Disasters/Disease

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

Highlights The six-month increase in European bank credit flows amounts to an underwhelming $70 billion, compared to a record high $660 billion in the US and $550 billion in China. Underweight European domestic cyclicals versus their peers in the US and China. Specifically, underweight euro area banks versus US banks. Overweight equities on a long-term (2 years plus) horizon. The mid-single digit return that equities are offering makes them attractive versus ultra-low yielding bonds. But remain neutral equities on a 1-year horizon, until it becomes clear that we can prevent a second wave of the pandemic. Fractal trade: long bitcoin cash, short ethereum. Feature Chart I-1Bank Credit 6-Month Flow Up $70 Bn ##br##In The Euro Area… Bank Credit 6-Month Flow Up $70 Bn In The Euro Area... Bank Credit 6-Month Flow Up $70 Bn In The Euro Area... Chart I-2…But Up $700 Bn ##br##In The US ...But Up $700 Bn In The US ...But Up $700 Bn In The US Governments and central banks are dishing out an alphabet soup of stimulus. The question is: how much is reaching those that need it? Our preferred approach to assessing monetary stimulus is to focus on the evolution of bank credit flows and bond yields over a six-month period. Bank Credit Flows Have Surged In The US And China, Not In Europe On our preferred assessment, Europe’s monetary stimulus is underwhelming compared with that in the US and China. The six-month increase in US bank credit flows, at $660 billion, is the highest in a decade and not far from the highest ever. In China, the equivalent six-month increase is $550 billion. But in the euro area, the six-month increase in bank credit flows amounts to an underwhelming $70 billion (Charts I-1 - Chart I-4). Chart I-3Bank Credit 6-Month Flow Up $550 Bn In China… Bank Credit 6-Month Flow Up $550 Bn In China... Bank Credit 6-Month Flow Up $550 Bn In China... Chart I-4...And Up ##br##Globally ...And Up Globally ...And Up Globally Admittedly, US firms are drawing on pre-arranged bank credit lines rather than taking out new loans. Furthermore, the link between bank credit flows and final demand might be compromised during the current economic shutdown. For example, if firms are borrowing to pay workers who are not producing any output, then the transmission of a credit flow acceleration to a GDP acceleration would be weakened. Europe’s monetary stimulus is underwhelming compared with that in the US and China. Nevertheless, some bank credit flows will still reach the real economy. And the US and China are creating more bank credit flows than Europe. Focus On The Deceleration Of The Bond Yield Turning to the bond yield, it is important to focus not on its level, and not on its decline. Instead, it is important to focus on its deceleration. The focus on the deceleration of the bond yield sounds counterintuitive, but it results from a fundamental accounting identity. The next two paragraphs may seem somewhat technical but read them carefully, as they are important for understanding the transmission of stimulus. GDP is a flow. It measures the flow of goods and services produced in a quarter. Hence, GDP receives a contribution from the flow of credit. The flow of credit, in turn, is established by the level of bond yields. When we talk about stimulating the economy, we mean boosting the GDP growth rate from, say, -1 percent to +1 percent, which is an acceleration of GDP. This acceleration in the GDP flow must come from an acceleration in the flow of credit. This acceleration in the flow of credit, in turn, must come from a deceleration of bond yields. In other words, the bond yield decline in the most recent period must be greater than the decline in the previous period. Banks tend to perform better after bond yields have decelerated. The good news is that in the US and China, bond yields have decelerated; the bad news is that in Europe, they have not. Over the past six months, the 10-year bond yield has decelerated by 40 bps in the US and by 65 bps in China. Yet in France, despite the coronavirus crisis, the 10-year bond yield has accelerated by 60 bps (Charts I-5 - Chart I-8).1 Chart I-5The Bond Yield Has Accelerated ##br##In The Euro Area... The Bond Yield Has Accelerated In The Euro Area... CHART B The Bond Yield Has Accelerated In The Euro Area... CHART B Chart I-6...Decelerated ##br##In The US... ...Decelerated In The US... ...Decelerated In The US... Chart I-7...Decelerated In China... ...Decelerated In China... ...Decelerated In China... Chart I-8...And Decelerated Globally ...And Decelerated Globally ...And Decelerated Globally European bond yields are struggling to decelerate because of their proximity to the lower bound to bond yields, at around -1 percent. The inability to decelerate the bond yield constrains the monetary stimulus that Europe can apply compared to the US and China, whose bond yields are much further from the lower bound constraint. Compared to Europe, the US and China have much stronger decelerations in their bond yields and much stronger accelerations in their bank credit flows. This suggests underweighting European domestic cyclicals versus their peers in the US and China. Specifically, banks tend to perform better after bond yields have decelerated; and they tend to perform worse after bond yields have accelerated. On this basis, underweight euro area banks versus US banks (Chart I-9). Chart I-9Banks Perform Better After Bond Yields Have Decelerated, Worse After Bond Yields Have Accelerated Banks Perform Better After Bond Yields Have Decelerated, Worse After Bond Yields Have Accelerated Banks Perform Better After Bond Yields Have Decelerated, Worse After Bond Yields Have Accelerated Long-Term Asset Allocation Is Straightforward, Shorter-Term Is Not The level of the bond yield, or of so-called ‘financial conditions’, does not drive the short-term oscillations in credit flows. To repeat, it is the acceleration and deceleration of the bond yield that matters. Yet when it comes to the long-term valuation of assets, the level of the bond yield does matter, and when the bond yield is ultra-low it matters enormously. An ultra-low bond yield justifies a much lower prospective return on competing long-duration assets, like equities. The reason is that when bond yields approach their lower bound, bond prices can no longer rise, they can only fall. This higher riskiness of bonds justifies an abnormally low (or zero) ‘risk premium’ on equities. In this world of ultra-low numbers – for both bond yields and equity risk premiums – the low to mid-single digit long-term return that equities are offering makes them attractive versus bonds (Chart I-10). Chart I-10Equities Are Offering Mid-Single Digit Long-Term Returns Equities Are Offering Mid-Single Digit Long-Term Returns Equities Are Offering Mid-Single Digit Long-Term Returns But this long-term valuation argument only works for those with long-term investment horizons. What does long-term mean? There is no clear dividing line, but we would define long-term as two years at the very minimum. For a one-year investment horizon, the much more important question is: what will happen to 12-month forward earnings (profits)?  In the stock market recessions of 2008-09 and 2015-16, the stock market reached its low just before forward earnings reached their low. Assuming the same holds true in 2020-21, we must establish whether forward earnings are close to their low or not. In 2008-09, world forward earnings collapsed by 45 percent. In the current recession, which is putatively worse, world forward earnings are down by less than 20 percent to date. To have already reached the cycle low in forward earnings with only half the decline of 2008, the current recession needs to be much shorter than the 2008-09 episode (Chart I-11 and Chart I-12). Chart I-11In The Global Financial Crisis, Forward Earnings Collapsed By 45 Percent In The Global Financial Crisis, Forward Earnings Collapsed By 45 Percent In The Global Financial Crisis, Forward Earnings Collapsed By 45 Percent Chart I-12In The Current Crisis, Forward Earnings Are Down 20 Percent. Is That Enough? In The Current Crisis, Forward Earnings Are Down 20 Percent. Is That Enough? In The Current Crisis, Forward Earnings Are Down 20 Percent. Is That Enough? Whether this turns out to be the case or not hinges on the pandemic and our response to it. A controlled easing of lockdowns will boost growth as more of the economy comes back to life. But too rapid an easing of lockdowns will unleash a second wave of the pandemic, requiring a second wave of economic shutdowns, a double dip recession and a new low in the stock market. Hence, if you have a long-term (2-year plus) investment horizon, the choice between equities and bonds is very straightforward: overweight equities. On this long-term horizon, German and Swedish equities are especially attractive versus negative-yielding bonds. On a 1-year investment horizon, the key question is: can we avoid a second wave of the pandemic? But if you have a 1-year investment horizon, the choice is less straightforward, because it hinges on whether we can avoid a second wave of the pandemic or not. Until it becomes clear that governments will not reopen economies too quickly, remain neutral equities on the 1-year horizon. Fractal Trading System* This week’s recommended trade is a pair-trade within the cryptocurrency asset-class. Long bitcoin cash / short ethereum. Set the profit target at 21 percent with a symmetrical stop-loss. The 12-month rolling win ratio now stands at 61 percent. Chart I-13Bitcoin Cash Vs. Ethereum Bitcoin Cash Vs. Ethereum Bitcoin Cash Vs. Ethereum When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated  December 11, 2014, available at eis.bcaresearch.com.   Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1 In the US, the 10-year bond yield has declined by 120 bps in the past six months compared with 80 bps in the preceding six months, which equals a deceleration of 40 bps; in China, the 10-year bond yield has declined by 73 bps in the past six months compared with 18 bps in the preceding six months, which equals a deceleration of 65 bps; but in France, the 10-year bond yield has increased by 12 bps in the past six months compared with a 48 bps decline in the preceding six months, which equals an acceleration of 60 bps. Fractal Trading System   Cyclical Recommendations Structural Recommendations Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

