Corporate

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

Highlights Portfolio Strategy We remain comfortable with a 3,000 SPX fair value estimate backed up by our DDM, forward ERP and sensitivity analyses. The path of least resistance remains higher for the SPX on a 9-12 month cyclical time horizon. The oil price collapse is eliciting a massive supply response that should help rebalance the oil markets, and coupled with glimmers of hope on reopening the economy, it should put a floor under oil prices. CB are injecting unprecedented amounts of liquidity in the markets and at some point this will lead to a growth revival which is negative for gold prices. Taken together, and given all-time lows in relative valuations and technicals, we are compelled to go long US oil & gas exploration & production stocks at the expense of global gold miners. We are putting the S&P managed health care index on downgrade alert to reflect the risk that rising unemployment poses to health care enrollment. Falling interest rates also weigh on industry profitability at a time when relative valuations are perky and technicals are overbought. Recent Changes Initiate a long S&P oil & gas exploration & production/short global gold miners pair trade, today. Table 1 Gauging Fair Value Gauging Fair Value Feature Equities marked time last week, despite the passage of a fresh mini fiscal 2.0 package and efforts to restart the economy in parts of the globe. In contrast, news that President Trump may delay reopening the economy along with negative crude oil prices weighed heavily on the S&P 500. Nevertheless, energy equities fared very well, defying the oil market carnage and impressively relative energy share prices have led the SPX trough (Chart 1). We remain constructive on the broad equity market on a cyclical 9-12 month time horizon. Following up from last week’s SPX dividend discount model (DDM) update, we complement our research with two additional ways of approximating the SPX fair value: EPS and multiple sensitivity analysis and a forward equity risk premium (ERP) analysis. While at the nadir the stock market priced in a collapse in EPS close to $104 for the current year (please refer to our analysis here1), in 2021 EPS can return to their long-term trend line near $162. At first sight this spike in EPS seems unrealistic. However, here are two salient points: Chart 1Energy As A Leading Indicator Energy As A Leading Indicator Energy As A Leading Indicator First, hard-hit COVID-19 subsectors are a small fraction of SPX profits and market capitalization. In other words, the S&P 500 is a market cap weighted index and has already filtered out hotels, cruises, restaurants, homebuilders, autos, auto parts, airlines, and even energy as they comprise a small part of the SPX. Second, historical precedents show an explosive year-over-year growth increase in EPS from recessionary troughs. In fact, the steeper the collapse the more violent the rebound. Hence, our recovery EPS estimate is more or less in line with empirical evidence (Chart 2). Chart 2Violently Oscillating EPS Violently Oscillating EPS Violently Oscillating EPS For comparison purposes, the Street is still penciling in EPS near $135 and $170 for 2020 and 2021, respectively. Table 2 shows our sensitivity analysis and an SPX ending value of just above 2,900 using $162 EPS and an 18x forward multiple as our base case. This multiple is slightly below the historical time trend using IBES data dating back to 1979, and represents our fair value PE estimate (please see page 17 of our April 6, 2020 webcast2 available here). Table 2SPX EPS & Multiple Sensitivity Gauging Fair Value Gauging Fair Value With regard to the forward ERP analysis, our starting point is an equilibrium ERP of 440 basis points (bps). The way we derived this number was using the last decade’s average observed forward ERP (middle panel, Chart 3). We used to think equilibrium ERP was closer to 200bps. However, if the Fed’s extraordinary – and unorthodox – measures since the onset of the GFC did not manage to bring down the ERP (middle panel, Chart 3), then in the current recession with uncertainty on the rise, it only makes sense to model a higher than previously thought equilibrium ERP (middle panel, Chart 4). Chart 3The Forward Equity Risk Premium… The Forward Equity Risk Premium… The Forward Equity Risk Premium… Chart 4…Will Recede …Will Recede …Will Recede And, just to put the forward ERP in perspective, keep in mind that it jumped from 350bps to just below 600bps year-to-date (Chart 4)! A doubling in the 10-year US treasury yield to 120bps is another assumption we are making along with using our trend EPS estimate of $162 for calendar 2021. Backing out price results in a roughly 2,900 SPX fair value estimate (Table 3). Table 3Forward Equity Risk Premium Analysis Gauging Fair Value Gauging Fair Value We remain comfortable with a 3,000 SPX fair value estimate backed up by our DDM, forward ERP and sensitivity analyses. Despite the much needed current consolidation phase, the path of least resistance is higher for the SPX on a 9-12 month cyclical time horizon. This week we are putting a health care subgroup on downgrade alert and initiating a high-octane intra-commodity market-neutral pair trade to benefit from the looming handoff of liquidity to growth. Time To Buy “Black Gold” At The Expense Of Gold Bullion We have been long and wrong on the S&P energy sector and its subcomponents, as neither we nor our Commodity & Energy Strategists anticipated -$40/bbl WTI crude oil futures prices. Nevertheless, as the energy sector is drifting into oblivion within the SPX – it is now the second smallest GICS1 sector with a 2.77% market cap weight slightly higher than materials – we think that WTI May contract reaching -$40/bbl marked the recessionary trough. Similar to the early-2018 “volmageddon” incident when a volatility exchanged trade product blew up and got dismantled and marked that cyclical peak in the VIX, the recent near collapse of USO and shuttering of another oil related levered exchange traded product serve as the anecdotes that likely mark the low in oil prices. True, negative WTI futures prices are no longer taboo and the CME prepared for them by reprograming its systems to handle negative futures prices, thus they can happen again. With regard to the significance of anecdotes in market tops and bottoms, another interesting one that comes to mind is from our early days at BCA in May of 2008 where we worked for the Global Investment Strategy team as a senior analyst. Back then, we vividly remember a Goldman Sachs analyst slapping a $150/bbl target on crude oil,3 and only days later in unprecedented hubris Gazprom’s CEO upped the ante with an apocalyptic $250/bbl prediction.4 This prompted us to create our first mania chart at BCA with crude oil prices on June 20, 2008 (please see chart 16 from that report available here5), which proved timely as oil prices peaked less than a month later at $147/bbl. Today, we are compelled to perform the opposite exercise and run a regression of previous equity sector market crashes on the S&P oil & gas exploration & production index (E&P, that most closely resembles WTI crude oil prices) in order to gauge a recovery profile. Chart 5 suggests that if the anecdotes are accurate in calling the trough in oil prices, then E&P stocks should enjoy a steep price appreciation trajectory in the coming two years. Beyond the overweights we continue to hold in the S&P energy sector and all the subgroups we cover, we believe that there is an exploitable trading opportunity to go long S&P E&P/short global gold miners (Chart 6). Chart 5Heed The US Equity Strategy’s Crash Index Message Heed The US Equity Strategy’s Crash Index Message Heed The US Equity Strategy’s Crash Index Message This high-octane trade is extremely volatile, but the recent carnage in the oil markets offers a great entry point for investors that can stomach heightened volatility, with an enticing risk/reward tradeoff. The gold/oil ratio (GOR) is trading at 112 as we went to press and we think that it will have to settle down. The Fed is doing its utmost to dampen volatility, and historically, suppressed volatility has been synonymous with a falling GOR (Chart 7). As a result, our pair trade will have to at least climb back to its recent breakdown point, representing a near 34% return (top panel, Chart 6). Chart 6Buy E&P Stocks At The Expense Of Gold Miners Buy E&P Stocks At The Expense Of Gold Miners Buy E&P Stocks At The Expense Of Gold Miners From a macro perspective the time to buy oil equities at the expense of gold miners is when there is a handoff from liquidity to growth (bottom panel, Chart 6). While we are still in the liquidity injection phase we deem the Fed and other Central Banks (CB) are committed to do “whatever it takes” to sustain the proper functioning of the markets. Therefore, at some point likely in the back half of the year when the economy slowly reopens, all these CB programs will bear fruit and growth will recover violently (middle panel, Chart 6), especially given our long-held view that the US will avoid a Great Depression. Chart 7VIX Says Sell The GOR VIX Says Sell The GOR VIX Says Sell The GOR With regard to balancing the oil market, nothing like price to change behavior. In more detail, the recent collapse in oil prices will work like magic to bring some semblance of normality back to the crude oil market, as it will naturally cause a shut in of production; there is no doubt about it. Not only has the supply response commenced, but it is also accelerating to the downside as the plunging rig count depicts (Chart 8). This will lead to some longer-term bullish oil price ramifications. As a reminder, while demand drives prices in the short-term, supply dictates the oil price direction in the long-term. Chart 8Oil Price Collapse Induced Supply Response Oil Price Collapse Induced Supply Response Oil Price Collapse Induced Supply Response Turning over to gold and gold miners, all this liquidity is forcing investors to chase bullion and related equities higher. Tack on that every CB the world over is trying to debase their currency, and factors are falling into place for sustainable flows into gold and gold mining equities. However, there are high odds that all this money sloshing around will eventually generate growth especially in the western hemisphere that is slowly contemplating of restarting its economic engines. As a result, real yields will rise which in turn is negative for gold and gold miners (Chart 9). Finally, relative valuations and technicals could not be more depressed, which is contrarily positive (Chart 10). Chart 9Liquidity To Growth Handoff Beneficiary Liquidity To Growth Handoff Beneficiary Liquidity To Growth Handoff Beneficiary Netting it all out, the oil price collapse is eliciting a massive supply response that should help rebalance the oil markets, and coupled with glimmers of hope on reopening the economy, it should put a floor under oil prices. CB are injecting unprecedented amounts of liquidity in the markets and at some point this will lead to a growth revival which is negative for gold prices. Taken together, and given all-time lows in relative valuations and technicals, we are compelled to go long US oil & gas exploration & production equities at the expense of global gold miners. Chart 10As Bad As It Gets As Bad As It Gets As Bad As It Gets Bottom Line: Initiate a long US oil & gas exploration & production/short global gold miners pair trade today. The ticker symbols for the stocks in these indexes are: BLBG: BLBG: S5OILP – COP, EOG, HES, COG, MRO, NBL, CXO, APA, PXD, DVN, FANG, (or XOP:US exchange traded fund) and GDX:US exchange traded fund, respectively. Put HMOs On Downgrade Alert We upgraded the S&P managed health care index last April, the Monday after Bernie Sanders re-introduced his “Medicare For All” bill.6 Our thesis was that the drubbing in this sector was a massive overreaction and we, along with our Geopolitical Strategists, thought that he would have low chances of clinching the Democratic Presidential candidacy and threatening to render HMOs obsolete. A year later, this thesis has panned out and the S&P managed care index is up 30% versus the S&P 500. Nevertheless we do not want to overstay our welcome and are putting it on our downgrade watch list and instituting a 5% rolling stop in order to protect gains in our portfolio (top panel, Chart 11). Relative share prices have broken out to fresh all-time highs, not only courtesy of a more moderate Democratic Presidential candidate, but also because a significant boost to margins and profits is looming. The delayed effect of fewer elective procedures (i.e. hip and knee replacements and even non-life threatening bypass surgeries) owing to the coronavirus pandemic will result in a sizable, yet temporary, margin expansion phase (second panel, Chart 11). Tack on, still roughly 20% health care insurance CPI and the outlook for HMO margins and profits further improves (bottom panel, Chart 11). Nevertheless, there are some negative offsets. Over the past 5 weeks unemployment insurance claims have soared to 26.5mn, erasing all the employment gains of the past decade, thus private insurance enrollment will take a sizable hit (top panel, Chart 12). Chart 11The Good… The Good… The Good… Chart 12…And The Bad …And The Bad …And The Bad Moreover on the income side, the premia that HMOs take in are typically invested in the risk free asset and given the two month fall from 1.5% to around 0.6% in the 10-year Treasury yield, managed health care earnings will also, at the margin, suffer a setback (bottom panel, Chart 12). True, the HMOs earnings juggernaut has been one of a kind over the past decade underpinning relative share prices (top panel, Chart 13). However, we reckon a lot of the good news and very little if any of the bad news is priced in extremely optimistic relative profit expectation going out five years (middle panel, Chart 13). Keep in mind that the bulk of the M&A activity is behind this industry as the dust has now settled from the previous two year frenzied pace of inter and intra industry combinations (top panel, Chart 14). Chart 13Lots Of Good News Is Already Priced In Lots Of Good News Is Already Priced In Lots Of Good News Is Already Priced In Chart 14Preparing Not To Overstay Our Welcome Preparing Not To Overstay Our Welcome Preparing Not To Overstay Our Welcome Finally, relative technicals are in overbought territory close to one standard deviation above the historical mean and relative valuations are also becoming a tad too lofty for our liking (middle & bottom panel, Chart 14). Adding it all up, we are putting the S&P managed health care index on downgrade alert to reflect the risk that rising unemployment poses to health care enrollment. Falling interest rates also weigh on industry profitability at a time when relative valuations are perky and technicals are overbought. Bottom Line: Stay overweight the S&P managed health care index, but it is now on our downgrade watch list. We are also instituting a rolling 5% stop as a portfolio management tool in order to protect profits. Stay tuned. The ticker symbols for the stocks in this index are: BLBG: S5MANH-UNH, ANTM, HUM, CNC.   Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com     Footnotes 1     Please see BCA US Equity Strategy Weekly Report, “What Is Priced In?” dated March 30, 2020, available at uses.bcaresearch.com. 2     https://www.icastpro.ca/events/bca/2020/04/06/us-equity-market-what-the-future-holds/play/16925 3    https://www.nytimes.com/2008/05/21/business/21oil.html 4    https://www.reuters.com/article/gazprom-ceo/russias-gazprom-sees-higher-gas-prices-ceo-idUSL1148506420080611 5    Please see BCA Global Investment Strategy Weekly Report, “Strategy Outlook - PART 1 - Third Quarter 2008” dated June 20, 2008, available at gis.bcaresearch.com. 6    Please see BCA US Equity Strategy Weekly Report, “Show Me The Profits” dated April 15, 2019, available at uses.bcaresearch.com.   Current Recommendations Current Trades Strategic (10-Year) Trade Recommendations Gauging Fair Value Gauging Fair Value 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 Why is the gap between the stock market and the economy so wide?: It is well established that stocks can diverge considerably from fundamentals in the near term, but lately it is as if the stock tables and the front-page headlines are from entirely different newspapers. It may be because the virus poses much less of a threat to the owners of equities than the general populace: More affluent households are more readily able to work from home and to practice social distancing. They also have access to better medical care. With the S&P 500 having hit technical resistance, however, the gap may be nearing its upper limit: Large-caps have run in place since retracing half of their peak-to-trough losses, and the next Fibonacci resistance level is only another 5% higher. Where are the shoddy loans?: During the expansion, corporations were able to borrow on prodigally easy terms. If banks aren't holding the loans, who is? Feature That’s New York’s future, not mine – “Hold On” (Reed) For someone who entered the business as a sell-side trader, it is a matter of course that prices can diverge from fundamentals. The trading desk had a one-day horizon, and the traders necessarily made their way on price signals while barely considering fundamentals. Though the junior traders had been exposed to dividend discount models at their fancy colleges, the ones who lasted recognized they weren’t relevant to the desk’s mission. Trading the daily flow required accepting that new news can have a dramatically larger effect on stocks in the here and now than it would on the lifetime stream of earnings available to common shareholders. Long-run fair value might solely turn on the fundamentals, but animal spirits hold sway over any given tick. The sudden stop imposed by stay-at-home orders has made backward-looking economic data nearly irrelevant, but the sizable upward surprises in unemployment claims should not be ignored. Our Global Investment Strategy colleagues showed last week just how difficult it is for even severe near-term shocks to materially alter the present value of aggregate future earnings.1 Furthermore, the market effects of negative earnings shocks are inherently self-limiting at the margin because they tend to be accompanied by lower interest rates, driving up the equity risk premium and making stocks more attractive relative to “safe” fixed income alternatives. Bear markets coincide with recessions, though, as near-term earnings expectations are revised lower and animal spirits droop (Chart 1). Given that the recession just begun is expected to be the worst since the Great Depression, one would expect that equities would be stumbling in search of a bottom as investors remained fearful of taking on risk. Chart 1Joined At The Hip Joined At The Hip Joined At The Hip They have instead been acting like the S&P 500 found that bottom on March 23rd, when the index completed a 35% peak-to-trough decline in just 23 sessions. It then proceeded to gain 28.5% over the next eighteen sessions. Some retracement is to be expected after a sudden, sharp move, and the S&P 500 has only recovered half of the ground that it lost. It certainly priced in a great deal of bad news on the way down, but the data have been worsening, and investors have been forced to give up on the notion of a swift economic recovery. Why are stocks rising when economic projections are being downwardly revised and good virus news has been few and far between? We ourselves have been barely glancing at backward-looking economic data releases that merely confirm the well-understood fact that draconian social distancing measures have wrung much of the life out of the economy. The degree to which job losses have outrun consensus forecasts stands out nonetheless. Aggregate initial unemployment claims over the last five weeks have exceeded consensus expectations by 5.5 million (Table 1). Even though the forecasts have caught up to the situation on the ground, the claims data suggest that unemployment is now pushing 20%, a worst-case-scenario level that is far above the first forecasts that incorporated the effects of stay-at-home orders. Claims may well have peaked, but they’re still an order of magnitude higher than normal, and they are not finished exerting upward pressure on the unemployment rate. Table 1Job Losses Have Been Worse Than Expected Dichotomy Dichotomy Meanwhile, COVID-19 data have yet to provoke much optimism. The rate of US infections has yet to come down to Italy’s level (Chart 2), and hopes that remdesivir might prove to be a wonder drug were dashed late last week. Clients are increasingly asking us why the stock market is traveling such a dramatically different path than the economy and the virus. How could stocks have plunged at a record rate as the coronavirus drew a bead on the United States, but surged after crippling social distancing measures were put in place? Chart 2The US Has Fallen Behind Italy's Pace Dichotomy Dichotomy A Tale Of Two Boroughs The simplest answer is that the Fed’s response was swifter and more far-reaching than expected. Ditto Congressional actions, and we expect that DC will continue to deploy its fiscal firepower to try to shield households and businesses from the worst of the effects of the anti-virus measures. We believe the monetary and fiscal efforts will make a difference, and do not think it’s a coincidence that equities turned around the week of March 23rd, which began with the Fed’s rollout of a formidable new arsenal and ended with the passage of the CARES Act. But the market action has not accounted for the shift from expectations of a V-bottom to talk of Us, Ls and Ws. Two articles published a week apart in The New Yorker vividly illustrated a demographic virus gap. The first looked at COVID-19 from the perspective of financial professionals at hedge funds and other sophisticated investment aeries.2 Although the views of the investors in the profile shifted with the tide of the incoming data, they were generally of the mind that the health threat was being dramatically overhyped. One retired hedge fund manager boasted about his and his family’s non-stop early March air travel between New York, London and a Wyoming ski resort. The second article followed an emergency room resident at Elmhurst, a publicly funded hospital in a working-class Queens neighborhood, which has been described as the epicenter of the outbreak in several local media reports.3 “‘It’s become very clear to me what a socioeconomic disease this is,’” he said. “‘Short-order cooks, doormen, cleaners, deli workers – that is the patient population here. Other people were at home, but my patients were still working. A few weeks ago, when they were told to socially isolate, they still had to go back to an apartment with ten other people. Now they are in our cardiac room dying.’” Stock ownership is largely reserved to the affluent, with the top percentile of households owning 53% of equities as of the end of 2019, and the rest of the top decile owning another 35% (Chart 3). For households in the top decile, maintaining a healthy distance from the virus isn’t that difficult. Knowledge workers equipped with a laptop and a reliable internet connection can work from anywhere, unlike the Elmhurst patients in low-skilled service positions who have to work onsite. The tonier precincts of Manhattan feel nearly deserted, with their residents having decamped for second homes in lower-density areas. Perhaps it's because the Fed's attempts to shore up the economy have far more personal relevance for investors than the spread of the virus. There are no comprehensive data series on virus infections and outcomes by zip code, which would facilitate analysis of the link between household wealth and COVID-19, but New York state reports age-adjusted fatality rates in four racial/ethnic categories. In New York state ex-New York city, which has lesser extremes of wealth than the city itself, the cross-category disparities are striking (Chart 4). Race/ethnicity is far from an ideal proxy for inequality, but it is fair to conclude that financial market participants have a sound basis for being more sanguine about the virus than the overall population. Assuming that more affluent households will be able to remain out of the virus’ reach, the dichotomy can persist for as long as the economic impacts do not become so bad that investors cannot reasonably look through them. Chart 3Demographics Drive Stock Ownership ... Dichotomy Dichotomy Chart 4... And COVID-19 Fatalities Dichotomy Dichotomy Technical Resistance Back on the trading desk, technical analysis was the go-to tool for traders pricing large blocks of stock in real time. Following sizable moves, the Fibonacci sequence provided a popular method for assessing how far a stock might retrace its steps before resuming its course. The most widely used Fibonacci retracement levels are 38% and 62%, and 50%, a round number exactly between the two, has also become an anticipated stopping point. From the February 19 closing high of 3,386.15 to the March 23 closing low of 2,237.40, the S&P 500 lost 1,148.75 points. The 38%, 50% and 62% retracement levels are 2,673.93, 2,811.78 and 2,949.63, respectively. The S&P paused at the 38% level for just two days before breaking through it decisively, but it’s had more trouble making its way through 2,812, failing to hold above it for more than a day or two at a time (Chart 5). Should it escape 2,812, the 2,950 level waits just 5% higher. Chart 5Fibonacci Retracement Levels For The S&P 500 Fibonacci Retracement Levels For The S&P 500 Fibonacci Retracement Levels For The S&P 500 We are fundamental investors who do not get hung up on technical levels, though they can become self-fulfilling prophecies if enough participants are following them. Given the popularity of Fibonacci retracement, it is possible that a critical mass of short-term investors may view 2,812 and 2,950 as preferred levels for exiting long positions in the S&P. Our bigger near-term concern is that it is hard to see US equities making much more headway while the virus and ongoing distancing measures have the potential to cause investors to revise their fundamental expectations lower and/or lose a little bit of their policy-fueled nerve. Who's Left Holding The Bag? Multiple commentators have expressed alarm at the post-2008 increase in corporate debt, especially given anecdotal reports that lending covenants had been loosened dramatically. If the banks don’t hold the debt, as we’ve argued, who does, and could a wave of virus-inspired defaults cause larger problems in the financial system? The Fed’s fourth quarter Flow of Funds report, published last month, provides some clues, but does not answer the question definitively. As we saw in higher frequency data on aggregate banking system exposures, bank loans to nonfinancial corporations grew modestly (3.2% annualized) since December 31, 2008. Nonfinancial corporations borrowed in the bond market at double that rate (6.2% annualized). Foreign loans, powered by near doubling in 2017 and 2018, grew at an annualized 13.4% pace, and are four times as large as they were at the end of 2008. Finance company loans have shrunk, and trade payables grew at a modest 2% rate. (Chart 6). Chart 6Debt Risks Are Pretty Well Diffused Dichotomy Dichotomy Publicly available data from Preqin on the capital raised by direct lending funds suggests that their impact has been modest, accounting for only about a quarter of outstanding bank loans if every dollar they’ve raised is currently deployed. Demand for leveraged loans, senior floating-rate debt issued to high-yield borrowers, was occasionally intense as investors sought protection from rising rates. The desire for duration protection has faded as rates have plunged to new lows, but ETFs and CLOs were eager buyers at points during the last expansion. In a Special Report published last summer, our US Bond Strategy and Global Fixed Income Strategy services concluded that the ownership of leveraged loans is diffuse enough that credit strains are unlikely to pose a systemic threat. They were also encouraged that leveraged loans and high yield corporate bonds act as substitutes, keeping one another in check as investor preferences for fixed and floating instruments wax and wane. They also noted that leveraged loan lending standards had tightened last year, with a reduced share of covenant-lite loans being issued, though standards have eased again since they published their report (Chart 7). Chart 7Covenant Protections Have Eroded Covenant Protections Have Eroded Covenant Protections Have Eroded Chart 8Diverse Corporate Bond Ownership Will Help Mitigate The Effect Of Defaults Dichotomy Dichotomy There is no way around the fact that high yield corporate bondholders (Chart 8), owners of CLO tranches rated below AAA and leveraged loan holders face elevated credit losses as the broad economic shutdown provokes a wave of defaults in instruments without Fed support. We expect that the default losses will be spread out across enough constituents that they will not become worryingly concentrated, but they may contribute to a further erosion of risk appetites.       Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 Please see the April 23, 2020 Global Investment Strategy Weekly Report, "Could The Pandemic Actually Raise Stock Prices?" available at gis.bcaresearch.com. 2 Paumgarten, Nick. "The Price of a Pandemic." The New Yorker, April 20, 2020, pp. 20-24. The article, relaying traders’ conversations, contains some profanity. 3 Galchen, Rivka. "The Longest Shift." The New Yorker, April 27, 2020, pp. 20-26. The article, relaying ER conversations, contains some profanity.

