart 4) – the ongoing implementation of the Tier 3 legislation will continue to gradually increase palladium content in autocatalysts until 2025. For 2020, we do not expect this to significantly boost loadings per vehicle and are factoring in 2% growth. These legislative changes in major automotive markets produced a structural break in our palladium demand model (Chart 5). After adjusting our estimates for greater palladium content in gasoline aftertreatment systems, our model suggests that demand provides strong support to palladium prices, but also suggests other factors – i.e. supply and inventory – are at play. Chart 4North America's Auto Sector Remains A Large Share Of Palladium Demand Epic Palladium Rally Likely Continues Epic Palladium Rally Likely Continues Chart 5Higher Palladium Loadings Largely Explains Last Year's Price Surge Epic Palladium Rally Likely Continues Epic Palladium Rally Likely Continues In the US and Europe, consumers can absorb higher vehicle sales despite being close to saturated in terms of vehicle ownership. We expect the COVID-19 outbreak to delay the recovery in global gasoline-powered vehicle production and consumption to 2H20. In China, we expect the government will overstimulate its economy to meet its long-term goal of doubling its GDP and per capita income by 2020.2 Automobile ownership and vehicle sales there are low vs. DM economies, suggesting more upside for sales in China (Chart 6). In the US and Europe, consumers can absorb higher vehicle sales despite being close to saturated in terms of vehicle ownership. Car sales move in cycles around long-term demographic trends: The longer the current economic expansion, the further above-trend car sales can rise (Chart 7). Chart 6China: Structural Outlook For Autos Is Bright China Car Consumption Will Rebound In 2H20... Epic Palladium Rally Likely Continues Epic Palladium Rally Likely Continues Chart 7... Likewise For Europe And US Epic Palladium Rally Likely Continues Epic Palladium Rally Likely Continues Bottom Line: The combination of stricter environmental regulations in key gasoline-powered automobile markets and the post-coronavirus rebound in global auto consumption will push the palladium market further in deficit this year as it faces an inelastic supply, critically low inventories and low substitutability over the short-term (more on this below). Palladium Supply In 2020: Weak growth And Low Price-Elasticity Palladium supply is highly constrained. The largest supplies are concentrated in Russia (42%), South Africa (36%) and North America (14%). From 2015 to 2019, supply and capex grew by a very subdued 7% and 15.2% respectively, completely disregarding the 200% rise in prices (Chart 8, panel 1). This illustrates palladium supply’s extremely low price-elasticity.3 Palladium supply growth will remain muted for the foreseeable future, as Eskom begins long-delayed maintenance to refurbish its derelict generation fleet. Primary supplies declined by close to 2% last year on falling shipments from Russia and record electricity load-shedding – i.e. blackouts – in South Africa (Chart 8, panel 2).4 As tight as palladium markets are fundamentally, South Africa’s crippled power grid – long in need of upgrading and repair – has been, and remains, a key driver of short-term platinum-group metals (PGM) prices.5 Following the breakdown of close to 25% of the country’s generating capacity, Eskom – the nation’s utility monopoly responsible for ~ 90% of its electricity generation – has been forced to implement rolling blackouts to balance power supply and demand and prevent permanent damage to the country’s power grid. Palladium supply growth will remain muted for the foreseeable future, as Eskom begins long-delayed maintenance to refurbish its derelict generation fleet. Consequently, Stage 6 load-shedding events likely will become more frequent. These efforts are complicated by massive debt – ~ $30 billion – which has required government bailouts and forced the company to take loans from a Chinese industrial bank. Chart 8Top Palladium Producers' Capex Price-Elasticity Is Low Epic Palladium Rally Likely Continues Epic Palladium Rally Likely Continues This is playing havoc with PGM supplies. During the unmatched Stage 6 load-shedding in December 2019 – cutting power to 37% of grid users – PGM supplies were reduced by 50%. Stockpiles covered the loss, but persistent blackouts lasting years could push markets into an actual shortage of palladium as inventories would rapidly be depleted. This is a significant risk: Eskom itself warned rolling blackouts will persist for the next 18 months.6 Elevated local currency PGM prices are postponing