Dear Client, This week, in lieu of our regular report, we are sending you a Special Report from my colleague Jonathan LaBerge. Jonathan discusses the global fiscal response to the COVID-19 pandemic, and provides some perspective on whether the response will be enough to prevent an "L-shaped" economic outcome. I hope you find the report insightful. Last Friday, I participated in a webcast with my fellow BCA Strategists Caroline Miller and Arthur Budaghyan where we discussed the outlook for developed and emerging market equities over the immediate (0-3 month) and cyclical (12 month) horizon. You can access a replay of the webcast here. Please note we will be sending out our regular weekly report next week. Best regards, Peter Berezin, Chief Global Strategist Highlights 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. Feature 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 1 presents the IMF’s estimate of the total fiscal response to the crisis across major countries, as of April 23, 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 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. Chart 1The Global Fiscal Response Is Huge When Including All Measures The Global COVID-19 Fiscal Response: Is It Enough? The Global COVID-19 Fiscal Response: Is It Enough? Instead, Chart 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.1 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 2The Picture Changes When Excluding Below-The-Line Measures The Global COVID-19 Fiscal Response: Is It Enough? The Global COVID-19 Fiscal Response: Is It Enough? Analysis by Bruegel, provides somewhat different estimates of the global COVID-19 fiscal response for select European countries as well as the US (Table 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 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. Table 1The Type Of Fiscal Response Varies Significantly Across Countries The Global COVID-19 Fiscal Response: Is It Enough? The Global COVID-19 Fiscal Response: Is It Enough? Chart 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.2Chart 3 is based on a combination of data from the IMF, Bruegel analysis, and BCA estimates and news analysis. Chart 3When Narrowly Defined, Several Countries Are Responding Forcefully, But Many Countries Are Not The Global COVID-19 Fiscal Response: Is It Enough? The Global COVID-19 Fiscal Response: Is It Enough? Overall, investors can draw the following conclusions from Charts 1 – 3 and Table 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 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 4 illustrates the total impact of this approach for key developed and emerging economies. Chart 4Annual GDP Will Be 1.5%-2.5% Lower For Each Month Lockdowns Are In Effect The Global COVID-19 Fiscal Response: Is It Enough? The Global COVID-19 Fiscal Response: Is It Enough? 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 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). 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 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). Chart 5Additional Lockdown Events Are A Greater Risk Than First Wave After-Effects The Global COVID-19 Fiscal Response: Is It Enough? The Global COVID-19 Fiscal Response: Is It Enough? 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 2 and 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. 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 2 and 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 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). Table 2Fiscal Multipliers Are Much Larger During Recessions Than Expansions The Global COVID-19 Fiscal Response: Is It Enough? The Global COVID-19 Fiscal Response: Is It Enough? Table 3Models Suggest The Multiplier Is Quite High At The Zero Lower Bound The Global COVID-19 Fiscal Response: Is It Enough? The Global COVID-19 Fiscal Response: Is It Enough? Second, Table 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 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 1The 'Bucket' Approach To Estimating Fiscal Multipliers The Global COVID-19 Fiscal Response: Is It Enough? The Global COVID-19 Fiscal Response: Is It Enough? 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 1 - 3 on pages 3-5. 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. Chart 6Much Of The US Fiscal Response Is Going To Households And Small Businesses The Global COVID-19 Fiscal Response: Is It Enough? The Global COVID-19 Fiscal Response: Is It Enough? 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. For now, we limit our distributional analysis to the US, and hope to expand our approach to other countries in future research. Chart 6 presents a breakdown of the US fiscal response by recipient, which informs the following observations. Households: Chart 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 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.   Table 4US Household Relief Is Just As Generous As Seemingly Better Programs The Global COVID-19 Fiscal Response: Is It Enough? The Global COVID-19 Fiscal Response: Is It Enough? 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.   Firms: On April 16 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.   Table 5Help For Small Businesses Will Replace A Significant Amount Of Lost Income The Global COVID-19 Fiscal Response: Is It Enough? The Global COVID-19 Fiscal Response: Is It Enough? 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 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. 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 30 when most of the assistance from CARES must be spent.   Chart 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 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 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.3 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 8 reproduces Chart 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 8 explicitly excludes below-the-line measures. Chart 8Several Important Countries Seem To Be Doing Enough, But More Is Needed In Europe Ex-Germany The Global COVID-19 Fiscal Response: Is It Enough? The Global COVID-19 Fiscal Response: Is It Enough? However, there are two important caveats to this conclusion. First, Chart 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. 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 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.4 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 6By Re-Opening Soon, The US May Be Risking A Damaging Second Wave The Global COVID-19 Fiscal Response: Is It Enough? The Global COVID-19 Fiscal Response: Is It Enough? The table highlights that these methods generally prescribe a reopening date of May 31 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 6 is that US newly confirmed cases are only currently projected to fall to zero as of February 2021. Chart 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 9No Clear Downtrend Yet Outside Of New York State The Global COVID-19 Fiscal Response: Is It Enough? The Global COVID-19 Fiscal Response: Is It Enough? 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 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 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 11). Chart 11Multiple Equilibria In Debt Markets Are Possible Without A Lender Of Last Resort The Global COVID-19 Fiscal Response: Is It Enough? The Global COVID-19 Fiscal Response: Is It Enough? 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 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. Third, Chart 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. Chart 12Italy's Structural Budget Balance Has Improved Italy's Structural Budget Balance Has Improved Italy's Structural Budget Balance Has Improved Chart 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   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 jonathanl@bcaresearch.com Footnotes 1 “Skeptical economists call Japan’s largest-ever stimulus package ‘puffed-up’, Keita Nakamura, The Japan Times, April 8, 2020. 2 Please note that Chart 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. 3 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, available at gps.bcaresearch.com. 4 School and work closure dates have been sources from the Oxford COVID-19 Government Response Tracker. Global Investment Strategy View Matrix The Global COVID-19 Fiscal Response: Is It Enough? The Global COVID-19 Fiscal Response: Is It Enough? Current MacroQuant Model Scores The Global COVID-19 Fiscal Response: Is It Enough? The Global COVID-19 Fiscal Response: Is It Enough?  

Highlights Even as a net oil importer, China loses more than it gains when oil prices collapse. An oil price collapse generates a formidable deflationary force, which will further depress China’s industrial pricing power and profit growth in Q2. There are early signs that demand in some sectors is gaining traction in the first three weeks of April. A full removal of travel restrictions in late May in China should help speed up the return of domestic business activities. We maintain our view that China’s economic recovery will pick up momentum in H2, underpinning our cyclical overweight stance on Chinese risk assets. Feature The nosedive in oil futures last week was a rude awakening of the enormous and unpredictable impact the pandemic has on the global economy and financial markets. WTI futures for May 2020 delivery fell to -$40.40 per barrel on April 20, an unprecedented event.  The collapse in oil prices since March will generate substantial deflationary headwinds to China’s economy in the months ahead (Chart 1). Producer prices are already in contraction. An imported deflation from low oil prices will weaken industrial pricing power even more, pushing up real rates. China’s industrial profit growth also moves in lockstep with producer prices. A deepening in PPI contraction means industrial profit growth will remain underwater, underscoring our view that the near-term outlook for Chinese stocks is yet to turn sanguine (Chart 2). Chart 1Falling Oil Prices: A Substantial Deflationary Force Falling Oil Prices: A Substantial Deflationary Force Falling Oil Prices: A Substantial Deflationary Force Chart 2Deflation Weakens Industrial Profit Growth Deflation Weakens Industrial Profit Growth Deflation Weakens Industrial Profit Growth   Oil prices will likely rebound in Q3 when the global economy re-opens, oil supply cuts take hold and the US dollar peaks. Our Commodity and Energy strategist estimates that WTI spot prices will reach $38/barrel by end-2020.1 A modest recovery in oil prices alone will not be enough to lift Chinese producer prices back to positive. The substantial reflationary efforts from China’s policymakers since Q1 should start to have an impact on the real economy in H2. The exponential credit growth should effectively prop up investment and consumption growth, and reduce inventory overhang in the industrial sector. We expect industrial producer prices and profits to turn slightly positive in Q3/Q4, underpinning our constructive view on Chinese stocks in the next 6- to 12-months. Oil Price Collapse: A Bane, Not A Boon China, as a net oil importer, stands to lose more than gain in an oil price war. This is contrary to commonly held economic