Dear Client, Please join me and my fellow BCA Strategists Caroline Miller and Arthur Budaghyan for a live webcast tomorrow, Friday, April 24 at 8:00 AM EDT (1:00 PM BST, 2:00 PM CEST, 8:00 PM HKT) where we will discuss the outlook for developed and emerging market equities over the immediate (0-3 month) and cyclical (12 month) horizon. In lieu of our regular report next week, we will be sending you a Special Report from my colleague Jonathan LaBerge. Jonathan will discuss the global fiscal response to the COVID-19 pandemic, and will provide some perspective on whether the response will be enough to prevent an "L-shaped" economic outcome. I hope you find the report insightful. Best regards, Peter Berezin, Chief Global Strategist Highlights Theoretically, the pandemic could raise the long-term fair value of equities – as proxied by the present value of future cash flows – if it causes the discount rate to fall by more than enough to offset the decline in corporate earnings. While such a seemingly bizarre outcome is not our base case, it cannot be easily dismissed, especially since the evidence suggests that real long-term interest rates have fallen a lot more since the start of the pandemic than have earnings estimates. We consider a number of challenges to this claim, including: current earnings estimates are too optimistic; long-term interest rates are being distorted by QE and other factors; and the equity risk premium will be higher in a post-pandemic world. While all these counterarguments have merit, none of them are airtight. Even if the pandemic ultimately boosts stock prices, the path to new highs will be a bumpy one. In the near term, a slew of bad economic data could cause another bout of market turbulence. Nevertheless, over a 12-month horizon, investors should continue to overweight equities relative to cash and bonds. The plunge in front-end oil futures this week was a timely reminder of the extent to which the pandemic has suppressed crude demand. Oil prices should bounce back later this year as global growth recovers, the dollar weakens, and more oil supply is taken offline. A Counterintuitive Scenario Chart 1EPS Growth Scenarios Could The Pandemic Lead To Higher Stock Prices? Could The Pandemic Lead To Higher Stock Prices? Could the pandemic end up raising the long-term fair value of equities – as proxied by the present value of future cash flows – compared with a scenario in which the virus never emerged? Such an outcome sounds far-fetched but could occur if the pandemic causes the discount rate to fall by more than enough to offset the decline in corporate earnings. How likely is such an outcome? To get a sense of the answer, let us consider a simple example where, prior to the pandemic, cash flows to shareholders were expected to grow by 2% per annum, the risk-free interest rate was 2%, and the equity risk premium was 5% (implying a discount rate of 7%). Let us suppose that the pandemic temporarily reduces corporate profits by 60% in 2020, 40% in 2021, and 20% in 2022 relative to the aforementioned baseline, with earnings returning to trend beyond then (Chart 1, Scenario 1). All things equal, an earnings shock of this magnitude would reduce the present value of corporate profits by 5.4%. For the present value to return to its original level, the discount rate would have to fall by 27 bps. How does this example square with reality? While it is impossible to know what would have happened in the absence of the pandemic, we can observe that S&P 500 EPS estimates have so far fallen by 22% for 2020 and 11% for both 2021 and 2022 since the start of the year. Meanwhile, the 30-year TIPS yield – a proxy for long-term real interest rates – has fallen by 75 bps, and is down 138 bps since the beginning of 2019. Based on this comparison, one can conclude that the decline in rate expectations has been large enough to offset the drop in projected earnings. Four Counterarguments The discussion above makes a number of assumptions that could easily be challenged. Let us consider four counterarguments to the claim that the pandemic has increased the long-term fair value of equities. As we shall see, while all four counterarguments are valid, none of them are bulletproof. Bottom-up earnings estimates are too optimistic. As estimates come down, so will stock prices. Calculations of long-term risk-free rates are being distorted by QE and other factors. If a more cautious mindset results in a lower risk-free rate, it should also result in a higher equity risk premium (ERP). A higher ERP would push up the discount rate, reducing the fair value of the stock market. The pandemic could lead to a variety of investor-negative outcomes, including further deglobalization, higher corporate taxes, and the loss of policy maneuverability during the next downturn. Let us examine all four of these counterarguments in turn. 1.   Are Earnings Estimates Too Optimistic? BCA’s US equity strategists expect S&P 500 companies to generate $104 in EPS this year and $162 in 2021. A simple weighted-average of these estimates implies a forward 12-month EPS of $123, compared with the current consensus of $140. Could the pandemic end up raising the long-term fair value of equities? Granted, consensus estimates for any given calendar year usually start high and drift lower over time, reflecting the overoptimistic bias of bottom-up analysts (Chart 2). Nevertheless, the gap between where consensus is today and where we think it will end up is large enough that further negative revisions could still weigh on stocks. As evidence, note that stock prices tend to move in the same direction as earnings revisions and 12-month ahead earnings estimates (Chart 3). Chart 2Are Earnings Estimates Too Optimistic? Could The Pandemic Lead To Higher Stock Prices? Could The Pandemic Lead To Higher Stock Prices? Chart 3Negative Earnings Revisions Will Weigh On Stocks In The Near Term Negative Earnings Revisions Will Weigh On Stocks In The Near Term Negative Earnings Revisions Will Weigh On Stocks In The Near Term The discussion above suggests that stocks could face some downward pressure in the near term, reflecting the tendency for investors to myopically focus on earnings over the next 12 months. This does not, however, negate the possibility that the pandemic could raise the long-term present value of future cash flows. After all, even the earnings projections from our equity strategists are much more benign than those in the stylized example of a 60%, 40%, and 20% decline in EPS for the next three years. In fact, to get something that fully offsets the decline in real yields since the start of the year requires a scenario that not only assumes a 60%, 40%, and 20% drop in earnings, but also assumes that profits remain 10% lower forever relative to the baseline (Chart 1, Scenario 2). 2.    Are Estimates Of Long-Term Risk-Free Rates Distorted To The Downside? Chart 4Rate Expectations Have Come Down Rate Expectations Have Come Down Rate Expectations Have Come Down So far, we have argued that earnings are unlikely to fall by enough over the next few years to counteract the steep drop in long-term interest rates. But, perhaps the problem is not with the earnings projections? Perhaps the problem is with the estimates of the long-term risk-free rate? Conceptually, long-term government bond yields should incorporate the market’s expectation of how short-term interest rates will evolve over the life of the bond plus a “term premium.” The inelegantly named term premium is a catch-all, unobservable variable that captures everything that affects bond yields other than changes in rate expectations. Term premia have fallen in global bond markets since the start of the year, partly because central banks have ramped up bond buying programs with the express intent of pushing down long-term yields. Nevertheless, rate expectations have also come down, as can be gleaned from forward contracts linked to expected overnight rates (Chart 4). This suggests that expectations of lower rates have played an important role in explaining the decline in bond yields. In any case, it is not clear why one should control for the term premium in calculating discount rates. If the idea is to compare bonds with stocks, then one should look at bond yields directly, rather than trying to ascertain what yields would hypothetically be in the absence of various distortions – especially if these distortions are unlikely to go away anytime soon. You can’t eat hypothetical profits. 3.    Projecting The Equity Risk Premium If overly optimistic earnings estimates and a distorted risk-free rate cannot fully counteract the claim that the pandemic has raised the long-term fair value of equities, what about the third driver of present value calculations: the equity risk premium (ERP)? While the ERP cannot be observed directly, it is possible to infer it by looking at the difference between the long-term earnings yield and the real bond yield. Under some simplifying assumptions, the earnings yield provides a good estimate of the long-term real total return to holding stocks.1 To the extent that the earnings yield has risen this year, while the risk-free rate has fallen, one can infer that the equity risk premium has gone up. However, there is no money in observing today’s equity risk premium; the money is in projecting it. The equity risk premium can shift a lot over the course of the business cycle. This is why the stock-to-bond ratio moves so closely with, say, the ISM manufacturing index (Chart 5). Chart 5Stock-To-Bond Ratio And Economic Growth Go Hand-In-Hand Stock-To-Bond Ratio And Economic Growth Go Hand-In-Hand Stock-To-Bond Ratio And Economic Growth Go Hand-In-Hand Like many financial market variables, the ERP has tended to be mean reverting. Today, the ERP is above its long-term average both in the US and the rest of the world, which suggests that it may decline over time (Chart 6). If that were to happen, stocks would almost certainly outperform bonds. Chart 6Favor Equities Over Bonds Over A 12-Month Horizon Favor Equities Over Bonds Over A 12-Month Horizon Favor Equities Over Bonds Over A 12-Month Horizon Yet, in an environment where caution reigns supreme, might the ERP stay elevated? After all, if risk-free bond yields remain low because people are more reluctant to spend, wouldn’t that mean that investors will continue to demand an additional premium to holding stocks? Perhaps, but this assumes that bonds will retain their safe-haven characteristics. There are two reasons to think that these characteristics may fray in a post-pandemic world. First, with policy rates now close to zero in most markets, there is a limit to how much further bond yields can decline. This means that bond prices will not rise much even if the recession lasts much longer than expected  (Table 1). Table 1Bonds Won't Provide Much Of A Hedge Even In A Severe Recession Scenario Could The Pandemic Lead To Higher Stock Prices? Could The Pandemic Lead To Higher Stock Prices? Second, looking further out, highly indebted governments may try to dissuade central banks from raising rates even once unemployment has fallen back to normal levels. This could lead to higher inflation, imperiling bond investors. While such an outcome would not necessarily be good for stocks, equities will be more insulated than bonds because nominal profits tend to rise more quickly in an environment of higher inflation. As such, one could plausibly argue that the equity risk premium should not be any higher, and conceivably should be lower, in a post-pandemic world. 4.     Unintended Consequences Chart 7Global Trade Was Already Stalling Global Trade Was Already Stalling Global Trade Was Already Stalling While it is too early to say with any confidence what the long-term effects of the pandemic will be, it is certainly possible that they will be momentous. Globalization had already stalled before the eruption of the Sino-US trade war (Chart 7). It could go into reverse if trade tensions remain elevated and countries increasingly focus on ensuring that they have enough domestic capacity to produce various essential goods. Support for pro-business, laissez-faire policies could also wane further. Prior to the pandemic, BCA’s geopolitical team gave President Trump a 55% chance of being re-elected. Now, with the economy in shambles, they only give him a 35% chance. If the Democrats take control of the White House and both Houses of Congress, Trump’s corporate tax cuts are sure to be watered down if not fully reversed. The pandemic could also limit the ability of policymakers to respond to the next downturn. Interest rates cannot be cut further and high debt levels may limit fiscal maneuverability, especially for countries that do not have access to their own printing press. To be sure, there could be some silver linings. Many lessons have been learned over the past few months. If another pandemic were to occur, we will be better prepared. Meanwhile, gratuitous business travel will be curtailed now that people have grown more comfortable with videoconferencing. And just like the space race inspired a generation of scientists and engineers, the pandemic could motivate more young people to pursue a career in medical research. Investment Conclusions While not our base case, we would subjectively assign a 25% probability to an outcome where the pandemic ends up raising the long-term present value of corporate cash flows by pushing down the discount rate by more than enough to offset the near-term drop in profits. Chart 8Don't Rush Into Growth Stocks Just Yet, As Value Stocks Are Still Cheap Don't Rush Into Growth Stocks Just Yet, As Value Stocks Are Still Cheap Don't Rush Into Growth Stocks Just Yet, As Value Stocks Are Still Cheap Even if the pandemic leaves stocks lower than they otherwise would have been, the current equity risk premium is high enough to warrant overweighting global equities over bonds on a 12-month horizon. Of course, stocks are unlikely to sail smoothly to new highs on the back of lower interest rates alone. As we discussed last week in a reported entitled “Still Stuck in The Tree,” it will be difficult to dismantle ongoing lockdown measures until a mass-testing regime is put in place, something that is still at least a few months away at best.2 With the data on the economy and corporate earnings set to disappoint in the near term, stocks could give up some of their recent gains. Thus, while we are still bullish on equities on a long-term horizon, we are more cautious on a short-term, 3-month horizon.  Drilling further down, the decline in long-term rates this year is likely to create winners and losers across all asset classes. Some of the winners and losers are fairly straightforward to identify. For instance, growth stocks, whose market value hinges on anticipated cash flows that may not be realized until far into the future, gain relatively more from lower rates than value stocks. Banks, which are overrepresented in value indices, have suffered from the flattening of yield curves and lower rates in general. That said, given that value stocks currently trade at a multi-decade discount to growth stocks, we would not recommend that clients chase growth stocks at this juncture (Chart 8). Other winners and losers from lower rates may be less readily discernible. For example, consider the US dollar. The greenback benefited over the past few years from the fact that US rates were higher than those abroad. That rate differential has narrowed significantly recently as the Fed brought interest rates down to zero (Chart 9). Yet, the dollar has managed to remain well bid thanks to safe-haven flows into the Treasury market. Looking out, if the Fed succeeds in easing dollar funding pressures, as we expect will be the case, the dollar will weaken. Chart 9Rate Differentials Are No Longer A Tailwind For The US Dollar Rate Differentials Are No Longer A Tailwind For The US Dollar Rate Differentials Are No Longer A Tailwind For The US Dollar The plunge in near-term oil futures this week was a reminder of the extent to which the pandemic has suppressed crude demand. Transportation accounts for over half of global oil usage. Going forward, the combination of a weaker dollar, increased supply discipline, and a rebound in global growth in the second half of this year will help lift oil prices (Chart 10). Our energy analysts see WTI and Brent returning to $38/bbl and $42/bbl, respectively, by the end of the year following the drumming they received this week (Chart 11).3 Chart 10Commodity Prices Usually Rise When The Dollar Weakens Commodity Prices Usually Rise When The Dollar Weakens Commodity Prices Usually Rise When The Dollar Weakens Chart 11Oil Prices Expected To Recover Oil Prices Expected To Recover Oil Prices Expected To Recover Oil prices tend to be strongly correlated with inflation expectations (Chart 12). As inflation expectations rise, real rates could fall further, giving an additional boost to equity valuations.   Chart 12Inflation Expectations And Oil Prices Tend To Move Closely Together Inflation Expectations And Oil Prices Tend To Move Closely Together Inflation Expectations And Oil Prices Tend To Move Closely Together Peter Berezin Chief Global Strategist peterb@bcaresearch.com   Footnotes 1  For a more in-depth discussion on this, please see Global Investment Strategy Special Report, “TINA To The Rescue,” dated August 23, 2019. 2  Please see Global Investment Strategy Weekly Report, “Still Stuck In The Tree,” dated April 16, 2020. 3  Please see Commodity & Energy Strategy Weekly Report, “USD Strength Restrains Commodity Recovery,” dated April 23, 2020; Special Alert, “WTI In Free Fall,” dated April 20, 2020; and Weekly Report, “US Storage Tightens, Pushing WTI Lower,” dated April 16, 2020. Global Investment Strategy View Matrix Could The Pandemic Lead To Higher Stock Prices? Could The Pandemic Lead To Higher Stock Prices? Current MacroQuant Model Scores Could The Pandemic Lead To Higher Stock Prices? Could The Pandemic Lead To Higher Stock Prices?

