Disasters/Disease

Highlights Policy Responses To The Virus: Markets are now pricing in significant monetary policy easing in response to the growth shock from the COVID-19 outbreak and related financial market instability. It is not yet clear, however, that central banks will NOT ease by as much as currently discounted in the low level of bond yields – especially as risk assets will riot anew if policymakers are not dovish enough. Duration: Raise overall global duration exposure to neutral on a tactical basis (0-3 months) until there is greater clarity on the full magnitude of the hit to global growth from the virus. Spread Product: The widening of global corporate bond spreads during last week’s equity market correction was relatively modest, suggesting that the COVID-19 outbreak has not become a credit event that raises downgrade/default risks. Maintain an overall overweight allocation to global corporates versus government bonds. Downgrade US MBS to neutral, however, given the risk of higher prepayments from falling mortgage rates. Feature What a wild ride it has been for investors. Equity markets worldwide corrected sharply last week as investors were forced to downgrade global growth expectations with the COVID-19 outbreak spreading more rapidly outside of China. US equities were particularly savaged with the S&P 500 shedding -11% of its value in a mere five trading sessions, with the VIX index of implied equity volatility spiking over 40, evoking comparisons to some of the darkest days of the 2008 financial crisis. Chart of the WeekCOVID-19 Concerns Causing Market Jitters COVID-19 Concerns Causing Market Jitters COVID-19 Concerns Causing Market Jitters Government bond yields have collapsed alongside plunging equity values, with the benchmark 10-year US Treasury yield hitting an all-time intraday low of 1.04% yesterday. Investors are betting on aggressive rate cuts by global central bankers to offset weak growth momentum and disinflationary pressures that were already in place before the arrival of COVID-19. At the same time, corporate credit spreads widened worldwide last week, but the moves were relatively subdued and do not signal growing concern over future default losses (Chart of the Week). In this report, we discuss how to best position a global bond portfolio given these competing messages from government bond and credit markets. We conclude that maintaining selective strategic (6-12 months) overweights in global spread product versus governments, while also maintaining a neutral tactical (0-3 months) overall duration exposure - as a hedge against a more “U-shaped” recovery from the virus-driven downturn in global growth - is the best way to position for a backdrop where policymakers will need to be as easy as possible in a more uncertain world. What To Do Next On … Duration Risk assets were staging a massive rebound yesterday as we went to press, after policymakers worldwide signaled the need for stimulus measures to offset the COVID-19 growth shock. Both Fed Chairman Jerome Powell and Bank of Japan (BoJ) Governor Haruhiko Kuroda promised to ease monetary policy, if necessary, to stabilize markets. Meanwhile, looser fiscal policy may finally be on the way in Europe. The government of virus-stricken Italy announced a €3.6 billion stimulus package, while the German Finance Minister has hinted at a temporary suspension of Germany’s constitutional “debt brake” on deficit spending. A true coordinated global easing of both monetary and fiscal policy, would be very bullish for beaten-down growth-sensitive assets like equities and industrial commodities that have been focused on the shutdown of China’s economy in February to combat the spread of the virus. A true coordinated global easing of both monetary and fiscal policy, would be very bullish for beaten-down growth-sensitive assets like equities and industrial commodities that have been focused on the shutdown of China’s economy in February to combat the spread of the virus (Chart 2). It’s a different story for government bonds, however, as a rebound in yields from current depressed levels is not assured, even if monetary policy is eased further. This is because central bankers must maintain a dovish bias until the virus-driven uncertainty over global growth begins to fade, or else risk assets will riot once again. It’s all about financial conditions now, especially in the US where COVID-19 and the stock market selloff have become front-page news in a presidential election year. Chart 2How Quickly Will China Rebound? How Quickly Will China Rebound? How Quickly Will China Rebound? For example, the entire US Treasury curve now trades below the mid-point of the fed funds target range, with the market now pricing in a very rapid dovish move by the Fed (Chart 3). Chart 3A Big Grab For Global Duration A Big Grab For Global Duration A Big Grab For Global Duration Yield curves are now very flat in other major developed market (DM) economies, as well. This is partly due to the risk aversion bid for safe assets, which is evident in the deeply negative term premium component of bond yields. Flat curves also reflect a more long-lasting component, with markets pricing in lower equilibrium rates in the future. Investors are not only demanding immediate rate cuts to boost growth and stabilize financial markets, but also see little chance of those cuts eventually being reversed in the future. Chart 4Markets Increasingly Pricing In Global ZIRP Markets Increasingly Pricing In Global ZIRP Markets Increasingly Pricing In Global ZIRP Our simple proxy for the market expectation of the nominal terminal rate- the 5-year overnight index swap (OIS) rate, 5-years forward – is between 0-1% for all major DM countries (Chart 4). The implication is that investors are not only demanding immediate rate cuts to boost growth and stabilize financial markets, but also see little chance of those cuts eventually being reversed in the future. Chart 5Our Central Bank Monitors Say More Easing Is Needed Our Central Bank Monitors Say More Easing Is Needed Our Central Bank Monitors Say More Easing Is Needed Chart 6Global Yields Reflect Dovish Rate Expectations Global Yields Reflect Dovish Rate Expectations Global Yields Reflect Dovish Rate Expectations At the moment, our global Central Bank Monitors – a compilation of economic and financial variables that influence monetary policy decisions – are all signaling a need for rate cuts (Chart 5). This is a function of sluggish growth & weak inflation. The plunge in global government bond yields already reflects that dovish shift in market expectations for central banks. Our 12-month discounters, which measure the expected change in short-term interest rates over the next year as extracted from OIS curves, are all priced for lower policy rates in the US (-97bps as of last Friday’s close), the euro area (-15bps) the UK (-35bps), Japan (-17bps), Canada (-72bps) and Australia (-46bps) (Chart 6). In the US, the current level of the benchmark 10-year Treasury yield is consistent with the extended slump in US industrial activity – as measured by the fall in the ISM manufacturing index – and risk-off sentiment measures like the CRB Raw Industrials/Gold price ratio (Chart 7). Yet at the same time, financial conditions remain very accommodative despite last week’s selloff, suggesting that the US economy can potentially weather a bout of COVID-19 uncertainty – as long as the Fed does not disappoint by delivering fewer rate cuts than the market is demanding and creating another down leg in the equity market. Chart 7UST Yields Need To Stay Lower For Longer UST Yields Need To Stay Lower For Longer UST Yields Need To Stay Lower For Longer Outside the US, other central banks that have non-zero policy rates – like the Bank of Canada, Reserve Bank of Australia and Bank of England – can deliver on the rate cuts discounted in their OIS curves to fight a COVID-19 global growth downturn, if needed. Chart 8UST Bullishness Still Not At Historical Extremes UST Bullishness Still Not At Historical Extremes UST Bullishness Still Not At Historical Extremes The negative rate club of the ECB and BoJ, however, is far less likely to actually cut rates and will rely on greater asset purchases and forward guidance to try and provide more policy stimulus. We prefer to view duration exposure – on a tactical basis – as a hedge to owning risk assets like corporate bonds, where we see some value now opening up after last week’s selloff, rather than a way to express a directional view on interest rates where we have less visibility and conviction. So what should a bond investor do with duration exposure? It is a difficult call with so many uncertainties on global growth momentum, the spread of the virus outside China, the size of any monetary or fiscal policy stimulus measures, and the degree of risk aversion still evident in financial markets. We prefer to view duration exposure – on a tactical basis – as a hedge to owning risk assets like corporate bonds, where we see some value now opening up after last week’s selloff, rather than a way to express a directional view on interest rates where we have less visibility and conviction. Therefore, we are raising our recommended overall duration exposure to neutral this week on a tactical basis. At the same time, we are maintaining an underweight stance on government bonds versus an overweight on corporate debt. We think a true bottom in yields will be reached when there are more decisive signs that bond positioning has reached a bullish extreme, according to indicators like the JP Morgan duration survey and the Market Vane US Treasury bullish sentiment index (Chart 8). In our model bond portfolio, we are expressing that extension of duration by shifting exposure from shorter maturity buckets to longer duration buckets in most countries. While also increasing exposure to “higher-beta” government bond markets like the US and Canada, at the expense of lower-beta Japanese government bonds. Bottom Line: Raise overall global duration exposure to neutral on a tactical basis (0-3 months) until there is greater clarity on the full magnitude of the hit to global growth from the COVID-19 outbreak. Increase allocations to countries with higher yield betas, like the US and Canada, at the expense of low-beta markets like Japan. What To Do Next On … Spread Product Allocations Chart 9US HY Selloff Was Focused On Energy Names US HY Selloff Was Focused On Energy Names US HY Selloff Was Focused On Energy Names Last week’s equity market meltdown did spill over into corporate bond markets, with credit spreads widening for both investment grade and high-yield corporate debt in the US and Europe. In the US, however, the jump in high-yield spreads was particularly acute among Energy names, with the index option-adjusted spread (OAS) climbing over 1000bps as oil prices plunged (Chart 9). US high-yield ex-energy has been relatively more stable, with the spread climbing to 436bps, despite the surge in equity volatility. Stepping back and looking at US investment grade and high-yield corporates, more broadly, last week’s selloff has restored some value, most notably in high-yield. Stepping back and looking at US investment grade and high-yield corporates, more broadly, last week’s selloff has restored some value, most notably in high-yield.  According to our framework for calculating spread targets for global credit, last week’s selloff pushed US investment grade spreads back to our spread targets from very expensive levels (Chart 10).1 Baa-rated US investment-grade moved slightly above our spread target, but we would describe investment grade spreads as now overall fairly valued. US high-yield spreads, on the other hand, have widened well in excess of our spread targets across all credit rating tiers (Chart 11). Chart 10US Investment Grade Spreads Now Fairly Valued US Investment Grade Spreads Now Fairly Valued US Investment Grade Spreads Now Fairly Valued Chart 11US High-Yield Spreads Look Very Cheap US High-Yield Spreads Look Very Cheap US High-Yield Spreads Look Very Cheap In our framework, the spread targets are determined by looking at 12-month breakeven spreads – the amount of spread widening necessary to eliminate the yield cushion of owning corporates over government bonds on a one-year horizon – relative to their long-run history. We group those spreads according to phases of the monetary policy cycle, as defined by the slope of the US Treasury yield curve. The spread target is then calculated based on the median breakeven spread for that phase of the cycle. Currently, we are in “Phase 2” of the policy cycle, which means that the Treasury yield curve (10-year minus 3-year) is positively sloped between 0 and 50bps. In Charts 10 & 11, we add a new wrinkle to our existing way to present the spread targets. We also calculate the targets using the 25th and 75th percentile observations for the breakeven spreads for that phase of the monetary policy cycle. This gives us a range for the spread target that encompasses more of the historical data. Given the improved valuations in US junk bonds, however, we think increasing allocations in our model bond portfolio makes sense. The spread widening in US high-yield has very clearly restored value to spreads, which are well above the upper level of our spread target range. The same cannot be said for US investment grade, where spreads are in the middle of the target range. Chart 12European Corporates Now Offer Better Value European Corporates Now Offer Better Value European Corporates Now Offer Better Value Based on this analysis, we remain comfortable in maintaining our neutral recommended stance on US investment grade corporates and overweight stance on US high-yield. Given the improved valuations in US junk bonds, however, we think increasing allocations in our model bond portfolio makes sense. Thus, this week, we are adding to our recommended high-yield exposure (see Page 12). That increased allocation is “funded” by reducing our US Agency MBS exposure from overweight to neutral. Our colleagues at BCA Research US Bond Strategy are concerned that MBS spreads are likely to widen in the next few months to reflect the higher prepayment risk from the recent steep fall in US mortgage rates. One final note: our spread target framework for euro area corporates also indicates that last week’s global risk-off event also restored some value to European credit (Chart 12). Thus, we are maintaining our recommended overweights for both euro area investment grade and high-yield. Bottom Line: The widening of global corporate bond spreads during last week’s equity market correction was relatively modest, suggesting that the COVID-19 outbreak has not become a credit event that raises downgrade/default risks. Maintain an overall overweight allocation to global corporates versus government bonds. Downgrade US MBS to neutral, however, given the risk of higher prepayments from falling mortgage rates.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 We presented our framework for calculating global corporate spread targets, which builds on the work from our US Bond Strategy sister service, back in January. Please see BCA Research Global Fixed Income Strategy Special Report, "How To Find Value In Global Corporate Bonds", dated January 21, 2020, available at gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index What Bond Investors Should Do After The "Great Correction" What Bond Investors Should Do After The "Great Correction" ​​​​​​​ Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Feature “Bayesian: …statistical methods that assign probabilities or distributions to events…based on experience or best guesses before experimentation and data collection and that apply Bayes' theorem to revise the probabilities and distributions after obtaining experimental data.” — Merriam-Webster Dictionary Markets have reacted pretty rationally to the outbreak of the COVID-19 virus. Equities initially rebounded a few days ahead of the peak of new cases in China (Chart 1). But then, once the number of cases in the rest of the world started to accelerate, stock markets sold off again sharply. The MSCI All Country World Index is now down 13% from its peak on February 12. Recommended Allocation Monthly Portfolio Update: A Classic Bayesian Dynamic Monthly Portfolio Update: A Classic Bayesian Dynamic Chart 1Markets Have Reacted In Line With New COVID-19 Cases Monthly Portfolio Update: A Classic Bayesian Dynamic Monthly Portfolio Update: A Classic Bayesian Dynamic No one knows whether this episode will turn into an unprecedented pandemic, which will kill millions worldwide, last for months, and trigger a global recession. So it is the sort of environment in which Bayesian analysis becomes useful. Our “prior” for the probability of a full pandemic would be around 10-20%. If it doesn’t happen, an attractive buying opportunity for risk assets should present itself soon. But there could be further downside first, especially if the number of cases in major countries such as the US, Germany, and the UK were to accelerate significantly. There are some sign that Chinese activity is beginning to recover. There are some signs that Chinese activity is beginning to recover, as new cases of COVID-19 slow, thanks to the draconian measures taken by the authorities. Big Data can help analyze this. For example, live traffic statistics from TomTom show that by February 28, weekday road congestion in Shanghai was back to 50% of its normal level, compared to 19% on February 14 (Chart 2). The Chinese authorities have relaunched fiscal and monetary stimulus, causing short-term rates to fall to their lowest level since 2010 (Chart 3). Monetary policy has been upgraded from “prudent” to “flexible and moderate.” BCA Research’s China strategists believe there is even an increasing possibility of a stimulus overshoot in the next 6-12 months, as the authorities plan for the worst-case scenario but the economy rebounds.1 Chart 2Chinese People Getting Back On The Roads Monthly Portfolio Update: A Classic Bayesian Dynamic Monthly Portfolio Update: A Classic Bayesian Dynamic Chart 3Chinese Stimulus Pushing Down Rates Monthly Portfolio Update: A Classic Bayesian Dynamic Monthly Portfolio Update: A Classic Bayesian Dynamic In the short-term, it is clear that global growth will weaken, though quantifying this is hard. A 1% quarter-on-quarter decline in Chinese GDP in Q1 would bring growth down to 3.5% year-over-year. Our colleagues in BCA’s Global Investment Strategy estimate this would cause global growth to fall 0.8% below trend in Q1, mainly from a contraction in tourism, but that this would be largely made up in Q2, assuming that the epidemic is over by then (Chart 4).2 Could even a limited epidemic tip the world into recession? We doubt it. Consumer confidence remains strong in developed economies (Chart 5) and the virus is not yet serious enough to stop most consumers going out to spend. The global economy was in the process of bottoming out before COVID-19 hit (Chart 6) and there is little reason to think that we will not return to the status quo ante. Chart 4Global Growth To Slow In Q1, But Rebound In Q2 Monthly Portfolio Update: A Classic Bayesian Dynamic Monthly Portfolio Update: A Classic Bayesian Dynamic   Chart 5Consumers Remain Confident Monthly Portfolio Update: A Classic Bayesian Dynamic Monthly Portfolio Update: A Classic Bayesian Dynamic Chart 6Before COVID-19, Growth Was Bottoming Out Monthly Portfolio Update: A Classic Bayesian Dynamic Monthly Portfolio Update: A Classic Bayesian Dynamic We see the two biggest risks being: 1) a rise in defaults in China, especially among smaller companies, that the government is unable or unwilling to prevent (Chart 7); and 2) a deterioration in the jobs market in the US, as companies start to postpone hiring, or lay off staff (Chart 8). We will watch these carefully over coming weeks. Chart 7Are Chinese Companies Vulnerable? Monthly Portfolio Update: A Classic Bayesian Dynamic Monthly Portfolio Update: A Classic Bayesian Dynamic Chart 8Is The US Job Market Starting To Wobble? Monthly Portfolio Update: A Classic Bayesian Dynamic Monthly Portfolio Update: A Classic Bayesian Dynamic Chart 9Markets Believe Trump Would Beat Sanders Monthly Portfolio Update: A Classic Bayesian Dynamic Monthly Portfolio Update: A Classic Bayesian Dynamic There is one other risk that might give equity markets an excuse for a further sell-off: November’s US presidential election. The probability that Bernie Sanders wins the Democratic nomination has risen to 60% from 15% over the past two months. The consensus believes that Trump can easily defeat Sanders, which is why the President’s probability of being reelected has risen in tandem (Chart 9). But, if the economy starts to weaken and Trump’s approval rating slips, investors could become nervous about the likelihood of a market-unfriendly Sanders administration. We would not recommend long-term investors sell out of risk assets at this point. There could be an attractive buying opportunity over the next few weeks, and investors who have derisked should be looking for a reentry point. With US 10-year bonds yields at 1.2% and German yields at -60 basis points, it is hard to see much further upside for risk-free bonds. Equities should be able to outperform over the next 12 months, as growth rebounds following the COVID-19 episode. We have been recommending overweights in cash and gold, as hedges, since December, and these still make sense. However, if events over the coming weeks point to the risk of global pandemic being higher than we currently think, then investors should Bayesianally adjust and move more risk-off. Otherwise, a peak in COVID-19 cases ex-China should be a strong signal to buy risk assets again. Chart 10Why Should Long-Run Inflation Expectations Fall? Monthly Portfolio Update: A Classic Bayesian Dynamic Monthly Portfolio Update: A Classic Bayesian Dynamic Fixed Income: US Treasurys have become investors’ safe haven of choice over the past few weeks. A marked drop in long-run inflation expectations (Chart 10), in particular, has