theory that net oil importing countries are winners from cheaper oil. In theory falling oil prices reduces import prices, improves net oil importers’ term of trade, and in turn contributes positively to their GDP growth. In reality oil prices rarely fall in isolation. A precipitous fall in oil prices is almost always triggered by a sharp decline in global demand, accompanied with a spike in the US dollar, and results in a turmoil in the global financial markets (Chart 3). Therefore, depending on where an economy is positioned in the global value chain, a net oil importer may lose even more than a net oil exporter when oil prices collapse. Chart 3Global Trade Remains Under Pressure Until Dollar Peaks Global Trade Remains Under Pressure Until Dollar Peaks Global Trade Remains Under Pressure Until Dollar Peaks Chart 4China Loses More From Falling Trade Than Gains From Falling Oil Prices China Loses More From Falling Trade Than Gains From Falling Oil Prices China Loses More From Falling Trade Than Gains From Falling Oil Prices At only 14% of world oil consumption, China’s demand for oil alone is not enough to support a price recovery. But as a global manufacturing powerhouse, the benefits China has gained from cheaper oil in the past cycles were often more than offset by the economic and financial shocks from an oil price collapse (Chart 4). The small positive contribution to China’s GDP growth via savings on oil import bills is further discounted by losses from China’s own oil and oil-product exports (Chart 4, middle panel). China’s oil and gas sector does not necessarily benefit from collapsing oil prices. The country’s domestic oil exploration becomes deeply unprofitable when international oil prices collapse. Falling domestic demand for finished oil products and rising competition in the industry when prices are low squeeze out any extra profits for oil refineries (Chart 5). Chart 5China’s Energy Sector Suffers Too In An Oil Bear Market China's Energy Sector Suffers Too In An Oil Bear Market China's Energy Sector Suffers Too In An Oil Bear Market Chart 6Energy Costs: A Small Part Of Chinese CPI Energy Costs: A Small Part Of Chinese CPI Energy Costs: A Small Part Of Chinese CPI Chart 7US Consumers Benefit Much More From An Oil Price Decline Than Chinese Consumers US Consumers Benefit Much More From An Oil Price Decline Than Chinese Consumers US Consumers Benefit Much More From An Oil Price Decline Than Chinese Consumers Furthermore, unlike the US, Chinese household consumption does not get a boost from cheaper oil. Food prices, rather than energy, drive the overall consumer price inflation in China (Chart 6). In addition, China’s domestic petrol market is heavily regulated and retail prices for energy are set by the Chinese government. China does not pass on the entire benefit of an energy price decline to its consumers, a rigid policy that has not been changed since 2016.2 As such, the current reduction in oil prices will not have the same “tax cut” benefit as it does for US consumers (Chart 7). Bottom Line: Low oil prices, accompanied by a strong dollar and depressed global trade, create a self-feeding deflationary feedback loop to China’s industrial sector, reducing the effects of the existing reflationary measures on its economy. Budding Signs Of Reflation A modest recovery in oil prices in Q3 will not be enough to return China's PPI to positive territory. Even when the global economy re-opens, the initial recovery in business activities and demand will likely be gradual, a situation China has experienced in the past two months (Chart 8). Thus, China’s domestic demand will bear most of the brunt to shore up inflation in produced goods, by propping up investment and consumption growth. We expect China’s substantial reflationary measures to start filtering into the real economy in H2. China’s industrial sector should get a boost from an acceleration in infrastructure investment and producer prices should turn moderately positive later in Q3 (Chart 9). Chart 8China’s Export Growth Set To Decline Further In Q2 China's Export Growth Set To Decline Further In Q2 China's Export Growth Set To Decline Further In Q2 Chart 9Huge Credit Wave Should Start Lifting Industrial Profits In H2 Huge Credit Wave Should Start Lifting Industrial Profits In H2 Huge Credit Wave Should Start Lifting Industrial Profits In H2 High-frequency data point to some early signs of a rebound in China’s domestic demand. The annual growth in the transaction volume of rebar steel rebounded from an 8% decline in March to 4% growth in the first three weeks in April.3 The contraction in passenger car sales also narrowed from -38% in March to -7.3% so far in April.4 China is ramping up its COVID-19 antibody testing to prevent a second-wave outbreak and is preparing for the National People’s Congress (NPC), which may take place in mid-May. Inter-provincial travel restrictions have limited the speed of recovery in business operations, but we expect such cautionary measures to be fully lifted in late May. The removal of logistic restrictions will help to accelerate a return to normal in both domestic production and demand. As we noted in our last week’s report,5 the April 17 Politburo meeting confirmed a policy shift to maximum reflation. President Xi’s new slogan, “The Six Stabilities and The Six Guarantees,” sets the tone that the government will increase investments to ensure that China’s post-pandemic economic growth is strong enough to stabilize employment. Bottom Line: Chinese business activities continue to inch up.  The recovery in domestic demand should pick up momentum in H2 to offset imported deflationary pressures on China’s industrial profits.  Investment Conclusions In the near term, a strong US dollar is a key risk to the recovery of China’s industrial profits.  The greenback not only generates downward pressure on oil prices and global trade, but also puts the RMB in a poor position of depreciating against the dollar but at the same time appreciating against China’s export competitors (Chart 10). All are creating headwinds to China’s economic recovery. We recommend that investors stay on the sidelines in the near term until the dollar peaks and oil prices rebound, probably in Q3.  However, on a cyclical time horizon, as the global economy re-opens and demands slowly recovers in H2, the flood of stimulus including China's own reflation efforts should help to restore investors’ risk appetite and lift the prices of risk assets. Although Chinese stocks have passively outperformed global stocks this year, the strong rebound in the SPX in recent weeks has made Chinese stocks slightly less overbought in relative terms (Chart 11). Chart 10A Tough Combination For The RMB A Tough Combination For The RMB A Tough Combination For The RMB Chart 11Chinese Stocks: Slightly Less Overbought In Past Weeks Chinese Stocks: Slightly Less Overbought In Past Weeks Chinese Stocks: Slightly Less Overbought In Past Weeks We expect China’s corporate profit growth to outpace global earnings growth this year, even as other economies re-open and start to recover. This warrants an overweight stance on Chinese stocks after near-term risks and market gyrations subside.   Jing Sima China Strategist jings@bcaresearch.com     Footnotes 1Please see Commodity & Energy Strategy Weekly Report "USD Strength Restrains Commodity Recovery," dated April 23, 2020, available at ces.bcaresearch.com 2The floor for retail fuel prices is set at $40 a barrel to limit losses at China’s state-owned oil companies, which generally have average production costs in the range of $40-$50 per barrel. http://english.www.gov.cn/news/top_news/2016/01/13/content_281475271410529.htm 3Based on daily data from MySteel. 4Based on weekly data from China Passenger Car Association. 5Please see China Investment Strategy Weekly Report "Three Questions Following The Coronacrisis," dated April 23, 2020, available at cis.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations

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.

Highlights The collapse in oil prices supercharges the geopolitical risks stemming from the global pandemic and recession. Low oil prices should discourage petro-states from waging war, but Iran may be an important exception. Russian instability is one of the most important secular geopolitical consequences of this year’s crisis. President Trump’s precarious status this election year raises the possibility of provocations or reactions on his part. Europe faces instability on its eastern and southern borders in coming years, but integration rather than breakup is the response. Over a strategic time frame, go long AAA-rated municipal bonds, cyber security stocks, infrastructure stocks, and China reflation plays. Feature Chart 1Someone Took Physical Delivery! Someone Took Physical Delivery! Someone Took Physical Delivery! Oil markets melted this week. Oil volatility measured by the Crude Oil ETF Volatility Index surpassed 300% as WTI futures for May 2020 delivery fell into a black hole, bottoming at -$40.40 per barrel (Chart 1). Our own long Brent trade, initiated on 27 March 2020 at $24.92 per barrel, is down 17.9% as we go to press. Strategically we are putting cash to work acquiring risk assets and we remain long Brent. The forward curve implies that prices will rise to $35 and $31 per barrel for Brent and WTI by April 2021. We initiated this trade because we assessed that: The US and EU would gradually reopen their economies (they are doing so). Oil production would be destroyed (more on this below). Russia and Saudi Arabia would agree to production cuts (they did). Monetary and fiscal stimulus would take effect (the tsunami of stimulus is still growing). Global demand would start the long process of recovery (no turn yet, unknown timing). On a shorter time horizon, we are defensively positioned but things are starting to look up on COVID-19 – New York Governor Andrew Cuomo has released results of a study showing that 15% of New Yorkers have antibodies, implying a death rate of only 0.5%. The US dollar and global policy uncertainty may be peaking as we go to press (Chart 2). However, second-order effects still pose risks that keep us wary. Chart 2Dollar And Policy Uncertainty Roaring Dollar And Policy Uncertainty Roaring Dollar And Policy Uncertainty Roaring Geopolitics is the “next shoe to drop” – and it is already dropping. A host of risks are flying under the radar as the world focuses on the virus. Taken alone, not every risk warrants a risk-off positioning. But combined, these risks reveal extreme global uncertainty which does warrant a risk-off position in the near term. This week’s threats between the US and Iran, in particular, show that the political and geopolitical fallout from COVID-19 begins now, it will not “wait” until the pandemic crisis subsides. In this report we focus on the