announced shafts closures, as miners seek to profit from the favorable pricing environment (Chart 9). But insufficient electricity capacity will weigh on mine supply growth over the next few years as companies hold-back on much-needed long-term investments. The final units of Eskom’s Medupi and Kusile projects are expected to be completed over the next two years – adding 4800MW to its installed capacity. This can partially alleviate South Africa’s electricity difficulties, but these units are not enough to support a rebound in economic and mine production growth. South Africa is in profound need of large-scale investments in its power sector. Close to 5000MW of power capacity is scheduled to shut down over the next five years (Chart 10). Chart 9Favorable Domestic Metal Prices For South African Miners Epic Palladium Rally Likely Continues Epic Palladium Rally Likely Continues Chart 10South Africa Needs Additional Power Generation Capacity Epic Palladium Rally Likely Continues Epic Palladium Rally Likely Continues After years of pressure from mining companies, South Africa’s minister of Mineral Resources and Energy announced it would allow companies to generate unlimited electricity for their own activities. The current political and economic climate is not constructive for meeting this challenge. The World Bank recently slashed South Africa’s 2020 GDP growth forecast to 0.9% from 1.5% previously on the back of electricity and infrastructure constraints impeding domestic growth and weak external demand. Likewise, rating agency Moody's signaled – ahead of its review of South Africa’s Baa3 credit rating in March – it could downgrade the country to speculative grade, citing the detrimental impact of recurring power outages on manufacturing and mining output. After years of pressure from mining companies, South Africa’s minister of Mineral Resources and Energy announced it would allow companies to generate unlimited electricity for their own activities. This will provide much-needed help to the country’s power sector. According to the Minerals Council South Africa, mining companies could bring an additional ~ 1500MW capacity online in the next 9 to 36 months. But doubts remain with regard to the timeline for companies to obtain the necessary licenses and if these can easily be acquired. Johnson Matthey expects supply growth in Russia – the largest producer – will be capped this year as Nornickel’s processing of old mines' copper concentrate – which boosted the company’s palladium supply over the past few years – is finalized. Still, a paltry 1% gain is possible from expected efficiency gains at existing mines, according to Nornickel. The company also announced it will increase production at its Talnakh and South Cluster mines, but this additional supply will only reach markets gradually as processing capacity constraints won’t be resolved until 2023, according to Johnson Matthey. Bottom Line: Growth prospects in the top two palladium-producing countries are weak in 2020. This will not suffice to meet the soaring autocatalyst demand. Higher recycling and inventory releases – both incentivized by higher prices – will be needed to balance the market. Palladium Stockpiles Are Dangerously Low We expect palladium prices will move higher on the expanding deficit, and backwardation in the forward curve will persist to incentivize the release of inventories to market (Chart 11). Yet, global palladium stockpiles have been declining since 2014 and are now at critically low levels, raising the risk of a disrupting shortage of the metal:7 ETF and exchange inventories now stand at a paltry 600k oz (Chart 12). These are the most price-elastic stocks and will get close to zero as prices increase. Chart 10Expect Backwardation To Persist Epic Palladium Rally Likely Continues Epic Palladium Rally Likely Continues Chart 12Price-Sensitive Stockpiles Are Dangerously Low Epic Palladium Rally Likely Continues Epic Palladium Rally Likely Continues Exhaustion of inventory would spike prices until demand destruction or additional supply – both inelastic in the short-run – are able to balance the market. The Russian Ministry of Finance’s reserves – a state secret – are now almost exhausted, according to Russia’s Norilsk Nickel, the largest supplier of physical palladium in the world. Last year, Norilsk Nickel held an estimated 1mm oz of the metal in its Global Palladium Fund, and signaled it is increasingly using its reserves to balance markets and provide needed liquidity. Earlier this year, the company released 3 MT of palladium to the market from stocks. Complete exhaustion of inventory would spike prices until demand destruction or