pushed the 10-year yield to a record low. This seems somewhat illogical, since the Fed will announce this summer the results of its review of monetary policy, which is likely to lead to a more dovish long-term inflation target (perhaps a commitment to achieve 2% on average over the cycle). The market has also priced in at least three Fed rate cuts by year-end (Chart 11). The Fed will certainly cut rates if US growth falters as a result of COVID-19, but this is by no means a certainty. History shows that Treasury yields jumped sharply once previous viral outbreaks ended (Chart 12). We expect yields to be significantly higher in 12 months, and so are underweight duration and prefer TIPS over nominal bonds. Credit will continue to underperform in the risk-off phase, but some interesting opportunities should arise soon, especially among the lowest-rated credits and in the Energy sector. Chart 11Will The Fed Really Be This Accommodating? Monthly Portfolio Update: A Classic Bayesian Dynamic Monthly Portfolio Update: A Classic Bayesian Dynamic Chart 12After Previous Virus Outbreaks, Rates Leapt Monthly Portfolio Update: A Classic Bayesian Dynamic Monthly Portfolio Update: A Classic Bayesian Dynamic Equities: The sell-off has already put on fire sale some stocks most affected by the epidemic. For example, cruise lines are down by 40% over the past month or so, European oil stocks 25%, some luxury goods makers 30%, and airlines 30%. Opportunistic investors might want to buy a basket of the most oversold quality names. Our overweight on euro area stocks has not worked in the sell-off. But, as a cyclical, export-oriented market, we continue to expect Europe to outperform when global growth rebounds. Euro area banks, in particular, represent the best call option on a rise in bond yields, since their performance is highly correlated to the shape of the yield curve. We continue to have a somewhat cyclical tilt among our sector weightings (with overweights on, for example, Energy and Industrials), but may adjust this in our Quarterly Portfolio Outlook in early April if we decide to reduce risk. The sell-off has already put on fire sale some stocks most affected by the epidemic. Currencies: The dollar is a safe-haven currency and so, unsurprisingly, has benefitted from the rush to safety in recent weeks. However, it remains overvalued (Chart 13), and interest rate differentials would move further against it if the Fed does cut rates, since other major developed central banks have much less room to move (Chart 14). This suggests that it will probably resume the weakness it experienced from August to December last year as soon as global growth rebounds. Chart 13Dollar Is Overvalued... Monthly Portfolio Update: A Classic Bayesian Dynamic Monthly Portfolio Update: A Classic Bayesian Dynamic Chart 14...And Interest Differentials Have Moved Against It Monthly Portfolio Update: A Classic Bayesian Dynamic Monthly Portfolio Update: A Classic Bayesian Dynamic Chart 15Metals Prices Stabilized In Recent Weeks Monthly Portfolio Update: A Classic Bayesian Dynamic Monthly Portfolio Update: A Classic Bayesian Dynamic Commodities: Industrial metals fell sharply on the outbreak of COVID-19 in China, but have bottomed in line with the stabilization of the situation in that country (Chart 15). Gold has worked predictably as the best hedge in the sell-off. While it is starting to look technically overbought and would be hurt by a rise in bond yields (Chart 16), for prudent investors it remains a useful hiding place amid heightened risk and ultra-low interest rates. Oil is the commodity that has fallen the most surprisingly, with Brent close to the low it reached during the sell-off in December 2018 (Chart 17).  It is much less dependent on Chinese demand than metals are, and so is maybe pricing in a global recession – as well as questioning the commitment of OPEC to cut production further. This would suggest upside to the oil price if global growth turns out not to be so bad, oil demand continues to pick up, and supply remains constrained.   Chart 16How Much Could Gold Overshoot? Monthly Portfolio Update: A Classic Bayesian Dynamic Monthly Portfolio Update: A Classic Bayesian Dynamic Chart 17Oil Discounting A Global Recession Monthly Portfolio Update: A Classic Bayesian Dynamic Monthly Portfolio Update: A Classic Bayesian Dynamic Garry Evans, Senior Vice President Chief Global Asset Allocation Strategist garry@bcaresearch.com Footnotes 1    Please see China Investment Strategy Weekly Report, “China: Back To Its Old Economic Playbook?” dated 26 February 2020, available at cis.bcaresearch.com 2   Please see Global Investment Strategy Weekly Report, “Market Too Complacent About The Coronavirus,” dated 21 February 2020, available at cis.bcaresearch.com GAA Asset Allocation  

Highlights Portfolio Strategy It is still early to bottom fish, and trying to catch the proverbial falling knife does not interest us for cyclically oriented capital. Uncertainty surrounding the coronavirus epidemic and its effects on economic and profit growth, and uncertainty with regard to US elections both signal that it still pays to be cautious on the prospects of the broad equity market on a cyclical 9-12 month time horizon. Lofty valuations, stretched technicals, souring macro and cresting capex, underscore that the time is ripe to take profits in software stocks and move to the sidelines. Faltering operating metrics, stretched relative valuations, a firming greenback, looming fed funds rate cuts and a contracting capex backdrop, all suggest that an underweight stance is now warranted in tech stocks. Recent Changes Book gains of 51% in the S&P software index and downgrade to neutral, today. Downgrade the S&P tech sector to underweight, today. We got stopped out and booked gains of 10% in the Global Gold Mining index. It is now neutral, from previously overweight. Table 1 From "Stairway To Heaven" To "Highway To Hell"? From "Stairway To Heaven" To "Highway To Hell"? Feature The SPX convulsed last week, as investors grappled with the risk of the coronavirus epidemic becoming a true pandemic (Chart 1A), and with Bernie Sanders likely clinching the Democratic nomination (Chart 1B). While a technical reflex rebound is in order as indiscriminate selling took center stage and we are looking to deploy short term oriented capital from current SPX levels all the way down to 2714 (or 20% SPX correction from recent peak), the cyclical outlook for the broad equity market remains grim. Chart 1ABlame The Virus…. Blame The Virus…. Blame The Virus…. Chart 1B…And Bernie …And Bernie …And Bernie We have been cautioning investors all year long in our reports, warning that the stock market’s advance has been precarious on a number of fronts and have been recommending investors sell the market’s strength. First, the extreme concentration of returns in a handful of teflon-tech stocks has been disconcerting, heralding an equity market wobble.1 Likely, a mania has taken root in certain tech stocks and the inevitable bursting of the “ATLAS” mania (Apple, Tesla, Lam Research, AMD and Salesforce) would end in tears.2 As an update, as we went to press these five stocks were down 21% from their all-time highs. Second, on January 13 we highlighted that gold has been trumping the SPX and sniffing out two-to-three fed funds rate cuts, leading the fed fund futures market, similar to last spring (top & middle panels, Chart 2).3 Third, we highlighted that the recent positive correlation between the VIX and the SPX was disquieting and signaling that a pullback was nearing.4 Now the jump in the VIX along with the vol curve inversion and the collapse in the stock-to-bond ratio all warn that the path of least resistance for the market and the forward multiple remains lower (Chart 3). Chart 2Gold Sniffed Out Fed Cuts First Gold Sniffed Out Fed Cuts First Gold Sniffed Out Fed Cuts First Chart 3Financial Conditions Are … Financial Conditions Are … Financial Conditions Are … This has already tightened financial conditions according to the soaring junk spread (top panel, Chart 4), and we deem that unless the Fed relents and eases monetary policy, the stock market will remain in melt down mode. Fourth, market internals have been screaming “get out” of the broad equity market for some time now (bottom panel, Chart 4) and the epitome was when semi stocks stalled versus the NASDAQ 100 (middle panel, Chart 4).5 Fifth, the “tenuous trio” as we have coined it (stock prices, bond prices and the US dollar) cannot all rise simultaneously. Typically we cautioned, this gets resolved with an equity market pullback as a rising greenback is deflationary for US profits (bottom panel, Chart 2). Finally, in our “Sell The Rip” report, we worried about extreme investor complacency and showed that the economic backdrop was soft owing to the collapse in imports in Q4 2019, predating the coronavirus epidemic.6 Tying everything together, ultimately what matters most to equity investors is profit growth. On that front we have heavily relied on the message of our four-factor EPS growth model, which has consistently delivered. Chart 4…Tightening Rapidly …Tightening Rapidly …Tightening Rapidly   In mid-January, our SPX profit growth model continued to have no pulse, warning that the Street’s 10% profit growth estimate for calendar 2020 was unattainable. Our analysis of three EPS scenarios showed that at the time the SPX was overvalued by 8% according to the SPX 3,049 expected value for end-2020 that was actually hit last week.7 Recently, we have been inundated with client requests to update our analysis and incorporate the coronavirus epidemic to our adverse EPS scenario. Chart 5 shows that in our worst case scenario, EPS will contract by 2.41% in calendar 2020. Assuming final 2019 EPS comes in at 162.95, using I/B/E/S’ latest estimate, then the 2020 EPS level falls to 159.02. Assigning a trough multiple of 16x results in a 2,544 SPX ending value as a worst case outcome. Chart 5Our EPS Model Has Delivered Our EPS Model Has Delivered Our EPS Model Has Delivered Importantly, our newly weighted expected 2020 EPS falls to 164.48 versus 169.40 previously as we penciled in a 60% and 50% probability that our worst case scenario materializes in EPS and multiple assumptions, respectively (Chart 6). As a result our expected end-2020 SPX value falls to 2,755 which makes the S&P 500 still 4% overvalued (please find the assumptions on the four factor model along with the updated table of expected outcomes in the Appendix below). While no one really knows how this virus outbreak will evolve, there are two predominant market narratives that can serve as positive catalysts: a.) China will massively ease both on the monetary and fiscal policy fronts (Chart 7) and b.) the Fed (and likely other CBs) will be forced to cut interest rates despite the fact that lower fed funds rates will likely not fix the supply side global problems owing to the corona virus. In other words, liquidity injections will remain upbeat. However, if these measures – especially on the Fed’s side – prove ineffective to generate GDP growth, then the risk of a recession will skyrocket for 2020, a presidential election year. Chart 6Updated Three EPS Scenarios Updated Three EPS Scenarios Updated Three EPS Scenarios   Chart 7How Much Will China Stimulate? How Much Will China Stimulate? How Much Will China Stimulate? As a reminder, parts of the US yield curve (YC) first inverted in December 2018 and currently the 2-year/fed funds rate slope is inverted, implying that the bond market deems the Fed will ease monetary policy. In fact, the latest CME probability of a 50bps cut on March 18 last stood at 100%. Importantly, the YC inversions did not predict the oil embargoes of the 70s, or the 9/11 attacks or the sub-prime crisis or the coronavirus outbreak. Typically, the YC inverts at the point of maximum economic strength and signals that the cycle is long in the tooth, i.e. in the current episode, 2018 registered roughly 3% real GDP growth and 25% SPX EPS growth. Put differently, the YC inversion suggests that the economy is, at the margin, vulnerable to an external shock as economic growth settles down to a lower rate trajectory. While the YC inversion does not predict recession, it forewarns recession and we continue to heed this message (Chart 8). It will not be different this time. In sum, it is still early to bottom fish, and trying to catch the proverbial falling knife does not interest us for cyclically oriented capital. Uncertainty surrounding the coronavirus epidemic and its effects on economic and profit growth, and uncertainty with regard to US elections both signal that it still pays to be cautious on the prospects of the broad equity market on a cyclical 9-12 month time horizon. This week we are making some tech sector adjustments. Chart 8The Yield Curve is ALWAYS Right! The Yield Curve is ALWAYS Right! The Yield Curve is ALWAYS Right! Crystalize Software Gains And Downgrade To Neutral… Market events last week compel us to take profits of 51% in the S&P software index above and beyond the S&P 500’s return since the late-2017 inception and downgrade exposure to neutral. The multiyear juggernaut in software stocks is primed for a much needed pause. Its appeal is well known as within the tech space software is considered a defensive holding owing to the productivity enhancing properties it enjoys in both good and bad times. Anecdotally, it was disquieting that the Standard & Poor’s decided to add two additional cloud stocks to the S&P 500 recently, further boosting the software group’s weight in the tech sector and in the SPX. Likely, the reason was the flurry of M&A deals that has been ongoing for years. Most recently however, this M&A frenzy hit a wall (top panel, Chart 9). Meanwhile, last Monday we wrote that AAPL’s profit warning was the tip of the iceberg and an avalanche of warnings would ensue.8 MSFT followed suit and issued their own profit warning and this negative backdrop is not yet reflected in the sell side’s S&P software profit and revenue forecasts. Tack on the message from the contracting software sector deflator and odds are high that sales will underwhelm in the coming quarters (middle panel, Chart 9). The latest GDP report also revealed that, up to recently bulletproof, software capex growth sunk to nil in Q4 (bottom panel, Chart 9). Not only in absolute, but also in relative terms software outlays have petered out and have been decreasing in intensity as measured by the decelerating contribution to GDP growth (Chart 10). Chart 9Softening… Softening… Softening… Chart 10…Software Capex …Software Capex …Software Capex Beyond investment, the recent plunge in the Markit services PMI that really ignited the recent selling in equities, warns that the time is ripe to cement software gains and move to the sidelines (Chart 11). Moreover, there is a high chance that IPOs peaked last year and will dry up in 2020, which is slightly negative for overall market sentiment in general and for market darlings software stocks in particular (Chart 11). From a technical perspective, software equities went ballistic. Relative momentum surged north of 25%/annum, a nineteen-year high (middle panel, Chart 12). Similarly, relative valuations went parabolic. The S&P software index trades at a 60% premium to the broad market on a forward P/E basis (bottom panel, Chart 12). Such overvaluation was last seen in 2003. Chart 11Do Not Overstay… Do Not Overstay… Do Not Overstay… Chart 12…Your Welcome …Your Welcome …Your Welcome Finally, we refrain from getting bearish this heavyweight tech subindex. Our long-held belief is that SaaS, the broader push to the cloud, augmented reality, AI and autonomous driving, which are all software dependent, are not fads, but are here to stay.  Netting it all out, we do not want to overstay our welcome in the S&P software index and are cementing gains and moving to the sidelines, for now. Bottom Line: Take profits of 51% since inception in the S&P software index and downgrade to neutral. The ticker symbols for the stocks in this index are: BLBG: S5SOFT – MSFT, ADBE, CRM, ORCL, INTU, NOW, ADSK, ANSS, SNPS, CDNS, FTNT, PAYC, CTXS, NLOK.   …Which Pushes Tech To Underweight Our intra-sector positioning shifts with the recent S&P tech hardware storage & peripherals downgrade to underweight9 and today’s trimming of the S&P software index to neutral, reduce the S&P tech sector to a below benchmark allocation. Tech stocks are stretched, trading near two standard deviations above the historical time trend, a level that has marked three previous peaks since 1960 (top panel, Chart 13). From a macro perspective, when the Fed cuts rates as the end of the cycle is nearing it has been a treacherous time to own tech stocks. If we are entering a recession owing to the coronavirus epidemic, underweighting tech stocks is the right portfolio strategy to generate alpha (Chart 13). Chart 13End Of Cycle Dynamics End Of Cycle Dynamics End Of Cycle Dynamics Business investment in tech has been losing market share for the better part of the last year and according to the national accounts tech capex is contracting. Excluding the software industry, capital outlays are in dire straits (top & second panels, Chart 14). Meanwhile, lofty valuations, with the tech forward P/E trading at a 20% premium to the overall market, signal that there is no cushion for this deep cyclical sector that has 60% of sales originating abroad, the largest among its GICS1 peers (third panel, Chart 14). While the Fed will likely cut interest rates soon, the stampede in the US dollar, the reserve currency of the world, is unwelcome news for the heavily export-dependent US technology sector (trade-weighted US dollar shown inverted, middle panel, Chart 15). Chart 14Red Flag: Crumbling Tech Capex Red Flag: Crumbling Tech Capex Red Flag: Crumbling Tech Capex Chart 15Large Foreign Sales Exposure Is Problematic Large Foreign Sales Exposure Is Problematic Large Foreign Sales Exposure Is Problematic Turning over to tech-heavy Korean and Taiwanese exports, they peaked in 2017, and the coronavirus epidemic guarantees that they will suffer a steep decline in the coming months, dealing a blow to the tech sector’s top line growth prospects (bottom panel, Chart 15). If supply chain breakdowns increase over the course of the next few weeks as the coronavirus related shut downs accelerate, then more tech profit warnings are looming and the resulting hit to still ultra-wide relative profit margins and EPS will likely be severe (bottom panel, Chart 14). In more detail on the operating front, the coincident San Francisco Fed Tech Pulse Index is sinking like a stone and this weakness predates the coronavirus epidemic. The implication is that highly inflated relative share prices are vulnerable to a sizable pullback (second panel, Chart 16). Worrisomely, the industry’s new orders-to-inventories ratio is contracting at the fastest pace in eight years and bodes ill for still accelerating relative forward profit growth estimates (bottom panel, Chart 16). Finally, given the severity of recent market moves, when investors typically get margin calls they tend to sell their high flying stocks that currently are mostly concentrated in the tech space. Tack on the proliferation of passive investment, and as everyone is headed for the exit doors simultaneously, tech stocks that dominate hundreds of popular and large capitalization exchange traded funds are at risk of liquidation. Adding it all up, faltering operating metrics, stretched relative valuations, a firming greenback, looming fed funds rate cuts and a contracting capex backdrop, all signal that an underweight stance is now warranted in tech stocks. Bottom Line: Trim the S&P tech sector to underweight, today. Chart 16Weakening Operating Metrics Weakening Operating Metrics Weakening Operating Metrics Housekeeping Our long GDX:US / short ACWI:US portfolio position got stopped out at a 10% gain. The global gold mining index is now back to neutral, from previously overweight.   Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com   Appendix Table A1 From "Stairway To Heaven" To "Highway To Hell"? From "Stairway To Heaven" To "Highway To Hell"? Table A2 From "Stairway To Heaven" To "Highway To Hell"? From "Stairway To Heaven" To "Highway To Hell"? Table A3 From "Stairway To Heaven" To "Highway To Hell"? From "Stairway To Heaven" To "Highway To Hell"?     Footnotes 1     Please see BCA US Equity Strategy Weekly Report, “Three EPS Scenarios”, dated January 13, 2020, available at uses.bcaresearch.com. 2     Please see BCA US Equity Strategy Weekly Report, “When The Music Stops…” dated January 27, 2020, available at uses.bcaresearch.com 3    Please see BCA US Equity Strategy Weekly Report, “Three EPS Scenarios” dated January 13, 2020, available at uses.bcaresearch.com. 4    Please see BCA US Equity Strategy Weekly Report, “Will The Fed Save The Day, Again?” dated February 18, 2020, available at uses.bcaresearch.com. 5    Please see BCA US Equity Strategy Weekly Report, “Crosscurrents” dated February 3, 2020, available at uses.bcaresearch.com. 6    Please see BCA US Equity Strategy Weekly Report, “Sell The Rip” dated February 10, 2020, available at uses.bcaresearch.com. 7     Please see BCA US Equity Strategy Weekly Report, “Three EPS Scenarios”, dated January 13, 2020, available at uses.bcaresearch.com. 8    Please see BCA US Equity Strategy Weekly Report, “Vertigo” dated February 24, 2020, available at uses.bcaresearch.com. 9    Please see BCA US Equity Strategy Weekly Report, “Crosscurrents” dated February 3, 2020, available at uses.bcaresearch.com. Current Recommendations Current Trades Strategic (10-Year) Trade Recommendations From "Stairway To Heaven" To "Highway To Hell"? From "Stairway To Heaven" To "Highway To Hell"? Size And Style Views June 3, 2019 Stay neutral cyclicals over defensives (downgrade alert)  January 22, 2018 Favor value over growth May 10, 2018 Favor large over small caps (Stop 10%) June 11, 2018 Long the BCA  Millennial basket  The ticker symbols are: (AAPL, AMZN, UBER, HD, LEN, MSFT, NFLX, SPOT, TSLA, V).