risks from oil-producing economies, but we first we update our fiscal stimulus tally. Stimulus Tsunami Chart 3Stimulus Tsunami Still Building Drowning In Oil (GeoRisk Update) Drowning In Oil (GeoRisk Update) Policymakers responded to COVID-19 by doing “whatever it takes” to prop up demand (Chart 3). Please see the Appendix for our latest update of our global fiscal stimulus table. The latest fiscal and monetary measures show that countries are still adding stimulus – i.e. there is not yet a substantial shift away from providing stimulus: China has increased its measures to a total of 10% of GDP for the year so far, according to BCA Research China Investment Strategy. This includes a general increase in credit growth, a big increase in government spending (2% of GDP), a bank re-lending scheme (1.5% of GDP), an increase in general purpose local government bonds (2% of GDP), plus special purpose bonds (4% of GDP) and other measures. On the political front, the government has rolled out a new slogan, “the Six Stabilities and the Six Guarantees,” and President Xi Jinping said on an inspection tour to Shaanxi that the state will increase investments to ensure that employment is stabilized. This is the maximum reflationary signal from China that we have long expected. The US agreed to a $484 billion “fourth phase” stimulus package, bringing its total to 13% of GDP. President Trump is already pushing for a fifth phase involving bailouts of state and local governments and infrastructure, which we fully expect to take place even if it takes a bit longer than packages that have been passed so far this year. German Chancellor Angela Merkel has opened the way for the EU to issue Eurobonds, in keeping with our expectations. Germany is spending 12% of GDP in total – which can go much higher depending on how many corporate loans are tapped – while Italy is increasing its stimulus to 3% of GDP. As deficits rise to astronomical sums, and economies gradually reopen, will legislatures balk at passing new stimulus? Yes, eventually. Financial markets will have to put more pressure on policymakers to get them to pass more stimulus. This can lead to volatility. In the US the pandemic is coinciding with “peak polarization” over the 2020 election. Lack of coordination between federal and state governments is increasing uncertainty. Currently disputes center on the timing of economic reopening and the provisioning bailout funds for state and local governments. Senate Majority Leader Mitch McConnell is threatening to deny bailouts for American states with large, unfunded public pension benefits (Chart 4A). He is insisting that the Senate “push the pause button” on coronavirus relief measures; specifically that nothing new be passed until the Senate convenes in Washington on May 4. He may then lead a charge in the Republican Senate to try to require structural reforms from states in exchange for bailouts. Estimates of the total state budget shortfall due to the crisis stand at $500 billion over the next three years, which is almost certainly an understatement (Chart 4B). Chart 4AUS States Have Unfunded Liabilities Drowning In Oil (GeoRisk Update) Drowning In Oil (GeoRisk Update) Chart 4BUS States Face Funding Shortfalls Drowning In Oil (GeoRisk Update) Drowning In Oil (GeoRisk Update) Could a local government or state declare bankruptcy? Not anytime soon. Technically there is no provision for states to declare bankruptcy. A constitutional challenge to such a declaration would go to the Supreme Court. One commonly cited precedent, Arkansas in 1933, ended up with a federal bailout.1 A unilateral declaration could conceivably become a kind of “Lehman moment” in the public sector, but state governors will ask their legislatures to provide more fiscal flexibility and will seek bailouts from the federal government first. The Federal Reserve is already committed to buying state and local bonds and can expand these purchases to keep interest rates low. Washington would be forced to provide at least short-term funding if state workers started getting fired in the midst of the crisis because of straightened state finances – another $500 billion for the states is entirely feasible in today’s climate. Constraints will prevail on the GOP Senate to provide state bailout funds. This conflict over state finances could have a negative impact on US equities in the near term, but it is largely a bluff – McConnell will lose this battle. The fundamental dynamic in Washington is that of populism combined with a pandemic that neutralizes arguments about moral hazard. Big-spending Democrats in the House of Representatives control the purse strings while big-spending President Trump faces an election. Senate Republicans are cornered on all sides – and their fate is tied to the President’s – so they will eventually capitulate. Bottom Line: The global fiscal and monetary policy tsunami is still building. But there are plenty of chances for near-term debacles. Over the long run the gargantuan stimulus is the signal while the rest is noise. Over the long run we expect the reflationary efforts to prevail and therefore we are long Treasury inflation-protected securities and US investment grade corporate bonds. We recommend going strategically long AAA-rated US municipal bonds relative to 10-year Treasuries. Petro-State Meltdown Since March we have highlighted that the collapse in oil prices will destabilize oil producers above and beyond the pandemic and recession. This leaves Iran in danger, but even threatens the stability of great powers like Russia. Normally there is something of a correlation between the global oil price and the willingness of petro-states to engage in war (Chart 5). Chart 5Petro-States Cease Fire When Oil Drops Drowning In Oil (GeoRisk Update) Drowning In Oil (GeoRisk Update) When prices fall, revenues dry up and governments have to prioritize domestic stability. This tends to defer inter-state conflict. We can loosely corroborate this evidence by showing that global defense stocks tend to be correlated with oil prices (Chart 6). Global growth is the obvious driver of both of these indicators. But states whose budgets are closely tied to the commodity cycle are the most likely to cut defense spending. Chart 6Global Growth Drives Oil And Guns Global Growth Drives Oil And Guns Global Growth Drives Oil And Guns Russia is case in point. Revenues from Rostec, one of Russia’s largest arms firms, rise and fall with the Urals crude oil price (Chart 7). The Russians launch into foreign adventures during oil bull markets, when state coffers are flush with cash. They have an uncanny way of calling the top of the cycle by invading countries (Chart 8). Chart 7Oil Correlates With Russian Arms Sales Drowning In Oil (GeoRisk Update) Drowning In Oil (GeoRisk Update) Chart 8Russian Invasions Call Peak In Oil Bull Markets Russian Invasions Call Peak In Oil Bull Markets Russian Invasions Call Peak In Oil Bull Markets Chart 9Turkish Political Risk On The Rise Turkish Political Risk On The Rise Turkish Political Risk On The Rise In the current oil rout, there is already some evidence of hostilities dying down in this way. For instance, after years of dogged fighting in Yemen, Saudi Arabia is finally declaring a ceasefire there. Turkey, which benefits from low oil prices, has temporarily gotten the upper hand in Libya vis-à-vis Khalifa Haftar and the Libyan National Army, which depends on oil revenues and backing from petro-states like Russia and the GCC. Of course, Turkey’s deepening involvement in foreign conflicts is evidence of populism at home so it does not bode well for the lira or Turkish assets (Chart 9). But it does highlight the impact of weak oil on petro-players such as Haftar. However, the tendency of petro-states to cease fire amid low prices is merely a rule of thumb, not a law of physics. Past performance is no guarantee of future results. Already we are seeing that Iran is defying this dynamic by engaging in provocative saber-rattling with the United States. Iran And Iraq The US and Iran are rattling sabers again. One would think that Iran, deep in the throes of recession and COVID-19, would eschew a conflict with the US at a time when a vulnerable and anti-Iranian US president is only seven months away from an election. Chart 10US Maximum Pressure On Iran US Maximum Pressure On Iran US Maximum Pressure On Iran Iran has survived nearly two years of “maximum pressure” from President Trump (Chart 10), and previous US sanction regimes, and has a fair chance of seeing the Democrats retake Washington. The Democrats would restart negotiations to restore the 2015 nuclear deal, which was favorable to Iran. Therefore risking air strikes from President Trump is counterproductive and potentially disastrous. Yet this logic only holds if the Iranian regime is capable of sustaining the pain of a pandemic and global recession on top of its already collapsing economy. Iran’s ability to circumvent sanctions to acquire funds depended on the economy outside of Iran doing fine. Now Iran’s illicit funds are drying up. This could lead to a pullback in funding for militant proxies across the region as Iran cuts costs. But it also removes the constraint on Iran taking bolder actions. If the economy is collapsing anyway then Iran can take bigger risks. Furthermore if Iran is teetering, there may be an incentive to initiate foreign conflicts to refocus domestic angst. This could be done without crossing Trump’s red lines by attacking Iraq or Saudi Arabia. With weak oil demand, Iran’s leverage declines. But a major attack would reduce oil production and accelerate the global supply-demand rebalance. Iran’s attack on the Saudi Abqaiq refinery last September took six million barrels per day offline briefly, but it was clearly not intended to shut down that production permanently. Threats against shipping in the Persian Gulf bring about 14 million barrels per day into jeopardy (Chart 11). Chart 11Closing Hormuz Would Be The Biggest Oil Shock Ever Drowning In Oil (GeoRisk Update) Drowning In Oil (GeoRisk Update) Iran-backed militias in Iraq have continued to attack American assets and have provoked American air strikes over the past month, despite the near-war scenario that erupted just before COVID. Iranian ships have harassed US naval ships in recent days. President Trump has ordered the navy to destroy ships that threaten it; Iranian commander has warned that Iran will sink US warships that threaten its ships in the Gulf. There is a 20% chance of armed hostilities between the US and Iran. Why would Iran be willing to confront the United States? First, Iran rightly believes that the US is war-weary and that Trump is committed to withdrawing from the Middle East. But this could prompt a fateful mistake. The equation changes if the US public is incensed and Trump’s election campaign could benefit