Highlights In mainstream EM, foreign currency debt restructuring is more likely to occur among corporates than governments. Thus, dedicated EM credit investors should overweight mainstream EM sovereign credit and underweight EM corporate debt. Urgency among EM companies and banks to hedge their large foreign currency liabilities will continue exerting downward pressure on EM exchange rates. Ongoing currency depreciation and the lack of buyers of last resort for EM credit underpin the following strategy: short EM sovereign and corporate credit / long US investment-grade corporate credit. Feature Scope And Focus Of Analysis This report re-visits the issue of EM foreign currency debt, assessing EM debt vulnerability. This report focuses on mainstream EM (countries included in Table 1), excluding Gulf countries and frontier markets. Frontier markets like Argentina, Ecuador, Egypt, Ukraine, Lebanon and sub-Saharan African countries occupy somewhat idiosyncratic positions and are therefore not part of this report. Gulf countries on the other hand, are extremely leveraged to oil prices and, unlike mainstream EMs they have currency pegs warranting a separate analysis.1 Chart 1Favor EM Sovereign Against EM Corporate Credit Favor EM Sovereign Against EM Corporate Credit Favor EM Sovereign Against EM Corporate Credit Among mainstream EM countries, public debt restructuring is not imminent and in the majority of cases is unlikely. However, there is a growing risk of foreign currency debt restructuring among EM companies and banks. Hence, we make a new investment recommendation: overweight mainstream EM sovereign credit / underweight EM corporate debt (Chart 1). We also reiterate the short EM sovereign and corporate credit / long US investment-grade corporate credit strategy. In this report, foreign currency debt is defined as the sum of foreign debt securities (i.e., foreign currency bonds) and foreign currency loans. In short, foreign currency debt measures foreign currency borrowing of companies, banks and governments. These statistics do not include foreign holdings of local currency bonds and equities or any other local currency liability of residents to foreigners. Overall, the level of foreign currency debt is pertinent in assessing EM debt vulnerability originating from exchange rate depreciation. Table 12 offers comprehensive foreign currency debt statistics for each individual country and EM as a whole. It details foreign currency debt by type of borrower - the government, corporates and banks – and also reveals the breakdown between foreign debt securities and foreign currency loans for each segment. Table 1EM FX Debt: Who Owes How Much EM: Foreign Currency Debt Strains EM: Foreign Currency Debt Strains Chart 2EM FX Debt Has Doubled Since 2008 EM FX Debt Has Doubled Since 2008 EM FX Debt Has Doubled Since 2008 The foreign currency debt of Chinese companies and banks is quite substantial relative to other EM countries. Hence, including China in the EM aggregates would materially affect these EM aggregates. We thus focus our analysis on EM ex-China and present China’s numbers separately. Since early 2009, EM ex-China aggregate foreign currency debt has doubled to about $3 trillion (Chart 2). Furthermore, this $3 trillion EM ex-China foreign currency debt is split as follows in terms of borrower type: non-financial corporates ($1.25 billion), banks ($846 billion) and governments ($878 billion). Government Foreign Currency Debt Among mainstream EM countries, foreign currency government debt is not vulnerable to restructuring or default. The reason is that the foreign currency debt burden of governments is low, having declined dramatically in the last decade. Table 2 illustrates that the share of local currency government debt is by far greater than the foreign currency debt in each EM country. Table 2EM Public Debt: Local Currency Exceeds FX Debt EM: Foreign Currency Debt Strains EM: Foreign Currency Debt Strains In the past 10 years, EM governments have deliberately replaced their foreign currency debt with local currency debt. Search for yield by international fixed-income investors has facilitated this debt swap: enormous foreign demand for EM domestic bonds has allowed EM governments to issue a considerable amount of local currency bonds. Chart 3EM Foreign Exchange Reserves Are Large EM Foreign Exchange Reserves Are Large EM Foreign Exchange Reserves Are Large In addition, mainstream EM countries, with exception of Turkey and South Africa, hold large foreign currency reserves (Chart 3). Lately, several mainstream EM countries have gained a new defense tool from the Federal Reserves – US dollar swap lines. EM central banks’ swap lines with the Fed are primarily intended to instill confidence among investors in financial markets. They could be used to fend off short-term speculative attacks on EM currencies. Nevertheless, they cannot alleviate insolvency problems. We will elaborate more about these swap lines with the Fed in another report this week. As to local currency public debt, the odds of debt restructuring are also low. First, the majority of EM countries have low aggregate public debt burdens as a share of the GDP (Table 2). Second, the majority of these nations have flexible currency regimes. This means that their central banks control the printing press. In the worst-case scenario - when investors become reluctant to own EM local currency government bonds, EM central banks can buy those bonds in both the secondary or primary markets if needed. In short, EM central banks can resort to a form of quantitative easing, i.e., purchasing local currency government bonds that would amount to public debt monetization. The wild card in this case will be the exchange rate – the currencies could depreciate substantially amid public debt monetization by central banks. Given that government liabilities in foreign currencies have declined substantially, exchange rate depreciation will not be a constraint for policymakers’ ability to monetize local currency debt. Remarkably, in the past two months amid the global indiscriminate selloff, central banks in several EM countries have begun purchasing government bonds or have stated that they will do so if required. This has created a precedent that will be used in future. One country that has large local currency government debt is Brazil. We have previously argued that Brazil requires robust nominal GDP growth to climb out of a public debt trap. With the COVID-19 crisis, the outbreak for its public debt has worsened considerably. Without the central bank monetizing public debt, it will be difficult for Brazil to escape rising government debt strains and, ultimately, local currency debt restructuring. In short, the cost of avoiding local currency public debt restructuring in Brazil could be large currency depreciation. Bottom Line: In mainstream EM, neither foreign currency nor local currency government debt face an imminent risk of restructuring. Public debt restructuring and defaults are occurring in Argentina and among frontier markets like Ecuador, Lebanon and a few sub-Saharan nations that are beyond the scope of this report. If local currency government bond markets become anxious about public debt sustainability, EM central banks could purchase government paper. If done on large scale, this will cause further currency depreciation. Corporate Foreign Currency Debt From a macro perspective, there are presently some pre-conditions that herald rising odds of foreign currency debt restructuring among EM corporates and banks: (1) rapid and massive foreign currency debt built up in the past 10-15 years; (2) substantial plunge in corporate revenues; and (3) massive currency depreciation. Taken together, these create fertile ground for debt restructuring by some corporate debtors. Foreign currency debt of companies and banks in mainstream EM ex-China countries has swelled in the past 10 years reaching $2.1. Bonds account for about $1.4 trillion while foreign currency loans account for the remaining $0.7 trillion. The global recession brought about by the COVID-19 pandemic is producing a collapse in EM companies’ local currency revenues and exports. Notably, EM ex-China exports were contracting even before the COVID-19 outbreak and they are currently crashing (Chart 4). Chart 4EM Exports & Corporate Credit Spreads EM Exports & Corporate Credit Spreads EM Exports & Corporate Credit Spreads Chart 5Commodities Prices And Currencies Drive EM Credit Spreads Commodities Prices And Currencies Drive EM Credit Spreads Commodities Prices And Currencies Drive EM Credit Spreads The top panel of Chart 5 illustrates EM corporate credit spreads (inverted) correlate with commodities prices. Hence, plunging commodities prices entail growing foreign currency debt stress for EM companies and banks. Finally, EM ex-China currencies have depreciated substantially making foreign currency debt more expensive to service (Chart 5, bottom panel). Please refer to Box 1 attesting that for EM debtors with US dollar liabilities, EM exchange rate depreciation is worse than that of higher US bond yields.     Box 1 What Is More Imperative For EM FX Debt: Exchange Rates Or Interest Rates? EM debtors with dollar debt are much more vulnerable to an appreciating dollar than rising US interest rates. Table 3 illustrates this point using the following hypothetical simulation: We consider a conjectural Brazilian debtor with $1,000 in debt with five years remaining to maturity, and a starting point exchange rate of 4 BRL per USD. In our example, a 5% depreciation in local currency against the dollar boosts the overall debt burden by 200 BRL (please refer to row 2 of Table 3). This does not include the rise in local currency costs of interest payments. It reflects only the increased burden of principal. Table 3A Hypothetical Simulation: FX Debt Burden Is More Sensitive To Exchange Rate Than Borrowing Costs EM: Foreign Currency Debt Strains EM: Foreign Currency Debt Strains An equivalent rise in debt servicing costs in local currency will require a 100-basis-point increase in US dollar borrowing costs. In brief, US dollar rates should rise by 100 basis points for interest payments to increase by BRL 200 over a five-year period, the time remaining to maturity. This simulation reveals that a 5% dollar appreciation versus local currency is as painful as a 100 basis points rise in US dollar rates and is more burdensome if the cost of coupon payments is accounted for. Provided there are higher odds of 5% currency depreciation in many EMs than a 100-basis-point rise in US dollar borrowing costs, we infer that EM FX debtors’ creditworthiness is more sensitive to exchange rates than to US Treasury yields. As the bottom panel of Chart 5 above clearly demonstrates, EM corporate and sovereign credit spreads correlate strongly with EM exchange rates. Consequently, the trend in EM exchange rates versus the US dollar is much more important for EM credit spreads than fluctuations in US bond yields. As to the currency composition of EM FX debt, about 82% of EM external debt is in US-dollar terms. Bottom Line: So long as EM currencies depreciate against the greenback, EM FX debt stress will mount, and EM corporate and sovereign credit spreads will widen. This will occur irrespective of whether US Treasury yields rise or drop.   If the bear market in commodities persists and/or EM currencies depreciate further – which is our baseline scenario, defaults on and restructuring of foreign currency debt among EM companies and banks are probable. One avenue to avoid corporate defaults is for the government to guarantee or assume the banks’ and companies’ foreign currency liabilities. It is probable because many of these borrowers are large entities with close links to their governments. However, governments will step in only after a debtor is on the brink default and its credit spreads are very wide. Briefly put, investors should be careful not to bet too early on government backstops of EM corporates’ and banks’ foreign currency debt. Identifying which corporate issuers could default or restructure debt involves bottom-up analysis that is beyond the scope of the macro research that BCA specializes in. An important question is what portion of corporate foreign currency liabilities have these debtors already hedged? Unfortunately, there are no macro data to answer this question either. Judging by the magnitude and speed of EM currency depreciation we have seen in the past two months, odds are that they have already partially hedged their exchange rate risk. Yet, given the sheer size of foreign currency liabilities, it is hard to imagine that corporates and banks have hedged all of them. Below we analyze each countries’ ability to service its foreign currency debt from a macro perspective. Vulnerability Assessment From a macro standpoint, foreign debt servicing vulnerability can be measured by foreign debt obligations (FDOs) and foreign funding requirements (FFRs). Chart 6EM FDOs And FFRs (Annualized) EM FDOs And FFRs (Annualized) EM FDOs And FFRs (Annualized) FDOs are the sum of debt expiring in the next 12 months, and interest as well as amortization payments over the next 12 months. FDO data are available until Q3 of 2019 (Chart 6, top panel). Hence, using this latest datapoint is pertinent to gauging the ability of individual countries to service their foreign debt over the coming six months. FFRs are the sum of FDOs in the next 12 months and current account balance (Chart 6, bottom panel). It measures the amount of foreign capital inflows required in the next 12 months for a country to cover any shortfalls in its balance of payment dynamics. Exports Coverage Of FDO: This measure compares annualized US dollar export revenues available to each country to its foreign debt service obligations in the next 12 months (Chart 7). The most vulnerable countries according to this measure are Brazil, Colombia, Turkey and Peru. On the other hand, Russia, Mexico, India & Korea have higher exports-to-FDO ratios. Chart 7Exports-To-Foreign Debt Obligations Ratio EM: Foreign Currency Debt Strains EM: Foreign Currency Debt Strains Foreign Exchange Reserves-to-FFRs Ratio: These metrics compare the size of foreign exchange reserves held by each nation’s central bank to its FFRs in the next 12 months (Chart 8). By this measure, Chile, Colombia, Turkey, Indonesia and Mexico have large FFRs relative to their central bank foreign exchange reserves. Meanwhile, Russia, Korea and Thailand fare well on this metric. Chart 8FX Reserves-To-Foreign Funding Requirements EM: Foreign Currency Debt Strains EM: Foreign Currency Debt Strains On the whole, Chart 9 is a scatter plot combining both FDO and FFR measures to determine the most and least vulnerable EMs. The most vulnerable EMs are Brazil, Turkey, Colombia and Chile. Meanwhile, Russia, Korea, India and the Philippines are the least vulnerable. Chart 9EM FX Debt And Currency Vulnerability EM: Foreign Currency Debt Strains EM: Foreign Currency Debt Strains Investment Recommendations So long as EM currencies depreciate against the greenback, EM foreign currency debt stress will mount, and EM corporate and sovereign credit spreads will widen. We remain bearish on EM currencies. They usually trade with the global business cycle and the latter remains in free fall. We continue recommending shorting a basket of the following currencies versus the US dollar: BRL, CLP, ZAR, IDR, PHP and KRW. There will likely be no imminent restructuring or default on public debt in mainstream EM countries, outside frontier markets like Argentina, Ecuador, Lebanon and sub-Saharan African countries. However, there could be meaningful credit stress among EM corporate issuers. Consequently, dedicated EM credit investors should overweight mainstream EM sovereign credit and underweight EM corporate debt. We continue to recommend underweighting EM sovereign and corporate credit versus US investment-grade corporate credit (Chart 10). Not only is the Fed buying US investment-grade and some high-yield bonds but US companies will also benefit from the substantial fiscal stimulus. In EM, corporates and banks lack such support. Crucially, in contrast to US corporates, EM issuers also suffer from currency depreciation. Within the EM sovereign credit universe, our overweights are Russia, Mexico, Peru, Thailand and Malaysia. Underweights include South Africa, Brazil, Indonesia, the Philippines and Turkey. The rest warrant a neutral allocation within an EM sovereign credit portfolio. Finally, within corporate credit, we reiterate our long-standing recommendation of long Asian investment-grade corporates / Asian short high-yield corporate (Chart 11). We continue recommending shorting a basket of the following currencies versus the US dollar: BRL, CLP, ZAR, IDR, PHP and KRW. Chart 10Remain Underweight EM Credit Versus US IG Credit Remain Underweight EM Credit Versus US IG Credit Remain Underweight EM Credit Versus US IG Credit Chart 11Long Asian IG Corporate / Short Asian HY Corporate Long Asian IG Corporate / Short Asian HY Corporate Long Asian IG Corporate / Short Asian HY Corporate     Andrija Vesic Associate Editor andrijav@bcaresearch.com Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Footnotes 1We will publish a report on Saudi Arabia in the coming weeks. 2We have compiled data on foreign currency securities issued by non-financial companies and banks from Bloomberg. Bloomberg data accounts for the nationality of debt issuers. For instance, a US dollar bond issued by a Brazilian corporate subsidiary or a shell company located in the Cayman Islands is counted as Brazilian foreign corporate debt, rather than a Cayman Island debt security. For foreign loans, we use the Bank of International Settlements (BIS) datasets on Banking Statistics.