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

Highlights It is too soon to bottom feed with fears of a global pandemic and “socialist” boom in the United States. China’s government will do “whatever it takes” to stimulate the economy – but animal spirits need to revive for it to work. European political risk and policy uncertainty are clearly on the rise, albeit from low levels. Bernie Sanders could become the presumptive nominee for president on Super Tuesday – if Biden fails to make a comeback. The market is underrating the Sanders risk to US equities – particularly tech and health. Assuming pandemic fears subside, the Fed put, the China put, and the Trump reflation put will fuel risk-on sentiment in H2 2020. Feature Chart 1Risk-Off Mood Dominates Markets... Risk-Off Mood Dominates Markets... Risk-Off Mood Dominates Markets... Financial markets awoke to the confluence of negative news this year on February 20. The S&P 500 has fallen 8.0% from this year’s peak while the 10-year US Treasury yield dove to 1.33%. Gold reached the highest level since 2013. The yield curve inverted again (Chart 1). It is too soon to buy into the equity selloff. Fear of the coronavirus is spreading, not abating, while Vermont Senator Bernie Sanders – a democratic socialist who would turn the regulatory pen against corporations – is running away with the Democratic Party’s nomination for US president. Chart 2...Amid Fears Over Coronavirus And Sanders ...Amid Fears Over Coronavirus And Sanders ...Amid Fears Over Coronavirus And Sanders The market selloff is well correlated with fear of the coronavirus, but there is also some correlation with Sanders’s success (Chart 2). This should intensify if Sanders becomes the presumptive nominee following “Super Tuesday,” March 3, by which time 39% of the Democratic Party delegates will have been chosen. Sanders poses a more systemic risk to corporate profits than the virus as he emblematizes a generationally driven sea change looming over US national policy: a shift from capital to labor. A greater tightening of financial conditions would prompt the Federal Reserve to cut interest rates, possibly as soon as its meeting on March 17-18. But the Fed is not yet signaling cuts. Also, cuts may not pacify the market as easily this time as in the last major pullback in Q4 2018. Tightening monetary policy was the culprit for that selloff and therefore the Fed’s policy reversal on January 4, 2019 gave the market just what it needed to rally. Today the Fed has no control over the causes: virus fears and “socialism.” President Trump is manifestly uneasy as the virus spreads. Anything that weakens the US manufacturing sector is a direct threat to his reelection, regardless of how he spins it. The statewide coincident indicators provided by the Philadelphia Fed show that Pennsylvania’s economy is deteriorating, while a relapse in Michigan will push it into the Democratic camp according to our quantitative election model. This would leave Trump with only Wisconsin standing between him and the shame of a one-term presidency (Chart 3). Chart 3Trump’s Narrow Victory At Risk Of Virus-Induced Slowdown GeoRisk Update: Leap Year, Or Steep Year? GeoRisk Update: Leap Year, Or Steep Year? What can Trump do to feed the markets and economy some good news? Not much. The Democrats control the House of Representatives and will refuse any fiscal stimulus unless a total collapse is occurring, in which case Trump is doomed anyway. Given the strong dollar, the Fed’s reluctance to cut rates, and Trump’s paternalist proclivities, we can fully envision him attempting to strong-arm the Treasury Department into intervening against the dollar. But intervention would have a fleeting impact without Fed cooperation – and again, the economic crisis required for the Fed to intervene decisively would likely seal Trump’s fate regardless. What remains for Trump is his ability to enact surprise “rate cuts” of his own via tariff rollback on China. This is fully within his power. All he has to do is hold a phone conference with Xi Jinping and then declare that China is complying with the “phase one” trade deal in good faith and therefore deserves assistance amid the coronavirus economic shock. But the impact of a positive tariff surprise would be limited. And such rate cuts are likely to be reactive rather than proactive, as with the Fed. We shifted to a cautious, neutral stance on global risk assets on January 24 and we maintain that position. China is stimulating the economy, meaning that the dominant trend in H2 should be a global “risk on.” Thus we are keeping our China and emerging market trades open. But volatility will likely remain elevated through March, at minimum, given the toxic combination of a slowing global economy and an increasingly likely Sanders nomination. China Stimulus: "Whatever It Takes" Chart 4Xi Administration Is Getting Out The Big Guns Xi Administration Is Getting Out The Big Guns Xi Administration Is Getting Out The Big Guns One near certainty of the coronavirus outbreak is that it will catalyze greater economic stimulus in China. Last year we argued that the trade war had derailed Beijing’s financial deleveraging agenda and hence that the risk of a stimulus overshoot was greater than an undershoot. The Xi Jinping administration limited the degree of reflation for most of the year, but by autumn it was incontrovertible: stabilizing growth and the labor market had taken priority over deleveraging. Local government bond issuance picked up and the government relaxed its grip on informal lending and the shadow banks (Chart 4). Now, with the coronavirus outbreak, the Xi administration is getting out the big guns. The People’s Bank of China has cut key interest rates below where they stood in 2015-16, the last major bout of stimulus (Chart 5), as our China Investment Strategy has noted. Beijing officials have announced they will dial up fiscal policy to build infrastructure and boost purchases of homes and cars. President Xi Jinping has personally assured the world that China will meet its economic growth target for the year. Compared with the 6.1% real GDP growth achieved in 2019, our China Investment Strategy believes a conservative estimate is 5.6% for 2020. Assuming China’s real GDP growth slows to 3.5% in Q1 on a year-over-year basis, China would need at least 6.3% average real growth year-over-year for the next three quarters to hit its target. This growth rate would be 0.3 percentage points higher than in the second half of 2019. Credit expansion and government spending in the next six-to-12 months would need to outpace that of last year. Will the government succeed in firing up demand? If getting back to work results in further outbreaks, then China may see greater difficulty in using its old-fashioned stimulus tools. Moreover Chinese households and corporates are more indebted than ever and have suffered a series of blows in recent years that have weighed on animal spirits: a political purge, slowing trend growth, corporate deleveraging, trade war, and now the virus. It is essential for consumer confidence and the velocity of money to keep recovering (Chart 6). Our Emerging Markets Strategy rightly insists that without a revival in animal spirits, stimulus will be pushing on a string. Chart 5Key Chinese Interest Rates Now Below 2015-16 Levels Key Chinese Interest Rates Now Below 2015-16 Levels Key Chinese Interest Rates Now Below 2015-16 Levels Chart 6Animal Spirits A Precondition For Chinese Recovery Animal Spirits A Precondition For Chinese Recovery Animal Spirits A Precondition For Chinese Recovery Yet it is also true that most of the negative shocks were policy decisions, especially deleveraging and trade war. With these decisions reversed – and likely to stay that way for at least this year – there is no reason to assume a priori that animal spirits will remain depressed. Furthermore, we see little room for the Xi administration to revert to tightening measures until a general economic recovery is well advanced. As we highlighted in our annual strategic outlook, it is necessary to stabilize the economy ahead of the 100th anniversary of the Communist Party in 2021 and – more importantly – the leadership reshuffle to take place in 2022. Chinese consumer confidence and the velocity of money need to recover for stimulus to have an impact. On a side note, Hong Kong is also implementing stimulus measures. This is positive for the city-state in the short run but it is unlikely to revive its fortunes over the long run. What made Hong Kong special was its position as a well-governed ally of the West during the heyday of globalization and the backdoor to mainland China during its rapid, catch-up phase of industrialization. Now globalization is slowing, Beijing is tightening central control, and the West has lost the appetite to defend its influence in Hong Kong. This influence is part and parcel with Hong Kong’s freedoms and privileges. This means that while the country’s equities can see a cyclical improvement we are structurally negative. Bottom Line: We are maintaining our cyclically constructive outlook on global growth and risk assets, as our view on China’s “Socialism Put” has been reinforced. We are keeping open our China Play Index and other EM trades. However, near-term risks are extremely elevated and our cyclical view could change quickly if the virus fear factor proves insurmountable for China and the global economy. China Sneezes, Europe Catches A Cold … And Its Immune System Is Weak Chart 7Our European GeoRisk Indicators Are Springing Back Our European GeoRisk Indicators Are Springing Back Our European GeoRisk Indicators Are Springing Back The European economy was on track to rebound in 2020 prior to the coronavirus, but only tentatively, as sentiment and manufacturing were fragile. The virus struck at the heart of demand for European exports, China, and now is hitting European demand directly via the outbreak in Italy and across the continent. As fear of the virus spreads country by country, households and corporations will cut back on activity. It could take weeks or even months to resume business as usual. And it will take 6-12 months for China’s stimulus to kick in fully and lift demand for European goods. European political risk is thus no longer slated to remain subdued. Our indicators already show it is springing back. The most significant player is Germany, but Italy is the weakest link in the Euro Area, and non-negligible risks are affecting France, Spain, and the United Kingdom (Chart 7). German political risk will be highly market-relevant between now and the federal election slated for October 2021. De-globalization is a structural headwind for the German economy and Chancellor Angela Merkel’s attempt to stage manage a smooth succession has collapsed. The Christian Democratic Union is now plunging into a truly competitive leadership contest that will keep uncertainty elevated, at least until the aftermath of the election. Friedrich Merz is the leading contender (Chart 8) and is attempting to rope more conservative voters back into the Christian Democratic fold so that they do not stray into the populist Alternative für Deutschland (AfD). While a similar dynamic led the British Conservative Party into Brexit, German politics are less polarized than British politics. The Christian Democrats are nowhere near being overtaken by the far right. First, the CDU is still the most popular party and its closest competitors are the Green Party and the Social Democrats, while the AfD polls at 13.3% support and is opposed by all other parties. The AfD’s popularity, while growing, is still very small. Second, a majority of the public still approves of Merkel (Chart 9), signaling a tailwind for centrists within and without her party. Chart 8Merz Is The Top Contender In Germany’s Leadership Contest GeoRisk Update: Leap Year, Or Steep Year? GeoRisk Update: Leap Year, Or Steep Year? Third, the German public is still the most supportive of the euro and EU, for the obvious reason that its economic success is integrally bound up in the union (Chart 10A). Nor is Germany alone, since the only country that looks truly concerning by these measures is Italy and even Italy’s populists remain engaged in the European project (Chart 10B). Chart 9Merkel's Popularity A Sign Of German Centrism Merkel's Popularity A Sign Of German Centrism Merkel's Popularity A Sign Of German Centrism   Chart 10ASupport For The Euro Still Strong (But Watch Italy) (I) Support For The Euro Still Strong (But Watch Italy) (I) Support For The Euro Still Strong (But Watch Italy) (I) Chart 10BSupport For The EU Still Strong (But Watch Italy) (II) Support For The EU Still Strong (But Watch Italy) (II) Support For The EU Still Strong (But Watch Italy) (II) Immediate economic challenges favor Merz’s bid to lead the party. However, if they do not give way to an economic rebound by fall 2021 (i.e. if Chinese and global growth worsen in the lead-up to the general election), then these challenges will undercut the Christian Democrats’ bid to remain in power regardless of whether Merz or a more dovish chancellor-candidate emerges from Merkel’s exit. The Green Party offers a viable alternative to lead the next government. Chart 11Coronavirus Will Weigh On France's Tourism Sector And Macron's Popularity Coronavirus Will Weigh On France's Tourism Sector And Macron's Popularity Coronavirus Will Weigh On France's Tourism Sector And Macron's Popularity In the short run, Germany can ease fiscal policy marginally to help offset the current slowdown. But a game changer in fiscal policy will require either for the current economy to collapse or a resolution to the succession crisis. Finance Minister Olaf Scholz, of the Social Democrats, has just proposed a significant revision to the schuldenbremse, or “debt brake,” which keeps budget deficits pinned above -0.35% of GDP. He would allow Germany’s state and local governments to suspend the debt brake temporarily so as to boost fiscal spending to mitigate the slowdown. A formal suspension requires a constitutional change that would in turn require a two-thirds vote in both houses of the legislature. There are enough votes in the Bundestag and possibly in the Bundesrat but it requires the economic shock to get bigger first so as to force the conservatives to capitulate and court the help of smaller parties. Otherwise Scholz is making an election gambit to distinguish the Democratic Socialists from the fiscally conservative Christian Democrats. In the meantime, limited moves to loosen the belt are perfectly countenanced by existing law which allows for deviations from the debt brake during recessions and emergencies. France is also seeing a spike in political risk. President Emmanuel Macron has slogged through the massive labor strikes against his pension reform, as we expected. The reform would streamline a complex web of pension programs into a single national program, providing incentives for workers to work longer without making spending cuts. It will likely pass into law through his En Marche party’s control of the National Assembly. However, Macron’s political capital is spent and his party is expected to sustain heavy losses in municipal elections from March 15-22. The service-oriented economy will also suffer a blow from reduced tourism amid the coronavirus scare (Chart 11), further eroding Macron’s already low popularity. The loss of influence at home will reinforce Macron’s pivot to foreign policy. Macron can play the leader of Europe at a time when the UK is leaving and Germany is consumed with a leadership contest. In this role he will clash with the UK over Brexit and the US over trade – but this can only go so far given the need to sustain the French economy. Negotiations with the UK will involve brinkmanship but will result in a delay of the end-of-year deadline, or a deal, given the fragile economic backdrop affecting all players. Economic constraints also imply that negotiations with the US will not spiral into a major confrontation unless and until Trump is reelected. Therefore Macron’s gaze will turn to security and immigration, challenges that have the potential to fuel anti-establishment sentiment that could hurt him in the French election of 2022 and undermine his vision of a more integrated Europe. While terrorism has abated for the time being (Chart 12), the trend cannot be guaranteed. The Middle East is extremely unstable amid the global slowdown, virus, drop in oil prices, and general destabilization emanating from the underlying US-Iran conflict. Immigration is also starting to rise again, particularly along the western North African route into Spain and France that bypasses the fighting in Libya (Chart 13). Chart 12A Pickup In Terrorism Would Fuel Populist Sentiment... A Pickup In Terrorism Would Fuel Populist Sentiment... A Pickup In Terrorism Would Fuel Populist Sentiment... Turkey’s foreign policy confrontation with the West threatens an increase in immigration in the east as well as a Turkish client-state in western Libya that France fears could become a militant safe haven. Chart 13...As Would An Increase In Immigration ...As Would An Increase In Immigration ...As Would An Increase In Immigration France is therefore taking a harder line with Turkey and providing maritime assistance to Greece (see Chart 13 above). The Mediterranean is becoming a geopolitical hot spot that could lead to negative surprises – and not only for Turkish assets. European populism is under control for now but a new wave of immigration would spark a new wave of populism that would increase policy uncertainty and the risk premium in equities. Italy has shifted from being an overstated to an understated political risk. Chart 14Italian Right-Wing Parties Are Gaining Strength Italian Right-Wing Parties Are Gaining Strength Italian Right-Wing Parties Are Gaining Strength Politically, Italy remains the weakest link in Europe – and this long-term risk is now becoming more pressing. Support for the euro and EU is among the weakest (see Chart 10 above). The ruling coalition is rickety and groping toward an election, with a popular referendum on the electoral law dated March 29. The country is poorly equipped to handle the virus outbreak. The virus will also call attention to the porous borders, fueling anti-establishment sentiment – after all the anti-establishment League is still the top party in polls while the right-wing Brothers of Italy’s support is surging (Chart 14). This is the case even though immigration into Italy is under control at the moment, particularly with renewed fighting in Libya discouraging flows through the central North African route. In short a full-fledged recession will unleash the furies in Italian politics and the country has shifted from being an overstated to an understated political risk. Bottom Line: The UK-EU trade talks threaten volatility for the pound this year, on top of the key continental risks: succession crisis in Germany, the potential for Macron’s centrist political movement to falter in France, and the possible election of a right-wing anti-establishment government emerging in Italy. Populist sentiment can emerge from the economic slowdown even if terrorism and immigration remain contained, but the recent uptick in immigration and new sources of instability in the Middle East, North Africa, and the Mediterranean show clouds gathering on the horizon. The Euro Area’s fiscal thrust is expected to be a measly 0.015% of potential GDP in 2020. The trends above suggest that this number could increase substantively, albeit reactively, due to fiscal easing in Germany and several other states along with France’s lack of real cuts in its pension reform. United States: Can A Northern Progressive Win In The South? In February 1980, Democratic presidential contender Jimmy Carter won the New Hampshire primary with 51% of the vote. Carter would go on to become the first Democrat from the Deep South to win the presidency since Woodrow Wilson. His triumph in New Hampshire proved, as he said, “that a progressive southerner can win in the North.” Fast forward to February 2020 and Vermont Senator Bernie Sanders, the most left-wing candidate vying for the nomination, is attempting to perform the equally dazzling feat of winning a primary election in the conservative southern state of South Carolina. If Sanders pulls it off then it will trigger an earthquake. For a progressive who can win in the South is likely to score big on Super Tuesday, March 3, and if Sanders pulls that off then he will become the country’s first “socialist” presumptive nominee for president (Chart 15). This would be a huge upset, primarily for former Vice President Joe Biden, who has long led the opinion polls in South Carolina and recently has even rebounded. Biden expects strong support from the African American community – which is staunchly Democratic, moderate in ideology, and favorable toward Biden due to his close association with former President Barack Obama. The problem is that Biden’s latest rebound in the polls may be too little, too late. He made more gaffes in the debate performance and, most importantly, Sanders’s polling has improved among African Americans (Chart 16). Chart 15A Sanders Win In The South Will Help Him Score Big On Super Tuesday GeoRisk Update: Leap Year, Or Steep Year? GeoRisk Update: Leap Year, Or Steep Year? Chart 16Sanders’s Polling Has Improved Among African-Americans GeoRisk Update: Leap Year, Or Steep Year? GeoRisk Update: Leap Year, Or Steep Year? Sanders performed well with almost every demographic in Nevada – if he can do well among blacks, and in the south as well as the north and west, then his ability to unify the party will be incontrovertible and moderate Democratic primary voters looking for a winner will start to resign themselves to his nomination. What is more likely is that Biden wins in South Carolina, declares himself the “comeback kid,” and prolongs the uncertainty regarding the Democratic nomination. Chart 17A Biden Win In Texas Would Reenergize The Establishment GeoRisk Update: Leap Year, Or Steep Year? GeoRisk Update: Leap Year, Or Steep Year? If South Carolina propels Biden to a strong performance on Super Tuesday, particularly a win in Texas, it could usher in a new phase of the primary election since it would suggest the possibility that the establishment has not lost the nomination and is striking back against Sanders (Chart 17). Failing that, any “Never Sanders” movement will face an uphill battle. After March 3, about 39% of the Democratic Party’s delegates will be “pledged,” or committed, to one of the candidates. Two weeks later, fully 61.5% of delegates will be chosen. Which means that the best chance for a conservative counter-revolution against Sanders comes over the next three weeks. Regardless of South Carolina, Biden’s structural limitation on Super Tuesday is the well-known phenomenon of vote-splitting. Five centrist candidates are dividing the moderate vote, leaving Sanders to engross the 40%-45% of the vote that is progressive all to himself.1 This is a compelling reason to believe that Sanders will continue to amass the most delegates. What would change the equation would be a mustering of the centrists under a single competitive candidate. The latter requires candidates to be forced out of the race through defeat or to drop out of the race willingly for the good of the party. If Mayor Pete Buttigieg or Senator Amy Klobuchar should fall short of the 15% to qualify for delegates in South Carolina, they would need to bow out of the race (they might be persuaded by promises of high appointments). Most importantly, if Biden should squander South Carolina then he would need to take one for the team and drop out, passing the baton to Bloomberg. It will be hard for any one of these politicians to quit unless it is coordinated with the