from conflict. Chart 12Youth Pose Stability Risk To Iran Youth Pose Stability Risk To Iran Youth Pose Stability Risk To Iran Second, the US is never going to engage in a ground invasion of Iran. Airstrikes would not easily dislodge the regime. They could have the opposite effect and convert an entire generation of young, modernizing Iranians into battle-hardened supporters of the Islamic revolution (Chart 12). This is a dire calculation that the Iranian leaders would only make if they believed their regime was about to collapse. But they are quite possibly the closest to collapse that they have been since the 1980s and nobody knows where their pain threshold lies. They are especially vulnerable as the regime approaches the uncharted succession of Supreme Leader Ali Khamanei. Since early 2018 we have argued that there is a 20% chance of armed hostilities between the US and Iran. We upgraded this to 40% in June 2019 and downgraded it back to 20% after the Iranians shied from direct conflict this January. Our position remains the same 20%. This is still a major understated risk at a time when the global focus is entirely elsewhere. It will persist into 2021 if Trump is reelected. If the Democrats win the US election, this war risk will abate. The Iranians will play hard to get but they are politically prohibited from pursuing confrontation with the US when a 2015-type deal is available. This would open up the possibility for greater oil supply to be unlocked in the future, but sanctions are not likely to be lifted till 2022 at earliest. Russia Russia may not be on the verge of invading anyone, but it is internally vulnerable and fully capable of striking out against foreign opponents. Cyberattacks, election interference, or disinformation campaigns would sow confusion or heighten tensions among the great powers. The Russian state is suffering a triple whammy of pandemic, recession, and oil collapse. President Vladimir Putin’s approval rating has fallen this year so far, whereas other leaders in the western world have all seen polling bounces (even President Trump, slightly) (Chart 13). Putin postponed a referendum designed to keep him in office through 2036 due to the COVID crisis. In other words, the pandemic has already disrupted his carefully laid succession plans. While Putin can bypass a referendum, he would have been better off in the long run with the public mandate. Generally it is Putin’s administration, not his personal popularity, that is at risk, but the looming impact on Russian health and livelihoods puts both in jeopardy (Chart 14) and requires larger fiscal outlays to try to stabilize approval (Chart 15). Chart 13Putin Saw No COVID Popularity Bump Drowning In Oil (GeoRisk Update) Drowning In Oil (GeoRisk Update) Chart 14Russian Regime Faces Political Discontent Russian Regime Faces Political Discontent Russian Regime Faces Political Discontent Moreover, regardless of popular opinion, Putin is likely to settle scores with the oligarchs. The fateful decision to clash with the Saudis in March, which led to the oil collapse, will fall on Igor Sechin, Chief Executive of Rosneft, and his faction. An extensive political purge may well ensue that would jeopardize domestic stability (Chart 16). Chart 15Russia To Focus On Domestic Stability Russia To Focus On Domestic Stability Russia To Focus On Domestic Stability Chart 16Russian Political Risk Will Rise Russian Political Risk Will Rise Russian Political Risk Will Rise Russian tensions with the US will rise over the US election in November. The Democrats would seek to make Russia pay for interfering in US politics to help President Trump win in 2016. But even President Trump may no longer be a reliable “ally” of Putin given that Putin’s oil tactics have bankrupted the US shale industry during Trump’s reelection campaign. The American and Russian air forces are currently sparring in the air space over Syria and the Mediterranean. The US has also warned against a malign actor threatening to hack the health care system of the Czech Republic, which could be Russia or another actor like North Korea or Iran. These issues have taken place off the radar due to the coronavirus but they are no less real for that. Venezuela We have predicted Venezuela’s regime change for several years but the oil meltdown, pandemic, and insufficient Russian and Chinese support should put the final nail in the regime’s coffin. Hugo Chavez’s rise to power, the last “regime change,” occurred as oil prices bottomed in 1998. Historically the Venezuelan armed forces have frequently overthrown civilian authorities, but in several cases not until oil prices recovered (Chart 17). Chart 17Venezuelan Coups Follow Oil Rebounds Venezuelan Coups Follow Oil Rebounds Venezuelan Coups Follow Oil Rebounds The US decision to designate Nicolas Maduro as a “narco-terrorist,” to deploy greater naval and coast guard assets around Venezuela, to reassert the Monroe Doctrine and Roosevelt Corollary, and to pull Chevron from the country all suggest that Washington is preparing for regime change. Such a change may or may not involve any American orchestration. Venezuela is an easy punching-bag for President Trump if he seeks to “wag the dog” ahead of the election. Venezuela would be a strategic prize and yet it cannot hurt the US economy or financial markets substantially, giving limited downside to President Trump if he pursues such a strategy. Obviously any conflict with Venezuela this year is far less relevant to global investors than one with Iran, North Korea, China, or Russia. Regime change would be positive for oil supply and negative for prices over the long run. But that is a story for the next cycle of energy development, as it would take years for government and oil industry change in Venezuela to increase production. The US election cycle is a critical aggravating factor for all of these petro-state risks. Shale producers are going bankrupt, putting pressure on the economy and some swing states. The risk of a conflict arises not only from Trump playing “wag the dog” after the crisis abates, but also from other states provoking the president, causing him to react or overreact. The “Other Guys” Oil producers outside the US, Canada, gulf OPEC, and Russia – the “other guys” – are extremely vulnerable to this year’s global crisis and price collapse. Comprising half of global production, they were already seeing production declines and a falling global market share over the past decade when they should have benefited from a global economic expansion. They never recovered from the 2014-15 oil plunge and market share war (Chart 18). Angola (1.4 million barrels per day), Algeria (one million barrels per day), and Nigeria (1.8 million barrels per day) are relatively sizable producers whose domestic stability is in question in the coming years as they cut budgets and deplete limited forex reserves to adjust to the lower oil price. This means fewer fiscal resources to keep political and regional factions cooperating and provide basic services. Algeria is particularly vulnerable. President Abdelaziz Bouteflika, who ruled as a strongman from 1999, was forced out last year, leaving a power vacuum that persists under Prime Minister Abdelaziz Djerad, in the wake of the low-participation elections in December. An active popular protest movement, Hirak, already exists and is under police suppression. Unemployment is high, especially among the youth. Neighboring Libya is in the midst of a war and extremist militants within Libya and North Africa would like to expand their range of operations in a destabilized Algeria. Instability would send immigrants north to Europe. Oil production will be reduced involuntarily as well as voluntarily this year due to regime failures. Brazil is not facing the risk of state failure like Algeria, but it is facing a deteriorating domestic political outlook (Chart 19). President Jair Bolsonaro’s popularity was already low relative to most previous presidents before COVID. His narrow base in the Chamber of Deputies got narrower when he abandoned his political party. He has defied the pandemic, refused to endorse social distancing or lockdown orders by local governments, and fired his Health Minister Luiz Henrique Mandetta. Chart 18Petro-States: 'Other Guys' Face Instability Petro-States: 'Other Guys' Face Instability Petro-States: 'Other Guys' Face Instability Chart 19Brazilian Political Risk Rising Again Brazilian Political Risk Rising Again Brazilian Political Risk Rising Again Brazil has a high number of coronavirus deaths per million people relative to other emerging markets with similar health capacity and susceptibility to the disease. This, combined with sharply rising unemployment, could prove toxic for Bolsonaro, who has not received a bounce in popular opinion from the crisis like most other world leaders. Thus on balance we expect the October local elections to mark a comeback for the Worker’s Party. The limited fiscal gains of Bolsonaro’s pension reform are already wiped out by the global recession, which will set back the country’s frail recovery from its biggest recession in a century. The country is still on an unsustainable fiscal path. Bolsonaro does not have a strong personal commitment to neoliberal structural reform, which has been put aside anyway due to the need for government fiscal spending amid the crisis. Unless Bolsonaro’s popularity increases in the wake of the crisis – due to backlash against the state-level lockdowns – the economic shock is negative for Brazil’s political stability and economic policy orthodoxy. Bottom Line: Our rule of thumb about petro-states suggests that they will generally act less aggressive amid a historic oil price collapse, but Iran may prove a critical exception. Investors should not underestimate the risk of a US-Iran conflict this year. Beyond that, the US election will have a decisive impact as the Democrats will seek to resume the Iranian nuclear deal and Iran would eventually play ball. Venezuela is less globally relevant this year – although a “wag the dog” scenario is a distinct possibility – but it may well be a major oil supply surprise in the 2020s. More broadly the takeaway is that oil production will be reduced involuntarily as well as voluntarily this year due to regime failures. Investment Takeaways Obviously any conflict with Iran could affect the range of Middle Eastern OPEC supply, not just the portion already shuttered due to sanctions on Iran itself. Any Iran war risk is entirely separate from the risk of supply destruction from more routine state failures in Africa. These shortages have been far less consequential lately and have plenty of room to grow in significance (Chart 20). The extreme lows in oil prices today will create the conditions for higher oil prices later when demand recovers, via supply destruction. Chart 20More