Highlights Investment Grade: Investors should overweight investment grade corporate bonds relative to a duration-matched position in Treasury securities, with a particular focus on bonds that are eligible for the Fed’s purchase programs. High-Yield: Caution is still warranted in the high-yield market. At current levels, spreads do not adequately compensate investors for the coming default cycle. We would recommend buying high-yield if the average index spread rises to a range of 1075 bps – 1290 bps. Fed Purchases: Fed corporate bond purchases will cause investment grade spreads to tighten, particularly out to the 5-year maturity point. However, the program won’t stop the coming onslaught of ratings downgrades. High-Yield Sectors: The Energy, Transportation, Capital Goods, Consumer Cyclical and Consumer Noncyclical sectors are all highly exposed to the looming default cycle. Financials and Utilities look like the best places to hide out. Feature Chart 1Will The Fed's Corporate QE Mark The Top In Spreads? Will The Fed's Corporate QE Mark The Top In Spreads? Will The Fed's Corporate QE Mark The Top In Spreads? The COVID pandemic and associated recession have already caused turmoil in financial markets and prompted a policy response from the Federal Reserve that is unprecedented in its aggressiveness. US investment grade and high-yield corporate spreads widened 280 bps and 764 bps, respectively, to start the year. Then, they tightened by 78 bps and 179 bps, respectively, after the Fed announced it is stepping into the corporate bond market for the first time (Chart 1). Clearly, this is a challenging time for corporate bond investors. But sifting through all the noise, we think there are three key questions to stay focused on: How will the Federal Reserve’s support for the corporate bond market impact spreads? At what level do spreads fully discount the looming default cycle? What sectors within the corporate bond market are most/least at risk of experiencing large-scale defaults? What Can The Fed Hope To Accomplish By Buying Corporate Debt? As part of its package of monetary policy stimulus measures to combat the US COVID-19 recession, the Fed has undertaken a dramatic new step to try and lower borrowing costs for US businesses – the outright buying of US investment grade corporate bonds. The main details of these new programs are as follows: The Fed will purchase investment grade corporate bonds, loans and related exchange-traded funds (ETFs) as part of these programs. Bonds can be purchased in the primary (newly-issued) and secondary markets. The purchases will not be held on the Fed’s balance sheet. Instead, two off-balance sheet Special Purpose Vehicles (SPVs), one for primary market purchases and one for secondary market purchases, will buy the bonds. Both SPVs are initially funded by the US Treasury and will be levered up via loans from the Fed. The primary market SPV will buy newly-issued bonds with credit ratings as low as BBB- and maturities of four years or less.  Eligible issuers are US businesses with material operations in the United States; that list of companies may be expanded in the future. Eligible issuers do not include companies that are expected to receive direct financial assistance from the US government (i.e. no buying of bonds from companies getting bailout funds). The secondary market SPV will buy bonds with maturities of up to five years and credit ratings as low as BBB-, with a buying limit of 10% of the entire stock of eligible debt of any single company. This secondary market SPV will also buy investment grade bond ETFs, up to 20% of the outstanding shares of any single ETF. Through the primary market facility, any eligible company can “borrow” from the Fed, through bond purchases or direct loans, an amount greater than its maximum outstanding debt (bonds plus loans) on any day over the past twelve months. Specifically: 140% of all debt for AAA-rated issuers, 130% for AA-rated issuers, 120% for A-rated issuers and 110% for BBB-rated issuers. Since those percentages are all greater than 100, this effectively means that the Fed will allow eligible companies to potentially roll over their entire stocks of debt through this program, plus some net new borrowing. With the primary market facility, issuers can even defer interest payments on the funds borrowed from the Fed for up to six months, with the interest payments added to the final repayment amount (any company choosing this option cannot do share buybacks or make dividend payments). These programs are set to run until September 30 of this year, with an option to extend as needed. The Fed’s new initiatives represent a new step for the central bank, providing direct lending to any company that needs it. The Fed had to do this through off-balance-sheet SPVs, since direct buying of corporates is not permitted under the Federal Reserve Act. With this structure, it is technically the US Treasury department that bears the initial credit risk through its seed funding of each SPV. The BoJ was the first of the major central banks to start buying corporate bonds. This structure is different than the recent corporate bond QE programs of the European Central Bank (ECB), Bank of England (BoE) and Bank of Japan (BoJ), where the credit risk was directly taken onto the central bank balance sheets. But from an investment perspective, the difference in structure between the Fed’s corporate bond buying program and that of other central banks is nothing more than a technicality. It is still worthwhile to see if any lessons can be learned from these other countries.     The Corporate Bond Buying Experience Of Other Central Banks The BoJ was the first of the major central banks to start buying corporate bonds, in a program that began in February 2009 and continued until October 2012. The program initially involved only the purchase of very high-quality corporate debt (rated A or higher) and only for maturities up to one year. The pool of eligible bonds was later increased to allow for lower credit quality (rated BBB or higher) and longer maturities (up to three years). The BoJ ended up buying a total of 3.2 trillion yen (US$30 billion) of bonds during that program, representing nearly 50% of total Japanese investment grade nonfinancial debt (Chart 2). Credit spreads tightened modestly over the life of the program, particularly for the shorter maturity debt that the BoJ was directly buying.1 Research from the BoJ concluded that the corporate bond buying did improve liquidity for the bonds that were eligible for the program, although there was no discernable pickup in overall Japanese corporate bond issuance.2 The BoE started its Corporate Bond Purchase Scheme (CBPS) in August 2016, as part of a package of stimulus measures to cushion the economic blow from the UK’s stunning vote to leave the European Union. The CBPS bought £10bn of UK nonfinancial investment grade corporate bonds over a period of 18 months, with ratings as low as BBB-. This was a relatively modest share of all eligible nonfinancial bonds (4.7%), but UK credit spreads did tighten over the life of the program (Chart 3). The BoE’s own research has determined that the spread tightening was due to lower downgrade/default risk premiums, and that the program triggered a surge in investment grade issuance in the weeks and months following its launch.3 Chart 2The BoJ's Corporate Bond Buying Experience The BoJ's Corporate Bond Buying Experience The BoJ's Corporate Bond Buying Experience Chart 3The BoE's Corporate Bond Buying Experience The BoE's Corporate Bond Buying Experience The BoE's Corporate Bond Buying Experience The ECB announced its Corporate Sector Purchase Program (CSPP) in March 2016, with the actual bond purchases beginning three months later. This was an expansion of the ECB’s overall Asset Purchase Program that had previously been focused on government debt. Like the BoJ and BoE programs, only nonfinancial debt of domestic euro area companies rated BBB- or higher was eligible. The ECB did buy bonds across a wide maturity spectrum of 1-30 years. The ECB’s purchases in the first 18 months of the CSPP were sizeable, between €60-80bn per month, reaching a cumulative total of nearly 20% of the stock of eligible bonds (Chart 4). This not only drove credit spreads tighter for bonds in the CSPP, but also pushed spreads lower for bonds that were not directly purchased by the ECB, like bank debt. The ECB described this as evidence of a strong “portfolio balance effect”, where investors who sold their bonds to the central bank ended up redeploying the proceeds into other parts of the euro area corporate bond market.4  One major difference between the ECB CSPP and the BoJ and BoE programs was that the ECB could conduct the necessary purchases in the primary market, if necessary. This represented a major new source of funding for smaller euro area companies that did not previously issue corporate bonds, preferring to get most of their debt financing through bank loans. As evidence of this, the year-over-year growth rate of euro area corporate bond issuance soared from 2.5% to 10% in the first year of the CSPP (Chart 5). Chart 4The ECB's Corporate Bond ##br##Buying Experience The ECB's Corporate Bond Buying Experience The ECB's Corporate Bond Buying Experience Chart 5ECB Primary Market Buying Spurred A Boom In Issuance ECB Primary Market Buying Spurred A Boom In Issuance ECB Primary Market Buying Spurred A Boom In Issuance Investment Conclusions Applying these lessons to the US, the first conclusion we reach is that Fed corporate bond purchases will tighten spreads for eligible securities. In this case, eligible securities include all investment grade rated US corporate bonds with maturities less than five years. In effect, the Fed’s primary market facility could be thought of as adding an agency backing to these eligible bonds since the Fed has effectively guaranteed that this debt can be rolled over and that bond investors will be made whole. It’s noteworthy that last week saw a record amount of new investment grade corporate bond issuance as firms rushed to take advantage of the program.    Second, we should see some positive knock-on effects on spreads of ineligible investment grade securities, i.e. investment grade corporate bonds with maturities greater than five years. The impact will not be as large as for eligible securities, but since many of the same issuers operate at both ends of the curve, long-maturity spreads will benefit at the margin from any reduction in interest expense for the issuer. Third, any trickle-down effects to high-yield spreads will be much smaller. No high-yield issuers can benefit from the program, and while the Fed could eventually open up its facilities to include high-yield debt, we wouldn’t count on it. We suspect the moral hazard of “bailing out the junk bond market” would simply be a step too far for the Federal Reserve. We should see some positive knock-on effects on spreads of ineligible securities. In sum, we would advocate an overweight allocation to US investment grade corporate bonds today – especially on securities eligible for the Fed’s programs. We do not recommend a similar overweight stance on US high-yield, where spreads will continue to fluctuate based on the fundamental default outlook (see section titled “Assessing The Value In High-Yield” below). Can The Fed Re-Steepen US Credit Spread Curves And Prevent Ratings Downgrades? Prior to the Fed’s announcement of the new programs, the US investment grade corporate spread curve had become inverted, with shorter maturity spreads exceeding longer maturity ones. This has historically been a harbinger of increased investment grade downgrades and high-yield defaults (Chart 6). With the Fed’s new programs focusing on bonds with maturities of up to five years, the Fed’s buying can potentially lead to a re-steepening of the investment grade spread curve by driving down shorter maturity spreads. Chart 6Inverted US Credit Spread Curves Are Flashing An Ominous Message Inverted US Credit Spread Curves Are Flashing An Ominous Message Inverted US Credit Spread Curves Are Flashing An Ominous Message Already, the investment grade spread curve has begun to disinvert in the first week of the Fed’s programs (Chart 7). At the same time, the bond rating agencies are moving aggressively to adjust credit opinions in light of the US recession. Already, downgrades from Moody’s and S&P are outpacing upgrades by a 3-1 ratio year-to-date – a pace not seen since the depths of the financial crisis, according to Bloomberg.5  Chart 7The Fed's New Programs Are Already Helping Disinvert Investment Grade Spread Curves The Fed's New Programs Are Already Helping Disinvert Investment Grade Spread Curves The Fed's New Programs Are Already Helping Disinvert Investment Grade Spread Curves The Fed’s actions should be successful at re-steepening the investment grade credit curve. However, we doubt that they will have much impact on ratings decisions. While the Fed can reduce borrowing costs and prevent default by rolling over maturing debt for investment grade issuers, this has a relatively minor impact on corporate balance sheet health. In fact, the Fed's programs will only improve balance sheet health for firms that just roll over existing debt loads and don’t take on any new debt. Any firm that takes on new debt during this period will come out of the crisis with more leverage than when it entered. All else equal, that should warrant a downgrade. Bottom Line: Fed corporate bond purchases will cause investment grade spreads to tighten, particularly out to the 5-year maturity point. However, the program won’t stop the coming onslaught of ratings downgrades. Assessing The Value In High-Yield What Kind Of Default Cycle Is Already “In The Price”? High-yield debt may not benefit from the Fed’s corporate bond-buying programs. But, as in every other cycle, there will come a time when spreads discount the full extent of future default losses. At that point it will be appropriate to increase allocations to the sector. Our Default-Adjusted Spread will guide us as we make that determination. Our Default-Adjusted Spread is the excess spread available in the Bloomberg Barclays High-Yield index after subtracting realized default losses. Specifically, we calculate the Default-Adjusted Spread as: Index OAS – [Default Rate x (1 – Recovery Rate)] The default and recovery rates apply to the 12-month period that follows the index spread reading. For example, the Default-Adjusted Spread for January 2019 uses the index OAS from January 2019 and default losses incurred between February 2019 and January 2020. Table 1 shows that there is a strong link between the Default-Adjusted Spread and excess High-Yield returns relative to duration-matched Treasuries. Specifically, we see that losses are a near certainty if the Default-Adjusted Spread is negative and that return prospects are poor for spreads below 150 bps. A Default-Adjusted Spread above its historical average of 250 bps is an obvious buying opportunity, while a spread above 400 bps virtually guarantees strong returns. Table 1The Default-Adjusted Spread & High-Yield Excess Returns Trading The US Corporate Bond Market In A Time Of Crisis Trading The US Corporate Bond Market In A Time Of Crisis This helps clarify the task at hand. We must make an assumption about what the default and recovery rates will be for the next 12 months, then apply those assumptions to the current index spread. The resulting Default-Adjusted Spread will tell us if High-Yield bonds are worth a look. Table 2 shows the Default-Adjusted Spread that results from different combinations of default and recovery rates.6 For example, a 10% default rate and 35% recovery rate together imply a Default-Adjusted Spread of 271 bps, suggesting an attractive buying opportunity. Table 2Default-Adjusted Spread (BPs) Given Different Assumptions For Default And Recovery Rates Trading The US Corporate Bond Market In A Time Of Crisis Trading The US Corporate Bond Market In A Time Of Crisis What Sort Of Default Cycle Should We Expect? To answer this question we turn to Table 3. Table 3 lists periods since the mid-1980s when the default rate rose above 4%, along with several factors that influence the level of default losses: The magnitude of the economic downturn, proxied by the worst year-over-year real GDP growth reading recorded during that timeframe. The duration of the economic downturn, measured as the number of quarters from the peak to trough in real GDP. Nonfinancial corporate leverage – measured as total debt divided by book value of equity – at the cycle peak. Table 3A Brief History Of Default Cycles Trading The US Corporate Bond Market In A Time Of Crisis Trading The US Corporate Bond Market In A Time Of Crisis Alongside these determining factors, the table also shows the peak 12-month default rate seen during the cycle and the recovery rate that occurred alongside it. First, we notice a strong relationship between the magnitude of the economic shock and the peak default rate. Meanwhile, corporate leverage does a better job explaining the recovery rate. Notice that recoveries were greater in 2008 than in 2001, despite 2008’s larger economic shock. Turning to the current situation, our base case assumption is that we will see severe economic contraction in Q1 and Q2 of this year followed by some recovery in the third and fourth quarters. All told, 2020 annual GDP growth could be close to the -3.9% seen in 2008, though the duration of the peak-to-trough economic shock will be only two quarters instead of six.7 Based on the historical comparables listed in Table 3, this sort of economic shock could generate a peak default rate somewhere between 11% and 13%. As for recoveries, nonfinancial corporate leverage is currently higher than during any of the prior episodes in our study. It follows that the recovery rate will be very low, perhaps on the order of 20%-25%. Turning back to Table 2, we see that our default and recovery rate assumptions imply a Default-Adjusted Spread somewhere between -119 bps and +96 bps. This is too low to be considered a buying opportunity. A Default-Adjusted Spread above its historical average of 250 bps is an obvious buying opportunity, while a spread above 400 bps virtually guarantees strong returns. Table 4 flips this analysis around and shows the option-adjusted-spread on the Bloomberg Barclays High-Yield index that would generate a Default-Adjusted Spread of 250 bps based on different assumptions for the default and recovery rates. Recall that we consider a Default-Adjusted Spread of 250 bps or above as a buying opportunity. Using the aforementioned default and recovery rate assumptions, we would see a buying opportunity in high-yield if the average index spread rose to a range of 1075 bps – 1290 bps, or above. As of Friday’s close, the index option-adjusted spread was 921 bps. Table 4High-Yield Index Spread (BPs) That Would Imply A Buying Opportunity* In Different Default Loss Scenarios Trading The US Corporate Bond Market In A Time Of Crisis Trading The US Corporate Bond Market In A Time Of Crisis Bottom Line: High-yield spreads do not discount the full extent of the looming default cycle and will not benefit from the Fed’s asset purchase programs. Investors should stay cautious on high-yield for now and look to increase allocations when the average index spread moves into a range of 1075 bps to 1290 bps. Which High-Yield Sectors Are Most Exposed? Even during a period of large-scale defaults, sector and firm selection are vital in the high-yield bond market. In fact, you could argue that sector selection becomes even more important during a default cycle, as some sectors bear the brunt of default losses while others skate through relatively unscathed. To wit, Chart 8plots the 12-month trailing speculative grade default rate alongside a diffusion index that shows the percentage of 30 high-yield industry groups – as defined by Moody’s Investors Service – that have a trailing 12-month default rate above 4%. Even at the peaks of the default cycles during the last two recessions, only 47% and 63% of industry groups experienced significant default waves. Chart 8Sector Selection Is Vital In A Default Cycle Sector Selection Is Vital In A Default Cycle Sector Selection Is Vital In A Default Cycle To help identify which sectors are most at risk during the current default cycle, we consider how the 10 main high-yield industry groups, as defined by Bloomberg Barclays, stack up on three crucial credit metrics: The share of firms rated Caa Growth in par value of debt outstanding since the last recession Change in the median firm’s net debt-to-EBITDA ratio since the last recession8 Charts A1-A10 in the Appendix show how the three credit metrics for each industry group have evolved over time. In the remainder of this report we compare the sectors against each other across each of the above three dimensions. Note that Box 1 provides a legend for the sector name abbreviations used in Charts 9, 10 and 11. Box 1Sector Abbreviations Trading The US Corporate Bond Market In A Time Of Crisis Trading The US Corporate Bond Market In A Time Of Crisis Chart 9OAS Versus Share Of Caa-Rated Debt Trading The US Corporate Bond Market In A Time Of Crisis Trading The US Corporate Bond Market In A Time Of Crisis Chart 10OAS Versus Debt Growth Trading The US Corporate Bond Market In A Time Of Crisis Trading The US Corporate Bond Market In A Time Of Crisis   Chart 11OAS Versus Net Debt-To-EBITDA Trading The US Corporate Bond Market In A Time Of Crisis Trading The US Corporate Bond Market In A Time Of Crisis Share Of Caa-Rated Debt Even during a large default cycle the bulk of default losses will be borne by firms rated Caa and below. In Chart 9, we see that if we ignore the outlying Technology, Transportation and Energy sectors, there is a fairly linear relationship between credit spreads and the share of firms rated Caa in each sector. Transportation and Energy currently trade at very wide spreads because those sectors’ revenues are heavily impacted by the current crisis. Technology spreads remain low because, despite the high percentage of Caa-rated debt, the sector has one of the lower net debt-to-EBITDA ratios (see Chart A6). All in all, Chart 9 suggests that Capital Goods, Communications, Consumer Cyclicals and Consumer Noncyclicals all carry a large proportion of low-rated debt. In contrast, Financials and Utilities appear much safer. Debt Growth Another good way to assess which sectors are most likely to experience defaults is to look at which sectors added the most debt during the economic recovery (Chart 10). On that note, the rapid levering-up of the Energy sector clearly sticks out. Beyond that, Capital Goods, Consumer Noncyclicals and Technology also added significant amounts of debt during the recovery. In contrast, the Utilities sector actually reduced its debt load. Change In Net Debt-to-EBITDA Finally, it’s important to note that simply adding debt does not necessarily put a sector at greater risk of default if earnings are rising even more quickly. For this reason we also look at recent trends in net debt-to-EBITDA (Chart 11). Here, we see that wide spreads in Energy and Transportation are justified by large increases in net debt-to-EBITDA. Conversely, Financials and Communications have seen improvement. Bottom Line: Based on a survey of three important credit metrics: The Energy, Transportation, Capital Goods, Consumer Cyclical and Consumer Noncyclical sectors are all highly exposed to the looming default cycle. In contrast, Financials and Utilities look like the best places to hide out. Appendix Chart A1Basic Industry Credit Metrics Basic Industry Credit Metrics Basic Industry Credit Metrics Chart A2Capital Goods Credit Metrics Capital Goods Credit Metrics Capital Goods Credit Metrics Chart A3Consumer Cyclical Credit Metrics Consumer Cyclical Credit Metrics Consumer Cyclical Credit Metrics Chart A4Consumer Non-Cyclical Credit Metrics Consumer Non-Cyclical Credit Metrics Consumer Non-Cyclical Credit Metrics Chart A5Energy Credit Metrics Energy Credit Metrics Energy Credit Metrics Chart A6Technology Credit Metrics Technology Credit Metrics Technology Credit Metrics Chart A7Transportation Credit Metrics Transportation Credit Metrics Transportation Credit Metrics Chart A8Communications Credit Metrics Communications Credit Metrics Communications Credit Metrics Chart A9Utilities Credit Metrics Utilities Credit Metrics Utilities Credit Metrics Chart A10Financial Institutions Credit Metrics Financial Institutions Credit Metrics Financial Institutions Credit Metrics     Ryan Swift US Bond Strategist rswift@bcaresearch.com Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Jeremie Peloso Senior Analyst jeremiep@bcaresearch.com Footnotes  1 The March 2011 earthquake and tsunami in Japan created a lot of short-term credit spread volatility, but even then, shorter-maturity bonds saw less spread widening than the overall index. 2 https://www.imes.boj.or.jp/research/papers/english/18-E-04.pdf 3  https://www.bankofengland.co.uk/quarterly-bulletin/2017/q3/corporate-bond-purchase-scheme-design-operation-and-impact 4 The ECB described this effect in a 2018 report that can be accessed here: https://www.ecb.europa.eu/pub/pdf/other/ecb/ebart201803_02.en.pdf 5  https://www.bloomberg.com/news/articles/2020-03-26/s-p-moody-s-cut-credit-grades-at-fastest-pace-since-2008-crisis 6 Calculations are based on the index spread as of market close on Friday March 27. 7 For more details on BCA’s assessment of the economic outlook please see Global Investment Strategy Second Quarter 2020 Strategy Outlook, “World War V”, dated March 27, 2020, available at gis.bcaresearch.com 8 Median net debt-to-EBITDA is calculated from our bottom-up sample of high-yield firms that consists of all the firms in the Bloomberg Barclays High-Yield index for which data are available. Data are retrieved on a quarterly basis and the sample is adjusted once per year based on changes in the composition of the Barclays indexes. As of Q2 2019, this sample includes 354 companies.

