Equities

Highlights The S&P 500 is in a bear market, and a recession appears to be inevitable, … : The longest bull market in S&P 500 history succumbed last week to the Saudi-Russia oil war, the relentless drumbeat of spreading COVID-19 disruptions and the realization that it will take even worse market conditions to prompt a meaningful fiscal response. … but it is BCA’s view that the recession will be short, if sharp: Although our conviction level is low, and our view is subject to change as more information becomes available, we expect that the recession is much more likely to produce a V-bottom than a U-bottom. Pent-up demand will be unleashed once the coronavirus runs its course, stoked by monetary and fiscal stimulus initiatives around the world. Are central banks out of bullets?: We are not yet ready to embrace the most provocative idea that came up at our monthly View Meeting last week, but the question highlights the uncertainty that currently pervades markets. First, do no harm: What should an investor do now? Watch and wait. It is too early to re-risk a portfolio, but safe-haven assets are awfully overbought. Cash is worth its weight in gold right now, and those who have it should remember that they call the shots. Feature The S&P 500 entered a bear market last Thursday, bringing down the curtain on the longest US equity bull market in recorded history at just under 11 years.1 We are duly chastened by the misplaced bravado we expressed in last week’s report, which crumbled under the force of the ensuing weekend’s oil market hostilities between Saudi Arabia and Russia. We see the plunge in oil prices, and the looming spike in oil-patch defaults, bankruptcies and layoffs, as the straw that broke the camel’s back, ensuring a 2020 recession. Now that it has slid so far, we expect that the S&P 500 will generate double-digit returns over the next twelve months, but we do not believe that investors should be in any rush to buy. Wild oscillations are a sign of an unhealthy market, and stocks don’t establish a durable bottom while they are still experiencing daily spasms. The Fundamental Take (For What It’s Worth) We nonetheless believe that the recession will be fairly brief, even if it is sharp. The global economy was clearly turning around before the virus emerged, and the US economy was as fit as a fiddle. Data releases across February were decidedly positive, on balance, and the year-to-date data, as incorporated in the Atlanta Fed’s GDPNow model, pointed to robust first quarter growth in an economy that was firing on all cylinders (Chart 1). We continue to believe that most of the demand that goes missing across the first and the second quarters will not be lost for good, but will simply be deferred to the second half of this year and the beginning of next year. The coronavirus has brought an end to the expansion, but the US economy was in rude health before it was infected, and we expect it will make a full and swift recovery. Chart 1The First Quarter Had Been Shaping Up Really Well Chart 2Old Faithful That pent-up demand will be goosed by abundant monetary and fiscal stimulus. We expect that China and the US will take the lead, and will have the most impact on global aggregate demand, but that policymakers in other major economies will also lend a hand. Central banks in Australia, Canada and England have all cut rates in the last two weeks, and British policymakers took the boldest step, pairing last week’s rate cut with an immediate 30-billion-pound infusion of emergency spending, and a pledge to spend 600 billion pounds on infrastructure upgrades between now and 2025.2 Australia announced a plan to inject fiscal stimulus equivalent to about 1% of GDP Thursday morning, and Germany’s ruling party indicated a willingness to run a budget deficit to combat the virus.3 Our China Investment Strategy team notes that the Chinese authorities are already supporting domestic demand via aid to threatened businesses and out-of-work individuals, and are poised to open the infrastructure taps (Chart 2). Global aggregate demand is also set to receive a boost from the oil plunge, although it will arrive with a lag. Energy sector layoffs and the tightening in monetary conditions from wider bond spreads and marginally tighter bank lending standards will exert an immediate drag on activity. Once that drag fades, however, the positive supply-shock effects will take hold, helping households stretch their paychecks and non-energy businesses expand their profit margins. Although the effect of falling oil prices is mixed for the US now that fracking has made it a heavyweight oil producer, more economies are oil importers than exporters, and global growth is inversely related to oil price moves. We are keenly aware that markets are paying no attention whatsoever to economic data releases right now. They are backward-looking, after all, and fundamentals are not the driving force behind current market moves anyway. The data are useful, however, for evaluating the fundamental backdrop once the non-stop selling abates, as it eventually will. When it becomes important to take the measure of the economy and where it’s headed, investors will be able to make a more informed judgment if they have a good read on how the economy was doing before it was exposed to the virus (Chart 3). Chart 3Layoffs Are Coming, But They Hadn't Started By Early March Investment Strategy The near-term equity view was cautious when we held our View Meeting Wednesday morning before the open. No one thought investors should be in any hurry to buy, and while not everyone shared the bleakest S&P 500 