Unplanned Outages To Come Drowning In Oil (GeoRisk Update) Drowning In Oil (GeoRisk Update) Chart 21European Political Risk No Longer Underrated European Political Risk No Longer Underrated European Political Risk No Longer Underrated An important implication – to be explored in future reports – is that Europe’s neighborhood is about to get a lot more dangerous in the coming years, as the Middle East and Russia will become less stable. Middle East instability will result in new waves of immigration and terrorism after a lull since 2015-16. These waves would fuel right-wing political sentiment in parts of Europe that are the most vulnerable in today’ crisis: Italy, Spain, and France (Chart 21). This should not be equated with the EU breaking apart, however, as the populist parties in these countries are pursuing soft rather than hard Euroskepticism. Unless that changes the risk is to the Euro Area’s policy coherence rather than its existence. Finally Russian domestic instability is one of the major secular consequences of the pandemic and recession and its consequences could be far-reaching, particularly in its great power struggle with the United States. We are reinitiating a strategic long in cyber security stocks, the ISE Cyber Security Index, relative to the S&P500 Info Tech sector. Cyberattacks are a form of asymmetrical warfare that we expect to ramp up with the general increase in global geopolitical tensions. The US’s recent official warning against an unknown actor that apparently intended to attack the health system of the Czech Republic highlights the way in which malign actors could attempt to capitalize on the chaos of the pandemic. We also recommend strategic investors reinitiate our “China Play Index” – commodities and equities sensitive to China’s reflation – and our BCA Infrastructure Basket, which will benefit from Chinese reflation as well as US deficit spending. China’s reflation will help industrial metals more so than oil, but it is positive for the latter as well. Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com   Footnotes 1 John Mauldin, "Don't Be So Sure That States Can't Go Bankrupt," Forbes, July 28, 2016, forbes.com.   Section II: Appendix : GeoRisk Indicator China China: GeoRisk Indicator China: GeoRisk Indicator Russia Russia: GeoRisk Indicator Russia: GeoRisk Indicator UK UK: GeoRisk Indicator UK: GeoRisk Indicator Germany Germany: GeoRisk Indicator Germany: GeoRisk Indicator France France: GeoRisk Indicator France: GeoRisk Indicator Italy Italy: GeoRisk Indicator Italy: GeoRisk Indicator Canada Canada: GeoRisk Indicator Canada: GeoRisk Indicator Spain Spain: GeoRisk Indicator Spain: GeoRisk Indicator Taiwan Taiwan: GeoRisk Indicator Taiwan: GeoRisk Indicator Korea Korea: GeoRisk Indicator Korea: GeoRisk Indicator Turkey Turkey: GeoRisk Indicator Turkey: GeoRisk Indicator Brazil Brazil: GeoRisk Indicator Brazil: GeoRisk Indicator Appendix Table 1 The Global Fiscal Stimulus Response To COVID-19 Drowning In Oil (GeoRisk Update) Drowning In Oil (GeoRisk Update) Section III: Geopolitical Calendar

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 The Chinese economy is recovering at a slower rate than the equity market has priced in. There is a high likelihood of negative revisions to Q2 EPS estimates and an elevated risk of a near-term price correction in Chinese stocks.  We expect a meaningful pickup in credit growth in H1 to improve domestic demand gain tractions in H2. This supports our overweight stance on Chinese stocks in the next 6-12 months, in both absolute and relative terms. There is still a strong probability that the yield curve will flatten, and the 10-year government bond yield may even dip below 2% in the wake of disappointing economic data in Q2. But our baseline scenario suggests the 10-year government bond yield should bottom no later than Q3 of this year. Feature This week’s report addresses pressing concerns from clients in China’s post-Covid-19 environment. China’s economy contracted by 6.8% in Q1, the largest GDP growth slump since 1976. Furthermore, the IMF’s baseline scenario projects a 3% contraction in global economic growth in 2020, with the Chinese economy growing at a mere 1.2%.1 This dim annual growth outlook means that the contraction in China’s economy will likely extend to Q2, dragging down corporate profit growth. In our April 1st report2 we recommended that investors maintain a neutral stance on Chinese stocks in the next three months due to uncertainties surrounding the pandemic, the oversized passive outperformance in Chinese stocks, and heightened risks for further risk-asset selloffs. On a 6- to 12-month horizon, however, we have a higher conviction that Chinese stocks will outperform global benchmarks. Our view is based on a decisive shift by policymakers to a “whatever it takes” approach to boost the economy. We believe that the speed of China’s economic recovery in the second half of 2020 will outpace other major economies.  Q: China’s economy is recovering ahead of other major economies. Why did you recently downgrade your tactical call on Chinese equities from overweight to neutral relative to global stocks? A: China’s economy is recovering, but it is recovering at a slower rate than the equity market has fully priced in (Chart 1A and 1B). We believe the likelihood of negative revisions to Q2 EPS estimates is high, and the risk of a near-term price correction in Chinese stocks remains elevated.  Chart 1AElevated Chinese Equity Outperformance Relative To Global Stocks Elevated Chinese Equity Outperformance Relative To Global Stocks Elevated Chinese Equity Outperformance Relative To Global Stocks Chart 1BChinese Stocks Largely Ignored Weakness In Domestic Economy Chinese Stocks Largely Ignored Weakness In Domestic Economy Chinese Stocks Largely Ignored Weakness In Domestic Economy The lackluster March data suggests that the pace of China’s economic recovery in April and even May will likely disappoint, weighing on the growth prospects for Q2’s corporate earnings (Chart 2). Chart 2EPS Growth Estimates Likely To Capitulate In Q2 EPS Growth Estimates Likely To Capitulate In Q2 EPS Growth Estimates Likely To Capitulate In Q2 The work resumption rate in China’s 36 provinces jumped sharply between mid-February and mid-March. However, since that time, the resumption rate among large enterprises has hovered around 80% of normal capacity (Chart 3). Chart 3Work Resumption Hardly Improved Since Mid-March Three Questions Following The Coronacrisis Three Questions Following The Coronacrisis The flattening of the work resumption rate curve is due to a lack of strong recovery in demand. Chart 4So Far No Strong Recovery In Domestic Demand So Far No Strong Recovery In Domestic Demand So Far No Strong Recovery In Domestic Demand The flattening of the resumption rate curve is due to a lack of strong recovery in demand. Although there was a surge in Chinese imports in crude oil and raw materials, the increase was the result of China taking advantage of low commodity prices. This surge cannot be sustained without a pickup in domestic demand. The March bounce back in domestic demand from the manufacturing, construction, and household sectors has all been lackluster (Chart 4). External demand, which growth remained in contraction through March, will likely worsen in Q2 (Chart 5). Exports shrunk by 6.6% in March, up from a deep contraction of 17.2% in January-February. Export orders can take more than a month to be processed, therefore, March’s data reflects pent-up orders from the first two months of the year. The US and European economies started their lockdowns in March, so Chinese exports will only feel the full impact of the collapse in demand from its trading partners in April and May. The work resumption rate will advance only if the momentum in domestic demand recovery increases to fully offset the collapse in external demand. The current 83% rate of work resumption implies that industrial output growth in April will remain in contraction on a year-over-year basis (Chart 6). Chart 5External Demand Will Worsen In Q2 External Demand Will Worsen In Q2 External Demand Will Worsen In Q2 Chart 6Will Q2 Industrial Output Growth Remain In Contraction? Will Q2 Industrial Output Growth Remain In Contraction? Will Q2 Industrial Output Growth Remain In Contraction? Although we maintain a constructive outlook on Chinese risk assets in the next 6 to 12 months, the short-term picture remains volatile in view of the emerging economic data. As such, we recommend investors to maintain short-term hedges for risk asset positions. Q: China’s policy response to mitigate the economic blow from COVID-19 has been noticeably smaller than programs rolled out in key developed economies, especially the US. Why do you think such measured stimulus from China warrants an overweight stance on Chinese stocks in the next 6-12 months relative to global benchmarks? A: It is true that the size of existing Chinese stimulus, as a percentage of the Chinese economy, is smaller than that has been announced in the US. But this is due to a different approach China is taking in stimulating its economy. In addition, both the recent policy rhetoric and PBoC actions suggest a large credit expansion is in the works. This will likely overcompensate the damage on China’s aggregate economy, and generate an outperformance in both Chinese economic growth and returns on Chinese risk assets in the next 6 to 12 months. China’s policy responses have an overarching focus on stimulating new demand and investment, which is a different approach from the programs offered by its Western counterparts. In the US, the combination of fiscal and monetary stimulus amounts to 11% of GDP as of April 16, with almost all policy support targeted at keeping companies and individuals afloat. In comparison, China’s policy response accounts for a mere 1.2% of its GDP.3  However, this direct comparison understates the enormous firepower in the Chinese stimulus toolkit, specifically a credit boom. As noted in our February 26 report,4 China has largely resorted to its “old economic playbook” by generating a huge credit wave to ride out the economic turmoil. Our prediction of the policy shift towards a significant escalation in stimulus was confirmed at the March 27 Politburo meeting. Moreover, the April 17 Politburo meeting reinforced a “whatever it takes” policy shift with direct calls on more forceful central bank policy actions, a first since the global financial crisis in 2008.5 Since 2008, the overnight repo rate’s breaking into the IORR-IOER corridor has been a reliable indicator leading to impressive credit upcycles. The PBoC’s recent aggressive easing measures have pushed down the interbank repo rate below the central bank’s interest rate on required reserves (IORR). The price for interbank borrowing is now near the lower range of the rate corridor, between the IORR and the interest rate on excess reserves (IOER).  