Dear client, Next Monday instead of sending you a Weekly Report we will be hosting a live webcast at 10am EST, addressing the recent market moves and discussing the US equity market outlook.  Kind Regards, Anastasios Highlights Portfolio Strategy The passing of the mega fiscal package, turning equity market internals, the collapse in net earnings revisions all underscore that we may have already seen the recessionary equity market lows. Investors with higher risk tolerance and a cyclical 9-12 month time horizon will be handsomely rewarded. Firming operating metrics, the defensive nature of tech services at a time when macro data are about to nosedive, compel us to boost the S&P data processing index to overweight. Grim macro data, the rising threat of a debt deflation spiral, poor operating metrics and lofty valuations, all warn that the path of least resistance is lower for REITs. Recent Changes Boost the S&P data processing index to overweight today. Last week we obeyed our rolling stops in our cyclically underweight position in the S&P homebuilders index and cyclically overweight positions in the S&P hypermarkets and S&P household products indexes for gains of 41%, 26% and 5%, respectively.1 Feature The SPX had a streak of three green days last week as congress finally passed a $2tn fiscal easing bill. In fact the last time the S&P 500 had two consecutive green days was right before its February 19 peak. Our view remains that the risk/reward tradeoff for owning equities is favorable for investors with higher risk tolerance and a cyclical 9-12 month time horizon, as we highlighted last Monday in our “20 reasons to start buying equities” part of our Weekly Report.2 As a reminder, during the Great Recession, equities troughed 20 days after the American Recovery and Reinvestment Act of 2009 took effect on February 17, 2009. Thus if history rhymes, an equity market bottom is likely near if not already behind us.  Does this mean the SPX has definitively troughed? Not necessarily, but our playbook/roadmap calls for a retest and hold of the recent lows as we have been highlighting in recent research.3 Keep in mind that S&P 500 futures (ES) have fallen over 36% from peak to trough. This is similar to the median fall during recession bear markets dating back to the Great Depression. Most importantly, comparing the two most recent iterations is instructive in attempting to figure out what is baked in the cake. Namely, in the 9/11 catalyzed recession and subprime mortgage collapse catalyzed recession, EPS got halved. Similarly, equities fell 50% from their respective peaks. If we use that assumption – i.e. a recessionary equity bear market fall predicts the eventual profit drubbing – then what the ES futures clocking in at 2174 discounted is that trailing EPS will fall from $162 to $104 and forward EPS from $177 to $113 (Chart 1). Chart 1Joined At The Hip Joined At The Hip Joined At The Hip While we have no real visibility on EPS, our sense is that we will not fall further than what was already discounted in the broad market. If we are offside and a GFC or Great Depression ensues, then profits will get halved to $81 and the SPX will fall to 1700. Another simple way of looking at the EPS drawdown is by considering $162 as trend EPS. Then for every month that the economy is shut down roughly $13.5 get shaved off EPS. Thus, triangulating both approaches, a $104 EPS level has discounted a shutdown lasting 4 months and 10 days. This is a tall order and we would lean against such extreme pessimism. Meanwhile, analysts are scrambling to cut estimates the world over. Not only SPX net earnings revisions (NER) are at the lowest point since the GFC, but so is the emerging market NER ratio. The Eurozone and Japan are following close behind (Chart 2). Once again the speed of this downward adjustment suggests that a lot of bad news is already priced in now depressed NER. Chart 2Bad News Is Priced In Bad News Is Priced In Bad News Is Priced In Chart 3Market Internals Ticking Higher Market Internals Ticking Higher Market Internals Ticking Higher Moreover, equity market internals underscore that we may have already seen the recessionary equity market lows. Chart 3 shows that hypersensitive small caps have been outperforming their large cap peers of late, chip stocks are sniffing out a reflationary impulse and even emerging markets are besting the SPX. Finally, the best China proxy out there, the Aussie dollar, corroborates the bullish signal from all these indicators and suggests that this mini “risk-on” phase can last a while longer (third panel, Chart 3). Nevertheless, the spike in the TED spread (Treasury-EuroDollar spread, gauging default risk on interbank loans) was quite unnerving last week. While we have shown in the past that equity volatility and credit risk are joined at the hip, this parabolic move in the, up to very recently calm, TED spread disquieted us. We will keep on monitoring it closely as the coronavirus pandemic continues to unfold (Chart 4). Chart 4Disquieting Disquieting Disquieting Another significant risk that this crisis has exposed is the massive non-financial business debt uptake that has taken root during the ten-year expansion (top panel, Chart 5). We deem investors will be more mindful of debt saddled companies going forward, despite the government’s sizable looming bailout of select severely affected industries from the coronavirus pandemic. Stock market reported data also corroborate the national accounts’ debt deterioration data (bottom panel, Chart 5). Chart 5Watch The Debt Burden… Watch The Debt Burden… Watch The Debt Burden… The yield curve has already forewarned that a significant default cycle is looming (Chart 6) and this time is not different. Chart 6…A Default Cycle Looms …A Default Cycle Looms …A Default Cycle Looms Importantly, both the equity and bond markets have been sending these debt distress signals for quite some time now (Chart 7). Chart 7Distress Signals Sent A long Time Ago Distress Signals Sent A long Time Ago Distress Signals Sent A long Time Ago What interest us most from a US equity sector perspective is identifying weak spots that may come under intense pressure in the coming weeks as the economy remains shut down likely until Easter Sunday. Chart 8 shows the current level of net debt-to-EBITDA for the overall non-financial equity market, and the 10 GICS1 sectors (we use telecom services instead of communications services and exclude financials). In more detail, the bar represents the 25 year range of net debt-to EBITDA and the vertical line the current reading for each sector (Appendix 1 below showcases the net debt-to-EBITDA time series for the GICS1 sectors). Chart 8Mind The… What Is Priced In? What Is Priced In? Chart 9 goes a step further and juxtaposes EV/EBITDA with net debt-to EBITDA on a two dimensional map. Real estate and utilities clearly stand out as the most debt burdened sectors, with a pricey valuation (For completion purposes Appendix 2 below delves deeper into sectors and shows net debt-to-EBITDA for the GICS2 sectors). Chart 9…Outliers What Is Priced In? What Is Priced In? Frequent US Equity Strategy readers know that we believe the excesses this cycle have been in the commercial real estate (CRE) segment of the economy, where prices are one standard deviation above the previous peak and cap rates have collapsed to all-time lows fueled by an unprecedented credit binge (Chart 10). This week we reiterate our underweight stance in the S&P real estate sector and boost a defensive tech services index to an overweight stance. Chart 10CRE: The Epitome This Cycle’s Excesses CRE: The Epitome This Cycle’s Excesses CRE: The Epitome This Cycle’s Excesses Reality Bites We continue to recommend investors avoid the S&P real estate sector. For investors seeking defensive protection we would recommend hiding in the S&P health care sector instead, as we highlighted in our mid-March report.4 Chart 11 shows a disturbing breakdown in the inverse correlation between the relative share price ratio and the 10-year Treasury yield. While it makes intuitive sense that this fixed income proxy sector (i.e. high dividend yielding) should move in the opposite direction of the competing risk free yielding asset, at times of tumult this correlation reverts to positive (top panel, Chart 11). In other words, fear grips investors and they frantically shed REITs despite the fact that interest rates collapse. Why? Because these are highly illiquid assets that these REITs are holding and investors demand the “return of” their capital instead of a “return on” their capital when volatility and credit risk soar in tandem (see TED spread, Chart 4). While CRE prices remain extended and vulnerable to a deflationary shock (bottom panel, Chart 11), there is no real price discovery currently as no landlord would dare put any properties for sale in this market starved for liquidity. With the exception of distressed sales, we deem that the “mark to model” mantra will make a comeback, eerily reminiscent of the GFC. Using an example of how all this may play out in the near-term is instructive. As the economy remains shut down, a tenant may forego a rent payment to a landlord and if the landlord is levered and starved of cash, he/she in turn may miss a debt payment to the outfit that holds his mortgage, typically a bank. Chart 11Breakdown Breakdown Breakdown At first sight this may not seem as a big problem on a micro level as the bank may have enough liquidity to withstand a delinquent borrower’s no/late payment. If, however, the bank is itself scrambling for cash, it will foreclose and then put this asset for sale in order to recover some capital. This will put downward pressure on the underlying asset’s price that all borrowing was based upon and a debt deflation spiral ensues (Chart 12). Chart 12Debt Deflation Warning Debt Deflation Warning Debt Deflation Warning The biggest problem however arises from the bond market. If these deflating assets are all in a CLO or concentrated in a select REIT, then our current financial system setup is not really equipped to handle a failure/delay of payment. This is especially true if some bond holders have hedged their bets and bought CDS on these bonds and demand payment as a “default clause” will in practice get triggered.  The longer the economy remains shut down, the higher the credit, counterparty and default risks will rise. Therefore, given that the real estate sector has an extremely high reading on a net debt-to-EBITDA basis (Chart 8), we are concerned about the profit prospects of this niche sector in the coming months. Moreover, the economy is in recession and the recent Markit services PMI is a precursor of grim data to follow. Historically, REITs move in the opposite direction to the PMI services survey and the current message is to expect a catch down phase in the former (Chart 13). Adding insult to injury, the supply response especially on the multi-family construction side is perturbing. In fact, multi-family housing starts have gone parabolic hitting 619K recently, the highest reading since 1986! Such a jump in supply is deflationary and will weigh on the relative share price ratio (multi-family starts shown inverted, bottom panel, Chart 13). Chart 13Tiiimber Tiiimber Tiiimber Finally, lofty valuations warn that if our bearish thesis pans out in the coming months, there is no cushion left to absorb a significant profit shock that likely looms (Chart 14). Chart 14No Valuation Cushion No Valuation Cushion No Valuation Cushion In sum, grim macro data, the rising threat of a debt deflation spiral, poor operating metrics and lofty valuations, all warn that the path of least resistance is lower for REITs.   Bottom Line: Shy away from the S&P real estate sector. The ticker symbols for the stocks in this index are: BLBG: S5RLST – CCI, AMT,  PLD, EQIX, DLR, PSA, SBAC, AVB, EQR, FRT, SPG, WELL, ARE, CBRE, O, BXP, ESS, EXR, DRE, PEAK, HST, MAA, UDR, VTR, WY, AIV, IRM, PEG, VNO, SLG. Boost Data Processing To Overweight We have been offside on the data processing tech sub-index and today we are booking losses of 39% and boosting exposure to overweight. Data processing stocks are a services-based defensive tech index that typically thrive in deflationary and recessionary environments, according to empirical evidence (Chart 15). We are currently in recession, thus a deflationary impulse will grip the economy and investors will flock to defensive tech stocks when growth is scarce. Tack on the spike in the greenback, and the disinflationary backdrop further boosts the allure of these tech services stocks (third panel, Chart 15). Beyond the recessionary related tailwinds, data processing stocks should also enjoy firming relative demand. While the two bellwether stocks, V and MA, will suffer from the decrease in consumption that requires physical visits and from select services outlays that are severely affected by the coronavirus, online spending by households and corporations should at least serve as a partial offset. Chart 15Time To Buy Defensive Tech Time To Buy Defensive Tech Time To Buy Defensive Tech Chart 16What’s not To Like? What’s not To Like? What’s not To Like? Already, industry pricing power gains have been accelerating at a time when overall inflation has been tame. This will boost revenues – and given high operating leverage and high and rising profit margins – that will flow straight through to profits (Chart 16). While relative profit growth and sales estimates may appear uncharacteristically high and unrealistic to attain, this is what usually transpires in recessions: sell side analysts trim SPX profit and revenue forecasts more aggressively than they do for the defensive data processing index (Chart 17). In fact, given that we are still in the early stages of recession, we expect a further surge in relative EPS and sales estimates in the coming months. Chart 17Seeking Growth When Growth Is Scarce Seeking Growth When Growth Is Scarce Seeking Growth When Growth Is Scarce Chart 18Risk: Lofty Valuations Risk: Lofty Valuations Risk: Lofty Valuations However, there is a key risk to our bullish stance in this tech service index: valuations. Relative valuations are still pricey despite the recent fall from three standard deviations above the historical mean to half that, according to our relative valuation indicator. Technicals have also corrected from an extremely overbought reading, but a cleansing washout has yet to occur (Chart 18). Netting it all out, firming operating metrics and the defensive nature of tech services at a time when macro data are about to nosedive, compel us to boost the S&P data processing index to overweight.   Bottom Line: Boost the S&P data processing index to overweight today from previously underweight for a loss of 39% since inception. The ticker symbols for the stocks in this index are: BLBG: S5DPOS – ADP, V, MA, PYPL, FIS, FISV, GPN, PAYX, FLT, BR, JKHY, WU, ADS.   Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com   Appendix 1 Chart A1Appendix A1 Appendix A1 Appendix A1 Chart A2Appendix A2 Appendix A2 Appendix A2   Appendix 2 Chart A3 What Is Priced In? What Is Priced In? Chart A4 What Is Priced In? What Is Priced In? Footnotes 1     Please see BCA US Equity Strategy Daily Report, “Housekeeping” dated March 26, 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 Daily Report, “Gravitational Pull” dated March 12, 2020, available at uses.bcaresearch.com. 4    Please see BCA US Equity Strategy Weekly Report, “Inflection Point” dated March 16, 2020, available at uses.bcaresearch.com.   Current Recommendations Current Trades Strategic (10-Year) Trade Recommendations What Is Priced In? What Is Priced In? Size And Style Views June 3, 2019 Stay neutral cyclicals over defensives (downgrade alert)  January 22, 2018 Favor value over growth May 10, 2018 Favor large over small caps (Stop 10%) June 11, 2018 Long the BCA  Millennial basket  The ticker symbols are: (AAPL, AMZN, UBER, HD, LEN, MSFT, NFLX, SPOT, TSLA, V).

Highlights The global economy is in the midst of a painful recession. Monetary and fiscal authorities are responding forcefully to the crisis, but the lengths of the lockouts and quarantines remain a major source of downside risk to the economy. Investors should favor stocks over bonds during the next year. The short-term outlook remains fraught with danger, so avoid aggressive bets. Central banks can tackle the global liquidity crunch, thus spreads will narrow and the dollar will weaken. The long-term impact of COVID-19 will be inflationary. Feature “The only thing we have to fear is fear itself.”    Franklin Delano Roosevelt  1932 A violent global recession is underway. Last month, we wrote that a deep economic slump would be unavoidable if COVID-19 cases could not be controlled within two to three weeks.1 Since then, the number of new, recorded COVID-19 cases has mounted every day and fear prevails. Consumers are not spending; firms will face a cash crunch and/or bankruptcy, and employment will be slashed. The next few quarters could result in some of the worst GDP prints since the Great Depression. Risk assets have moved to discount this dire scenario. The global stock-to-bond ratio has collapsed by 47% since its peak on January 17th and stands at the 1st decile of it post-1980 distribution. 10-year US bond yields temporarily fell below 0.4%. The dollar has rallied against every currency and even gold traded below $1500 an ounce. Brent crude trades below $30/bbl. In this context, investors must assess if risk asset prices have declined enough to compensate for the economic hazards created by the COVID-19 pandemic. If the massive amount of monetary and fiscal stimulus announced can turn around the economy in the second half of the year, then stocks and risk assets are attractive. Otherwise, they are still not cheap enough and cash remains king. We think it is a good time to begin to parsimoniously deploy capital into risk assets. A Global Recession And An Extraordinary Response The global economy has suffered its worst shock since the Great Financial Crisis (GFC), but policymakers are deploying every tool available. In our base case, GDP will contract more quickly for two quarters than it did during the GFC, and then will recover smartly. It is hard to pinpoint exactly how quickly global GDP will contract in the next six months, but key indicators point to a grim outcome. Chart I-1Global Growth Is Plunging Global Growth Is Plunging Global Growth Is Plunging China’s economy was at the forefront of the COVID-19 pandemic and its trajectory provides a glimpse into what the rest of the world should anticipate. In February, Chinese retail sales contracted by 20.5% annually and industrial production plunged by 13.5%. The German ZEW survey for March paints an equally bleak picture. The growth expectations component for the Eurozone and Germany fell to its lowest level since the GFC. The same indicator, but computed as an average of US, European and Asian subcomponents is also collapsing at an alarming pace (Chart I-1). The European flash PMI for March also points to a deep slowdown, with the services PMI plunging to 28.4, an all-time low. The performance of EM carry trades flashes a somber warning for our Global Industrial Production Nowcast (Chart I-2). Carry trade returns are imploding because global liquidity is incapable of meeting the demand for precautionary money by economic agents. This lack of liquidity is inflicting enormous damage on worldwide growth. Live trackers for US and global economic activity are also melting down. Traffic in some of the US’s largest cities is a fraction of last year's (Chart I-3). Globally, restaurant bookings have dried up and fewer airlines are flying compared to 2008. Initial jobless claims in the US have surged to 3.28 million, rapidly and decisively overtaking the weaknesses seen during the GFC. Chart I-2The Liquidation Of Carry Trade Is A Bad Omen The Liquidation Of Carry Trade Is A Bad Omen The Liquidation Of Carry Trade Is A Bad Omen Chart I-3Live Trackers Are In Free Fall April 2020 April 2020   Despite the dismal situation, some positive developments are emerging. It has been demonstrated that quarantines contain the spread of the virus. On March 18th, Wuhan recorded no new COVID-19 cases. Moreover, 10 days after its January 24th quarantine began, new cases started to fall off quickly (Chart I-4) in the city. If the recent softening in new cases in Italy’s Lombardy region continues, it will illustrate that democratic regimes can also reduce the pace of infection. Chart I-4Quarantines Do Work April 2020 April 2020 Most importantly, policymakers around the world have shown their willingness to do “whatever it takes.” Governments are easing fiscal policy with abandon. Germany’s state bank KfW is setting aside EUR550 billion to support the economy. France will spend EUR45 billion and has earmarked EUR300 billion in small business loan guarantees. Spain announced EUR200 billion to protect domestic activity. The White House just passed a stimulus package of $2 trillion, and Canada follows suit with a CAD82 billion relief bill. (Table I-1). As A. Walter and J. Chwieroth showed, the growing financial wealth of the middle class is forcing governments to always provide large bailouts after financial crises and recessions. Otherwise, their political parties suffer extreme repudiation from power.2 Table I-1Massive Stimulus In Response To Pandemic April 2020 April 2020 Central bankers have also become extreme reflators. Nearly every central bank in advanced economies has cut interest rates to zero or into negative territory. Most importantly, central banks have become lenders of last resort. The US Federal Reserve has announced it will engage in unlimited asset purchases; it has reopened various facilities to provide liquidity to the market and is using the US Department of the Treasury to lend directly to the private sector. Among its many measures, the European Central Bank is scrapping artificial limits on its bond purchases that were its capital keys and has offered a EUR750 billion bond purchase program. The ECB is also looking to open its OMT program. Other central banks are injecting cash directly into their domestic markets (Table I-2). The list and size of actions will expand until the markets are satiated with enough liquidity. Table I-2The Central Banks Still Had Some Options When Crisis Hit April 2020 April 2020 The impact of these policy measures is threefold. First, the actions are designed to alleviate the global economy’s cash crunch. Secondly, they aim to support growth directly. The private sector needs direct backing to survive the lack of cash inflows that will develop in the coming weeks. If fiscal and monetary authorities can plug that hole, then spending will not have to collapse as deeply nor for as long as would otherwise be the case. Finally, it is imperative that policymakers boost confidence and ease financial conditions to allow “animal spirits” to stabilize. If risk-taking continues to tailspin, then spending will never recover and the demand for cash will only grow, creating the worst liquidity trap since the Great Depression. Policymakers around the world have shown their willingness to do “whatever it takes.” The economy will continue to weaken in the second half of 2020 if quarantines remain in place beyond the summer. Not being epidemiologists, we are not equipped to make this call with any degree of certainty. Much depends on the evolution of the disease and the political decisions taken. We do not yet know if the population will be willing to endure the economic pain of a depression, or if political pressures will rise to force isolation on those over age 60 and those suffering dangerous comorbidities who are at higher risk, and allow everyone else to return to work and school.3 Investment Implications Part 1: Bonds and Stocks Chart I-5The Stock-To-Bond Ratio Has Capitulated The Stock-To-Bond Ratio Has Capitulated The Stock-To-Bond Ratio Has Capitulated While the short-term outlook remains murky for asset markets, investors with a 12-month or longer investment horizon should begin to move capital into equities at the expense of bonds. Beyond the relative technical and valuation backdrops (Chart I-5), the outlook for fiscal and monetary policy favors this allocation decision. US Treasury yields have dropped from 1.9% at the turn of the year to as low as 0.31% on March 9th. According to the bond market, inflation will average less than 1% during the coming 10 years. The OIS curve is pricing in a fed funds rate of only 68 basis points in five years. In response to this extreme pricing, Treasury bonds are exceptionally expensive (Chart I-6). Moreover, using BCA Research’s Golden Rule of Treasury Investing, there is little scope for yields to fall any lower. The Golden Rule states that the return of Treasury bonds is directly linked to the Fed's rate surprises. If over the next year the Fed cuts interest rates more than is currently priced into the OIS curve, then bond yields will fall in the next 12 months (Chart I-7). Given that the fed funds rate is already at its lower limit, the Fed will not be able to deliver such a dovish surprise and yields will have limited downside. Chart I-6Bonds Are Furiously Expensive Bonds Are Furiously Expensive Bonds Are Furiously Expensive Chart I-7The Fed Cannot Pull Another Dovish Surprise Out Of Its Hat The Fed Cannot Pull Another Dovish Surprise Out Of Its Hat The Fed Cannot Pull Another Dovish Surprise Out Of Its Hat   The bond market is also vulnerable from a technical perspective. Our Composite Technical Indicator is as overbought today as it was in December 2008 (Chart I-8). Thus, bond prices are vulnerable to good news. Economic activity will be weak for many months, but the recent policy announcements will boost global fiscal deficits by more than $3 trillion in the next 12 to 18 months. Such a large supply of paper is bearish for bonds, especially when they are very expensive. Moreover, global central banks are engaging in large-scale quantitative easing (QE). Globally, monetary authorities have already announced the equivalent of at least $1.9 trillion in asset purchases. The GFC experience showed that QE programs put upward pressure on Treasury yields (Chart I-9). This time will not be