downside estimate of 2,400 (well within sight now), no one suggested that the index had already bottomed. One participant made the case for a negative 10-year Treasury yield, but we still have little appetite for Treasuries as a house. We expect the 10-year yield will be higher in twelve months than it is now, if perhaps only modestly. We like equities' 12-month prospects, but they may have to decline some more before Congress joins hands and puts a floor under them. For anyone expecting US fiscal stimulus to bail out the markets, our geopolitical team sounded a note of caution. A recession is kryptonite for incumbent presidential candidates, and the more the virus squeezes the economy, the greater the Democrats’ chances of capturing the White House and the Senate. Our Geopolitical Strategy service fully expects that Democrats will eventually agree to a sizable spending package, but only after allowing the situation to deteriorate some more. As long as they don’t look like they’re putting party concerns ahead of the nation’s welfare, they can dent the president’s re-election prospects by waiting to throw a lifeline to the economy and financial markets. The administration’s initial proposal, as alluded to in the president’s prime-time Oval Office address on Wednesday night, fell way short of what the market sought. Its small-bore items seemed woefully inadequate to stem the tide, and raised the unsettling prospect that the fiscal cavalry might fail to ride to the rescue because the administration didn’t think it needed to be summoned. The good news for markets is that governments get an almost unlimited number of do-overs.4 The first iteration’s failure ensures that the second will be more ambitious, and if that fails, the third iteration will be even bigger. Thank You, Sir, May I Have Another? News of disruptions to economic activity, and daily life, in the United States piled up last week. Colleges closed their gates en masse for what remains of the academic year; concerts and music festivals were cancelled; the NCAA basketball tournament was initially closed to fans, then cancelled altogether; and all of the major North American professional sports leagues have suspended their seasons. In many instances, city and state ordinances banning mass gatherings forced sports franchises’ and concert promoters’ hands. The relentless drumbeat of bad news did markets no favors, and it surely did not help business or consumer confidence as broadcasters, hotels, restaurants, bartenders, taxi drivers and arena staff totted up their lost income. Today’s pain may be tomorrow’s gain, however. While draconian measures weigh on peoples’ spirits and crimp economic activity in the immediate term, they increase the chances of limiting the virus’ spread and mitigating its ultimate effect. As our Global Investment Strategy colleagues have pointed out, there is a trade-off between health and growth. Bulking up health safeguards unfortunately involves some growth sacrifices. Are Central Banks Out Of Bullets? Chart 4If At First You Don't Succeed, ... The most provocative line of argument in last week’s firm-wide discussion was the idea that the coronavirus is a bit of a red herring, and that the true driver of the global market selloff is the failure of the policy put. That’s to say that the efficacy of, and the belief in, central banks’ ability to shore up markets and the economy has crumbled. So far, this round of emergency rate cuts has failed to stem the flow of red on Bloomberg terminals and television screens (Chart 4). Spending plans have underwhelmed as well, with British, Australian and Japanese equities all fizzling following the announcement of fiscal stimulus measures. The end of markets’ monetary policy era would mark a major inflection point, if not a full-on regime change. We are hesitant to make such a sweeping declaration now, however. As one of our colleagues put it in making the case for further declines in rates, the golden rule of investing is never to lean against a primary trend. Positioning for an end to central banks’ influence on markets would mean going against 33 years of history that began with the Fed’s post-Black Monday statement affirming its “readiness to serve as a source of liquidity to support the economic and financial system.” Central bankers are neither omniscient nor omnipotent, but there’s a reason why You can’t fight the Fed became a cherished truism. It affects the real economy when it turns its policy dials. If monetary stimulus is aligned with fiscal stimulus, as it just might be next week, it can make for a potent cocktail. A devotee of the Austrian School of Economics may grind his or her teeth to dust over the endless intervention in markets, but the results are popular with the public and elected officials, and we can expect that they’ll continue over most professional investors’ relevant timeframes. Public officials will let go of the Debt Supercycle controls only when they’re pried out of their cold, dead hands. What Now? It feels like it was a month ago, but just last week we were of the view that a correction was more likely than a bear market. As we wrote then: We remain constructive on risk assets because we think the selling has gotten overdone. There may well be more of it, and the S&P 500 could reach its 2,708.92 bear-market level before we can publish again next Monday, but we will be buying it in our own account all the way there. Compounding our embarrassment and regret, we actually did buy shares in a SIFI bank on Tuesday as they approached their tangible book value. Markets were unimpressed with the initial