others; he or she would have to forgo any hopes of emerging at the top of the ticket at a contested Democratic National Convention in July. If coordination fails, the centrist vote will become even more fragmented when Mayor Michael Bloomberg finally appears on the ballot on March 3. Last week we argued that if Sanders cannot clinch the nomination by winning a majority of the delegates by June, then he needs to win a commanding plurality of the delegates so that moderate unpledged delegates are forced to capitulate and vote for him at the Democratic National Convention. We argued that for this to happen he needs, at minimum, to improve upon his score in 2016, which was 43% of the popular vote and 40% of the delegate count. Otherwise, a sequential voting procedure among roughly equally weighted blocs will likely lead to his defeat, as the two other factions of the party (establishment Washington insiders like Biden and centrist Washington outsiders like Bloomberg) view Sanders-style socialism as their least preferred option. Is this 40%+ threshold enough? Nobody knows. Clearly it is harder to win the nomination with 40% of the delegates than with 49%, even if you are in first place. But if Sanders leads by double digits in terms of the share of delegates, has captured 43%+ of the popular vote, and has won the big swing state primaries across regions, then it will be hard for Democratic delegates to conclude that he is not the most competitive in the general election. Currently Sanders is slated to win California, Michigan, Wisconsin, Pennsylvania, Ohio, and possibly Texas. This is a strong argument for moderate unpledged delegates to swing behind him. It is even compelling for some of the Democratic Party’s “super delegates,” at least those who are wavering. Otherwise these party elders would break up an enormous amount of momentum in the name of a less popular Democratic candidate – and strengthen Trump. Bottom Line: Super delegates will vote as political actors facing constraints inherent in their situation. If the situation is that Sanders has won 43% of the vote, leads the next candidate by double digits, has won the most primary elections, and has won in the major states, including the swing states, then it will be a compelling constraint on voting against him. Investment Conclusions The daily new cases of the coronavirus outside China continues to surge, creating near-term headwinds for global risk assets. Ultimately the negative shock of the virus may be overstated, but we remain on the sidelines of any near-term equity rally due to the confluence of a global demand shock and a US socialism boom. With manufacturing already vulnerable, the coronavirus, insofar as it causes a harder hit to global and hence American manufacturing, is a threat to Trump’s reelection odds. This is true regardless of who takes the Democratic nomination. It is also true notwithstanding that pandemic risks may ultimately fuel xenophobic sentiment. Trump cannot argue his way out of rising unemployment in the Rust Belt. The market is underrating the Sanders risk to health care and technology stocks. This means that Sanders has a greater chance of winning the White House than the consensus holds. Financial markets should continue to discount his rising odds, at least until it becomes clear either that he is falling short of a strong plurality or that the global economy is shaking off its jitters. As the financial market stumbles Sanders will get more steam than other candidates, while Trump’s odds will suffer, which is a potentially self-reinforcing dynamic. Looking at the correlations between different candidates and US equity sectors, the market is underrating the Sanders risk to health care and technology stocks (Table 1). Sanders poses a threat to regulation in these spheres even if the Democrats do not take a majority in the Senate. And they are likely to take the Senate and have a one-seat majority in the event that they prove capable of ousting Trump (via the vice president). Table 1The Market Is Underrating The Sanders Risk To US Equities GeoRisk Update: Leap Year, Or Steep Year? GeoRisk Update: Leap Year, Or Steep Year? Ultimately Trump’s reelection also represents a threat to the tech sector, due to a “Phase Two” trade war, but the initial market reaction is likely to be risk-on. Assuming our base case that the virus fear eventually subsides, people get back to work, the world economy regains its footing, and monetary and fiscal stimulus get pumping (especially in China), the swing state economies may well be banging by November. In that context, the three pillars of our bullish 12-month view will be restored: the Fed put, the China put, and Trump’s reelection as a “buy the rumor, sell the news” phenomenon.   Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com Footnotes 1 This assumes Senator Elizabeth Warren of Massachusetts continues to fall short of the 15% threshold qualifying a candidate to receive pledged delegates to the Democratic National Convention. Appendix Germany Germany: GeoRisk Indicator Germany: GeoRisk Indicator France France: GeoRisk Indicator France: GeoRisk Indicator Italy Italy: GeoRisk Indicator Italy: GeoRisk Indicator Spain Spain: GeoRisk Indicator Spain: GeoRisk Indicator UK UK: GeoRisk Indicator UK: GeoRisk Indicator Canada Canada: GeoRisk Indicator Canada: GeoRisk Indicator China China: GeoRisk Indicator China: GeoRisk Indicator Taiwan Taiwan: GeoRisk Indicator Taiwan: GeoRisk Indicator Korea Korea: GeoRisk Indicator Korea: GeoRisk Indicator Russia Russia: GeoRisk Indicator Russia: GeoRisk Indicator Brazil Brazil: GeoRisk Indicator Brazil: GeoRisk Indicator Turkey Turkey: GeoRisk Indicator Turkey: GeoRisk Indicator Section III: Geopolitical Calendar

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

Dear Client, I participated in a webinar earlier this week with my fellow BCA Research strategists to discuss the coronavirus outbreak and other timely issues. A replay can be accessed from this link. In lieu of our regular report next week, we will be sending you a Special Report from Matt Gertken, BCA’s Research Chief Geopolitical Strategist. Matt will discuss the state of the Democratic Party’s presidential nomination process in the wake of “Super Tuesday” and address the market implications. Best regards, Peter Berezin, Chief Global Strategist Highlights The decline in the number of new infections in China suggests that the coronavirus can be contained, provided that governments are both able and willing to impose severe quarantine measures on their own citizens. It is far from clear whether all countries can introduce such measures. And even among those who can, the economic damage from prolonged work stoppages could end up being too much to bear. The spike in supplier delivery times in various purchasing manager indices suggests that the global supply chain is already showing signs of strain. If the outbreak morphs into a global pandemic, a recession on the scale of the 2008/09 downturn would likely ensue. The only economic consolation from such an outcome is that once everyone is in the same boat, the need for mass quarantines and business shutdowns will diminish. While stock valuations have improved markedly over the past week, we would still recommend that investors refrain from significantly adding to equity positions at the moment. Once COVID-19 cases start popping up all over the US, stocks could come under further pressure. That said, we would only become more constructive on the near-term outlook for global equities if prices were to fall another 5%-to-8% from current levels or if the risks of a pandemic recede. The Power Of Exponential Change Humans tend to think in linear rather than exponential terms. Thus, it is easy to forget that when dealing with exponential growth, what appears exceedingly slow at first can become exceedingly fast later on. Take the example of the COVID-19 outbreak. Suppose that R0 is 2, meaning that someone who contracts the virus will spread it to two other people on average. Also suppose that it takes one week to pass it on to someone else. In week 1, one person is infected; in week 2, two new people are infected; in week 3, four new people; in week 4, eight new people, and so on. If only a small percentage of people who are infected get sick enough to have to go to the hospital, it might not be until after the end of week 8, when 128 new people have been infected, that the authorities become aware of the epidemic. Once we reach this stage, the only two options left are to impose extreme quarantine measures in an effort to drive Ro below 1, or stand back and let the outbreak run its natural course. Not surprisingly, most governments have chosen the first approach in the hopes of limiting the outbreak to a few regional clusters. A vigilant approach also buys some time to develop a vaccine. Time will tell if this strategy succeeds. On the positive side, the number of new infections in China continues to trend lower. Outside of Hubei, only 66 new cases have been reported since February 22nd. This has allowed an increasing number of Chinese companies to resume operations. It is also encouraging that a few countries such as Japan, Singapore, and Thailand, which at one point seemed on track to experience major epidemics, have gotten the problem under some degree of control. Chart 1The Number Of New Cases Has Declined In China, But Has Jumped In South Korea, Italy, And Iran Health Versus Growth Health Versus Growth On the negative side, the number of cases in South Korea, Iran, and Italy has surged (Chart 1). In South Korea, there are now 1261 confirmed cases, up from 31 early last week. South Korea’s population is less than 4% of China’s. If the current trend continues, the infection rate in Korea could surpass that of China over the next two weeks. The situation in Iran appears to be out of control. Two people from Iran have already tested positive in Canada. Bahrain has recorded 33 cases linked to Iran. In perhaps one of the most surreal moments of the crisis, Iranian deputy health minister Iraj Harirchi, who had been charged with leading the nation’s efforts to stem the epidemic, was filmed wiping his brow one day before it was confirmed he had contracted the virus. None of this prevented President Rouhani from declaring that Iran must “not allow enemies to convert the coronavirus into a weapon in their hand in order to disrupt work and production in Iran”. He went on to denounce the US for failing to “pay attention to the 16,000 American victims who died after having the influenza virus.” Worse Than The Swine Flu? Looking at the global data in aggregate, the number of confirmed cases is increasing in a manner more similar to the swine flu (H1N1) outbreak in 2009/10 than the SARS outbreak in 2003 (Chart 2). The H1N1 virus ended up infecting 61 million people in the US and between 700 million-to-1.4 billion globally. Chart 2COVID-19: More Like Swine Flu Than SARS? Health Versus Growth Health Versus Growth Unlike SARS, the COVID-19 coronavirus appears to be extremely contagious and can be spread by people who show few or no symptoms. SARS was generally spread only by people who were already visibly ill. In terms of fatality rates, COVID-19 is not as lethal as SARS, but appears to be at least ten times as fatal as H1N1. At present, there are no effective vaccines for coronaviruses. While concerted efforts are underway to develop a vaccine for COVID-19, most medical professionals agree that it will take at least a year before one is widely available. Unfortunately, given the exponential dynamic described above, most of the people on the planet could be infected by then. Pandemic Risk No one knows what the probability of a pandemic is, but it is clearly not zero. As workers return to their jobs in China, the outbreak may flare up again, leading to a new wave of business closures. Countries that do not have the will or the means to quarantine their citizens on a massive scale may find themselves unable to keep the virus at bay. Investors are finally waking up to this reality. As we discussed in last week’s report entitled “Markets Too Complacent About The Coronavirus,” even in a best-case scenario where the virus is successfully corralled over the next month or so, sequential global growth will still fall to zero in the first quarter. If the outbreak is not contained and a full-fledged pandemic ensues, the world is likely to experience a recession on the scale of the 2008/09 downturn. Table 1COVID-19 Fatality Rates By Age Health Versus Growth Health Versus Growth The only economic consolation from such an outcome is that once everyone is in the same boat, the need for mass quarantines and business shutdowns will diminish. Table 1 shows preliminary age-specific estimates of the fatality rate from the COVID-19 virus, provided by the Chinese Center for Disease Control and Prevention (China CDC).1 The results are based on 44,672 confirmed cases.   Stocks Won’t Get Much Relief From Bonds Given that investors have known about the risks from the coronavirus for some time, why did it take so long for stocks to buckle? Part of the answer has to do with the sigh of relief investors breathed after the number of new COVID-19 cases peaked in China. As in the SARS episode, the peak in new cases marked a bottom in risk assets (Chart 3). Unfortunately, now that the number of cases has accelerated outside of China, this sanguine narrative has been dashed. Chart 3AJust As In The SARS Episode, Stocks Bottomed Around The Same Time The Number Of Infections Peaked... Health Versus Growth Health Versus Growth Chart 3B… But The Number Of New Cases Outside China Has Surged Health Versus Growth Health Versus Growth While the news flow about the coronavirus has been the dominant driver of stocks, there has also been another important factor at work. As Chart 4 shows, global bond yields have dropped sharply since the start of the year. Up until this week, equity investors clung to the hope that falling yields would cushion the blow to growth and earnings. They also figured that a decline in the discount rate applied to future cash flows would boost equity valuations. Not surprisingly, growth stocks, which are most sensitive to changes in the discount rate, led the charge higher (Chart 5).   Chart 4Global Bond Yields Are Back Near Record Lows Health Versus Growth Health Versus Growth Chart 5Growth Stocks Have Outperformed On Falling Yields Health Versus Growth Health Versus Growth           These rosy expectations could still be realized if the global outbreak is quickly contained. If it is not, there is not much more central banks can do. Easier monetary policy can help offset demand shocks. However, it cannot do much about supply shocks. Stocks sold off in late 2018 because investors concluded that the Fed had erred in raising interest rates four times over the course of nine months. As soon as the Fed pivoted in a more dovish direction, equities rallied. This time is different. The Fed is not responsible for the current sell-off; the virus is. Thus, while the Fed would almost certainly cut rates if the outbreak turns into a pandemic, this would have less of a soothing effect than it did in early 2019. Supply Chains At Risk The modern global economy is powered by an intricate division of labor. Widespread work stoppages across many countries would eviscerate the global supply chain. Ironically, investors were worried at the start of the year that manufacturing inventories were too high. As it turned out, excess inventories have proven to be a blessing rather than a curse because they have allowed companies to weather the supply shock longer than they could have otherwise. The grace period will expire soon. According to the latest PMI data, supplier delivery times have soared in the major economies. The latest Markit Flash Eurozone PMI noted “a marked lengthening of supplier delivery times, with delays for inputs the most widespread since December 2018, attributed in many cases to supply chain issues arising from the COVID-19 outbreak.”  In the UK, Markit reported that UK manufacturers had disclosed the “the largest month-on-month slide in supply chain performance since the survey began in 1992, exceeding the previous record seen during the UK fuel protests in September 2000.” Monetary policy will come in handy only after the outbreak subsides. The dislocations caused by the virus could push many businesses towards the brink of bankruptcy. This could trigger a feedback loop of reduced spending, less hiring, and even lower spending. Timely stimulus would short-circuit this vicious cycle. That said, given that interest rates are already close to zero in most countries, much of the burden of preventing an extended downturn will have to fall on fiscal policy. It's Not Just About The Risk-Free Rate Chart 6Risk-Off Has Been On Fire Health Versus Growth Health Versus Growth What about the valuation boost to stocks from falling bond yields? It is certainly true that, all things equal, lower bond yields are good for stocks. However, all things are rarely equal. We need to ask why yields have fallen. The value of the stock market does not just depend on the risk-free rate. It also depends on the additional return investors demand to hold stocks – the so-called equity risk premium – as well as expected earnings growth. If bond yields decline because skittish investors pile into safe-haven US Treasuries, while simultaneously cutting their earnings projections, this will almost certainly result in lower equity prices. What we have seen this past week is a classic risk-off event (Chart 6). Gold has surged to the highest level since 2013. Term premia in government bond markets have plunged. Tech stocks have underperformed other sectors despite the ostensible support from lower bond yields. The US dollar has rallied, even as interest rate differentials have moved against the greenback (Chart 7).   Chart 7The Dollar Has Rallied, Even As Interest Rate Differentials Have Moved Against The Greenback Health Versus Growth Health Versus Growth What are investors to do? While stock valuations have improved markedly over the past week, we would warn against deploying significant fresh capital to equities at the moment. Stocks were technically overbought going into this correction. Some degree of profit taking was likely no matter what transpired. Once COVID-19 cases start popping up all over the US, stocks could come under further pressure. Hence, we would only become more constructive on the near-term outlook for global equities if prices were to fall another 5%-to-8% from current levels or if the risks of a pandemic recede. Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1The Novel Coronavirus Pneumonia Emergency Response Epidemiology Team, "The Epidemiological Characteristics of an Outbreak of 2019 Novel Coronavirus Diseases (COVID-19) — China, 2020[J]," China CDC Weekly, 2020, 2(8): 113-122. Global Investment Strategy View Matrix Health Versus Growth Health Versus Growth MacroQuant Model And Current Subjective Scores Health Versus Growth Health Versus Growth Strategic Recommendations

Highlights Global growth will quickly recover if the Covid-19 outbreak is soon controlled. If the virus's spread doesn't slow, a worldwide recession will take hold in 2020. BCA remains cyclically bullish, but tactical caution is warranted as long as uncertainty around Covid-19 remains high. A strong dollar is generally good for the US, except for exporters. The dollar possesses greater cyclical upside, a trend that will affect global asset allocation. The dollar will correct in 2020, which could allow cyclical stocks and value stocks to outperform growth equities in the short term. Foreign equities will also temporarily outperform US stocks this year. Feature 10-year Treasury yields hit an all-time low of 1.26% this morning, and the S&P 500 finally buckled under the pressure. Meanwhile, the US dollar seems unstoppable and commodity prices are still hobbling near recent lows. The economic and financial outlook for 2020 is unusually divided. On the positive front, economic momentum slowly turned the corner after a soft 2019. Liquidity aggregates have been improving, economic sentiment is bottoming and inventories are melting away. However, if Covid-19 morphs into a global pandemic, then these nascent positives will disappear. Faced with mounting uncertainty, the S&P 500 could still face additional tactical downward pressure. However, if Covid-19 does not turn into a global pandemic, then equities should recover in the second quarter. Additionally, the dollar’s strength remains a great concern, and for 2020, it too will depend on Covid-19's continued spread. While the next 12 months are likely to be painful for the dollar, its cyclical highs still lie ahead. The dollar’s trend will affect relative sector and regional performance. Covid-19 Under Control? The Covid-19 outbreak is key to the 2020 outlook. If Covid-19 is contained, then global growth can recover after a dismal first quarter. However, if the recent uptick in cases outside of China continues to increase beyond the coming two to three weeks, 2020 will witness a quick but painful recession as governments will impose quarantines and consumer confidence will collapse. If Covid-19 is contained, then global growth can recover after a dismal first quarter. Our colleagues from BCA Research’s Global Investment Strategy service estimate that Covid-19 could easily curtail global growth by more than 1% this quarter. China’s economy is experiencing a severe contraction, which should result in negative seasonally adjusted quarterly growth in Q1.1 Live indicators, such as the number of traffic jams in Shanghai streets or daily coal consumption are very weak, standing 20% and 32% below last year’s levels. Moreover, China accounts for 19.3% of global GDP, and its imports account for 12.5% of the rest of the world’s exports. China’s weak domestic activity has a ripple effect around the world. Making matters worse, the recent factory closings are scuttling global supply chains, which further lowers non-Chinese output. Finally, Chinese tourism accounts for 4.7% of global service exports, which will be deeply negatively impacted by the current immobility of Chinese citizens. As severe as the impact of Covid-19 will be in Q1, it will be fleeting. Epidemics and natural disasters may stop economic activity for a finite time, but they create pent-up demand that boosts economic growth in the following quarters. In the case of SARS, the lost output was recovered over the subsequent two quarters. Excess money is expanding at a brisk pace, which confirms that both the quantity and price of global output can rebound quickly (Chart I-1). The same is true of various liquidity measures, such as BCA Research’s US Financial Liquidity Index, which has an excellent record of forecasting the Global Leading Economic Indicator, the US ISM, and EM export prices. Most importantly, deleveraging is a tertiary concern for Chinese policymakers for the next two years. PMIs show that inventory levels are rapidly falling around the world. A purge in inventory allows pent-up demand to boost economic activity. Nowhere is this trend more powerful than in Sweden. Manufactured goods, especially intermediate and capital goods, represent a large percentage of Sweden’s output and exports. Thus, Sweden sits early in the global supply chains. Today, the decline in Swedish inventories is so deep that the country’s new orders-to-inventories ratio is surging, which historically indicates increases in our Global Industrial Activity Nowcast as well as US and global capital expenditures (Chart I-2). Chart I-1Ample Liquidity Will Cushion The Blow Ample Liquidity Will Cushion The Blow Ample Liquidity Will Cushion The Blow Chart I-2Positive Signal From Inventories Positive Signal From Inventories Positive Signal From