Since 2008, the overnight repo rate’s breaking into the IORR-IOER corridor has been a reliable indicator leading to impressive credit upcycles (Chart 7).  Such credit super cycles, in turn, have led to both economic booms and an outperformance in Chinese stocks. Chart 7Another Credit Super Cycle Is In The Works Another Credit Super Cycle Is In The Works Another Credit Super Cycle Is In The Works Chart 8Financial Conditions Were Extremely Tight In 2011-2014 Financial Conditions Were Extremely Tight In 2011-2014 Financial Conditions Were Extremely Tight In 2011-2014 The 2012-2015 cycle was an exception to the relationship between the overnight interbank repo rate, credit growth and Chinese stock performance. A steep pickup in credit growth in 2012 coincided with a leap in the overnight interbank repo rate, and the credit boom did not help boost demand in the real economy or improve Chinese stock performance. This is because corporate borrowing was severely curtailed by high lending rates during a four-year monetary tightening cycle from 2011 to 2014 (Chart 8). The credit boom during that cycle was largely driven by explosive growth in short-term shadow-bank lending and wealth management products (WMP), and did not channel into the real economy.6 We do not think such an extreme phenomena will replay under the current circumstances. Monetary stance will likely remain tremendously accommodative through the end of the year to facilitate a continuous rollout of medium- to long-term bank loans and local government bonds. Chinese financial institutions’ “animal spirits” may have been unleashed. But under the scrutiny of the Macro-Prudential Assessment Framework and the New Asset Management Rules,7 the "animal spirits" are unlikely to run up enough risks to prompt the PBoC to prematurely tighten liquidity conditions in the interbank market. Marginal propensity in China is pro-cyclical, which tends to lag credit cycles by 6 months. Chart 9Marginal Propensity In China Is Pro-Cyclical Marginal Propensity In China Is Pro-Cyclical Marginal Propensity In China Is Pro-Cyclical Both corporate and household marginal propensity, a measure of the willingness to spend, will pick up as well. Marginal propensity is pro-cyclical, which tends to lag credit cycles by 6 months (Chart 9). In other words, when interest rates are low and credit growth improves, corporates and households tend to spend more.  The meaningful expansion in credit growth, which started in Q1 and will sustain in the coming two to three quarters, will help corporate and household spending gain tractions in H2. This constructive view on Chinese stimulus and economic recovery supports our overweight stance on Chinese stocks in the next 6-12 months, in both absolute and relative terms.  Q: The yield curve in Chinese government bonds has steepened following PBoC’s aggressive monetary easing announcements. Has the Chinese 10-year bond yield bottomed?   A: No, we do not think the 10-year bond yield has bottomed. There is probability the 10-year government bond yield may briefly dip below 2% in Q2. However, barring a multi-year global economic recession, we think the 10-year government bond yield will bottom no later than Q3 this year. Chart 10A Wide Gap Between The Long and Short A Wide Gap Between The Long and Short A Wide Gap Between The Long and Short The short end of the yield curve dropped disproportionally compared with the long end, following the PBoC’s announcement to place its first IOER cut since 2008 (Chart 10). This led to a rapid steepening in the yield curve. While our view supports a flattening of the yield curve in Q2 and even a 50bps drop in the 10-year government bond yield, we think that the capitulation will be brief. In order for the 10-year government bond yield to remain below 2% for an extended period of time, the market needs to believe one or more of the following will happen: The pandemic will cause a multi-year global economic recession, preventing the PBoC from normalizing its policy stance in the foreseeable future. The duration and depth of the economic impact from the pandemic are still moving targets. Our baseline scenario suggests that the Chinese economic recovery will pick up momentum in H2 this year. The PBoC will not normalize its policy stance even when the economy has stabilized. The PBoC has a track record as a reactive central bank rather than a proactive one. Still, during each of the past three economic and credit cycles, the PBoC has started to normalize its interest rate on average nine months following a bottom in the business cycle (Chart 11). The tightening of interest rate even applied to the prolonged economic downturn and deep deflationary cycle in 2015/16 (Chart 12).    Chart 11The 'Old Faithful' PBoC Policy Normalization Pattern The 'Old Faithful' PBoC Policy Normalization Pattern The 'Old Faithful' PBoC Policy Normalization Pattern Chart 12Policy Normalized Even After A Long Economic Downturn Policy Normalized Even After A Long Economic Downturn Policy Normalized Even After A Long Economic Downturn Chart 132008 Or 2015? 2008 Or 2015? 2008 Or 2015? How the yield curve has historically behaved also depended on the market’s expectations on the speed of the economic recovery, and the timing of the subsequent monetary policy normalization. The yield curved spiked in the wake of substantial monetary easing and pickup in credit growth, in both 2008 and 2015 (Chart 13). While in 2008 the yield curve moved in lockstep with the 3-month SHIBOR with a perfect reverse correlation, in the 2015/16 cycle the yield curve spiked initially but quickly flattened. The long end of the yield curve capitulated as soon as the market realized the economic slowdown was a prolonged one. The 10-year government bond yield, after trending sideways in early 2016, only truly bottomed after the nominal output growth troughed in Q1 2016 (Chart 13, bottom panel). Will the yield curve behave like in 2008, or more like in 2015 in this cycle? We think it will be somewhere in between. The current economic cycle bottomed in Q1, but the economy is only recovering slowly and we expect a U-shaped economic recovery rather than a 2008-style V-shaped one.  At the same time, our baseline scenario does not suggest the current environment will evolve into a 4-year deflationary cycle as in the 2012-2016 period. Therefore, we expect the low interest rate environment to endure for another two to three quarters before the PBoC starts to reverse its policy stance back to the pre-COVID-19 range. As such, the yield on 10-year government bonds will fall, possibly by as much as 50bps, when the economic data disappoint in Q2 and more rate cuts are forthcoming.  But it will bottom when the economic recovery starts to gain traction in H22020 and the market starts to price in a subsequent monetary policy normalization.  When growth slows and debt rises sharply, the PBoC will need to join its western counterparts to permanently maintain an ultra-low interest rate policy to accommodate its high debt level. We acknowledge the fact that China’s potential output growth is trending down (Chart 14).  But it has been trending downwards since 2011. A structurally slowing rate of economic growth has not prevented the PBoC from cyclically raising its policy rate. Hence, unless we see evidence that the pandemic is meaningfully lowering China’s potential growth on par with growth rates in the DMs, our baseline scenario does not support a structural ultra-low interest rate environment in China. China’s debt-to-GDP ratio will most likely rise substantially this year, given that the credit impulse will gain momentum and GDP will grow very modestly. However, this rapid rise in the debt-to-GDP ratio will most likely not be sustained beyond this year. Even if we assume that credit impulse will account for 40% of GDP in 2020 (the same magnitude as in 2008/09), a sharp reversal in the output gap in 2021, as predicted by IMF,8 will flatten the debt-to-GDP ratio curve (Chart 15).  Moreover, following every credit super cycle in the past, Chinese authorities have put a brake on the debt-to-GDP ratio. Chart 14China's Potential Growth Is Likely To Trend Lower... China's Potential Growth Is Likely To Trend Lower... China's Potential Growth Is Likely To Trend Lower... Chart 15...But Has Not Stopped PBoC From Flattening The Debt Curve ...But Has Not Stopped PBoC From Flattening The Debt Curve ...But Has Not Stopped PBoC From Flattening The Debt Curve   All in all, while we see a high possibility for the 10-year government bond yield to fall in Q2, the decline will be limited in terms of duration. Jing Sima China Strategist jings@bcaresearch.com   Footnotes   1IMF World Economic Outlook, April 2020 2Please see China Investment Strategy Weekly Report "Investing During A Global Pandemic," dated April 1, 2020, available at cis.bcaresearch.com 3IMF, Policy Responses To COVID-19 https://www.imf.org/en/Topics/imf-and-covid19/Policy-Responses-to-COVID-19#U 4Please see China Investment Strategy Weekly Report "China: Back To Its Old Economic Playbook?" dated February 26, 2020, available at cis.bcaresearch.com 5“Stable monetary policy must become more flexible” and “use RRR reductions, lower interest rates, re-lending and other measures to preserve adequate liquidity and guide the loan prime rate downwards.” Statements from Xi Jinping, April 17, 2020 Politburo Meeting. http://www.gov.cn/xinwen/2020-04/17/content_5503621.htm  6 Bankers’ acceptances - short-term debt instruments guaranteed by commercial banks - swelled by 887% between end-2008 and 2012. The outstanding amount of WMPs jumped from 1.7 trillion RMB in 2009 to more than 9 trillion RMB by H12013. In contrast, the amount of RMB-denominated bank loans increased by only 67% during the same period. 7The Macro-Prudential Assessment Framework and the New Asset Management Rules were implemented in 2016 and 2018, respectively. They are designed to create additional restrictions to curb shadow-bank lending and broaden the PBoC’s oversight on banks’ WMP holdings. 8The April IMF World Economic Outlook predicts a 1.2% Chinese GDP growth in 2020 and a 9.2% GDP growth in 2021. Cyclical Investment Stance Equity Sector Recommendations