additional supply – both inelastic in the short-run – are able to balance the market. Don’t Count On Substitution, Yet Switching to platinum requires significant capital- and resource-intensive R&D and appears to be beyond the current capabilities of automakers. We expect platinum prices to rise in 2020 supported by improving fundamentals, growing safe-haven demand, and markets pricing in increasing anticipation of substitution from palladium to platinum. Unlike palladium, platinum is also affected by safe-haven demand and gets bid up with gold and silver prices in periods of high uncertainty (Chart 13). With gold prices now above $1,600/oz, platinum will benefit from safe-haven flows due to its relative price advantage (Chart 14). Chart 13Safe-Haven Flows Support Platinum Prices Epic Palladium Rally Likely Continues Epic Palladium Rally Likely Continues Chart 14Platinum Is Cheap Relative To Gold Epic Palladium Rally Likely Continues Epic Palladium Rally Likely Continues We believe substitution will commence over the coming years, but this is a gradual process. Substitution from expensive palladium to low-priced platinum in industrial applications is the largest risk to our positive view on the palladium-to-platinum (Pd-to-Pt) ratio (Chart 15). This started in smaller and more price-elastic segments (e.g. dental, jewelry and diesel autocatalyst). However, to have a real impact on overall demand and thus the price ratio, substitution needs to take place in gasoline autocatalyst technology. The discount has been at a level consistent with substitution for more than a year, but the urgency to upgrade current designs to meet new environmental legislation and RDE regulations in China, Europe, and the US is the main focus of automakers this year. Switching to platinum requires significant capital- and resource-intensive R&D and appears to be beyond the current capabilities of automakers scrambling to meet the latest anti-pollution regulations globally. Moreover, large-scale substitution will take place only if automakers’ cost-benefit analysis points to significant long-term profits from switching. That said, platinum’s supply security remains a risk in the long-term: South Africa accounts for 73% of global production and our analysis suggests output growth there likely will remain weak over the next few years, especially as Eskom rebuilds its failing power grid. This lack of diversity increases sourcing risks for automakers, who, not without reason, would not want to switch over to platinum only to find that supply is also in doubt down the road. The overall platinum market is 26% smaller than that of palladium. Assuming a one-for-one substitution of Pd to Pt in gasoline catalyzers, a 1.2mm oz reduction in Pd demand – the amount required to reduce palladium’s deficit to zero – would send platinum markets to a 1.4mm oz deficit.8 Without substantial production growth, platinum prices would spike, reducing the profitability of investing in these new catalysts. Thus, substitution will eventually impact the price ratio, but will not be large enough to overturn absolute price level trends. In addition, the amount of PGMs in the typical autocatalyst – ~ 5 grams – adds $400 to the cost of the average automobile (Chart 15, lower panel). We do not believe this cost drives automakers' decisions, which is another reason the substitution of Pt for Pd likely will remain a topic of discussion more than action. Chart 15Palladium's Price Surge Adds ~0 Per Gasoline Car Epic Palladium Rally Likely Continues Epic Palladium Rally Likely Continues Bottom Line: We believe substitution will commence over the coming years, but this is a gradual process and it will not happen on a meaningful scale this year. Thus, we expect the continuation of relative demand and inventory trends will provide a favorable setting for the Pd-to-Pt ratio this year (Chart 16). Chart 16Pd-to-Pt Price Ratio Will Increase Again in 2020 Epic Palladium Rally Likely Continues Epic Palladium Rally Likely Continues   Hugo Bélanger Associate Editor Commodity & Energy Strategy HugoB@bcaresearch.com Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com   Commodities Round-Up Energy: Overweight Brent and WTI crude oil lost 5% and 4% this week, as fears of a global pandemic in the wake of the COVID-19 outbreak gripped markets. Reports of outbreaks in Asia ex-China, the Middle East and Europe fueled these concerns. Against this backdrop, OPEC 2.0 will be meeting in Vienna March 5 and 6 to consider cuts of 600k b/d recommended by its technical committee earlier this month. We continue to expect the full coalition to approve these cuts at the upcoming meetings. Saudi Arabia, Kuwait