Inventories   Improving liquidity and purged inventory bode very well for global economic activity. Our Global Growth Indicator, a variable mainly based on commodity prices and the bond yields of cyclical economies, has already predicted an improvement in global industrial production (Chart I-3). Our models showed that even Germany’s economy, which is largely driven by global economic gyrations, will experience a turnaround despite abysmal industrial production readings (Chart I-4). Chart I-3The Global Growth Indicator Continues To Rebound The Global Growth Indicator Continues To Rebound The Global Growth Indicator Continues To Rebound Chart I-4There's Hope Even For Germany There's Hope Even For Germany There's Hope Even For Germany The Federal Reserve is prepared to nurture the recovery. Falling job ads in the US, along with the New York Fed Underlying Inflation Gauge and BCA Research’s Pipeline Inflation Indicator point to a slowdown in core CPI (Chart I-5). Additionally, the FOMC wants to see inflation expectations recover toward the 2.3% to 2.5% zone reached when economic agents believe in the Fed’s capacity to sustain core PCE near 2%. BCA Research’s US Bond Strategy service’s adaptive expectations models show that based on current realized inflation trends, it would take a substantially long time for inflation expectations to move back into that zone. Chart I-5Disinflationary Pressures In The US Disinflationary Pressures In The US Disinflationary Pressures In The US The current health crisis is unleashing a wave of global stimulus. EM central banks, particularly in the Philippines and Indonesia, are cutting rates, thanks to low global and domestic inflation. Fiscal stimulus is expanding. Singapore has announced an SGD 800 million package aimed at fighting the impact of Covid-19; South Korea, Malaysia and Indonesia are also boosting spending. Even Germany is considering fiscal stimulus to support its economy. In China, the PBoC has injected RMB 2.3 trillion so far this year and cut rates. Most importantly, deleveraging is a tertiary concern for Chinese policymakers for the next two years. Factions opposed to President Xi will use his handling of the virus crisis to capitalize on discontent and gain more seats on the Politburo and Central Committee at the 2022 Communist Party Congress. To combat this opposition, President Xi is abandoning the deleveraging campaign and is generously stimulating the economy to generate greater income gains. The news is not all positive however, as the risk of a global pandemic remains elevated. There is no consensus in the medical community as to whether or not the pandemic is in remission. Chinese factories are re-opening and people are on the move, which is giving the virus an opportunity to spread again. Worryingly, new clusters of cases have popped up in South Korea, Iran, and Italy. In the US too, an individual without any links to previously known cases has fallen ill. These developments must be monitored closely. As BCA Research’s Global Investment Strategy service recently showed, the 2009/10 H1N1 outbreak (known as swine flu) affected between 700 million and 1 billion people worldwide.2 According to the Lancet, it resulted in 151,700 to 575,400 deaths or a fatality rate of 0.01% to 0.08%, well below current estimates of 2.3% for Covid-19. Thus, if Covid-19 spreads as much as H1N1, it could kill between 16 and 23 million people worldwide in a short amount of time. If such an outcome comes to pass, then we are looking at a global recession. Factory closures will grow in length and prevalence, which will paralyze global supply chains. International tourism will collapse and consumers around the world will shun crowded public places, which will hurt consumption substantially. Prudence forces us to not be cavalier and protect ourselves against what would be an extremely adverse outcome if Covid-19 were to spread much further. The uncertainty around such binary outcomes is hard to price for markets. As we argued last month, investors must input large risk premia in asset prices to compensate for this lack of visibility. When we last wrote, we saw no such margin of safety in the S&P 500, but its 11.5% collapse since February 19 has gone a long way in adjusting this mispricing. In fact, some bargains in the industrial, energy or transport sectors have emerged. Bottom Line: Investors should continue to hedge their exposure to risk assets until the situation becomes clearer. For now, our central scenario remains that new cases will soon peak and economic activity will recover. In this case, stocks and bond yields now have very limited downside, and they will recover later this year. Equities will ultimately reach new highs. However, prudence forces us to not be cavalier and protect ourselves against what would be an extremely adverse outcome if Covid-19 were to spread much further. The US Benefits From A Strong Dollar Looking beyond Covid-19, BCA Research expects the US dollar to correct in 2020. However, we increasingly view this downdraft as a temporary phenomenon. The dollar’s cyclical highs remain ahead in the next two to three years. Ultimately, the US is a consumer-driven economy and households benefit from a firm currency. A higher dollar also acts as a tax cut for consumers. Surprisingly, the dollar does not have a negative impact on employment. The unemployment rate and the dollar are negatively correlated (Chart I-6). The 27% dollar rally since 2011 is not antithetical with a US unemployment rate at a 51-year low of 3.6%. Less than 10% of US jobs are in the manufacturing sector, compared with 14.4% and 15.8% in Europe and Japan respectively (Chart I-7). Moreover, 93.6% of jobs created since the labor market troughed in 2010 have been in the service sector. Given that the service sector is domestically driven and is immune to the deflationary impact of a stronger dollar, the low share of manufacturing in the US’s GDP means that the labor market is resistant to a firm USD. Chart I-6The Labor Market Does Not Abhor A Strong Dollar... The Labor Market Does Not Abhor A Strong Dollar... The Labor Market Does Not Abhor A Strong Dollar... Chart I-7...Because The US Is Manufacturing Light ...Because The US Is Manufacturing Light ...Because The US Is Manufacturing Light   A higher dollar also acts as a tax cut for consumers. A dollar rally leads to a rapid decline in the share of disposable income spent on food and energy (Chart I-8). As a result, households have more discretionary disposable income to spend on services that generate domestic jobs. A strong dollar makes job creation less inflationary and permits the Fed to keep monetary policy easier for longer. A strengthening dollar redistributes income to the middle class, which supports consumption. When the dollar rallies, the share of salaries in national income increases because the dollar creates a headwind for profit margins (Chart I-9). Rich households garner more than 50% of their income from profits and rents. Therefore, if a stronger dollar increases the share GDP accounted for by wages, then a rising greenback redistributes income to middle-class households away from the rich. This redistribution is positive for consumption because middle-class households have a marginal propensity to consume of 90%, compared with 60% for households in the top decile of the income distribution. Furthermore, the more consumption can grow as a share of GDP, the more the economy can withstand a rallying currency. Chart I-8A Firm Dollar Cut "Taxes" A Firm Dollar Cut "Taxes" A Firm Dollar Cut "Taxes" Chart I-9The Dollar Is A Redistributor The Dollar Is A Redistributor The Dollar Is A Redistributor   Chart I-10A Strong Dollar Boosts Real Incomes A Strong Dollar Boosts Real Incomes A Strong Dollar Boosts Real Incomes A strong dollar also weighs on inflation, which has positive ramifications for consumers and the economy. By mid-2015, the dollar had rallied by an impressive 13.8%. While nominal wages grew at 2.2%, well below today’s rate of 3.8%, real wages were expanding at their highest rate in this cycle, courtesy of low inflation. Real consumption was also enjoying its largest gain in this cycle, expanding at 4.6% per annum (Chart I-10). A firm dollar also dampens inflation expectations (Chart I-11), allowing a flattening of the Phillips Curve, which links inflation to the unemployment rate. In other words, a strong dollar makes job creation less inflationary and permits the Fed to keep monetary policy easier for longer, delaying the inevitable date when the Fed kills the business cycle. Moreover, the disinflationary impact of a rising dollar puts downward pressure on interest rates (Chart I-12). In turn, lower rates keep financial conditions easier than would have otherwise been the case, which supports growth. Chart I-11A Hard Currency Dampens Inflation Expectations A Hard Currency Dampens Inflation Expectations A Hard Currency Dampens Inflation Expectations Chart I-12A Strong Dollar Depresses Interest Rates A Strong Dollar Depresses Interest Rates A Strong Dollar Depresses Interest Rates   A counterargument to the view that a strong US dollar is good for the business cycle is that it will hurt capex. While true, it is easy to overestimate this impact on growth. Not only does capex represent a much lower share of GDP than consumption, it most often contributes less to changes in GDP than consumer spending (Chart I-13). Moreover, lower interest rates triggered by a firm dollar support residential activity, which in turn mitigates some of the drag created by lower corporate capex. Finally, as Chart I-14 illustrates, 74.7% of the US’s capex emanates from sectors that are minimally affected by the dollar, creating greater resilience to a stronger currency than many realize. Chart I-13Consumption Dominates Capex Consumption Dominates Capex Consumption Dominates Capex Chart I-14Even Within Capex, The Dollar Is Not As Dominant As Believed Even Within Capex, The Dollar Is Not As Dominant As Believed Even Within Capex, The Dollar Is Not As Dominant As Believed   Chart I-15Symptoms Of US Resilience Symptoms Of US Resilience Symptoms Of US Resilience The US economy is indeed robust in the face of the strong dollar. If the dollar was hurting the US, then Germany should benefit from a falling euro. However, German net exports are weakening. Moreover, US profits are not lagging European ones as US firms continue to benefit from stronger global pricing power than their European counterparts. Finally, capex intentions in the US are surprisingly resilient (Chart I-15). Three forces increase the US’s economic capacity to withstand a strong dollar this cycle. First, the structural improvement in the US’s energy trade balance allows the US current account to remain stable at -2.5% of GDP despite a widening non-oil trade deficit. Secondly, the Trump Administration’s profligate spending boosts demand and insulates the economy from a rising dollar. BCA Research’s Geopolitical Strategy service expects President Trump to win the election, albeit with a conservative probability of 55%, but also believes a Democratic victory would lead to larger spending increases than tax hikes. The current expansive fiscal policy set up will thus remain in place going forward. Finally, the Sino-US Phase One deal will provide a welcome relief valve for US manufacturers, who are victims of the stronger dollar. While economic reality probably will not allow the deal to boost China’s purchases of US goods by $200 billion vis-à-vis the higher water mark of $186 billion of 2017 (Chart I-16), nonetheless it will force China to substitute goods purchases away from Europe and Japan in favor of the US. A hard dollar can feed on itself by widening the gap between US and foreign growth, a trend currently underway. Our favorite structural valuation measure also does not suggest that the dollar is currently a major hurdle for the US economy. BCA Research's Foreign Exchange Strategy service’s Long-Term Fair Value models, which account for differences in the productivity and neutral rate of interest of the US and its trading partners, show that the dollar is still roughly fairly valued and that its equilibrium is trending up (Chart I-17). Chart I-16The Phase One Deal Is Ambitious March 2020 March 2020 Chart I-17The Dollar Is Not Expensive Enough To Cause Pain The Dollar Is Not Expensive Enough To Cause Pain The Dollar Is Not Expensive Enough To Cause Pain   In this context, the US dollar has further cyclical upside. A strong dollar may not be as negative to the US economy as investors believe, but it hurts emerging economies. According to the Bank for International Settlements, there is more than US$12 trillion of USD-denominated foreign currency debt in the world. Therefore, a firm dollar tightens financial conditions outside the US. A hard dollar can feed on itself by widening the gap between US and foreign growth, a trend currently underway. Investment Implications For The Remainder Of The Cycle… Chart I-18The S&P 500 Likes A Firm Dollar The S&P 500 Likes A Firm Dollar The S&P 500 Likes A Firm Dollar The dollar’s additional cyclical upside is good news for US capital markets over the next few years. The S&P 500 performs better when the dollar is firm (Chart I-18). US stocks generated average annual returns of 12% during the 53% dollar rally of 1978 to 1985, 12% during the 33% dollar rally of 1995 to 2002, and 11% as the USD appreciated 27% during the past nine years. This compares well to an annualized return of 4% when the dollar suffers cyclical bear markets. The following observations explain why the US stock market performs better when the dollar appreciates: A strong dollar allows interest rates to remain lower than would have been the case otherwise, which also allows stock multiples to remain elevated. A strong dollar elongates the US business cycle by delaying the Fed’s tightening of monetary conditions. A longer business cycle dampens volatility and invites investors to bid down the equity risk premium. A strong dollar supports the US corporate bond market. A robust dollar may negatively impact bonds issued by energy or natural resources companies, but it also keeps the Fed at bay, which prevents a generalized increase in volatility and spreads. Lower rates allow for easy financial conditions and plentiful buybacks, a helpful combination for equities. Chart I-19The Dollar Holds The Key To Growth Vs Value The Dollar Holds The Key To Growth Vs Value The Dollar Holds The Key To Growth Vs Value A hard dollar is fundamental to the outperformance of US equities relative to global stocks. Global investors usually not do not hedge the currency component of equity returns. A firm USD automatically creates a powerful advantage for US stocks that invites greater inflows. In addition, a climbing dollar hurts value stocks (Chart I-19). Value stocks overweight cyclical sectors such as financials, industrials, materials and energy, sectors which depend on higher inflation, expanding EM economies and higher yields to outperform, three variables that suffer from an appreciating USD. An underperformance of value stocks also causes a poor outcome for foreign markets, which heavily overweight value over growth (Table I-1).   Table I-1Key Overweights By Market March 2020 March 2020 Chart I-20A Strong Dollar Fuels Tech Multiples A Strong Dollar Fuels Tech Multiples A Strong Dollar Fuels Tech Multiples The tech sector also benefits from a firm dollar. Tech stocks generate long-term earnings growth and they are generally not as sensitive to the global business cycle as traditional cyclical equities are. When the global business cycle weakens, yields decline and the dollar appreciates, then earnings growth becomes scarce. In this environment, investors willingly bid up assets that can generate a structural earning expansion. Tech multiples become the prime beneficiary of that phenomenon (Chart I-20), which allows US stocks to meaningfully outperform the rest of the world when the dollar hardens. Bottom Line: A firm dollar will allow the business cycle to expand for longer, which suggests that the dollar will make greater highs over the coming two to three years. Within this time frame, US stocks will likely continue to outperform their global counterparts, despite their valuations disadvantage. … And For 2020 In 2020, the dominant driver for the US dollar will be global growth. The pickup in BCA’s Global Growth Indicator and the elevated chance of a rising Chinese combined credit and fiscal impulse will lift global activity and thus, force down the USD (Chart I-21). Additionally, existing trends in global money supply growth reinforce the near-term downside risk to the dollar, assuming Covid-19 does not become a global pandemic (Chart I-22). Chart I-21China Stimulus Will Lift Growth chart 21 China Stimulus Will Lift Growth China Stimulus Will Lift Growth Chart I-22Bearish Monetary Dynamics For The Dollar In 2020 Bearish Monetary Dynamics For The Dollar In 2020 Bearish Monetary Dynamics For The Dollar In 2020   Chart I-23The Euro Is Not The Best Anti-Dollar Bet For 2020 The Euro Is Not The Best Anti-Dollar Bet For 2020 The Euro Is Not The Best Anti-Dollar Bet For 2020 The euro is unlikely to be the main beneficiary from a dollar correction. EUR/USD does not yet trade at a discount to our fair value estimates consistent with an intermediate-term bottom (Chart I-23). Moreover, the euro lags pro-cyclical currencies such as the AUD, CAD, NZD, or SEK, when global growth starts to recover but inflation remains weak. Finally, the Phase One Sino-US trade deal will create a drag on the positive impact of a Chinese recovery on European exports for machinery.3 Bottom Line: A dollar correction in 2020 is congruent with a period of underperformance for tech stocks relative to industrials, financials, materials and energy stocks. The correction also supports value relative to growth equities this year, as well as foreign bourses relative to the S&P 500. Investors who elect to bet against the dollar in 2020 should only do so with great caution as they will be betting against the broader cyclical trend. A correction in the dollar, by definition, is transitory. Thus, the aforementioned equity implications will also likely be temporary. Ultimately, the US economy remains the global growth leader in the post-2008 environment. Mathieu Savary Vice President The Bank Credit Analyst February 27, 2020 Next Report: March 26, 2020 II. Labor Strikes Back The balance of power in US labor negotiations has shifted infrequently in the industrial age. Successful strikes beget strikes. Key factors that have bolstered management for decades are poised to reverse. Public opinion has a significant impact on labor-management outcomes. Elections have consequences. Organized labor isn’t dead. Where will inflation come from, and when will it arrive? An investor who answers these questions will have advance notice of the end of the expansion and the bull markets in equities and credit. Per our base-case scenario, the expansion won’t end until monetary policy settings become restrictive, and the Fed won’t pursue restrictive policy unless inflation pressures force its hand. The fur flies when each party thinks the other should make the bulk of the concessions: labor negotiations over the next couple of years could be interesting. Inured by a decade of specious warnings that “money printing” would let the inflation genie out of the bottle, investors are skeptical that inflation will ever re-emerge. The inflation backdrop has become much more supportive in the last few years, however, upon the closing of the output gap, and the stimulus-driven jolt in aggregate demand. Output gaps in other major economies will have to narrow further (Chart II-1) for global goods inflation to gain traction, and mild inflation elsewhere in the G7 (Chart II-2) suggests that goods prices are not about to surge. Chart II-1There's Still Enough Spare Capacity ... March 2020 March 2020 Chart II-2... To Restrain Global Goods Inflation ... To Restrain Global Goods Inflation ... To Restrain Global Goods Inflation Services are not so easily imported, though, and services inflation is a more fully domestic phenomenon. Rising wages could be the spur for services inflation, and the labor market is tight on several counts: the unemployment rate is at a 50-year low; the broader definition of unemployment, also encompassing discouraged workers and the underemployed, reached a new all-time (25-year) low in December; the JOLTS job openings and quits rates at or near their all-time (19-year) highs; and the NFIB survey and a profusion of anecdotal reports suggest that employers are having a hard time finding quality candidates. With labor demand exceeding supply, wages for nonsupervisory workers have duly risen (Chart II-3). Gains in other compensation series have been muted, however, and investors have come to yawn and roll their eyes at any mention of the Phillips Curve. Chart II-3Wage Growth Is Solid, But It's Lost A Good Bit Of Momentum Wage Growth Is Solid, But It's Lost A Good Bit Of Momentum Wage Growth Is Solid, But It's Lost A Good Bit Of Momentum Perhaps it’s not the Phillips Curve that’s broken, but workers’ spirits. A supine organized labor movement could explain why the Phillips Curve itself is so flat. As the old saying goes, if you don’t ask, you know what you’re going to get, and beleaguered unions and their memberships, cowed by two decades of woe coinciding with China’s entry into the WTO (Chart II-4), have been afraid to ask. Strikes are the most potent weapon in labor’s arsenal; if it can’t credibly wield them, it is sure to be steamrolled. Chart II-4Globalization Has Been Unkind To Labor Globalization Has Been Unkind To Labor Globalization Has Been Unkind To Labor Two years of high-profile strike victories by public- and private-sector employees may suggest that the sands have begun to shift, however, and inspired our examination of labor’s muscle. An Investor’s Guide To US Labor History Let's begin our exercise with a review of US labor relations. The Colosseum Era (1800-1933) We view US industrial labor history as having three distinct phases. We label the first, which lasted until the New Dealers took over Washington, the Colosseum era (Figure II-1), because labor and management were about as evenly matched as the Christians and the lions in ancient Rome. Uprisings in textile mills, steel factories, and mines were swiftly squelched, often violently. Management was able to draw on public resources like the police and state National Guard units to put down strikes, or was able to unleash its own security or ad hoc militia forces on strikers or union organizers without state interference. The public, staunchly opposed to anarchists and Communists, generally sided with employers. Figure II-1Significant Events In The Colosseum Era March 2020 March 2020 Unions won some small-bore victories during the period, but they nearly all proved fleeting as companies regularly took back concessions and public officials and courts failed to enforce the loose patchwork of laws aimed at ameliorating industrial workers’ plight. Labor inevitably suffered the brunt of the casualties when conflicts turned violent. Workers were hardly choir boys, and seem to have initiated violence as often as employers’ proxies, but they were inevitably outgunned, especially when police, guardsmen or soldiers were marshaled against them. Societal norms have changed dramatically since the Colosseum era, but the lore of past “battles” encourages an us-versus-them union mentality that occasionally colors negotiations. Employees and employers need each other, and their tether can only be stretched so far before it starts pulling them back together. The UAW Era (1933-1981) Established presumptions about the employer-employee relationship were upended when FDR entered the White House. Viewing