monetary salvo, but there's more where that came from (and some fiscal artillery, too). We have learned our lesson and will wait before committing any more capital. We have also learned our lesson about “overdone selling.” Despite the dramatic gap between the S&P 500 and its 200-day moving average (Chart 5), every single sale over the last three weeks has proven to be a good one. Cutting one’s losses is a deservedly celebrated portfolio management rule, and we cannot object to any client who wants to take some exposure off the table. Chart 5The Equity Selloff Has Become Extreme We have little love for the havens that have already spiked, like gold, Treasuries, utilities and makers and sellers of hand sanitizer, disinfectant wipes and surgical masks. Insurance in the form of index puts is bracingly expensive. Our preferred way of taking advantage of the massive market disruption (Chart 6 and Table 1) is to write out-of-the money puts on individual stocks at strike prices where we’d be happy to own them. With the VIX in the 50s, much less the 60s or 70s, an investor writing puts 10% out of the money on a range of S&P 500 constituents5 can get paid double-digit annualized returns in exchange for agreeing to get hit down 10% between now and March 20th or April 17th. Chart 6Selling Insurance Looks More Appealing Than Buying It Right Now Table 1One Week, Two Historic Declines We recognize that not every investor has discretion to write puts, and it is not something to be done lightly in any event. The compensation is so high because it is a contractual agreement to buy stock in a relentlessly falling market. (Options only confer a right to transact for their buyers; they’re an iron-clad obligation to transact for their sellers.) Our species’ cognitive biases being what they are, however, we like the strapped-to-the-mast feature of writing puts because it commits an investor to following through on a course of action s/he decided upon before price declines had a chance to shake his/her resolve. It is one thing to have said that one would buy a 35-dollar stock if it ever got to 18, and quite another to follow through now that it’s gone from 35 to 21 in short order.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 The bull market began on March 10, 2009, at 676.53, and ended February 19, 2020, at 3,386.15. Its 400% advance was achieved at an annualized rate of 15.8%. 2 Nominal 4Q19 UK GDP was about 560 billion pounds. 3 Believe it or not, this is kind of a big deal for Berlin. 4 As we were going to press, it looked as if House Democrats and the administration were nearing agreement on a package to protect vulnerable workers and small businesses, while the combined private- and public-sector efforts outlined in the Rose Garden suggested that the US might be capable of stemming the spread of the virus soon. 5 Type [ticker]-F8-PUT into Bloomberg for the full menu of maturities and strike prices for any given stock. The annualized return for writing the put is equal to the option premium divided by the strike price, multiplied by (360/the number of days until expiration). For near-month contracts, if the premium is around 1% of the strike, the annualized return on the notional capital committed is 10%.

Feature “People have been asking me whether this is the time to buy. My answer is more nuanced: it’s probably a time to buy.” Howard Marks, Oaktree Capital, Monthly Memo March 2020   Markets have moved dramatically since we published our Monthly Portfolio Update on March 2. Global stocks have fallen by 27% since then. The 10-year US Treasury yield fell from 1.2% to 0.4% before rebounding to 0.8%. And there have been some strange market moves: the US dollar fell then rebounded, and the classic safe haven, gold, has fallen by 7%. Investors are struggling with how to think about this environment, and how to position. Chart 1Risk Assets Should Bottom When New Ex-China Cases Peak Table 1US Healthcare Is Top Quality Our view has not greatly changed. We still believe that risk assets will bottom around the time when global COVID-19 cases peak. They showed signs of a rebound when cases in China peaked on February 13. And they started their recent crash when ex-China cases began to accelerate dramatically (Chart 1). It is likely – and well anticipated – that there will be a sharp rises in cases in the US (and probably the UK and Canada too) over the coming two or three weeks. It is wrong to think, though, that the US is particularly badly prepared for this. The US has a high standard of healthcare, with many more intensive-care beds per person than other developed countries (Table 1) – though it is worrying that some 20% of the US population is uninsured. We see two possibilities for how the pandemic will pan out in coming weeks: The US is the last big cluster and new cases peak there in early April. This causes a two-quarter recession. But if COVID-19 turns out to be seasonal (it has not spread much in hot countries such as Singapore, or in the southern hemisphere where it is now summer – Chart 2) and by April and May it peters out. US consumers stop going out for a while (the professional hockey, basketball, and soccer seasons have been put on hold) and so demand falls. Typically, stocks fall by 25-30% in a recession of this type (Table 2) – and so this is already close to being discounted. There are no longer-term impacts, and soon the world economy is getting back close to normal. Chart 2Will Hot Weather End The Pandemic? Table 2Peak-To-Trough Falls In Equities In Bear Markets The pandemic continues for months. Governments are able to slow contagion via social