different given the combination of QE, supply disruptions caused by quarantines and large fiscal stimulus. Chart I-8A Dire Combination For Bonds A Dire Combination For Bonds A Dire Combination For Bonds Chart I-9QE Pushes Yields Up QE Pushes Yields Up QE Pushes Yields Up     Equities offer the opposite risk/reward ratio to bonds. Technical indicators are consistent with maximum pessimism toward equities and imply that most of the selloff is behind us, at least for the time being. The Complacency-Anxiety Indicator developed by BCA Research’s US Equity Strategy service points to widespread pessimism among investors,4 an intuition confirmed by our Sentiment indicator (Chart I-10). Moreover, our Equity Capitulation Index is as depressed as in March 2009. Investors with a 12-month or longer investment horizon should begin to move capital into equities at the expense of bonds. Despite the magnitude of the shock hitting the global economy, equities will rally if they become cheap enough and monetary conditions are accommodative enough. The BCA Valuation indicator has collapsed to “undervalued” territory and our Monetary Indicator has never been more supportive of equities (both variables are shown on page 2 of Section III). The gap between these two indicators is at its lowest level since Q1 2009 or 1982, two points that marked the end of bear markets (Chart I-11). Chart I-10Equities Have Capitulated Equities Have Capitulated Equities Have Capitulated Chart I-11Supportive Combined Valuation And Monetary Backdrop For Equities Supportive Combined Valuation And Monetary Backdrop For Equities Supportive Combined Valuation And Monetary Backdrop For Equities   Equity multiples also offer some insight into the risk/reward ratio for stocks. The S&P 500 has collapsed by 34% since its February 19th peak and trades at 13 times forward earnings. True, analysts will revise their forecasts, but the market also only trades at 14 times trailing earnings, which cannot be downgraded. Most importantly, investors are extremely gloomy about expected growth when multiples and risk-free rates are so subdued. Risk assets cannot stabilize durably as long as the demand for dollar liquidity is not satiated. Table I-3Evaluating Where The Floor Lies April 2020 April 2020 We can use a simple discounted cash flow model to extract the expected growth rate of long-term earnings embedded in the S&P 500. To do so, we assume that the ERP is 300 basis points, close to the long-term outperformance of stocks versus bonds. At current multiples and 10-year yields, investors are pricing in a long-term growth rate of -2% annually for earnings (Table I-3). In comparison, investors were more pessimistic in 1974, 2008 and 2011 when they anticipated long-term earnings contractions of -2.5% annually. If we assume that the long-term growth of expected earnings will fall to that depth, then we can estimate trailing P/E multiples will be under different risk-free rates. If yields fall to zero, then the P/E would be 17.7 or a price level of 2,692; however, if they rise to 1.5%, then the P/E would decline to 13.9 or a price level of 2,115 (Table I-3). Chart I-12Expected Earnings Growth And Interest Rates Are Co-Integrated Expected Earnings Growth And Interest Rates Are Co-Integrated Expected Earnings Growth And Interest Rates Are Co-Integrated This method suggests that 2200 is the S&P 500’s likely floor. Risk-free rates and the expected growth rate of long-term earnings are correlated series because the anticipated evolution of economic activity drives both real interest rates and earnings (Chart I-12). Thus, it is unlikely that yields will climb if expected earnings growth falls. Instead, if the expected growth rate of long-term earnings drops to -2.5%, then yields should stand between 1% and 0.5%, implying equilibrium trailing P/Es of 15 to 16.3 times, or prices levels of 2,278 to 2,468. P/E will only fall much further if the dollar scramble lasts longer. As investors seek cash and liquidate all assets, the process can push anticipated growth rates lower while pulling bond yields higher (see next section).   Investment Implications Part 2: The Uncontrolled Liquidity Crunch Is Still An Immediate Risk Risk assets cannot stabilize durably as long as the demand for dollar liquidity is not satiated. The large programs announced around the world seem to be calming this liquidity crunch. However, the situation is fluid and the crunch can come back at a moment's notice. Despite the magnitude of the shock hitting the global economy, equities will rally if they become cheap enough and monetary conditions are accommodative enough. Credit spreads blew up as investors priced in the inevitable increase in defaults that accompanies recessions (Chart I-13). Junk spreads moved to as high as 1100 basis points, their highest level since 2009. If we assume that next year, US EBITDA contracts by its average post-war magnitude (a timid assumption), then the interest coverage ratio will deteriorate to readings not seen since the S&L crisis, which will force default rates higher (Chart I-14). Chart I-13Defaults Will Rise Defaults Will Rise Defaults Will Rise Chart I-14Corporate Fundamentals Will Deteriorate Corporate Fundamentals Will Deteriorate Corporate Fundamentals Will Deteriorate     The anticipated contraction in cash flows creates another more pernicious and dangerous consequence: an insatiable demand for dollar liquidity by the private sector. Companies are worried they may not generate the necessary cash flows to service their debt. This is especially worrisome for foreign borrowers who have loans in US dollars. The BIS estimates that foreign currency debt denominated in USDs stands at $12 trillion. Meanwhile, these foreign borrowers are hoarding dollars. The risk aversion of US-based companies is accentuating the dollar crunch. US companies have pulled on their credit lines en masse. US commercial banks must provide this cash to their clients. However, US banks must still meet liquidity requirements imposed by the Basel III rules. As a result, the banks are also hoarding as much cash as possible in the form of excess reserves and curtailed their capital market lending, especially in the repo market. Repos are the lifeblood of capital markets and without repos, market liquidity (the ability to sell and buy securities) quickly deteriorates. This chain of events has caused a sharp widening in Treasury bid-ask spreads, LIBOR-OIS spreads and commercial paper-T-Bill spreads, and has fueled weaknesses in mortgage and municipal bond markets (Chart I-15). The evaporation of the repo market accentuates the foreign liquidity crunch. Without functioning repo markets, dollar funding in offshore markets becomes more onerous, as highlighted by the widening in global cross-currency basis swap spreads (Chart I-16). Borrowers are buying dollars at any cost. This has led to the surge in the dollar from March 9th, which forced the collapse of risky currencies such as the NOK, the BRL or the MXN, but also of safe-haven currencies such as the JPY and the CHF. Chart I-15Symptoms Of A Liquidity Crunch Symptoms Of A Liquidity Crunch Symptoms Of A Liquidity Crunch Chart I-16Offshore Funding Pressures Point To A Dollar Shortage Offshore Funding Pressures Point To A Dollar Shortage Offshore Funding Pressures Point To A Dollar Shortage   The strength in the dollar is problematic. As a symptom of the liquidity crunch, it accompanies forced selling of assets by investors seeking to acquire cash. Moreover, the USD is a funding currency, hence a strong dollar also tightens the global cost of capital for all foreign borrowers who have tapped into US capital markets. For US firms, it also accentuates deflationary pressures and the resulting lower price of goods sold increases the risk of bankruptcies. Thus, a strong dollar would feed the weakness in asset prices and further widen credit spreads. Moreover, because the liquidity crunch hurts growth and can concurrently push yields higher, it could pull P/Es below 15 and drive equity prices far below our 2,200 floor. On the positive side, central banks worldwide are keenly aware of the danger created by the liquidity crunch. The Fed has started and restarted a long list of liquidity facilities (Table I-2). Its unlimited QE program also addresses the dollar shortage directly by expanding the supply of money. Crucially, the Fed has re-opened dollar swap lines with other central banks, including emerging markets such as Korea, Singapore, Mexico and Brazil. Even the ECB and the Bank of England are relaxing liquidity ratios for their banks, which at the margin will alleviate the supply of liquidity in their domestic economies. The Fed will likely follow its European counterparts, which could play a large role in alleviating the global dollar shortage. Investors seeking to assess if the supply of liquidity is large enough should pay close attention to gold prices. The global, large-scale fiscal stimulus programs will also address the dollar liquidity crisis. When investors judge there is sufficient fiscal stimulus to put a floor under global economic activity, the markets will take a more sanguine view of the risk of default. If large enough, government spending will support corporate cash flows and, therefore, limit corporate bankruptcies. Consequently, demand for liquidity will also decline and mass asset liquidations will ebb. Chart I-17Gold Is The Ultimate Liquidity Gauge Gold Is The Ultimate Liquidity Gauge Gold Is The Ultimate Liquidity Gauge Investors seeking to assess if the supply of liquidity is large enough should look for some key market signals. We pay close attention to gold prices; after March 9th they fell despite the global spike in risk aversion due to gold's extreme sensitivity to global liquidity conditions. Both today and in the fall of 2008, gold prices fell when illiquidity grew. Our gold fair-value model shows that the precious metal is extremely sensitive to inflation expectations and real bond yields (Chart I-17). As illiquidity grows and the dollar appreciates, inflation breakevens collapse and real yields spike. Thus, the recent gold rebound suggests that the Fed and other major central banks have expanded the supply of liquidity sufficiently to meet demand, the price of money will fall (real interest rates) and inflation expectations will rebound. Monitor whether gold can remain well bid. Investment Implications Part 3: FX And Commodity Markets Chart I-18China's Stimulus Will Once Again Be Paramount China's Stimulus Will Once Again Be Paramount China's Stimulus Will Once Again Be Paramount China’s stimulus will be a key driver of the FX market in the post-liquidity-crunch world. Historically, because Chinese reflation has lifted the global manufacturing cycle, it possesses a large influence on the dollar’s trend (Chart I-18). We believe that China’s stimulus will be comparable to the one implemented in 2008 and will boost global growth. Moreover, the interest rate advantage of the US has declined and global macro volatility will not remain at current extremes for an extended time. These three factors (Chinese stimulus, lower interest rate differentials and declining volatility) will weigh on the USD in the coming 18 months (Chart I-18, bottom panel). EM currencies and the AUD will benefit most from the dollar depreciation later this year. In the short term, these currencies remain exposed to any flare up in the liquidity crunch and can cheapen further. But, as Chart I-19 highlights, investing in those currencies will likely generate long-term excess returns because they have cheapened significantly. Commodities, too, are becoming attractive at current valuations. Industrial metals such as copper will benefit greatly from China’s stimulus. A rising Chinese credit and fiscal impulse lifts the price of base metals because it pushes up Chinese infrastructure spending as well as residential and capex investment (Chart I-20). Moreover, a lower dollar and accommodative global monetary policy will further boost the appeal of industrial metals. Chart I-19EM FX Is Cheap EM FX Is Cheap EM FX Is Cheap Chart I-20China Will Drive Metal Prices Higher China Will Drive Metal Prices Higher China Will Drive Metal Prices Higher China’s stimulus will be a key driver of the FX market in the post-liquidity-crunch world. The oil outlook is particularly unclear as both demand and supply factors are in flux. At $27/bbl, Brent is cheap enough to compensate investors for the decline in demand that will emerge between now and the end of the second quarter. However, the market-share war between Saudi Arabia and Russia layers on the problem of supply risk. Saudi Aramco is set to increase production to 12.3 million barrels by April and Saudi’s GCC allies have announced they are increasing output as well. According to BCA Research’s Commodity and Energy Strategy service, the oil market is already oversupplied by 1.6 million barrels per day, a number that will expand if the KSA and its allies fulfill their production pledges. If this situation persists, oil will lag behind industrial metals when global risk aversion recedes. Nonetheless, our commodity strategists believe that the collapse in oil prices is more painful for Russia than for KSA. We believe there will be a compromise between OPEC and Russia in the coming weeks that will push supply lower.5 Additionally, the Texas Railroad Commission is preparing to impose limitations on Texas oil production, which has not been done since the 1970s. Such a decision would magnify any rebound in oil prices. Thinking Long-Term: The Return Of Stagflation? The COVID-19 outbreak will likely be viewed as an epoch-defining moment. The policy response to the outbreak will be far reaching and the disease will change the way firms manage supply chains for decades to come. There will be a substantial pullback in globalization. COVID-19 has generated an inflationary shock in the medium term. Chart I-21War Spending Is Always Inflationary War Spending Is Always Inflationary War Spending Is Always Inflationary COVID-19 has generated an inflationary shock in the medium term. Governments have suddenly abandoned their preferences for fiscal rectitude. The US deficit will reach a peacetime record of 15% of GDP. These are war-like spending measures. In history, gold standard or not, wars were the main reason for inflationary outbreaks as they involved massive budgetary expansions (Chart I-21). The large monetary easing accompanying the current fiscal expansion will only add to this inflationary impulse. Many of the proposals discussed by governments involve funneling cash directly to households, while central banks buy bonds issued by the same government. This is very close to helicopter money. These policies will increase the velocity of money, which is structurally inflationary (Chart I-22). Naysayers may point to the lack of inflation created by QE programs in the direct aftermath of the GFC. However, at that time, households and commercial banks were much sicker. Today, capital ratios in the US and the Eurozone are 60% and 33% higher than in 2007, respectively (Chart I-23). Thus, banks are much more likely to add to money creation instead of retracting from it as they did in the last cycle. Chart I-22If Velocity Rises, So Will Inflation If Velocity Rises, So Will Inflation If Velocity Rises, So Will Inflation Chart I-23Banks Are Much Healthier Than In 2008 April 2020 April 2020   Chart I-24Financial Assets Have No Inflation Cushion Financial Assets Have No Inflation Cushion Financial Assets Have No Inflation Cushion Markets are not ready for higher inflation. The 5-year/5-year forward CPI swaps in the US and the euro area stand at only 1.6% and 0.7%, respectively. Household long-term inflation expectations are also at all-time lows (Chart I-24). Therefore, an increase in inflation will have a deep impact on asset prices. The first implication is that gold prices have probably begun a new structural bull market. Inflation will surprise on the upside and keep real interest rates lower. Both these factors are highly bullish for the yellow metal. Additionally, easy fiscal policy and money printing will devalue currencies versus hard assets, which will benefit all precious metals, including gold. EM central banks have recently been diversifying aggressively in gold, which will add another impetuous to its rally. The second implication is that the stock-to-bond ratio has structural upside. Equities are not a perfect inflation hedge, but their profits can rise when selling prices accelerate. However, bonds display rock bottom real yields, inflation protection and term premia. Moreover, their low-running yields are below the dividend yields of equities, which has also boosted bond duration to record levels. Therefore, bonds offer even less protection against higher inflation. Hence, the stock-to-bond ratio will probably follow the historical experience of the 20th century structural bull market and inflect higher (Chart I-25). However, this outperformance will not stem from the superior performance of stocks in real terms; rather, it will emerge from a very poor performance by bonds. Chart I-25The Stock-To-Bond Ratio Will Follow The 20th Century Road Map The Stock-To-Bond Ratio Will Follow The 20th Century Road Map The Stock-To-Bond Ratio Will Follow The 20th Century Road Map Thirdly, the structural relative bear market in EM equities will likely end soon. EM equities will enjoy strong real asset prices and EM assets have much more appealing valuations than DM stocks. This is an imbedded inflation protection. The world is witnessing a fiscal and monetary push that will result in lower productivity growth and profit margins, along with feared inflation. The next decade could increasingly look like the stagflationary 1970s. Mathieu Savary Vice President The Bank Credit Analyst March 26, 2020 Next Report: April 30, 2020   II. Revisiting The Neutral Rate Of Interest: A Contrarian View In A Time Of Crisis Global investors have come to accept the secular stagnation narrative as described by Larry Summers in November 2013, and have gravitated to the only available real time estimate of the real neutral rate of interest: the Laubach & Williams (“LW”) “R-star” estimate. With this apparent visualization of secular stagnation as a guide, many investors have concluded that monetary policy ceased to be stimulative last year and that recent Fed rate cuts will be of limited benefit to economic activity even once economic recovery takes hold unless inflation meaningfully accelerates (thus pushing real rates lower for any given nominal Fed funds rate). This report revisits the “LW” R-star estimate in detail, and demonstrates why the estimation is almost certainly wrong, at least over the past two decades. We also outline an inferential approach that investors can use to monitor where the neutral rate is in real time and whether it is rising or falling. The core conclusion for investors is that US Treasury yields reflect a “low rates forever” view with much higher certainty than is analytically warranted and thus appear to be anchored by a false narrative. While bond yields may not rise significantly in the near-term, investors should avoid dogmatic medium-to-longer term views about yields as they may rise meaningfully over a cyclical and secular horizon once a post-COVID-19 expansion takes hold. Over the past several weeks financial markets have moved rapidly to price in a global recession stemming from the COVID-19 outbreak. As financial market participants began to turn to policy makers for support, eyes focused first on the Federal Reserve, and then fiscal authorities. Earlier this week, the ECB joined the party and announced aggressive further measures of its own. When responding to the Fed’s return to the lower bound and its other recent monetary policy decisions, many market participants have expressed the view that the Fed is largely impotent to deal with a global pandemic. There are three elements to this view. The first is that interest rate cuts are ill equipped to stimulate domestic demand if quarantine measures or other forms of “social distancing” are in effect. The second element is that the Fed has only been capable of delivering a fraction of the reduction in interest rates compared to what has occurred in response to previous contractions. The third aspect of this view is that because the neutral rate of interest is so much lower now than it was in the past, Fed rate cuts will not be as stimulative as they were before. Chart II-1Monetary Policy Ceased To Be Stimulative Last Year, According To The LW R-star Estimate Monetary Policy Ceased To Be Stimulative Last Year, According To The LW R-star Estimate Monetary Policy Ceased To Be Stimulative Last Year, According To The LW R-star Estimate While we at least partly agree with the first and second elements of this view, we feel strongly that the third is flawed. Global investors have come to accept the secular stagnation narrative as described by Larry Summers in November 2013,6 and have gravitated to the only available real time estimate of the neutral rate of interest: the Laubach & Williams (“LW”) “R-star” estimate. This time series, which is regularly updated by the New York Fed,7 suggests that the real fed funds rate reached neutral territory in the first quarter of 2019 (Chart II-1). With this apparent visualization of secular stagnation as a guide, many investors have concluded that monetary policy ceased to be stimulative last year and that recent Fed rate cuts will be of limited benefit to economic activity even beyond the near term unless inflation meaningfully accelerates (thus pushing real rates lower for any given nominal Fed funds rate). In this Special Report we revisit the “LW” R-star estimate in detail, and demonstrate why the estimation is almost certainly wrong, at least over the past two decades. Our analysis does not reveal a precise alternative estimate of the neutral rate, although we do provide some inferential perspective on how investors may be able to monitor where the neutral rate is in real time and whether it is rising or falling. However, the core insight emanating from our report, particularly for US fixed income investors, is that US Treasury yields reflect a “low rates forever” view with much higher certainty than is analytically warranted and thus appear to be anchored by a false narrative. While bond yields may not rise significantly in the near-term, this underscores that they have the potential to rise meaningfully over a cyclical and secular horizon once economic activity recovers. As such, we caution fixed-income investors against dogmatic medium-to-longer term views about bond yields, as their potential to rise may be larger than many investors currently expect. Demystifying The LW R-star Estimate The LW estimate of the neutral rate of interest has gained credibility for three reasons. First, as noted above, the evolution of the series fits with the secular stagnation narrative re-popularized by Larry Summers. Second, the series is essentially sponsored by the Federal Reserve even if it is not officially part of the Fed’s forecasting framework, as its two creators are long-time Fed employees (Thomas Laubach is a director of the Fed’s Board of Governors, and John Williams is the current President of the New York Fed). But, in our view, there is a third important reason that global investors have accepted the LW R-star estimate of the neutral rate of interest: the methodology used to generate the estimate is extremely technically complex, and thus is difficult for most investors to penetrate. Much of the technical complexity of the LW estimate is centered around the use of a statistical procedure called a Kalman filter (“KF”). Simply described, the KF is an algorithm that tries to estimate an unobservable variable based on 1) an idea of how the unobservable variable might relate to an observable variable (the “measurement equation”), and 2) an idea of how the unobservable variable might change through time (the “transition equation”). Through a repeated process of simulating the unobserved variable based on a set of assumptions, the KF is able to compare predicted results to actual results on an observation-by-observation basis, and use that information to generate ever more reliable future estimates of the unobserved variable (Chart II-2). Chart II-2A Very Simplified Overview Of The Kalman Filter Algorithm April 2020 April 2020 We acknowledge that a full technical treatment of the Kalman Filter as it relates to the LW estimate of the neutral rate of interest is beyond the scope of this report, and we provide a more technical overview in Box II-1. But what emerges from a detailed analysis of the model is that the Kalman Filter jointly estimates R-star, potential GDP growth, potential GDP, and the variable “z”, the determinants of R-star that are not explained by potential GDP growth. As we will highlight in the next section, this joint estimation of these four variables is a crucial aspect of the model, because a valid estimate of R-star necessitates a valid estimate of the remaining variables. BOX II-1 A Technical Overview Of The Laubach & Williams R-star Model Chart Box II-1 shows that there are three sets of formulas involved in the LW estimation: the “law of motion” for the neutral rate of interest, two measurement equations, and three transition equations. The law of motion for the neutral rate is fairly simple: R-star is a function of trend real GDP growth, as well as “other factors” represented by the variable “z”. Laubach & Williams note that z “captures factors such as households’ rate of time preference”. The measurement equations are also fairly straightforward. First, the (unobservable) output gap is a function of lagged values of itself as well as the lagged real Fed funds rate gap (relative to the unobservable neutral rate). Second, inflation is a function of lagged values of itself, past values of the output gap, relative core import prices, and lagged relative imported oil prices (the latter two variables are included to capture potential supply shocks to inflation). Note that this second measurement equation is required for the model to work, as it relates the unobservable output gap to observable inflation. As presented in Chart