labor organization as a way to ease national suffering, New Dealers passed the Wagner Act to grant private-sector workers unionization and collective bargaining rights, and created the National Labor Relations Board to ensure that employers respected them. The Wagner Act greatly aided labor organization, enabling unions to build up the heft to engage with employers on an equal footing. Unionized workers still fought an uphill battle in the wake of the Depression, but tactics like the sit-down strike (Box II-1) produced some early labor victories that paved the way for more. BOX II-1 David Topples Goliath: The Flint Sit-Down Strike   The broad mass of factory workers had not been organized to any meaningful degree before the New Deal, and the United Auto Workers (UAW) was not formed until 1935. Despite federal protections, the fledgling UAW had to conduct its operations covertly, lest its members face employer reprisals. At the end of 1936, when it took on GM, only one in seven GM employees was a dues-paying member. The strike began the night of December 30th when workers in two of GM’s Flint auto body plants sat down at their posts, ignoring orders to return to work. The sit-down action was more effective than a conventional strike because it prevented GM from simply replacing the workers with strikebreakers. It also made GM think twice about attempting to remove them by force, lest valuable equipment be damaged. GM was unsure how to dislodge the workers after a court injunction it obtained on January 2nd went nowhere once the UAW publicized that the presiding judge held today’s equivalent of $4 million in GM shares. It turned off the heat in one of the plants on January 11th, before police armed with tear gas and riot guns stormed it. The police were rebuffed by strikers who threw bottles, rocks, and car parts from the plant’s upper windows while spraying torrents of water from its fire hoses. No one died in the melee, but the strike was already front-page news across the country, and the attack helped the strikers win public sympathy. Michigan’s governor responded by calling out the National Guard to prevent a rematch, shielding the strikers from any further violence. The strike was finally settled on February 11th when GM accepted the UAW as the workers’ exclusive bargaining agent and agreed not to hinder its attempts to organize its work force. The UAW signed a similar accord with Chrysler immediately after the Flint sit-down strike, and the CIO (the UAW’s parent union) swiftly reached an agreement with US Steel that significantly improved steelworkers’ pay and hours. Labor unions’ path wasn’t always smooth – Ford fiercely resisted unionization until 1941, and ten protesters were killed, and dozens injured, by Chicago police at a peaceful Memorial Day demonstration in support of strikers against the regional steelmakers that did not follow US Steel’s conciliatory lead – but it generally trended upward after the New Deal (Figure II-2). From the 1950 signing of the Treaty of Detroit, a remarkably generous five-year agreement between the UAW and the Big Three automakers, the UAW ran roughshod over the US auto industry for three-plus decades. The New Deal’s encouragement of unionization had given labor a fighting chance, and was the foundation on which all of its subsequent gains were built. Figure II-2Significant Events In The UAW Era March 2020 March 2020 The Reagan-Thatcher Era (1981 - ??) The disastrous strike by the air traffic controllers’ union (PATCO) is the watershed event that heralded the end of unions’ golden age. Strikes by federal employees were illegal, so PATCO broke the law when it went on strike in April 1981, spurning the generous contract terms its leaders had negotiated with the Reagan administration. PATCO had periodically held the flow of air traffic hostage throughout the seventies to extract concessions from its employer, earning the lasting enmity of airlines, government officials and the public. Other unions were aghast at PATCO’s openly contemptuous attitude, and declined to support it with sympathy strikes, while conservatives blasted the new administration behind closed doors for the profligacy of its initial PATCO offer. President Reagan therefore had an unfettered opportunity to make an example out of the controllers, and he seized it, firing those who failed to return to work within 48 hours and banning them from ever returning to government employment. A fed-up public supported the president’s hard line, and employers and unions got the message that a new sheriff was in town. His deputies were not inclined to enforce labor-friendly statues, or investigate labor grievances, with much vigor, and they would not necessarily look the other way when public sector unions illegally struck. Management has been in the driver's seat, but the factors that have kept it there have a high risk of reversing. Unions also found themselves on the wrong side of the growing disaffection with bureaucracy that was bound up with the push for deregulation. The globalization wave further eroded labor’s power. Unskilled workers in the developed world would be hammered by the flat world that allowed people, capital and information to hopscotch around the globe. Eight years of a Democratic presidency brought no relief, as the “Third Way” Clinton administration embraced the free-market tide (Chart II-5), and the unionized share of employees has receded all the way back to mid-thirties levels (Chart II-6). Chart II-5Inequality Took Off ... Inequality Took Off ... Inequality Took Off ... Chart II-6... As Unions Lost Their Way ... As Unions Lost Their Way ... As Unions Lost Their Way A Fourth Phase? A handful of data points do not make a trend, especially in a series that stands out for its persistence, but the bargaining power pendulum could be shifting. Public school teachers won improbable statewide victories with illegal strikes in three highly conservative states in the first half of 2018 (Table II-1); a canny hotel workers union steered its members to big gains in their contract negotiations with Marriott in the second half of 2018; and the UAW bested General Motors and the rest of the Big Three automakers last fall. Unions may have more bargaining power than markets and employers realize, and they could be on the cusp of becoming more aggressive in flexing it. Table II-1Teachers' Unions Conquer The Red States March 2020 March 2020 Takeaways (I) There are two key takeaways from our historical review: 1. US industrial history makes it clear that employees are unlikely to gain ground if government sides with employers. Employees no longer have to fear that the state will look the other way while strikers are beaten, or fail to prosecute those responsible for loss of life, but they face especially long odds when the government is inclined to favor employers. Its thumb weighs heavily on the scale when it drags its feet on enforcement; cuts funding to agencies policing workplace standards; and appoints agency or department heads that are conditioned to see things solely from employers’ perspective, shaped by long careers in management. 2. Successful strikes beget strikes, and the converse is also true. Withholding their labor is employees’ most powerful weapon, and when employers can’t replace them cheaply and easily, strikes often succeed. Striking is frightening for an individual, however, because it cuts off his or her income (or sharply reduces it, if the striker’s union has a strike fund) until the strike is over. If the strike fails, the employee may find him/herself blacklisted, impairing his/her long-term income prospects on top of his/her short-term losses. Prudent workers should therefore strike sparingly, with the due consideration that a prudent poker player exercises before going all-in. Companies will do whatever they perceive to be socially acceptable in conflicts with employees, but no more. When other unions facing comparable conditions pull off successful strikes, it makes it much easier for another union to take the leap, in addition to making success more likely, provided conditions truly are comparable. “Before they occur, successful strikes appear impossible. Afterward, they seem almost inevitable .”4 The retrospective inevitability stiffens the spine of potential strikers who observe successful outcomes, and raises the bar for action among potential strikers who observe failures. “Just as defeats in struggle lead to demoralization and resignation, victories tend to beget more victories .”5 Public opinion matters just as surely as momentum, and it proved decisive in the Flint sit-down strike and in the air traffic controllers’ showdown with President Reagan. According to Gallup’s annual poll, Americans now regard unions as favorably as they did before Thatcher and Reagan came to power (Chart II-7). Chart II-7Could Unions Make A Comeback? Could Unions Make A Comeback? Could Unions Make A Comeback? Where Strikes Come From And Who Wins Them Since strikes are such an important determinant of the support for labor, what drives successful labor actions? The Origin Of Strikes Strikes (and lockouts) occur when labor and management cannot reach a mutually acceptable settlement, often because at least one side overestimates its bargaining power. It is easy to agree when labor and management hold similar views about each side’s relative power, as when both perceive that one of them is considerably stronger. In that case, a settlement favoring the stronger side can be reached fairly quickly, especially if the stronger side exercises some restraint and does not seek to impose terms that the weaker side can scarcely abide. Restraint is rational in repeated games like employer-employee bargaining, and when both parties recognize that relative bargaining positions are fluid, they are likely to exercise it. It's no surprise that unions have started to look pretty good to workers after a decade of sluggish growth and widening inequality. History shows that the pendulum between labor and management swings, albeit slowly, as societal views evolve6 and the business cycle fluctuates. As a general rule, management will have the upper hand during recessions, when the supply of workers exceeds demand, and labor will have the advantage when expansions are well advanced, and capacity tightens. A high unemployment rate broadly favors employers, and a low unemployment rate favors employees. Neither the number of work stoppages (Chart II-8, top panel), nor the number of workers involved (Chart II-8, middle panel) correlates very well with the unemployment gap (Chart II-8, bottom panel), in the Reagan-Thatcher era, however, as work stoppages have dwindled almost to zero. Chart II-8Swamped By The Legal And Regulatory Tide Swamped By The Legal And Regulatory Tide Swamped By The Legal And Regulatory Tide Game theory is better equipped than simple regression models to offer insight into the origin of strikes. We posit a simple framework in which each side can hold any of five perceptions of its own bargaining power, resulting in a total of 25 possible joint perceptions. Management (M) can believe it is way stronger than Labor (L), M >> L; stronger than Labor, M > L; roughly equal, M ≈ L; weaker than Labor, L > M; or way weaker than Labor, L >> M. Labor also holds one of these five perceptions, and the interaction of the two sides’ perceptions establishes the path negotiations will follow. Limiting our focus to today’s prevailing conditions, Figure II-3 displays only the outcomes consistent with management’s belief that it has the upper hand. For completeness, the exhibit lists all of labor’s potential perceptions, but we deem the two in which labor is feeling its oats (circled) to be most likely, given the success of recent high-profile strikes.7 Management’s confidence follows logically from four decades of victories, but may prove to be unfounded if its power has already peaked. Figure II-3The Eye Of The Beholder March 2020 March 2020 Strike outcomes turn on which side has overestimated its leverage. The broad factors we use to assess leverage are overall labor market slack; economic concentration; regulatory and legal trends; and the sustainability of either side’s accumulated advantage, which we describe as the labor-management rubber band. Other factors that matter on a case-by-case basis, but are beyond the scope of our analysis, include industry-level slack, a labor input’s susceptibility to automation, and the degree of labor specialization/skill involved in that input. For these micro-level factors, a given group of workers’ leverage is inversely related to the availability of substitutes for their input. Labor Market Slack              Despite muted wage growth, the labor market is demonstrably tight. The unemployment rate is at a 50-year low, the broader definition of unemployment is at the lowest level in its 26-year history, and the prime-age employment-to-population ratio is back to its 2001 levels, having surpassed the previous cycle’s peak (Chart II-9). The job openings rate is high, indicating that demand for workers is robust, and so is the quits rate, indicating that employers are competing vigorously to meet it. The NFIB survey’s job openings and hiring plans series (Chart II-10) echo the JOLTS findings. Chart II-9Prime-Age Employment Is At An 18-Year High ... Prime-Age Employment Is At An 18-Year High ... Prime-Age Employment Is At An 18-Year High ... Chart II-10... But There Are Still Lots Of Help Wanted Signs ... But There Are Still Lots Of Help Wanted Signs ... But There Are Still Lots Of Help Wanted Signs The lack of labor market slack decisively favors workers’ negotiating position. It is a sellers’ market when demand outstrips supply, and labor victories tend to be self-reinforcing. Successful strikes beget strikes, and management volunteers concessions as labor peace becomes a competitive advantage during strike waves. Given that the crisis-driven damage to the labor force participation rate has healed as the gap between the actual part rate (Chart II-11, solid line) and its demographically-determined structural proxy has closed (Chart II-11, dashed line), the burden of proof rests squarely with those who argue that there is an ample supply of workers waiting to come off the sidelines. Chart II-11The Labor Force Participation Gap Has Closed The Labor Force Participation Gap Has Closed The Labor Force Participation Gap Has Closed Economic Concentration The trend toward economic concentration (Chart II-12) has endowed the largest companies with greater market power, as evidenced by surging corporate profit margins. The greater the concentration of employment opportunities in local labor markets, the more closely they resemble monopsonies.8 Unfortunately for labor, monopsonies restrain prices just as monopolies inflate them. As we have shown,9 there is a robust inverse relationship between employment concentration and real wages (Chart II-13). Chart II-12Less Competition = More Power March 2020 March 2020 Chart II-13One Huge Buyer + Plus Multiple Small Sellers = Low Prices March 2020 March 2020 Economic concentration has been a major driver of management’s Reagan-Thatcher era dominance. Sleepy to indifferent antitrust enforcement has helped businesses capture market power, and it will continue to prevail through 2024 unless the Democrats take the White House in November. The silver lining for workers is that concentration could have the effect of promoting labor organization in services, where unions have heretofore made limited progress. The only way for employees to combat employers’ monopsony power is to organize their way to becoming a monopoly supplier of labor. Regulatory And Legal Trends Over the last four decades, unions have endured a near-constant drubbing from state capitols, federal agencies and the courts, as union and labor protections have been under siege from all sides. Since the air traffic controllers’ disastrous strike, labor’s regulatory and legal fortunes have most closely resembled the competitive fortunes of the Harlem Globetrotters’ beleaguered opposition. But the regulatory and legal tide has been such a huge benefit for management since the beginning of the Reagan administration that it cannot continue to maintain its pace. If the electorate has had enough of Reagan-Thatcher policies, elected officials will stop implementing them. Investors seem to assume that it will, however, to the extent that they think about it at all. It stands to reason that employers may be similarly complacent. We will look more closely at the presidential election and its potential consequences in Part 3, but labor concerns and inequality are capturing more attention, even among Republicans. With Republicans’ inclination to side with business only able to go in one direction, the chances are good that it has peaked. The Labor-Management Rubber Band For all of the romantic allure of labor’s battles with management in the Colosseum era, employees and employers have a deeply symbiotic relationship. One can’t exist without the other, and pursuing total victory in negotiations is folly. Even too many incremental wins can prove ruinous, as the UAW discovered to its chagrin in 2008. A half-century of generous compensation and stultifying work rules saddled Detroit automakers with a burden that would have put them out of business had the federal government not intervened. Table II-2Average Salaries Of Public School Teachers By State March 2020 March 2020 We think of labor and management as being linked by a tether with a finite range. Since neither side can thrive for long if the other side is suffering, the tether pulls the two sides closer together when the gap between them threatens to become too wide. When labor does too well for too long at management’s expense, profit margins shrink and the company’s viability as a going concern is threatened. When management does too well, deteriorating living standards drive the best employees away, undermining productivity and profitability. Before the low-paying entity’s work force becomes a listless dumping ground for other firms’ castoffs, it may rise up and strike out of desperation. Teachers’ unions might have appeared to be setting themselves up for a fall in 2018 by illegally striking in staunchly conservative West Virginia, Oklahoma and Arizona, but desperate times call for desperate measures. Per the National Education Association’s data for the 2017-18 academic year, average public school teacher pay in West Virginia ranked 50th among the 50 states and the District of Columbia, Oklahoma ranked 49th and Arizona ranked 45th (Table II-2). Adjusting the nominal salaries for cost disparities across states, West Virginia placed 41st, Oklahoma 44th and Arizona 48th. Given that real teacher salaries had declined by 8% and 9% since 2009-10 in West Virginia and Arizona, respectively, the labor-management rubber band had stretched nearly to the breaking point. Consolidating The Macro Message Parties to negotiations derive leverage from the availability of substitutes. When alternative employment opportunities are prevalent, workers have a lot of leverage, because they can credibly threaten to avail themselves of them. Teaching is a skill that transfers easily, and every state has a public school system, so teachers in low-salary states have a wealth of ready alternatives. The converse is true for low-salary states; despite much warmer temperatures, it is unlikely that teachers from top-quintile states will be willing to take a 25-33% cost-of-living-adjusted pay cut to decamp to Arizona (Table II-3). Table II-3Cost Of Living-Adjusted Public School Teacher Salaries By State March 2020 March 2020 It is easy to see from Figure II-4 why management has had the upper hand. Economic concentration and the legal and regulatory climate have increasingly favored it for decades. The immediate future seems poised to favor labor, however, as the legal and regulatory climate cannot get materially better for employers, and the labor-management rubber band has become so stretched that some sort of mean reversion is inevitable. We have high conviction that labor’s one current advantage, a tight labor market, will remain in its column over the next year or two. On a forward-looking basis, the macro factors as a whole are poised to support labor. Figure II-4Macro Drivers Of Negotiating Leverage March 2020 March 2020 Takeaways (II) We think it is more likely than not that the labor movement in the United States will remain weak relative to its 1950s to 1970s heyday. We do think, however, that the probability that unions could rise up to exert the leverage that accrues to workers in a tight labor market is considerably larger than the great majority of investors perceive. Alpha – market-beating return – arises from surprises. An investor captures excess returns when s/he successfully anticipates something that the consensus does not. If the disparity involves a trivial outcome, then any excess return is likely to be trivial, but if the outcome is significant, the investor who zigged when the rest of the market zagged stands to separate him/herself from the pack. We think the outcome of a shift in leverage from employers to employees would be very large indeed. We would expect that aggregate wage gains of 4% or higher would quickly drive the Fed to impose restrictive monetary policy settings, eventually inducing the next recession and the end of the bull markets in equities, credit and property. A union revival may be a low-probability event, but it would have considerable impact on markets and the economy. Given our conviction that the probability, albeit low, is much greater than investors expect, we think the subject is well worth sustained attention. The Public-Approval Contest The last question to approach is how does labor or management win in the court of public opinion? Capturing Hearts And Minds Public opinion has shaped the outcomes of labor-management contests throughout US labor relations history. Labor was continually outgunned before the New Deal, coming up against private security forces, local police and/or the National Guard when they struck. Employers were able to turn to hired muscle, or request the deployment of public resources on their behalf, because the public had few qualms about using force to break strikes. College athletes were even pressed into service as strikebreakers after the turn of the century for what was viewed at the time as good, clean fun.10 Public opinion is not immutable, however, and by the time of the Flint sit-down strike, it had begun to shift in the direction of labor. The widespread misery of the Depression went a long way to overcoming Americans’ deep-seated suspicion of the labor movement and the fringe elements associated with it. Some employers were slow to pick up on the change in the public mood, however, and Ford’s security force thuggishly beat Walter Reuther and other UAW organizers while they oversaw the distribution of union leaflets outside a massive Ford plant just three months after Flint. Ford won the Battle of the Overpass, but its heavy-handed, retrograde tactics helped cost it the war. Reuther, who later led the UAW in its ‘50s and ‘60s golden age, was a master strategist with a knack for public relations. Writing the playbook later used to great effect by civil rights leaders, Reuther invited clergymen, Senate staffers and the press to accompany the largely female team of leafleteers. When the Ford heavies commenced beating the men, and roughly scattering the women, photographers were on hand to document it all.11 The photos helped unions capture public sympathy, just as televised images of dogs and fire hoses would later help secure passage of landmark civil rights legislation. Unions’ Fall From Grace Figure II-5Unions' 1980s Public Opinion Vortex March 2020 March 2020 Labor unions enjoyed their