distancing in order to spread out the pressure on their health services over a longer period. But ultimately one-half to two-thirds of the world’s population gets the disease and the death rate among those people is 0.7% (the rate in Korea, which extensively tested for the virus and has a good medical system). This means worldwide deaths of about 20 million, disproportionately concentrated among the over-70-year-olds and those with chronic illnesses (Chart 3). The disease could spread to poor countries, such as India and Africa, where healthcare services would not be able to cope. The global economy would slow significantly, causing a severe recession. There would be second-round effects: for example, a blow-up in the US corporate credit markets, where debt is already high as a percentage of GDP (Chart 4), which could cause banks to drastically tighten lending conditions. This could cause problems with foreign-currency EM borrowers. It could trigger another euro zone crisis, as banks in southern Europe prove unable to cope with rising defaults. In this scenario, the peak-to-trough decline in global equities could be 40-50%. Chart 3COVID-19 Mostly Kills Old And Sick People Chart 4US Corporate Debt Is A Vulnerability   In our last Monthly, we talked about the usefulness of a Bayesian approach in this sort of uncertain environment. We ascribed a “prior” probability of 10-20% for the latter scenario. The probability has now risen, to perhaps 25%. Chart 5Close To Capitulation But the potential upside from Scenario 1) is considerable. Central banks around the world are throwing everything at the problem. Countries from the UK and Italy, to Japan and Australia have rolled out big fiscal packages this week. The key now is what will the US do. How positively would markets react if the US in coming days scripted a coordinated announcement, with the Fed cutting rates to zero, and the White House and Congress agreeing an $800 billion fiscal package. The Fed is likely to do this – indeed the market is pricing in the Fed Funds Rate at zero by the next FOMC meeting on March 18. The dynamics of fiscal stimulus are more complicated – the Democrats don’t want to give President Trump a boost that will help his election prospects, but they don’t want to be seen to be obstructive in a time of emergency either.1 So what should investors do? We have been tempted in recent days to lower our Overweight recommendation on equities, which has evidently proved wrong, to Neutral. But we fear it is too late to do this, particularly with equities having fallen by 15% over the past two days. There is probably still some downside. We would now look for signs of a bottoming-out, most notably the peak in new COVID-19 cases outside China, but also evidence of capitulation by investors (Chart 5). Moreover, we would pay attention to potential upside surprises (in addition to a Fed/White House/Congress joint package, maybe a making-up between Russia and Saudi Arabia on oil production cuts). In the meantime, when markets move as violently as they have, often the baby gets thrown out with the bathwater. There are many individual securities, in both debt and equity markets, that look very attractively valued now. For example, we see a lot of attraction in high-dividend-yield stocks, which might appeal to investors who no longer see the point of investing in government bonds, where the upside – even in a severe recession – is likely to be very limited. Table 3 shows a screening of large-cap stocks in developed markets with a dividend yield of more than 10%, taken from BCA Research’s ETS quants screening service. While many of these are in the Energy sector (where the price/book ratio is now below the lows of 2008 and 2015 – Chart 6), quality names among European Financials and Asia Industrials are also prominent. Table 3Stocks With Dividend Yield Above 10% Chart 6Energy Sector Valuation At Record Low For investors who want to remain risk-off, we would not recommend government bonds as a hedge. It is notable that the Swiss 10-year government bond yield has not fallen in the recent melt-down. They are simply at their theoretical lower bound. German Bunds must be close. The Fed has been clear that it will not cut policy rates below zero, which means that the lower limit for US Treasurys is probably around 0% too. Even in the severest recession, therefore, the upside for Treasurys is limited to 9% (Table 4). This means returns are likely to be very asymmetrical since, in a rebound in risk appetite, yields could rise sharply. Table 4Little Upside From Government Bonds We prefer cash as a hedge. This gives investors dry powder for use when they do want to reenter risk assets. We have been recommending gold, and it will probably continue to serve as a safe haven in the event of our most pessimistic scenario happening. But it looks very overbought in the short term (Chart 7) – as demonstrated by the way that it has recently been correcting even on days when equities fall. TIPS offer a better hedge than nominal bonds, given how low inflation expectations have fallen – the 5-year/5-year forwards now point to CPI inflation in 2025-2030 averaging 1.5% (Chart 8). This implies – highly unrealistically – that the Fed will miss its 2% PCE inflation target by 1 percentage point a year over that period. Chart 7Gold Is Overbought Chart 8Inflation Expectations Unrealistically Low Garry Evans, Senior Vice President Chief Global Asset Allocation Strategist garry@bcaresearch.com   Footnotes 1 Please see Geopolitical Strategy, Weekly Report, "GeoRisk Update: Leap Year, Or Steep Year?" available at gps.bcaresearch.com.  