Highlights Social distancing makes it impossible to do jobs that require close personal interaction, yet these are the very job sectors that have kept jobs growth alive in recent decades. If social distancing persists, then AI will penetrate these job sectors too. Aggregate wage inflation is set to collapse – not just temporarily, but structurally. Structurally overweight US T-bonds versus the core European bonds in Germany, France, Netherlands, Switzerland and Sweden. Structurally overweight big technology, structurally underweight banks. Structurally overweight S&P 500 versus Euro Stoxx 50. Fractal trade: long Australian 30-year bond versus US 30-year T-bond. Feature Social distancing will feature large in our lives for the foreseeable future, and it carries a profound consequence. Social distancing really means physical distancing. And physical distancing diminishes the ways that we can interact with other humans – through the qualities of empathy, sympathy, the ability to recognise and respond to emotional cues, and to express ourselves through complex movements. You cannot hug someone on Facetime. Social distancing makes it impossible to do jobs that require close personal interaction. From an economic perspective, social distancing makes it impossible to do jobs that require close personal interaction. It follows that in the recent bloodbath of job losses, the biggest casualties have been in employment sectors that rely on this close personal interaction: food services and drinking places (waitresses, bartenders, and baristas), ambulatory healthcare services, hotels, and social assistance (Table I-1). Table I-1Social Distancing Is Destroying Jobs That Require Close Personal Interaction Social Distancing Is Good For Robots, Bad For Humans Social Distancing Is Good For Robots, Bad For Humans A profound consequence arises because these are the very sectors that have kept jobs growth alive in recent decades (Table I-2). Millions of new jobs that rely on close personal interaction have more than offset the structural job destruction in manufacturing and finance. As well as being export-proof, jobs that require this close personal interaction have been ‘artificial intelligence (AI) proof’. That is, until now. Table I-2Jobs That Require Close Personal Interaction Have Been The Engine Of Jobs Growth Social Distancing Is Good For Robots, Bad For Humans Social Distancing Is Good For Robots, Bad For Humans One UK doctor told the New York Times “we’re basically witnessing 10 years of change in one week”. Before the virus, online consultations made up only 1 percent of doctors’ appointments. But now, three in four UK patients are seeing their doctor remotely. Moravec’s Paradox + Social Distancing = A Very Tough Jobs Market Regular readers will know that one of our mega-themes is the far-reaching societal and economic implications of Moravec’s Paradox. Named after the professor of robotics, Hans Moravec, the paradox points out that: For AI the hard things are easy, but the easy things are hard. By the hard things, we mean things that require ‘narrow-frame pattern recognition’ within a defined body of knowledge. For example, playing chess, translating languages, diagnosing medical conditions, and analysing legal problems. We find these tasks hard, but AI finds them effortless. By the easy things, we mean our social skills: empathy, sympathy, the ability to recognise and respond to emotional cues, and to express ourselves through complex movements. To us, all these things are second nature, but AI finds them very hard to replicate. The reason, it turns out, is that the higher brain that enables us to learn and play chess and solve similar abstract problems evolved relatively recently. Whereas the ancient lower brain that enables complex movement and the associated giving and receiving of emotional signals took much longer to evolve. As AI is just reverse engineering the human brain, AI has found it easy to replicate the less-evolved higher brain functions, but very difficult to replicate the skills that emanate from the deeply evolved lower brain. Millions of new jobs that rely on close personal interaction have more than offset the structural job destruction in manufacturing and finance. The far-reaching societal and economic implication is that we have misunderstood and mispriced what is difficult and what is easy. By reverse engineering the brain, AI is correcting this mispricing. So far, AI has been most disruptive to high-paying jobs requiring abstract problem-solving skills, such as in finance. AI has been less disruptive to jobs requiring close personal interaction (Table I-3). But if social distancing persists, then AI will disrupt those jobs too, especially during a recession. Table I-3New Jobs That Require Close Personal Interaction Have Offset Lost Jobs In Manufacturing And Finance Social Distancing Is Good For Robots, Bad For Humans Social Distancing Is Good For Robots, Bad For Humans Labour Market Disruption Intensifies During A Recession To paraphrase Ernest Hemingway, industries adopt labour-saving technologies gradually then suddenly. And the suddenly tends to be during a recession. This is because once an industry has already shed many workers, it is easier to restructure the industry with a new labour-saving technology that reduces labour input permanently. At the start of the Great Depression a substantial part of the US automobile industry was still based on skilled craftsmanship. These smaller, less productive craft-production plants were the ones that shut down permanently, while plants that had adopted labour-saving mass production had the competitive advantage that enabled them to survive. The result was a major restructuring of the auto productive structure. Likewise, until the late 1990s, the ‘typing pool’ was a ubiquitous feature of the office environment. But once the 2000 downturn arrived, these typing jobs became extinct to be replaced by the wholesale roll-out of Microsoft Word. After the 2008-09 recession, UK economic power became focussed in a few large firms that could access the finance to ensure their survival. As small firms went by the wayside, job growth came disproportionately from self-employment and the ‘gig economy’. In this case, the labour market disruption hurt productivity as an army of freelancers ended up doing their own sales, marketing and accounts in which they had no specialism (Chart I-1 and Chart I-2). Chart I-1The 1990s UK Recovery Produced No Increase In Self-Employment... The 1990s UK Recovery Produced No Increase In Self-Employment... The 1990s UK Recovery Produced No Increase In Self-Employment... Chart I-2...But The 2010s UK Recovery Produced A Huge Increase In Self-Employment ...But The 2010s UK Recovery Produced A Huge Increase In Self-Employment ...But The 2010s UK Recovery Produced A Huge Increase In Self-Employment The point is that all recessions produce major structural changes in the labour market and the current recession will be no different. If social distancing persists, it will nullify the social skill advantage that humans have over AI. Therefore, one structural change will be that AI disrupts the more ‘human’ job sectors that have so far escaped its penetration. All recessions produce major structural changes in the labour market. To repeat, labour market disruption arrives suddenly. Within the space of a few weeks, most UK patients have switched to receiving their medical care online or by telephone. Admittedly, the patients are still ‘seeing’ a human doctor, but the question and answer consultations are a classic example of narrow-frame pattern recognition. Meaning that it would be a small step to upgrade the human doctor to the superior diagnosis from AI. And if AI can produce a superior diagnosis to your human doctor, why can’t AI also produce a a superior legal analysis to your human lawyer? The Investment Implications Even when the labour market seemed to be humming and unemployment rates were at multi-decade lows, aggregate wage inflation was anaemic (Chart I-3 and Chart I-4). A major reason was the hollowing out of high paying jobs and substitution with low paying jobs. Now that unemployment rates are surging, and AI is penetrating even more job sectors, aggregate wage inflation is set to collapse – not just temporarily, but structurally. Chart I-3Unemployment Rates Have Been At Multi-Decade Lows... Unemployment Rates Have Been At Multi-Decade Lows... Unemployment Rates Have Been At Multi-Decade Lows... Chart I-4...But Wage Inflation Has Been ##br##Anaemic ...But Wage Inflation Has Been Anaemic ...But Wage Inflation Has Been Anaemic This leads to the following investment implications: 1. All bond yields will gravitate to their lower bound, so any bond yield that can go lower will go lower. 2. It follows that bond investors should continue to overweight US T-bonds versus the core European bonds in Germany, France, Netherlands, Switzerland and Sweden (Chart I-5). Chart I-5Any Bond Yield That Can Go Lower Will Go Lower Any Bond Yield That Can Go Lower Will Go Lower Any Bond Yield That Can Go Lower Will Go Lower 3. Underweight banks structurally. Depressed and flattening yield curves combined with shrinking demand for private credit constitutes a strong headwind. Banks are now underperforming in both up markets and in down markets (Chart I-6). Chart I-6Banks Are Underperforming In Both Up Markets And Down Markets Banks Are Underperforming In Both Up Markets And Down Markets Banks Are Underperforming In Both Up Markets And Down Markets 4. Overweight technology structurally. As AI penetrates even more job sectors, the superstar companies of big tech will continue to thrive. The duopoly of Apple and Google are designing proximity-tracking apps for every smartphone in the world. Big tech is laying down the law to governments, and there is not even a hint of antitrust suits. Tech is now outperforming in both up markets and in down markets (Chart I-7). Chart I-7Tech Is Outperforming In Both Up Markets And Down Markets Tech Is Outperforming In Both Up Markets And Down Markets Tech Is Outperforming In Both Up Markets And Down Markets 5. Finally, if big tech outperforms banks, the sector composition of the S&P 500 versus the Euro Stoxx 50 makes it inevitable that the US equity market will structurally outperform the euro area equity market (Chart I-8). Chart I-8If Big Tech Outperforms Banks, The S&P 500 Must Outperform The Euro Stoxx 50 If Big Tech Outperforms Banks, The S&P 500 Must Outperform The Euro Stoxx 50 If Big Tech Outperforms Banks, The S&P 500 Must Outperform The Euro Stoxx 50 Fractal Trading System* The steep decline in the US 30-year T-bond yield means that it has crossed below the Australian 30-year bond yield for the first time in recent history. Resulting from this dynamic, this week’s recommended trade is long the Australian 30-year bond versus the US 30-year T-bond. Set the profit target at 9 percent with a symmetrical stop-loss. Chart I-930-Year Govt. Bonds: Australia Vs. US 30-Year Govt. Bonds: Australia Vs. US 30-Year Govt. Bonds: Australia Vs. US In other trades, long IBEX versus Euro Stoxx 600 hit its 3 percent stop-loss, while long nickel versus copper is half way to its 11 percent profit target. The rolling 12-month win ratio now stands at 63 percent. When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated  December 11, 2014, available at eis.bcaresearch.com. 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