greatest public support in the mid-fifties, and largely maintained it well into the sixties, until rampant corruption and ties to organized crime undermined their public appeal. The shoddy quality of American autos further turned opinion against the UAW, the nation’s most prominent union, and a college football star named Brian Bosworth caused a mid-eighties furor by claiming that he had deliberately sought to prank new car buyers during his summer job on a Chevrolet assembly line. Bosworth later retracted the claim that GM workers had shown him how to insert stray bolts in inaccessible parts of car bodies to create a maddening mystery rattling, but the fact that so many Sports Illustrated readers found it credible eloquently testified to the UAW’s image problem. President Reagan accelerated the trend when he successfully stood up to the striking air traffic controllers, but his administration could not have taken such a hard line if unions hadn’t already been weakened by declining public support. Together, the public’s waning support for unions and the Reagan administration’s antipathy for them were powerfully self-reinforcing, and they fueled a vicious circle that powered four decades of union reversals (Figure II-5). As a prescient November 1981 Fortune report put it, “‘Managers are discovering that strikes can be broken, … and that strike-breaking (assuming it to be legal and nonviolent) doesn’t have to be a dirty word. In the long run, this new perception by business could turn out to be big news.’”12 Emboldened by the federal government’s replacement of the controllers, and the growing public perception that unions had devolved into an insular interest group driving the cost of living higher for everyone else, businesses began turning to permanent replacement workers to counter strikes.13 As an attorney that represented management in labor disputes told The New York Times in 1986, “If the President of the United States can replace [strikers], this must be socially acceptable, politically acceptable, and we can do it, also.”14 Labor’s New Face … Polling data indicate that unions have been recovering in the court of public opinion since the crisis, when the public presumably soured on them over the perception that the UAW was selfishly impeding the auto industry bailout. Their image got a boost in 2018 (Chart II-14), as striking red-state teachers embodied the shift from unions’ factory past to their service-provider present. “The teachers, many of them women, are redefining attitudes about organized labor, replacing negative stereotypes of overpaid and underperforming blue-collar workers with a more sympathetic face: overworked and underappreciated nurturers who say they’re fighting for their students as much as they’re fighting for themselves.”15 Chart II-14Feeling The Bern? Feeling The Bern? Feeling The Bern? Several commentators have heard organized labor’s death knell in US manufacturing’s irreversible decline. Unions gained critical mass on docks, factory floors, steel mills and coal mines, but few of today’s workers make their living there. Those who remain have little recourse other than to accept whatever terms management offers, as their jobs can easily be outsourced to lower-cost jurisdictions. The decline in private-sector union membership has traced the steady diminution of factory workers’ leverage (Chart II-15). Chart II-15Tracking Manufacturing's Slide Tracking Manufacturing's Slide Tracking Manufacturing's Slide Service workers represent unions’ future, and they have two important advantages over their manufacturing counterparts: many of their functions cannot be offshored, and a great deal of them are customer-facing. When MGM’s chairman was ousted from his job after clashing with Las Vegas’ potent UNITE-HERE local over the new MGM Grand Hotel’s nonunion policy, his successor explained why he immediately came to terms with the union. “‘The last thing you want is for people who are coming to enjoy themselves to see pickets and unhappy workers blocking driveways. … When you’re in the service business, the first contact our guests have is with the guest-room attendants or the food and beverage servers, and if that person’s [sic] unhappy, that comes across to the guests very quickly.’”16 … Management’s New Leaf … The Business Roundtable’s latest statement on corporate governance principles laid out a new stakeholder vision, displacing the Milton Friedman view that corporations are solely responsible for maximizing shareholder wealth. The statement itself is pretty bland, but the preamble in the press release accompanying it sounds as if it had been developed with labor advocates’ help (Box II-2). It is a stretch to think that the ideals in the Roundtable’s communications will take precedence over investment returns, but they may signal that management fears the labor-management rubber band has been stretched too far.17 The Environmental, Social and Governance (ESG) movement has the potential to improve rank-and-file workers’ wages and working conditions. ESG proponents have steadily groused about outsized executive pay packages, but if asset owners and institutional investors were to begin pushing for higher entry-level pay to narrow the income-inequality gap, unions could gain some powerful allies. BOX II-2 Farewell, Milton Friedman   America’s economic model, which is based on freedom, liberty and other enduring principles of our democracy, has raised standards of living for generations, while promoting competition, consumer choice and innovation. America’s businesses have been a critical engine to its success. Yet we know that many Americans are struggling. Too often hard work is not rewarded, and not enough is being done for workers to adjust to the rapid pace of change in the economy. If companies fail to recognize that the success of our system is dependent on inclusive long-term growth, many will raise legitimate questions about the role of large employers in our society. With these concerns in mind, Business Roundtable is modernizing its principles on the role of a corporation. Since 1978, Business Roundtable has periodically issued Principles of Corporate Governance that include language on the purpose of a corporation. Each version of that document issued since 1997 has stated that corporations exist principally to serve their shareholders. It has become clear that this language on corporate purpose does not accurately describe the ways in which we and our fellow CEOs endeavor every day to create value for all our stakeholders, whose long-term interests are inseparable. We therefore provide the following Statement on the Purpose of a Corporation, which supersedes previous Business Roundtable statements and more accurately reflects our commitment to a free market economy that serves all Americans. This statement represents only one element of Business Roundtable’s work to ensure more inclusive prosperity, and we are continuing to challenge ourselves to do more. Just as we are committed to doing our part as corporate CEOs, we call on others to do their part as well. In particular, we urge leading investors to support companies that build long-term value by investing in their employees and communities. … And The Public’s Left Turn Chart II-16Help! Help! Help! As our Geopolitical Strategy colleagues have argued since the 2016 primaries, the median voter in the US has been moving to the left as the financial crisis, the hollowing out of the middle class and the widening wealth gap have dimmed the luster of Reagan-Thatcher free-market policies.18 Globalization has squeezed unskilled labor everywhere in the developed world, and white-collar workers are starting to look over their shoulders at artificial intelligence programs that may render them obsolete as surely as voice mail and word processing decimated secretaries and typists. Banding together hasn’t sounded so good since the Depression, and nearly half of all workers polled in 2017 said they would join a union if they could (Chart II-16). Millennials are poised to become the single biggest voting bloc in the country. They were born between 1981 and 1996, and their lives have spanned two equity market crashes, the September 11th attacks, and the financial crisis, instilling them with a keen awareness of the way that remote events can upend the best-laid plans. Many of them emerged from college with sizable debt and dim earnings prospects. They would welcome more government involvement in the economy, and their enthusiastic embrace of Bernie Sanders and Elizabeth Warren (Chart II-17) indicates they’re on unions’ side. Chart II-17No 'Third Way' For Millennials March 2020 March 2020 Elections Have (Considerable Regulatory) Consequences Electoral outcomes influence the division of the economic pie between employers and employees. Labor-friendly presidents, governors and legislatures are more likely to expand employee protections, while more vigilantly enforcing the employment laws and regulations that are already on the books. The White House appoints top leadership at the Labor Department, the National Labor Review Board (NLRB), and the Occupational Safety and Health Administration (OSHA), along with the attorney general, who dictates the effort devoted to anti-trust enforcement. The differences can be stark. Justice Scalia’s son would no more have led the Obama Department of Labor than Scott Pruitt (EPA), Wilbur Ross (Commerce) or Betsy Devos (Education) would have found employment anywhere in the Obama administration. McDonald’s has good reason to be happy with the outcome of the 2016 election; its business before the NLRB wound up being resolved much more favorably in 2019 than it would have been when it began in 2014 (Box II-3). At the state level, Wisconsin public employees suffered a previously unimaginable setback when Scott Walker won the 2010 gubernatorial election, along with sizable legislative majorities (Box II-4). BOX II-3 The Right Referee Makes All The Difference The Fight for $15 movement that began in 2012 aimed to nearly double the median fast-food worker’s wages. A raise of that magnitude would pose an existential threat to fast-food’s business model, and McDonald’s and its franchisees sought to stymie the movement’s momentum. The NLRB opened an investigation in 2014 following allegations that employees were fired for participating in organizing activities. McDonald’s vigorously contested the case in an effort to avoid the joint-employer designation that would open the door for franchise employees to bargain collectively with the parent company. (Absent a joint-employer ruling, a union would have to organize the McDonald’s work force one franchise at a time.) When the case was decided in McDonald’s favor in December, the headline and sub-header on the Bloomberg story reporting the outcome crystallized our elections-matter thesis: McDonald’s Gets Win Under Trump That Proved Elusive With Obama Board led by Trump appointees overrules judge in case that threatened business model BOX II-4 Wisconsin Guts Public-Sector Unions Soon after Wisconsin Governor Scott Walker took office in January 2011, backed by sizable Republican majorities in both houses of the legislature, he sent a bill to legislators that would cripple the state’s public-sector unions. Protestors swarmed Madison and filled the capitol building every day for a month to contest the bill, and Democratic legislators fled the state to forestall a vote, but it eventually passed nonetheless. The bill struck at a rare union success story; nearly one-third of public-sector employees are union members and that ratio has remained fairly steady over the last 40 years (Chart II-18). Wisconsin’s public-sector unions now do little more than advocate for their members in disciplinary and grievance proceedings, and overall union membership in the state has fallen by a whopping 43% since the end of 2009. Judicial appointments make a difference, too. The Supreme Court’s Janus decision in April 2018, banning any requirement that public employees pay dues to the unions that bargain for them on not-so-readily-apparent First Amendment grounds,19 was widely viewed as a body blow to public-sector unions. The 5-4 decision would certainly have gone the other way had President Obama’s nominee to succeed the late Justice Scalia been confirmed by the Senate. Chart II-18Public-Sector Union Membership Has Held Up Well Public-Sector Union Membership Has Held Up Well Public-Sector Union Membership Has Held Up Well Final Takeaways We do not anticipate that organized labor will regain the position it enjoyed in the fifties and sixties, when global competition was weak and shareholders and consumers were anything but vigilant about corporate operations. Even a more modest flexing of labor muscle that pushes wages higher across the entire economy has a probability of less than one half. Investors seem to think the probability is negligible, though, and therein lies an opportunity. Elected officials deliver what their constituents want, as do the courts, albeit with a longer lag. Society’s view of striking/strikebreaking tactics heavily influences how they’re deployed and whether or not they’ll be successful. We believe that public opinion is beginning to coalesce on employees’ side as labor puts on a more appealing face; as businesses increasingly fret about inequality’s consequences; and as millennials swoon over progressives, undeterred by labels that would have left their Cold War ancestors reaching for weapons. The median voter theory has importance beyond predicting future outcomes; it directly influences them. As the center of the electorate leans to the left, elected officials will have to deliver more liberal outcomes if they want to keep their jobs. If the electorate has given up on Reagan-Thatcher principles, organized labor is bound to get a break from the four-decade onslaught that has left it shrunken and feeble. There is one overriding market takeaway from our view that a labor recovery is more likely than investors realize: long-run inflation expectations are way too low. Although we do not expect wage growth to rise enough this year to give rise to sustainable upward inflation pressures that force the Fed to come off of the sidelines, we do think investors are overly complacent about inflation. We continue to advocate for below-benchmark duration positioning over a cyclical timeframe and for owning TIPS in place of longer-maturity Treasury bonds over all timeframes. Watch the election, as it may reveal that labor’s demise has been greatly exaggerated. Doug Peta, CFA Chief US Investment Strategist Bibliography Aamidor, Abe and Evanoff, Ted. At The Crossroads: Middle America and the Battle to Save the Car Industry. Toronto: ECW Press (2010). Allegretto, S.A.; Doussard, M.; Graham-Squire, D.; Jacobs, K.; Thompson, D.; and Thompson, J. Fast Food, Poverty Wages: The Public Cost of Low-Wage Jobs in the Fast-Food Industry. Berkeley, CA. UC-Berkeley Center for Labor Research and Education, October 2013. Bernstein, Irving. The Lean Years: A History of the American Worker, 1920-1933. Boston: Houghton Mifflin (1960). Blanc, Eric. Red State Revolt: The Teachers’ Strike Wave and Working-Class Politics. Brooklyn, NY: Verso (2019). Emma, Caitlin. “Teachers Are Going on Strike in Trump’s America.” Politico, April 12, 2018, accessed January 20, 2020. Finnegan, William. “Dignity: Fast-Food Workers and a New Form of Labor Activism.” The New Yorker, September 15, 2014 Greenhouse, Steven. Beaten Down, Worked Up: The Past, Present and Future of American Labor. New York: Alfred A. Knopf (2019). Greenhouse, Steven. “The Return of the Strike.” The American Prospect, Winter 2019 Ingrassia, Paul. Crash Course: The American Auto Industry’s Road from Glory to Disaster. New York: Random House (2010). King, Gilbert. “How the Ford Motor Company Won a Battle and Lost Ground.” smithsonianmag.com, April 30, 2013, accessed January 24, 2020. Loomis, Erik. A History of America in Ten Strikes. New York: The New Press (2018). Manchester, William. The Glory and the Dream: A Narrative History of America, 1932-1972. New York: Bantam (1974). Norwood, Stephen H. “The Student As Strikebreaker: College Youth and the Crisis of Masculinity in the Early Twentieth Century. Journal of Social History Winter 1994: pp. 331-49. Sears, Stephen W. “Shut the Goddam Plant!” American Heritage Volume 33, Issue 3 (April/May 1982) Serrin, William. “Industries, in Shift, Aren’t Letting Strikes Stop Them.” The New York Times, September 30, 1986 Wolff, Leon. “Battle at Homestead.” American Heritage Volume 16, Issue 3 (April 1965) *Current newspaper and Bloomberg articles omitted. III. Indicators And Reference Charts Last month, we warned that the S&P 500 rally looked increasingly vulnerable from a tactical perspective and that the spread of Covid-19 was likely to be the catalyst of a pullback that could cause the S&P 500 to retest its October 2019 breakout. Since then, the S&P 500 has corrected significantly. As long as new cases of Covid-19 continue to grow quickly outside of China, the S&P 500 can suffer additional downside. Limited inflationary pressures, accommodative global central banks, and the potential for a large policy easing in China suggest that stocks have significant upside once Covid-19 becomes better contained. Nonetheless, despite the positive signals from our Willingness-To-Pay measure or our Monetary and Composite Technical Indicators, we recommend a cautious tactical stance on equities. Our BCA Composite Valuation index is not depressed enough to warrant closing our eyes when the risk of a recession caused by a global pandemic remains as high as it is today. Either valuations will have to cheapen further or Covid-19 will have to be clearly contained before we buy stocks without strong fears. 10-year Treasurys yields remain extremely expensive. However, our Composite Technical Indicator suggests that in such an uncertain climate, yields can fall a little more. Nonetheless, Treasurys seem like an asset that has nearly fully priced in the full impact of Covid-19, and thus, any downside in yield will be very limited.  The rising risk premia linked to the coronavirus is also helping the dollar right now, but as we have highlighted before, many signs show that global growth was in the process of bottoming before the outbreak took hold. As a result, we anticipate that the dollar could suffer plentiful downside if Covid-19 passes soon. Moreover, the rising probability that Senator Bernie Sanders wins the Democratic nomination could hurt the greenback over the remainder of the year. Finally, commodity prices have corrected meaningfully in response to the stronger dollar and the growth fears created by the spread of Covid-19. However, they have not pullback below the levels where they traded when they broke out in late 2019. Moreover, the advanced/decline line of the Continuous Commodity Index remains at an elevated level, indicating underlying strength in the commodity complex. Natural resources prices will likely become the key beneficiaries of both the eventual pullback in virus-related fears and the weaker dollar. EQUITIES: Chart III-1US Equity Indicators March 2020 March 2020 Chart III-2Willingness To Pay For Risk March 2020 March 2020 Chart III-3US Equity Sentiment Indicators March 2020 March 2020   Chart III-4Revealed Preference Indicator March 2020 March 2020 Chart III-5US Stock Market Valuation March 2020 March 2020 Chart III-6US Earnings March 2020 March 2020 Chart III-7Global Stock Market And Earnings: Relative Performance March 2020 March 2020 Chart III-8Global Stock Market And Earnings: Relative Performance March 2020 March 2020   FIXED INCOME: Chart III-9US Treasurys And Valuations March 2020 March 2020 Chart III-10Yield Curve Slopes March 2020 March 2020 Chart III-11Selected US Bond Yields March 2020 March 2020 Chart III-1210-Year Treasury Yield Components March 2020 March 2020 Chart III-13US Corporate Bonds And Health Monitor March 2020 March 2020 Chart III-14Global Bonds: Developed Markets March 2020 March 2020 Chart III-15Global Bonds: Emerging Markets March 2020 March 2020   CURRENCIES: Chart III-16US Dollar And PPP March 2020 March 2020 Chart III-17US Dollar And Indicator March 2020 March 2020 Chart III-18US Dollar Fundamentals March 2020 March 2020 Chart III-19Japanese Yen Technicals March 2020 March 2020 Chart III-20Euro Technicals March 2020 March 2020 Chart III-21Euro/Yen Technicals March 2020 March 2020 Chart III-22Euro/Pound Technicals March 2020 March 2020   COMMODITIES: Chart III-23Broad Commodity Indicators March 2020 March 2020 Chart III-24Commodity Prices March 2020 March 2020 Chart III-25Commodity Prices March 2020 March 2020 Chart III-26Commodity Sentiment March 2020 March 2020 Chart III-27Speculative Positioning March 2020 March 2020   ECONOMY: Chart III-28US And Global Macro Backdrop March 2020 March 2020 Chart III-29US Macro Snapshot March 2020 March 2020 Chart III-30US Growth Outlook March 2020 March 2020 Chart III-31US Cyclical Spending March 2020 March 2020 Chart III-32US Labor Market March 2020 March 2020 Chart III-33US Consumption March 2020 March 2020 Chart III-34US Housing March 2020 March 2020 Chart III-35US Debt And Deleveraging March 2020 March 2020   Chart III-36US Financial Conditions March 2020 March 2020 Chart III-37Global Economic Snapshot: Europe March 2020 March 2020 Chart III-38Global Economic Snapshot: China March 2020 March 2020   Mathieu Savary Vice President The Bank Credit Analyst Footnotes 1 Non-seasonally adjusted growth is always negative in Q1, due to the impact of the Chinese Lunar New Year Celebration. This is why we emphasize the seasonal adjustment. 2 Please see Global Investment Strategy Weekly Report "Markets Too Complacent About The Coronavirus," dated February 21, 2020, available at gis.bcaresearch.com 3 Please see The Bank Credit Analyst "February 2020," dated January 30, 2020 available at bca.bcaresearch.com 4 Blanc, Eric. Red State Revolt: The Teachers’ Strike Wave and Working-Class Politics, Verso: New York (2019), p. 204. 5 Ibid, p. 209. 6 We will discuss public opinion, and its impact on elected officials and courts, in Part 3. 7 Please see the January 13, 2020 US Investment Strategy Special Report, “Labor Strikes Back, Part 1: An Investor’s Guide To US Labor History,” available at www.bcaresearch.com. 8 A monopsony is a market with a single buyer, akin to a monopoly, which is a market with only one seller. 9 Please see the July 2019 Bank Credit Analyst Special Report, “ The Productivity Puzzle: Competition Is The Missing Ingredient,” available at bcaresearch.com. 10 Students were excused from classes and exams and sometimes even received academic credit for their work. 11 King, Gilbert, “How The Ford Motor Company Won a Battle and Lost Ground,” Smithsonian.com, April 30, 2013. 12 Greenhouse, Steven, Beaten Down, Worked Up, Alfred A. Knopf: New York (2019), pp. 137-8. 13 High unemployment, in addition to declining respect for unions, helped erase the stigma of crossing picket lines. 14 Serrin, William, “Industries, in Shift, Aren’t Letting Strikes Stop Them,” New York Times, September 30, 1986, p. A18. 15 Emma, Caitlin, “Teachers Are Going on Strike in Trump’s America,” Politico, April 12, 2018. 16 Greenhouse, p. 44. 17 Please see the January 20, 2020 US Investment Strategy Special Report, “Labor Strikes Back, Part 2: Where Strikes Come From And Who Wins Them,” available at usis.bcaresearch.com. 18 Please see the June 8, 2016 Geopolitical Strategy Monthly Report, “Introducing The Median Voter Theory,” available at gps.bcaresearch.com. 19 The Court found for the plaintiff in Janus, who bridled at the closed-shop law that forced him to join the union that bargained on his and his colleagues’ behalf, because the union’s espousal of views with which he disagreed constituted a violation of his free-speech rights as guaranteed by the First Amendment.