and the United Arab Emirates reportedly are considering an additional 300k b/d of cuts to offset the global demand hit delivered by COVID-19. The IEA estimates the COVID-19 outbreak will reduce Chinese refining throughput by 1.1mm b/d, and will reduce the call on OPEC crude by 1.7mm b/d in 1Q20. Base Metals: Neutral Iron ore prices weakened, following global equities lower, as the COVID-19 outbreak spread around the world. However, traders continue to report lower stocks of iron ore, which should keep prices supported, according to MB Fastmarkets (Chart 17). We remain long December 2020 high-grade iron ore (65% Fe) vs. short the benchmark 62% Fe contract on the Singapore Commodity Exchange, which we initiated November 7, 2019. This recommendation was up 5.3% as of Tuesday’s close, when we mark to market. Precious Metals: Neutral After retreating slightly from its run toward $1,700/oz earlier this week, gold remains well supported by safe-haven demand (Chart 18).  In addition, actual and expected policy stimulus – e.g., Hong Kong's “helicopter money” drop of USD 1,200 to all permanent residents over the age of 18 – and expectations of additional central bank easing globally to offset the global spread of COVID0-19 will keep gold and precious metals generally supported.  Markets should start pricing in higher inflation expectations as additional stimulus starts to roll in.  Ags/Softs:  Underweight Global grain markets could be set to rally sharply, as unusually wet weather in the Middle East and East Africa spawned by higher-than-usual cyclone activity produces perfect breeding conditions for desert locusts in the region over the next two months.  According to National Geographic, by June the locusts could increase their populations “400-fold compared with today, triggering widespread devastation to crops and pastures in a region that’s already extremely vulnerable to famine.”  This could put more than 13mm people in East Africa at risk of “severe acute food insecurity,” and imperil millions more.  Chart 17China's Iron Ore Stocks Tight Epic Palladium Rally Likely Continues Epic Palladium Rally Likely Continues Chart 18Safe Havens Gold, USD Well Bid Epic Palladium Rally Likely Continues Epic Palladium Rally Likely Continues   Footnotes 1     Please see New legislation planned in response to dieselgate, published by Autocar June 9, 2016. See also  Johnson Matthey’s February 2020 Pgm Market Report. 2     Our view of strong Chinese fiscal and monetary stimulus was discussed in detail in our February 13, 2020 weekly report titled Iron Ore, Steel Poised For Rally. 3    Historically produced as an inferior byproduct from nickel, gold, and platinum mines, the price incentive from palladium alone isn’t enough to generate the needed investments in new mine production. According to Nornickel, this is slowly changing, palladium is an increasingly large part of mining companies’ revenues, making the metal a valuable co-product. This could improve mines investments’ responsiveness to movement in palladium prices over the medium term. 4    According to Eskom, “Load shedding is aimed at removing load from the power system when there is an imbalance between the electricity available and the demand for electricity. If we did not shed load, then the whole national power system would switch off and no one would have electricity.” The company’s load-shedding program includes 8 stages, where each stage represents the removal of 1000MW of demand – e.g., stage 5 removes 5000MW. This is done by shutting down specific sections of the grid.  5    The PGMs are ruthenium, rhodium, palladium, osmium, iridium, and platinum. 6    Things got worse after the December load-shedding event.  Less than a month later, Reuters noted more than two times the power shed in December went “offline because of plant breakdowns. 7    This can be seen in the close to 12mm oz. decline in UK and Switzerland – home of the largest secured vaults of Palladium and Platinum – net imports. 8    Technological improvement in palladium catalysts has made the metal more efficient in for gasoline-powered engines vs. platinum. It has superior properties in terms of thermal durability and NOx reduction. Thus, the conversion could be greater than 1-to-1 and would imply a smaller share of palladium autocatalyst substitution could be absorbed by existing platinum supplies.   Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 2019 Q4 Epic Palladium Rally Likely Continues Epic Palladium Rally Likely Continues Commodity Prices and Plays Reference Table Trades Closed in 2020 Summary of Closed Trades Epic Palladium Rally Likely Continues Epic Palladium Rally Likely Continues