II-2, the three transition equations are present to simulate how the unobservable variables might move through time. Potential growth and potential output are a random walk, and “z” from the law of motion follows either a random walk or an autoregressive process. Chart Box II-1The Laubach & Williams R-star Model April 2020 April 2020 Debunking The LW R-star Estimate Before criticizing the LW estimate of the neutral rate of interest, it is important for us to note that we have the utmost respect for the Federal Reserve and its research methods. We fully acknowledge that the LW R-star estimation is rooted in solid economic theory, and we have identified no technical errors in the setup of the LW model. Nevertheless, valid analytical efforts sometimes lead to problematic real-world results, and there are two key reasons to believe that the Kalman filter in the LW model is almost certainly misspecifying R-star, at least in terms of its estimate over the past two decades. The first reason relates to the sensitivity of the model to the interval of estimation (the period over which R-star is estimated). Chart II-3 presents the range of quarterly estimates of R-star since 2005, along with the difference between the high and low end of the range in the second panel. The chart shows that while previous estimates of R-star have generally been stable for values ranging between the early-1980s and 2006/2007, pre-1980 estimates have varied quite substantially and we have seen material revisions to the estimates over the past decade. Q1 2018 serves as an excellent example: in that quarter R-star was estimated to be 0.14%; today, the Q1 2018 R-star estimate sits at 0.92%. Chart II-3Since 2005, There Has Been Some Instability In The LW R-star Estimates Since 2005, There Has Been Some Instability In The LW R-star Estimates Since 2005, There Has Been Some Instability In The LW R-star Estimates However, Table II-1 and Chart II-4 highlight the real instability of the Kalman filter estimation by demonstrating the effect of varying the starting point of the model (please see Box II-2 for a brief description of how our estimation of R-star using the LW approach differs slightly from the original procedure). Laubach & Williams originally estimated R-star beginning in Q1 1961; Table II-1 shows what happens to today’s estimate of R-star simply by incrementally varying the starting point of the model from Q1 1958 to Q4 1979. Table II-1Alternative Current LW Estimates Of R-star By Model Starting Point April 2020 April 2020 Chart II-4Alternative Starting Points Produce Wildly Different Estimates Of R-star Today April 2020 April 2020 BOX II-2 The Laubach & Williams R-star Model With Simplified Inflation Expectations To proxy inflation expectations in their model, Laubach & Williams use a “forecast of the four-quarter-ahead percentage change in the price index for personal consumption expenditures excluding food and energy (“core PCE prices”) generated from a univariate AR(3) of inflation estimated over the prior 40 quarters”. The authors note that a simplified measure of expectations, a 4-quarter moving average of quarterly annualized core inflation, does not materially alter their results. For the sake of parsimony we use this simplified measure in our analysis. We find that the effect shifts the current estimate of R-star only slightly (+10 basis points), and that the historical differences between our version of the 1961 estimation and the official series are indeed minor. The table highlights that the model fails to even generate a result in a majority of the cases (only 39 out of 88 of the model runs were error-free). In addition, Chart II-4 shows that of the successful estimates of R-star using the LW procedure and alternate starting dates of the model, the estimate of R-star today varies from -2% (in one case) to +2%. Excluding the one extremely negative outlier results in an effective estimate range of 0% to 2%, but the key point for investors is that this range is massive and underscores that the original model’s estimate of R-star today is heavily and unduly influenced by the interval of estimation. Investors should also note that of all of the alternative estimates of R-star today shown in Chart II-4, the estimate using the original interval is very much on the low end of the distribution. The second (and most important) reason to believe that the LW estimate is misspecifying R-star is that the output gap estimate generated by the model is almost certainly invalid, at least over the past two decades. Chart II-5presents the LW output gap estimate alongside an average of the CBO, OECD, and IMF estimates of the gap; panel 1 shows the official current LW output gap estimate, whereas panel 2 shows the range of output gap estimates that are generated using the different estimation intervals highlighted in Table II-1 and Chart II-4. Chart II-5The LW Output Gap Estimates, Upon Which R-star Depends, Have Been Wrong For Two Decades The LW Output Gap Estimates, Upon Which R-star Depends, Have Been Wrong For Two Decades The LW Output Gap Estimates, Upon Which R-star Depends, Have Been Wrong For Two Decades Given that the Kalman filter in the LW model jointly determines R-star and the output gap (by way of estimating potential output via estimating potential GDP growth) and that these estimates are dependent on each other, Chart II-5 highlights that in order to believe the LW R-star estimate investors must believe three things: That the US economy was chronically below potential in the late-1990s when the unemployment rate was below 5%, real GDP growth averaged nearly 5%, and the equity market was booming, That output exceeded potential in 2004/2005 by a magnitude not seen since the late-1970s / early-1980s despite an average unemployment rate, That the 2008/2009 US recession was not particularly noteworthy in terms of its deviation from potential output, and that the economy had returned to potential output by 2010/2011 when the unemployment rate was in the range of 8-9%. Chart II-6The US Economy Was Definitely Not At Full Employment In 2010 The US Economy Was Definitely Not At Full Employment In 2010 The US Economy Was Definitely Not At Full Employment In 2010 While we do not believe any of these three statements, the third is especially unlikely. Chart II-6 highlights that the economic expansion from 2009 – 2020 was the weakest on record in the post-war era in terms of average annual real per capita GDP growth. To us, this is a clear symptom of a chronic deficiency in aggregate demand, and that it is essentially unreasonable to argue that the economy was operating at full employment prior to 2014/2015. This means that the Kalman filter is generating incorrect and unreliable estimates of the output gap, which means in turn that the filter’s estimation of R-star is almost assuredly wrong. How Can Investors Tell What The Neutral Rate Is? An Inferential Approach Table II-2 presents the sensitivity of the original Q1 1961 LW estimate of R-star to a series of counterfactual scenarios for inflation, real GDP growth, nominal interest rates, and import and oil prices since mid-2009. While these scenarios do not in any way improve the validity of the LW R-star estimate, they do help clarify the theoretical basis of the model and they help reveal how investors may infer whether the neutral rate of interest is higher or lower than prevailing market rates, and whether it is rising or falling. Table II-2Sensitivity Of Current LW R-star Estimate To Counterfactual Scenarios (2009 - Present) April 2020 April 2020 Chart II-7Core Import Price Growth Has Been Weak On Average During This Expansion Core Import Price Growth Has Been Weak On Average During This Expansion Core Import Price Growth Has Been Weak On Average During This Expansion Table II-2 highlights that today’s estimate of R-star using the original LW approach is mostly sensitive to our counterfactual scenarios for growth and interest rates, but not inflation or oil prices. Shifting down import price growth also has a meaningful effect on R-star, but since core import price growth has been particularly weak over the past several years (Chart II-7), it seems unreasonable to suggest that they have been abnormally high and thus “explain” a low R-star estimate today. Table II-2 essentially highlights that the entire question of the neutral rate of interest over the past decade, and the core contradiction that led to the re-emergence of the secular stagnation thesis, can effectively be boiled down to the following simple question: “Why hasn’t US economic growth been stronger this cycle, given that interest rates have been so low?” Based on the (hopefully uncontroversial) view that interest rates influence economic activity and that economic activity influences inflation, we propose the following checklist for investors to ask themselves in order to not only determine the answer to this important question, but to help identify whether R-star in any given country is likely higher or lower than existing policy rates at any given point in time. Are interest rates above or below the prevailing level of economic growth? Are interest rates rising or falling, and how intensely? Are there identifiable non-monetary shocks (positive or negative) that appear to be influencing economic activity? Is private sector credit growth keeping pace with economic growth? Are debt service burdens in the economy high or low? The first question reflects the most basic view of R-star, which is that the real neutral rate of interest should be equal to, or at least closely related to, the potential growth rate of the economy, ceteris paribus. Questions 2 through 5 attempt to determine whether ceteris paribus holds. In terms of how the answers to these questions relate to identifying the neutral rate, consider two economies, “Economy A” and “Economy B” (Chart II-8). Economy A has broadly stable or slightly rising interest rates that are well below prevailing rates of economic growth (questions 1 & 2), no obvious beneficial shocks to domestic demand from fiscal policy or other factors (question 3), and strong private sector credit growth that is perhaps above or strongly above the current pace of GDP growth (question 4). Chart II-8'Economy A', Versus 'Economy B' April 2020 April 2020 Inferentially, it would seem that interest rates in this hypothetical economy are below R-star today. Question 5 is in our list because the more that active private sector leveraging occurs (thus pushing up debt burdens), the more that we would expect R-star in the future to fall. This is because debt payments as a share of income cannot rise forever, and we would expect that the capacity of economy A’s central bank to raise interest rates in the future are negatively related to economy A’s private sector debt service burden today. Now, imagine another economy (“Economy B”) with interest rates well below average rates of economic growth, an interest rate trend that is flat-to-down, no identifiable non-monetary policy shocks that are restricting aggregate demand, persistently sluggish credit growth, and high private sector debt service burdens in the past. If economy B is growing (even sluggishly) and not in the middle of a recession, it would seem that prevailing interest rates are below R-star, but not significantly so. In this scenario it would seem reasonable to conclude that R-star in economy B has fallen non-trivially below its potential growth rate, and that interest rate increases are likely to move monetary policy into restrictive territory earlier than otherwise would be the case. Is The United States “Economy B”? From the perspective of some investors, our description of economy B above perfectly captures the experience of the US over the past decade: an extremely low Fed funds rate, sluggish to weak growth and inflation, all the result of a huge build-up in leverage and debt service burdens during the last economic cycle. We do not doubt that R-star fell in the US for some period of time during the global financial crisis and in the early phase of the economic recovery. But we doubt that it is as low today as the secular stagnation narrative would imply, in large part because it ignores several important aspects concerning questions 2 through 5 noted above. Chart II-9Fiscal Austerity Has Been A Serious Non-Monetary Shock To Aggregate Demand Fiscal Austerity Has Been A Serious Non-Monetary Shock To Aggregate Demand Fiscal Austerity Has Been A Serious Non-Monetary Shock To Aggregate Demand Non-monetary shocks to the US and global economies: Over the past 12 years, there have been at least five deeply impactful non-monetary shocks to both the US and global economies that have contributed to the disconnect between growth and interest rates: 1) a prolonged period of US household deleveraging from 2008-2014, 2) the euro area sovereign debt crisis, 3) fiscal austerity in the US, UK, and euro area from 2010 – 2012/2014 (Chart II-9), 4) the US dollar / oil price shock of 2014, and 5) the recent trade war between the US and China. Several of these shocks have been policy-driven, and in the case of austerity the negative consequences of that policy has led to a lasting change in thinking among fiscal authorities (outside of Japan) that is unlikely to reverse in the near-future. Chart II-10Recent Trends In US Private Sector Leverage Do Not Suggest R-star Is Very Low Recent Trends In US Private Sector Leverage Do Not Suggest R-star Is Very Low Recent Trends In US Private Sector Leverage Do Not Suggest R-star Is Very Low Private sector credit growth: Chart II-10 highlights the extent of household deleveraging noted above by showing the growth in total household liabilities over the past decade alongside income growth. Panel 2 shows the leveraging trend of firms, as represented by the nonfinancial corporate sector debt-to-GDP ratio. Chart II-10 underscores two points: the first is that while US household sector credit contracted for several years following the global financial crisis, it is now growing again and has largely closed the gap with income growth. The second point is that the nonfinancial corporate sector has clearly leveraged itself over the course of the expansion, arguing that interest rates have not in any way been restrictive for businesses. While it is true that firms have largely leveraged themselves to buy back stock instead of significantly increasing capital expenditures, in our view this reflects the fact that US consumer demand was impaired for several years due to deleveraging. We doubt that firms would have altered their capital structures to this degree if they did not view interest rates as extremely low. Debt service burdens: Chart II-11 highlights that US household debt service burdens were at very elevated levels prior to the financial crisis, suggesting that the neutral rate did fall for some time following the recession. But today, the debt burden facing households is the lowest it has been in the past 40 years due to both rate reductions and deleveraging, arguing against the view that household debt levels will structurally weigh on interest rates in the years to come. Chart II-12 shows that the picture is different for nonfinancial corporations, as the substantial leveraging noted above has indeed raised debt service burdens for firms. However, the nonfinancial corporate sector debt service ratio remains 400 basis points below early-2000 levels when excess corporate sector liabilities had a clear impact on the economy, suggesting that the Fed’s capacity to raise interest rates still exists following the onset of economic recovery if corporate sector credit growth does not rise sharply relative to GDP over the coming 6-12 months. Chart II-11The Debt Burden Facing US Households Is At A Record Low The Debt Burden Facing US Households Is At A Record Low The Debt Burden Facing US Households Is At A Record Low Chart II-12Businesses Have Levered Up Their Balance Sheets, But There Is Still Room For Rates To Rise Businesses Have Levered Up Their Balance Sheets, But There Is Still Room For Rates To Rise Businesses Have Levered Up Their Balance Sheets, But There Is Still Room For Rates To Rise   The intensity of recent interest rate changes: Finally, many investors have pointed to sluggish housing activity over the past three years as evidence of a low neutral rate. However, Chart II-13 highlights that the rise in the 30-year US mortgage rate from late-2016 to late-2018 was one of the largest two-year changes in US history, and Chart II-14 shows that the growth in household mortgage credit did not fall below its trend during this period until Q4 2018, when the US stock market fell 20% from its high in response to the economic consequences of the US/China trade war. Chart II-14 also shows that mortgage credit growth responded sharply to a recent reduction in interest rates. All in all, Charts II-13 & II-14 cast doubt on the notion that the level of mortgage rates over the past three years reached restrictive territory. Chart II-13Mortgage Rates Rose Very Significantly From Late-2016 To Late-2018 Mortgage Rates Rose Very Significantly From Late-2016 To Late-2018 Mortgage Rates Rose Very Significantly From Late-2016 To Late-2018 Chart II-14A Record Rise In Mortgage Rates Did Not Crack The Housing Market A Record Rise In Mortgage Rates Did Not Crack The Housing Market A Record Rise In Mortgage Rates Did Not Crack The Housing Market   Investment Conclusions In the face of a global pandemic and an attendant global recession this year, the idea of eventual Fed rate hikes and the notion that the US economy will be able to tolerate them likely seems preposterous to many investors. We agree that over the coming 6-12 months US Treasury yields are unlikely to rise; even at current levels of the 10-year Treasury yield, we are reluctant to call a trough. Chart II-15US 10-Year Treasurys Are Mostly Priced For A Repeat Of The Past Decade US 10-Year Treasurys Are Mostly Priced For A Repeat Of The Past Decade US 10-Year Treasurys Are Mostly Priced For A Repeat Of The Past Decade However, Chart II-15highlights that over a long-term time horizon, the bond market is now essentially priced for a repeat of the ten-year path of the Fed funds rate following the global financial crisis. While some investors will view this as a reasonable expectation in the face of what they see as a persistent and unexplainable gap between growth and interest rates over the past decade, we think this gap is explainable and we highly doubt that a pandemic with minimal mortality risk to the working age population and the young will cause the US economy to be afflicted with active consumer deleveraging lasting 4 to 6-years, substantial and wide-ranging fiscal austerity, persistently rising trade tariffs, and sharply lower oil prices. So while we agree that the US economy will be substantially cyclically affected by COVID-19, US Treasury yields reflect a “low rates forever” view with much higher certainty than is analytically warranted and thus appear to be anchored by a false narrative. As such, we caution fixed-income investors against dogmatic medium-to-longer term views about bond yields, as their potential to rise following the upcoming recession may be larger than many investors currently believe.   Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com III. Indicators And Reference Charts Last month, we continued to strike a cautious tactical tone. Valuations were not depressed enough to compensate investors for the lack of clarity around the path of COVID-19. In other words, there was not enough of a risk premium imbedded in asset prices if COVID-19 cases were to spread around the world. Now that COVID-19 has spread around the planet, asset valuations have adjusted massively. The BCA Valuation Indicator for the S&P 500 is now in undervalued territory, thanks to both lower prices and interest rates. Meanwhile, the BCA Monetary Indicator has never been more accommodative than it is today. Together, these two indicators suggest that twelve months from now, equities will stand at higher levels than they do today. Tactically, equities have most probably found their floor. Both our Composite Sentiment Indicator and the VIX are consistent with a capitulation. Anecdotal evidences also point to a capitulation by retail investors. Additionally, Our RPI indicator is finally starting to try to turn up. Nonetheless, equities will likely re-test their Monday March 23rd floor as the length of US and global quarantines that are so damaging to growth (but for now, necessary) remain uncertain. The cleanest way to express a positive 12-month outlook on equities is to bet on a rise in the stock-to-bond ratio. 10-year Treasurys are as expensive as they were in late 2008 and early 1986, two periods followed by rapid rises in yields. Moreover, our Composite Technical Indicators is 2.5 sigma overbought. The yield curve is steepening anew, which confirms the intuition that yields will experience significant upside over the coming 12 months. On a longer-term basis, inflation expectations are too low to compensate investors for the inflation risk created by a larger monetary and fiscal expansion than the one witnessed in 2008. That being said, EM sovereigns are getting attractive for long-term investors.  Following the surge in the dollar that accompanied the liquidity crunch that surrounded the COVID-19 panic, the dollar is now trading at its most expensive level since 1985. The large liquidity injections by the Fed should cap the dollar for now, but the greenback will need more clarity on the end of global quarantines before it can fall decisively. Nonetheless, it will depreciate significantly once the global economy rebounds due to the powerful reflationary impulse building up around the world. Finally, commodity prices are retesting their 2008 lows. They are not as oversold as they were then, but this is good sign as the advance/decline line of our Continuous Commodity Index continues to trend higher. Thus, if as we expect, the dollar’s surge is ending, commodities are likely to be in the process of finding a floor right now. Once investors become more optimistic about the outlook for global growth, commodities will likely rebound sharply, maybe even more so than stocks. Therefore, it is a good time to begin accumulating metals, energy and equities as well as FX linked to natural resources prices. EQUITIES: Chart III-1US Equity Indicators US Equity Indicators US Equity Indicators Chart III-2Willingness To Pay For Risk Willingness To Pay For Risk Willingness To Pay For Risk Chart III-3US Equity Sentiment Indicators US Equity Sentiment Indicators US Equity Sentiment Indicators   Chart III-4Revealed Preference Indicator Revealed Preference Indicator Revealed Preference Indicator Chart III-5US Stock Market Valuation US Stock Market Valuation US Stock Market Valuation Chart III-6US Earnings US Earnings US Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance   FIXED INCOME: Chart III-9US Treasurys And Valuations US Treasurys And Valuations US Treasurys And Valuations Chart III-10Yield Curve Slopes Yield Curve Slopes Yield Curve Slopes Chart III-11Selected US Bond Yields Selected US Bond Yields Selected US Bond Yields Chart III-1210-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components Chart III-13US Corporate Bonds And Health Monitor US Corporate Bonds And Health Monitor US Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Global Bonds: Developed Markets Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets Global Bonds: Emerging Markets Global Bonds: Emerging Markets   CURRENCIES: Chart III-16US Dollar And PPP US Dollar And PPP US Dollar And PPP Chart III-17US Dollar And Indicator US Dollar And Indicator US Dollar And Indicator Chart III-18US Dollar Fundamentals US Dollar Fundamentals US Dollar Fundamentals Chart III-19Japanese Yen Technicals Japanese Yen Technicals Japanese Yen Technicals Chart III-20Euro Technicals Euro Technicals Euro Technicals Chart III-21Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart III-22Euro/Pound Technicals Euro/Pound Technicals Euro/Pound Technicals   COMMODITIES: Chart III-23Broad Commodity Indicators Broad Commodity Indicators Broad Commodity Indicators Chart III-24Commodity Prices Commodity Prices Commodity Prices Chart III-25Commodity Prices Commodity Prices Commodity Prices Chart III-26Commodity Sentiment Commodity Sentiment Commodity Sentiment Chart III-27Speculative Positioning Speculative Positioning Speculative Positioning   ECONOMY: Chart III-28US And Global Macro Backdrop US And Global Macro Backdrop US And Global Macro Backdrop Chart III-29US Macro Snapshot US Macro Snapshot US Macro Snapshot Chart III-30US Growth Outlook US Growth Outlook US Growth Outlook Chart III-31US Cyclical Spending US Cyclical Spending US Cyclical Spending Chart III-32US Labor Market US Labor Market US Labor Market Chart III-33US Consumption US Consumption US Consumption Chart III-34US Housing US Housing US Housing Chart III-35US Debt And Deleveraging US Debt And Deleveraging US Debt And Deleveraging   Chart III-36US Financial Conditions US Financial Conditions US Financial Conditions Chart III-37Global Economic Snapshot: Europe Global Economic Snapshot: Europe Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Global Economic Snapshot: China Global Economic Snapshot: China   Mathieu Savary Vice President The Bank Credit Analyst   Footnotes 1  Please see The Bank Credit Analyst "March 2020," dated February 27, 2020, available at bca.bcaresearch.com 2  Chwieroth, Jeffrey M., Walter, Andrew, The Wealth Effect: How the Great Expectations of the Middle Class Have Changed the Politics of Banking Crises, 2019. 3  A relaxation of social-distancing measures would likely mean that large-scale gatherings are still prohibited, and life would not return to normal for a long time. 4  Please see US Equity Strategy "The Darkest Hour Is Just Before The Dawn," dated March 23, 2020, available at uses.bcaresearch.com 5  Please see Commodity & Energy Strategy "KSA, Russia Will Be Forced To Quit Market-Share War," dated March 19, 2020, available at ces.bcaresearch.com 6  "IMF Fourteenth Annual Research Conference in Honor of Stanley Fischer," Washington DC, November 8, 2013. 7  "Measuring the Natural Rate of Interest," Federal Reserve Bank of New York.