Highlights In the past week, it is becoming evident that the Chinese leadership is willing to abandon its financial de-risking agenda in exchange for a rapid economic recovery. Monetary conditions are already more accommodative than during the last easing cycle in 2015/2016. The recently announced policy initiatives on infrastructure, housing, and automobile sectors also resemble policy supports that led to a V-shaped economic recovery in 2016. As manufacturers in regions other than Hubei are returning to work and their production capacity continues to rise, the outbreak-induced economic shock may be smaller than investors currently fear. Hence, the odds are rising that the upcoming “insurance stimulus” may end up overshooting the short-term economic shock. As such, we maintain a constructive view on Chinese stocks over the next 6-12 months. Feature A surge in the number of COVID-19 infections outside of China (including South Korea, Japan, Iran, and Italy) risks delaying a global economic recovery, and has cast doubt on the outlook for the global economy beyond Q1 (Chart 1). Chart 1Pandemic Threats Expanding Globally Pandemic Threats Expanding Globally Pandemic Threats Expanding Globally Despite the sharp uptick in global investor concern, our constructive view on Chinese stocks remains unchanged for the next 6-12 months. Our view on Chinese risk assets is based on a simple arithmetic framework that we described last year when the trade war tensions between the US and China were escalating. In short, when gauging the net impact of an economic shock, investors should determine which of the following two scenarios is most likely: Scenario 1 (Bearish): Stimulus – Shock ≤ 0 Scenario 2 (Bullish): Stimulus – Shock > 0 While this framework is quite simplistic, the point is to underscore that economic shocks are almost always met with a policy response, and the goal is to determine whether this response is sufficient enough to offset the impact of the shock. If the Chinese leadership underestimates the severity of the shock and undershoots on the stimulus, this would be bearish for Chinese stocks (Scenario 1). In the current situation, however, even if the near-term economic outlook is deeply negative, investors should maintain a bullish cyclical (i.e. 6-12 month) outlook for China-related assets as long as the impact of China’s reflationary efforts more than offsets the negative shock to aggregate demand (Scenario 2). Major Stimulus Around The Corner? It is becoming evident that the Chinese policymakers, when dealing with an unprecedented public health crisis, are returning to aggressive fiscal and monetary easing. In fact, the odds are rising that the magnitude of the upcoming stimulus may resemble that of 2015/2016, and has an increasing possibility to overshoot in the next 6-12 months. In the past week, there has been a clear shift of policy focus from “financial de-risking” to “mitigating the economic damage from shocks at all costs”, as indicated by high-profile policy announcements. In an unprecedented large-scale teleconference on February 23,1 President Xi stated that China will not lower its economic growth target for this year, and that fiscal policy will be “more proactive” while monetary policy was upgraded from “prudent” to “flexible and moderate". Chart 2PBoC Looks Set For Massive Stimulus PBoC Looks Set For Massive Stimulus PBoC Looks Set For Massive Stimulus Xi also pledged to “introduce new policy measures in a timely manner”. China’s central bank, the PBoC, issued a statement signaling further cuts ahead in the bank reserve requirement ratio rate and interest rate.2 The PBoC has already aggressively eased monetary conditions in the past two weeks, and both the central bank policy and average lending rates are now lower than they were during the last massive easing cycle in 2015/2016 (Chart 2).  Other policy initiatives also suggest the Chinese authorities are stepping up coordinated efforts to boost the economy, beyond short-term and targeted financial support. The stimulative measures now span from infrastructure to housing and automobile sectors, the exact “three prongs” that supported a V-shaped economic recovery in 2016.3 This is in sharp contrast with last year, when Chinese policymakers largely resisted resorting to large-scale stimulus, despite immense pressure from the US-China trade war and tariff impositions.4 The ongoing COVID-19 epidemic seems to have forced China to return to its old economic playbook, as the Xi administration is clearly unwilling to tolerate economic hardships driven by an endogenous crisis. The ongoing epidemic seems to have forced China to return to its old economic playbook, as the Xi administration is clearly unwilling to tolerate economic hardships driven by an endogenous crisis. As we predicted in November last year,5 China was to frontload additional fiscal stimulus in Q1 this year to secure an economic recovery, which started to bud in Q4 last year. The increase in January’s credit numbers confirms our projection: local government bond issuance picked up significantly from last year while the contraction in shadow bank lending continued to ease, signaling a less restrictive policy bias on both the monetary and fiscal fronts (Chart 3).  Chart 3Stronger Fiscal Support Likely To Soon Follow Stronger Fiscal Support Likely To Soon Follow Stronger Fiscal Support Likely To Soon Follow The exact economic and monetary expansion growth targets will be officially set at the National People’s Congress meeting, which has been postponed from its usual schedule on March 5. Compared with the 6.1% real GDP growth achieved in 2019, we now think a growth target of 5.6% would be conservative for this year. According to an estimate by BCA’s Global Investment Strategy,6 China’s real GDP growth in Q1 could slow to 3.5% on a year-over-year basis. To achieve 5.6% growth, China would need at least 6.3% average real growth (year-over-year) for the next three quarters, 0.3 percentage points higher than in the second half of 2019. The growth in credit expansion, infrastructure spending and government expenditures will need to significantly outpace last year in the next 6-12 months. Bottom Line: The government appears to be willing to abandon its financial de-risking agenda to secure economic recovery. There is an increasing possibility that the stimulus may overshoot the economic shock this year. China’s Economic Engine Warms Up There are increasing signs that the scale of the upcoming stimulus may match that of the 2015/2016 cycle. The likely magnitude of the shock, on the other hand, might be smaller than investors fear as the evidence is mounting that production is returning to normality in China. Despite a lack of employees and raw materials, industrial activity in regions outside of Hubei is resuming. Chart 4…Small Companies Are Not Far Behind China: Back To Its Old Economic Playbook? China: Back To Its Old Economic Playbook? A survey of China’s 500 top manufacturers by China Enterprise Confederation7 indicated that most of the 342 respondents had resumed production as of February 20. They also reported that more than half of their employees had returned to work and the average capacity utilization rate had reached nearly 60% (Table 1). Furthermore, the China Association of Small and Medium Enterprises8 survey of 6,422 small businesses showed that as of February 14, more than half of the companies have resumed operations (Chart 4). By February 21, the daily coal consumption in China’s six largest power plants has reached 62% of the consumption from the same period last year (adjusted for Lunar Year calendar), 14 percentage points higher than February 10 - the first day officially scheduled for people to return to work.9 Table 1Large Manufacturers Have Reached More Than Half Of Their Production Capacity… China: Back To Its Old Economic Playbook? China: Back To Its Old Economic Playbook? The resurgence in the number of new infections has not slowed those regions down from reopening businesses, particularly along the manufacturing belt in China’s coastal regions (Chart 5). China’s leadership has repeatedly urged local governments to relax aggressive containment measures to allow production to resume. Unless the number of new cases in China picks up again, we expect business operations in regions outside of Hubei to continue re-opening in the coming weeks. Chart 580% Of China’s Coastal Regions Are Back To Work China: Back To Its Old Economic Playbook? China: Back To Its Old Economic Playbook? Most manufacturers in regions other than Hubei are returning to work and are running at about half of last year’s production capacity. Bottom Line: The aggressive containment measures seem to be effective inside China. Most manufacturers in regions other than Hubei are returning to work and are running at about half of last year’s production capacity. We expect the rate to improve. This will mitigate the impact of the virus outbreak on the Chinese economy.  “Scenario 2” Implies An Upturn In The Corporate Earnings Cycle The impact of the COVID-19 outbreak on China’s economy may be smaller than investors currently fear. The country is also in a better economic condition than in 2015/2016. If the Chinese leadership believes an “insurance stimulus” is warranted and allows credit growth in 2020 to reach near 28% of GDP, as in 2015-2016, then the stimulus will more than offset the outbreak-induced economic shock from Q1 and lead to a meaningful rise in this year’s corporate earnings (Chart 6): China’s households and corporates are actually more willing to spend now than in 2015-2016. We agree that China’s households and companies are both highly leveraged, and re-leveraging may further diminish their debt-servicing ability and willingness to invest or spend. Debt as a share of Chinese household disposable income has climbed by 33 percentage points compared with five years ago (Chart 7). The increase in debt load makes Chinese households particularly vulnerable to income reductions. But this supports our view that policymakers will make every reflationary effort to avoid massive layoffs. Additionally, the willingness to spend among Chinese households is not less than during the down cycle in 2015-2016 (Chart 7 bottom panel). Chart 6A 2015/2016-Style Stimulus Will Likely Triumph Over Short-Term Economic Shocks A 2015/2016-Style Stimulus Will Likely Triumph Over Short-Term Economic Shocks A 2015/2016-Style Stimulus Will Likely Triumph Over Short-Term Economic Shocks Chart 7Chinese Households Are More Indebted, But Are Also More Willing To Spend Than In 2015/2016 Chinese Households Are More Indebted, But Are Also More Willing To Spend Than In 2015/2016 Chinese Households Are More Indebted, But Are Also More Willing To Spend Than In 2015/2016 The debt-to-GDP ratio and debt-servicing cost-to-income ratio in China’s non-financial private sector have trended sideways in the past five years (Chart 8). The corporate cash flow situation is only slightly worse than in 2015 (Chart 9). The virus outbreak and drastic containment measures will temporarily weaken the corporates’ cash positions, but this negative situation can be partially offset by tax, fee and interest relief measures.10 Chart 8Chinese Corporates Are In Fact Not More Indebted Than In 2015/2016... Chinese Corporates Are In Fact Not More Indebted Than In 2015/2016... Chinese Corporates Are In Fact Not More Indebted Than In 2015/2016... Chart 9...And Their Cash Flow Situation Is Only Slightly Worse ...And Their Cash Flow Situation Is Only Slightly Worse ...And Their Cash Flow Situation Is Only Slightly Worse   Furthermore, China’s non-financial corporates’ marginal propensity to spend is actually higher than in 2015-2016 (Chart 10). This may be due to the more accommodative monetary backdrop than in 2015-2016. If Chinese authorities are to significantly step up their reflationary efforts, the easy monetary policy stance may be here to stay throughout 2020. Prior to the COVID-19 outbreak, the mild deflation in China’s PPI growth was already turning slightly positive on the heels of an improving economy. The historical relationship between China’s producer prices and industrial profits suggests that profit growth for both China’s onshore and offshore markets is highly linked to fluctuations in producer prices (Chart 11). An ultra-easy monetary policy, a weak RMB, and a more forceful boost to domestic demand will provide strong reflationary support to producer prices and industrial profits. Chart 10Chinese Corporates' Willingness To Spend Also Higher Than In 2015/2016 Chinese Corporates' Willingness To Spend Also Higher Than In 2015/2016 Chinese Corporates' Willingness To Spend Also Higher Than In 2015/2016 Chart 11A 2015/2016-Style Reflation Will Likely Lead To A Strong Rebound In Corporate Profits A 2015/2016-Style Reflation Will Likely Lead To A Strong Rebound In Corporate Profits A 2015/2016-Style Reflation Will Likely Lead To A Strong Rebound In Corporate Profits   Bottom Line: Despite a short-term economic shock, China’s economy is at a better starting point than in 2015-2016. If monetary and fiscal easing in 2020 reaches the same magnitude as five years ago, then the economy and corporate profits will likely begin to respond to the stimulus. Investment Conclusions The clear sign of policy shift to shoring up the economy suggests that, our Scenario 2 is the most likely outcome. The fiscal and monetary easing initiatives seem to resemble those of 2015/2016. The short-term outbreak-induced economic shock, on the other hand, looks to be smaller than the market anticipates. Manufacturers in China continue to resume production in regions outside of Hubei, a trend we believe will go on unless there is a significant threat that the virus will break out again in these Chinese regions. This supports our constructive view on China-related assets over a 6-12 month time horizon. The fiscal and monetary easing initiatives seem to resemble those of 2015/2016, and will likely overshoot the short-term economic shock. There is a risk to our constructive view, though, that the more forceful policy response from the Chinese leadership may imply a greater than anticipated short-term economic shock from the outbreak. This would challenge our bullish stance on Chinese stocks in the next three months. Substantially weaker economic data in Q1 would likely trigger a selloff in Chinese risk assets, both onshore and offshore. However, a severe short-term economic shock, followed by a burst of stimulus, would create strong investment opportunities. If the scale of Chinese policymakers’ reflationary measures ramps up significantly in the coming months, they will likely overshoot the short-term economic shock. Another reflationary cycle would certainly have a positive impact on global investors’ sentiment and Chinese financial assets. Stay tuned.   Jing Sima China Strategist jings@bcaresearch.com   Footnotes 1    http://english.www.gov.cn/news/topnews/202002/23/content_WS5e5286cdc6d0… 2   http://www.pbc.gov.cn/goutongjiaoliu/113456/113469/3975864/index.html 3   Please see China Investment Strategy Weekly Report "Threading A Stimulus Needle (Part 2): Will Proactive Fiscal Policy Lose Steam?," dated July 24, 2019, available at cis.bcaresearch.com 4   Please see China Investment Strategy Weekly Reports "Threading A Stimulus Needle (Part 1): A Reluctant PBoC," dated July 10, 2019, "Threading A Stimulus Needle (Part 2): Will Proactive Fiscal Policy Lose Steam?," dated July 24, 2019, "Don’t Bottom-Fish Chinese Assets (Yet)," dated August 14, 2019 and "Mild Deflation Means Timid Easing," dated October 9, 2019. available at cis.bcaresearch.com 5   Please see China Investment Strategy Weekly Report "Questions From The Road: Timing The Turn," dated November 20, 2019, available at cis.bcaresearch.com 6   Please see Global Investment Strategy Weekly Report "Markets Too Complacent About The Coronavirus," dated February 21, 2020, available at cis.bcaresearch.com 7   http://www.cec-ceda.org.cn/view_sy.php?id=42633 8   http://www.ce.cn/xwzx/gnsz/gdxw/202002/18/t20200218_34298844.shtml 9   http://www.21jingji.com/2020/2-21/wOMDEzNzhfMTUzNjAwOA.html 10  China has announced targeted measures to defer or lower taxes and administrative fees. It will also provide interest rate subsidies to affected businesses. Cyclical Investment Stance Equity Sector Recommendations

Highlights Dear Client, This week, we had originally planned to publish a Special Report introducing a framework for modeling and selecting global yield curve trades. In light of the market turbulence of the past few days, however, we felt the need to provide a short note updating our current thoughts on the expanding threats to the global economy and financial markets from the coronavirus (a.k.a. 2019-nCoV, COVID-19). Thus, this week, you will be receiving two reports from BCA Research Global Fixed Income Strategy. Kind regards, Robert Robis Feature The news of more occurrences of the COVID-19 virus in countries outside China – South Korea, Italy, Iran, and Israel – has created a new wave of fear among investors who had started to see signs that the spread of the virus was losing some momentum in China. The appearance of COVID-19 infections in countries like Italy, where there was no obvious connection to the epicenter in China, raised new concerns that the outbreak could turn into a true global pandemic that would be a major negative shock to global growth. The latest market moves fit the profile of a major risk-off move driven by higher uncertainty. Global equities have sold off sharply over the past two trading sessions, and volatility measures like the VIX have spiked. The 10-year US Treasury yield reached a new all-time low (on an intraday basis) of 1.35% yesterday, leaving it -18bps below the 3-month US Treasury bill rate. That curve inversion has occurred alongside falling TIPS breakevens and rising expectations of Fed rate cuts in 2020, in a familiar parallel to the “tariff war shock” of 2019 that prompted the Fed to lower the funds rate by a cumulative 75bps. We see some similarities today to a more recent “black swan” event: the June 2016 UK Brexit vote, which was when the previous intraday all-time low in US Treasury yields was reached. Yield movements have been somewhat smaller in other countries where yields were already very low to begin with, like the 10-year German bund reaching -0.49% and 10-year UK Gilt hitting 0.54% yesterday. Global credit markets have also underperformed, with corporate bond spreads widening alongside spiking equity market volatility in the US and Europe. Amidst the fear, investors have been searching for a potential roadmap to follow, for economies and financial markets, based on past viral outbreaks like the 2003 SARS epidemic and the 2009 global swine flu (H1N1) pandemic. We see some similarities today to a more recent “black swan” event: the June 2016 UK Brexit vote, which was when the previous intraday all-time low for US Treasury yields was reached. After that stunning electoral outcome, investors worldwide tried to process the potential negative implications of an unexpected political outcome. Risk assets sold off and government bonds rallied sharply. Global policymakers responded with various easing measures, both direct (rate cuts and fresh QE from the Bank of England) and indirect (delayed Fed rate hikes, more QE from the ECB). This all came at a time when global growth momentum was already picking up before the Brexit vote, stoked by large-scale fiscal and monetary stimulus in China (Chart 1). In the end, the supportive monetary/fiscal backdrop, and not the political uncertainty, won out and the global economy – along with risk assets and bond yields – all recovered over the second half of 2016. Chart 1Doomsday? Or 2016 Revisited? The Pandemic Panic The Pandemic Panic Today, policymakers are starting to mobilize to fight the threat to growth from COVID-19, hinting at potential monetary easing measures. China is already set to deliver more monetary and fiscal easing, although it is not clear if those will be on the same massive scale as 2015/16. While the scale of the shock to global growth from a potential pandemic is obviously far different than the political uncertainty of Brexit, stimulus measures in 2020 could generate a similar positive response from financial markets if the coronavirus impacts growth less than currently feared. So what should investors expect next? We admit that we do not have a strong conviction level on near-term market moves, given how the coronavirus outbreak has set off an unpredictable chain of events that has gone against our base case expectation of a global growth rebound in 2020. Yet amidst all the uncertainty and fear, we can hazard a few guesses as to the potential future moves in global bond markets. For riskier borrowers, the ability to service debt is what matters most, and the majority of borrowers can still meet their interest payments with global borrowing costs near all-time lows. DURATION: A lot of bad news is discounted in current global bond yield levels, both in terms of absolute levels and expected rate cuts. Yet until there are signs of the virus being contained, both within and outside China, investors will continue to seek out hedges for the uncertainty. That means the any challenge to the current downward momentum in yields may not become evident until the economic data releases begin to show signs of a Q2 recovery from what is assuredly going to be an awful Q1 for the global economy. YIELD CURVE: A continuation of the risk-off momentum in global equity markets will put additional bull-flattening pressure on developed market government bond yield curves in the near term. The more medium-term move, however, should be towards steeper yield curves. Either the viral outbreak becomes contained and/or the growth shock is minimized, triggering a reversal of the latest risk-off bull flattening into risk-on bear-steepening; or the economic downturn and risk asset selloff intensifies and central banks deliver rate cuts that will bull-steepen global yield curves. CREDIT: Global corporate bond spreads should remain under upward pressure in the near term until the spread of the coronavirus outbreak begins to ease. However, the cumulative spread widening in credit markets could turn out to be surprisingly modest. The conditions that are typically in place before credit bear markets and periods of sustained spread widening – tight monetary policy and rapidly deteriorating corporate financial health – are not currently in place. This is true in both the US and Europe for high-yield, where our bottom-up Corporate Health Monitors are still sending a neutral message – thanks largely to interest coverage ratios that are still above typical pre-recessionary levels (Chart 2). For riskier borrowers, the ability to service debt is what matters most, and the majority of borrowers can still meet their interest payments with global borrowing costs near all-time lows - even in the event of a sharp, but short, global economic slowdown. Chart 2Low Yields Supporting High-Yield Borrowers The Pandemic Panic The Pandemic Panic   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com