Dear Client, Next week we will be publishing a joint Special Report on the Chinese infrastructure investment outlook with our Emerging Markets Strategy service, authored by my colleague Ellen JingYuan He. Best regards, Jing Sima, China Strategist Feature Chart I-1Chinese Non-Financial Corporations Are Heavily Indebted Chinese Non-Financial Corporations Are Heavily Indebted Chinese Non-Financial Corporations Are Heavily Indebted There are fears that the two-month hiatus in China’s business activities due to the COVID-19 epidemic has sparked acute cash shortages among Chinese companies. In turn, this has increased the danger that the highly leveraged Chinese corporate sector may be pushed into widespread insolvency (Chart I-1). The number of bankruptcies will undoubtedly climb, but small and micro firms are most at risk versus larger companies that have deeper cash reserves and easier access to financing. Our analysis shows that, before the outbreak hit China in January, companies listed in China’s onshore and offshore equity markets exhibited relatively healthy financial statements with adequate operating cash flows to cover debt obligations. This increases the probability that Chinese listed companies will survive the economic and financial shocks from the epidemic, and that their stock prices will rebound along with the expectations of a recovery in the Chinese economy. Chart I-2Both Chinese Economy And Corporate Profits Are Largely Driven By Domestic Demand Both Chinese Economy And Corporate Profits Are Largely Driven By Domestic Demand Both Chinese Economy And Corporate Profits Are Largely Driven By Domestic Demand It also appears that China’s domestic economy is relatively insulated from the global financial market turmoil and impending global recession. China’s corporate profit outlook is dominated by domestic economic conditions rather than external demands. This view is also reflected in the relative performance of Chinese onshore and offshore stocks (Chart I-2). Moreover, the charts in the Appendix illustrate that corporate financial ratios in almost all sectors of China’s onshore and offshore equity markets have somewhat improved from the previous economic down cycle that began in 2014. This underscores our view that if reflationary measures overcompensate for the economic slowdown, as in the 2015/2016 easing cycle, then Chinese stocks will likely rally in absolute terms, as well as outperform global benchmarks. We selected three categories of financial ratios to monitor profitability, leverage and operating cash flow conditions of Chinese domestic and investable listed non-financial companies (Table I-1).1 The financial data in our exercise are from Refinitiv Datastream Worldscope. Its corresponding stock price indexes for China’s overall market and sectors most closely resemble the MSCI China Index and the MSCI China Onshore index. Table I-1 Monitoring Cash Flow Conditions In Chinese Listed Companies Monitoring Cash Flow Conditions In Chinese Listed Companies It is also noted that the Chinese investable index, excluding financial companies, is dominated by large technology companies such as Alibaba, Tencent, and Baidu.2 These tech companies generally have more adequate cash flows and lower debt ratios than the more capital intensive sectors such as industrial and energy. The analysis we present in this report on non-financial companies in the offshore market, therefore, is not indicative of China’s overall corporate financial health. Rather, our findings are indicative of how investors should view the listed companies and their sector performance within China’s investable market. Several observations from our analysis of the listed companies’ financial ratios are noteworthy: Chinese non-financial corporations are highly leveraged, and have not de-levered much despite the financial deleverage campaign that began in late 2017. Contrary to the belief that Chinese corporates’ financial health is significantly weaker than that in developed economies, the leverage ratio, profit margins, and debt-servicing ability among Chinese domestic and investable non-financial companies are actually in the range of their global peers (Chart I-3). Yet, Chinese companies trade at substantial discounts to global benchmarks. This is particularly evident in the offshore market, whereas domestic Chinese stocks were priced at a discount until the recent global market selloffs (Chart I-4). This underpins our view that, when China’s economy and corporate profits recover, Chinese stocks should outperform their global benchmarks on a cyclical time horizon. Importantly, with a stronger aggregate corporate financial health and a large price discount. Chinese investable non-financial stocks have more upside potential than their domestic counterparts. Chart I-3Financial Health Among Listed Chinese Companies Comparable With DMs Financial Health Among Listed Chinese Companies Comparable With DMs Financial Health Among Listed Chinese Companies Comparable With DMs Chart I-4Chinese Investable Stock Prices Remain Deeply Discounted Relative To Global Benchmarks Chinese Investable Stock Prices Remain Deeply Discounted Relative To Global Benchmarks Chinese Investable Stock Prices Remain Deeply Discounted Relative To Global Benchmarks   Utilities, machinery, industrials and construction materials are among the sectors with the lowest cash flow-to-interest expense ratios, in both China’s domestic and investable markets. In particular, machinery, industrials and construction materials are pro-cyclical sectors and their profit growth is positively correlated with economic growth. Their low profitability and high leverage contribute to their poor cash flows. Those sectors have been severely impacted by the stoppages in manufacturing and construction activities due to the COVID-19 epidemic in China, making them vulnerable to cash shortages. However, there is a low risk of a broad-based default among these firms, because state-owned enterprises (SOEs) dominate these sectors in the Chinese equity market. The stock performance in these sectors is also extremely sensitive to shifts in China’s monetary and policy stance, and thus should benefit from the recent loosening in monetary conditions and the push for a substantial increase in infrastructure investment this year. Chart I-5Small Property Developers In China Are Much More Vulnerable To Cash Shortages Than Large Ones Small Property Developers In China Are Much More Vulnerable To Cash Shortages Than Large Ones Small Property Developers In China Are Much More Vulnerable To Cash Shortages Than Large Ones The leverage ratio in the real estate sector has doubled in the past 10 years. The sector’s cash flow-to-total liabilities ratio has also declined sharply since 2017, when the authorities tightened lending standards to property developers. However, the sector’s aggregate cash flow situation is still an improvement from its lowest point in 2014, in both China’s domestic and investable markets. The countrywide lockdowns in January and February will undoubtedly have severe impacts on Chinese property developers’ cash flows. But the real estate sector is perhaps the best example in exhibiting a pronounced divergence in cash flow conditions between larger and smaller firms. Chart I-5 shows that, while the median ratio of cash-to-total liabilities tuned negative among 76 domestic listed real estate developers, the average ratio from total companies in the same sector suggests that the cash situation has actually improved since mid-2018. This divergence indicates that larger developers have more solid financial fundamentals and easier access to liquidity compared with their smaller counterparts, even before the lockdowns. We expect the divergence in cash flow conditions to widen in the coming months, and smaller property developers will face intensifying pressure to consolidate. China’s domestic healthcare companies have a much better cash balance than the investable healthcare sector, which has the lowest ratio of cash-to-interest expenses among all sectors. The poor cash flow conditions in investable healthcare companies are due to high leverage and low profitability, as well as high operating costs and R&D expenses. Chinese domestic healthcare sector has outperformed the broad market since the epidemic broke out in January. While we think the overall Chinese investable stocks have more upside than their domestic peers, domestic healthcare companies’ lower leverage ratio, stronger cash flows, and much higher profit margin make the sector a better bet than investable healthcare stocks on a cyclical time horizon (Chart I-6).  Chart I-6Domestic Healthcare Sector Likely To Continue Outperforming The Broad Market Domestic Healthcare Sector Likely To Continue Outperforming The Broad Market Domestic Healthcare Sector Likely To Continue Outperforming The Broad Market Chart I-7Energy Stocks Will Remain Depressed Until Oil Prices Rebound Energy Stocks Will Remain Depressed Until Oil Prices Rebound Energy Stocks Will Remain Depressed Until Oil Prices Rebound Historically, there has been a strong positive correlation between the energy sector’s profitability, cash flow conditions, stock performance and crude oil prices (Chart I-7). In the past two years, the sector’s leverage ratio has risen, profit margins have thinned and the cash flow situation has sharply deteriorated to the same level as in 2014 when oil prices collapsed. The ongoing oil price rout will generate powerful deflationary forces in the energy sector and will likely further deteriorate energy firms’ profitability and cash flow. While we stay long cyclical stocks versus defensives on both a 0-3 month and a 6-12 month view, we recommend a cautious stance towards energy stocks until the evolving oil price war situation is clarified.   Qingyun Xu, CFA Senior Analyst qingyunx@bcaresearch.com Jing Sima China Strategist jings@bcaresearch.com Appendix Overall Markets Excluding Financials Overall Markets Excluding Financials Sector Overall Markets Excluding Financials Sector Consumer Discretionary Sector Consumer Discretionary Sector Consumer Discretionary Sector Consumer Staples Sector Consumer Staples Sector Consumer Staples Sector Real Estate Sector Real Estate Sector Real Estate Sector Automobile Sector Small Property Developers In China Are Much More Vulnerable To Cash Shortages Than Large Ones Small Property Developers In China Are Much More Vulnerable To Cash Shortages Than Large Ones Machinery Sector Machinery Sector Machinery Sector Industrials Sector Industrials Sector Industrials Sector Construction Materials Sector Construction Materials Sector Construction Materials Sector Telecommunications Sector Telecommunications Sector Telecommunications Sector Technology Sector Technology Sector Technology Sector Healthcare Sector Healthcare Sector Healthcare Sector Energy Sector Energy Sector Energy Sector   Utilities Sector Utilities Sector Utilities Sector   Footnotes 1    We exclude banks and financial institutions from this analysis, due to discrepancy in Chinese banks’ accounting measures from those of non-financial corporations’. 2   Alibaba, Tencent, Baidu, and JD together account for nearly 40% of the non-financial market cap in Chinese investable index. Cyclical Investment Stance Equity Sector Recommendations

Highlights For stock markets, the best inoculation against Covid-19 is ultra-low bond yields. Our tactical underweight to equities versus bonds achieved its 5 percent profit target and is now closed. We are now awaiting the fractal signal to go tactically overweight (Chart of the Week). Price to sales is a much better predictor of 10-year returns than is price to earnings, especially when profit margins are stretched as they are now. New long-term recommendation: overweight Swedish equities versus bonds. Germany and Switzerland also offer attractive excess 10-year equity returns over bonds. Fractal trade: the 130 percent outperformance of palladium versus nickel in just six months is now technically stretched. Chart of the WeekStocks Are Approaching Oversold – Stay Tuned Stocks Are Approaching Oversold - Stay Tuned Stocks Are Approaching Oversold - Stay Tuned For Stock Markets, The Best Inoculation Against Covid-19 Is Ultra-Low Bond Yields A global slowdown, exacerbated by the Covid-19 virus contagion, is dominating the news and financial headlines. There are worries that the stock market is still in denial and has a long way to fall – rather like Wile E. Coyote suspended in disbelief as he runs over the cliff-edge. In fact, some of the most economically sensitive equity sectors have already fallen a long way. For example, the oil and gas sector is down by 20 percent (Chart 2). Chart I-2Economically Sensitive Sectors And Bond Yields Have Plunged Economically Sensitive Sectors And Bond Yields Have Plunged Economically Sensitive Sectors And Bond Yields Have Plunged Meanwhile, bond yields have plunged to new lows, and in some cases all-time lows. Hence, we are pleased to report that our tactical underweight to equities versus 10-year bonds, initiated on January 9, has achieved its 5 percent profit target and is now closed.1 We are now awaiting the fractal signal to go tactically overweight. Bond yields have plunged to new lows. Having said that, when the world economy is set to grind to a halt in the first quarter, and halfway to a recession, is a 5 percent underperformance of equities versus bonds enough? There is certainly scope for some further downside, but for investors with a multi-year horizon, equities still win the ugly contest versus bonds. Where bond yields are approaching the lower limit to their yields – around -1 percent – it means they are approaching the upper limit to their prices. Hence, bonds become a ‘lose-lose’ proposition. Bond prices cannot rise much further, even in an economic slump, but they can fall a lot if sentiment suddenly recovers. As the riskiness of bonds rises relative to equities, the prospective return that investors will accept from equities rapidly collapses to the ultra-low level of bond yields. And as valuation is just the inverse of prospective return, this underpins and justifies an exponentially higher valuation of equities. How can we best gauge the prospective (long-term) returns that equities now offer? To answer this question, we need to take a Japanese lesson. A Japanese Lesson: Price To Sales Is The Best Predictor Of Prospective Return A great advantage of being a European investor is that the difficult investment questions have already been asked and answered by our friends in Japan – so we just need to take some Japanese lessons. One of the most important lessons is that the Japanese stock market’s price to sales multiple has a near-perfect predictive record for Japanese 10-year returns since the 1980s.2 For world equities, market capitalisation to GDP (which broadly equates to price to sales at a world level) also has a near-perfect predictive record for 10-year returns since the late 1990s.3 The corollary lesson is that the price to earnings multiple – either based on 12-month trailing or 12-month forward earnings – is not such a good predictor of prospective return. Price to earnings wrongly pinpointed Japan’s highest valuation in 1994 rather than at the peak of the bubble in 1989. Moreover, since 2000, price to earnings has suggested that Japan’s stock market is cheaper than it truly is, and grossly overestimated prospective returns. Price to earnings made the same mistake for world equities in the mid-noughties, understating valuations and thereby overestimating prospective returns. The trouble with price to earnings is that it takes no account of the likely evolution of profit margins – treating a stock market multiple of, say, 30 on a high profit margin the same as 30 on a low profit margin. The problem is that when the market is trading at 30 on a low margin it has the capacity for higher profit growth through margin expansion – and thereby a higher prospective return – than when it is trading at 30 on a high margin (Chart 3). Chart I-3Price To Earnings Takes No Account Of Changing Profit Margins Price To Sales Has An Excellent Predictive Record In Japan... Price To Sales Has An Excellent Predictive Record In Japan... It follows that a high price to earnings on a low profit margin makes the market appear more expensive than it truly is, and thereby underestimates prospective returns. In 1994, Japan appeared to be more expensive than at the peak of the bubble in 1989 because profit margins halved through 1989-94. The trouble with price to earnings is that it takes no account of the likely evolution of profit margins. Conversely, a low price to earnings on a high profit margin makes the market appear less expensive that it truly is, and thereby overestimates prospective returns (Chart 4 and Chart 5). Chart I-4Price To Sales Has An Excellent Predictive Record In Japan… ...Whereas Price To Earnings Has Made Many Mistakes ...Whereas Price To Earnings Has Made Many Mistakes Chart I-5…Whereas Price To Earnings Has Made Many Mistakes Price To Earnings Takes No Account Of Changing Profit Margins Price To Earnings Takes No Account Of Changing Profit Margins   In the mid-noughties, Japan appeared to be less expensive than it truly was because profit margins surged through 2001-07. The same was true for world equities. Hence, price to earnings grossly overestimated the prospective long-term return in 2007 (Chart 6). Chart I-6Profit Margins Are At Generational Highs Profit Margins Are At Generational Highs Profit Margins Are At Generational Highs Price to sales avoids the mistakes of price to earnings by removing profit margins from the equation. Put another way, it is like using price to earnings with a constant long-term profit margin. This tends to be more prudent – especially today when margins are close to generational highs and facing several threats in the coming years. One threat to profit margins comes from a growing populist backlash against record high corporate profitability, especially in the most profitable sectors. The threat manifests through populist politicians or parties which vow to rein in runaway profitability through higher taxes and/or regulation and/or nationalisation. Think Bernie Sanders. A second threat comes from environmental, social, and corporate governance (ESG). Think carbon taxes. A third threat comes the possible break-up of the pseudo-monopoly tech behemoths, killing both their pricing power and market penetration. Think antitrust suit against Google or Facebook. Admittedly, this is likely to be a US focussed threat, but the impact on stock markets would be felt worldwide. Given these threats, long-term investors should assume some pressure on profit margins from today’s generational highs. Accordingly, just as in 2007, price to sales is likely to be a much better predictor of prospective returns than is price to earnings (Chart 7 and Chart 8). Chart I-7At A World Level, Market Cap To GDP Has An Excellent Predictive Record… At A World Level, Market Cap To GDP Has An Excellent Predictive Record... At A World Level, Market Cap To GDP Has An Excellent Predictive Record... Chart I-8…Whereas Price To Earnings Was Very Wrong In 2007 ...Whereas Price To Earnings Was Very Wrong In 2007 ...Whereas Price To Earnings Was Very Wrong In 2007 Sweden Is An Attractive Long-Term Opportunity Price to sales predicts that stock markets, on average, are set to deliver feeble single-digit total nominal returns over the coming decade. Nevertheless, with bond yields even closer to zero, and the riskiness of bonds much higher at ultra-low yields, equities still beat bonds in the ugly contest of long-term prospective returns. In fact, in those countries where bond yields are approaching their lower limit of around -1 percent – meaning bond prices are approaching their upper limit – equities win the contest more handsomely. On this basis, the stock markets in Germany and Switzerland offer attractive excess 10-year returns over their bond markets. But the most attractive long-term opportunity is Sweden. Based on its price to sales multiple, Sweden’s stock market is set to deliver around 6 percent a year over the coming decade (Chart 9). Chart I-9Sweden’s Stock Market Is Set To Deliver 6 Percent A Year Sweden's Stock Market Is Set To Deliver 6 Percent A Year Sweden's Stock Market Is Set To Deliver 6 Percent A Year Given that Sweden’s 10-year bond yield is negative, Sweden’s stock market takes the honour of offering one of the world’s highest excess 10-year returns over its bond market (Chart 10). Chart I-10Sweden’s Stock Market Has The Highest Excess Return Over Bonds Sweden's Stock Market Has The Highest Excess Return Over Bonds Sweden's Stock Market Has The Highest Excess Return Over Bonds Accordingly, we are adding Sweden to our existing structural overweight to equities versus long-dated bonds in Germany, in a 50:50 combination. Fractal Trading System* As discussed, we are pleased to report that underweight S&P 500 versus the 10-year T-bond achieved its 5 percent profit target and is now closed. Elsewhere, the palladium price has surged. In just six months, palladium has outperformed nickel by 130 percent, making its 130-day fractal structure extremely fragile. Accordingly, this week’s recommended trade is short palladium versus nickel, setting a profit target of 32 percent with a symmetrical stop-loss. The rolling 1-year win ratio now stands at 60 percent. Palladium Vs. Nickel Palladium Vs. Nickel 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.   Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com   * 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 Footnotes 1 Our expression of this was underweight S&P 500 versus US 10-year T-bond. 2 Prospective returns are nominal total (capital plus income) 10-year returns, shown as an annualised rate. 3 Price/sales per share = (price*number of shares)/(sales per share * number of shares) = market capitalisation/total sales. At a global level, total sales broadly equal GDP, so price/sales per share = market capitalisation/GDP. But note that this does not apply at a regional or country level because sales can originate from outside the domestic economy.. Fractal Trading System Stocks Sold Off. Now What? Stocks Sold Off. Now What? Stocks Sold Off. Now What? Stocks Sold Off. Now What? 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