Highlights The path of least resistance for the DXY remains up. The internal dynamics of financial markets remain constructive for the DXY. We explore more key indicators to complement the analysis in our February 28 report. Our limit buy on NOK/SEK was triggered at parity. We were also stopped out of our long petrocurrency basket trade, which we will re-establish in the coming weeks. Feature Riot points in capital markets usually elicit a swathe of differing views. But more often than not, the internal dynamics of financial markets usually hold the key to a sober view. Given market action over the past few weeks, we are reviewing a few of the key indicators we look at for guidance on buying opportunities as well as false positives. In short, it is a story of standing aside on the DXY for now, while taking advantage of a few opportunities at the crosses. Currency Market Indicators Chart I-1The Dollar Has Scope To Rise Further Many currency market signals continue to point to a higher DXY index for the time being. One of our favorite risk-on/risk-off pairs is the AUD/JPY cross. Not surprisingly, it tends to correlate very strongly with the dollar, which is a counter-cyclical currency. The AUD/JPY cross has consistently bottomed at the key support zone of 70-72 since the financial crisis. This defensive line held notably during the European debt crisis, China’s industrial recession, and more recently, the global trade war. The latest market moves have nudged it decisively lower (Chart I-1). This pins the next level of support in the 55-57 zone, at par with the recessions of 2001 and 2008. The yen appears headed towards 100. A rising yen is usually accompanied by a dollar rally against other procyclical currencies. Outside of the Fukushima crisis, this was a key indicator that the investment environment was becoming precarious (Chart I-2). We laid out our conviction last week as to why we thought 100 is the resting spot for the yen.1 That said, in our trades, our 104 profit target for short USD/JPY was hit this week. We are reinstating this trade with a target of 100, but tightening the stop to 105.4. Chart I-2The Yen Rally Usually Stalls At 100 The recent drop in the dollar is perplexing to most, but it fits the profile of most recessions we have had in recent history. As the world’s reserve bank, the Federal Reserve tends to be the most proactive during a crisis. This means US interest rates drop faster than in the rest of the world, which tends to pressure the dollar lower. Eventually, as imbalances in the economic system come home to roost, the dollar rallies (Chart I-3). 62% of global reserves are still in dollars, suggesting it remains the currency of choice in a crisis. Currencies such as the Norwegian krone and Swedish krona that were already quite cheap are still selling off indiscriminately. Granted, the Norwegian krone has been hit especially hard due to the fallout of the OPEC cartel. But the Swedish krona and Australian dollar that were equally cheap are selling off as well. This suggests the currency market is making a binary switch from fundamentals to sentiment, as we highlighted last week. Chart I-3The Dollar And ##br##Recessions Chart I-4Carry Trades: Long-Term Bullish, Short-Term Cautious Correspondingly, high-beta currencies such as the RUB/USD, ZAR/USD and BRL/USD are plunging into uncharted territory. These currencies are usually good at sniffing out a change in the investment landscape, specifically one becoming precarious for carry trades. The message so far is that the drop in US bond yields may not have been sufficient to make these currencies attractive again (Chart I-4). On a similar note, it is interesting that the USD/CNY is still holding near the 7-defense line. We suggested in a previous report that this represented a handshake agreement between President Xi and President Trump during the trade negotiations. Should USD/CNY break decisively above 7.15 (for example, if Trump’s reelection chances dwindle), it will send Asian currencies into the abyss. The velocity of asset price moves is both surprising and destabilizing. At this rate, previously solvent countries can rapidly step into illiquid territory, especially those with already huge levels of external debt. Granted, this is more a problem for emerging markets than for G10 currencies. So far, it is encouraging that cross-currency basis swaps for the dollar (a measure of currency hedging costs) remain muted (Chart I-5). Chart I-5Hedging Costs Remain Contained In a nutshell, the message from currency markets warns against shorting the DXY for now. Bottom Line: Our profit target on short USD/JPY was hit at 104 this week. We are reinstating this trade with a new target of 100 and a stop-loss at 105.4. Currency market dynamics suggest the DXY is headed higher in the near term. The Message From Equity And Commodity Markets Equity and commodity market indicators continue to suggest the path of least resistance for the DXY remains up over the next few weeks. Since the 2009 lows, the S&P 500 has respected a well-defined upward-sloped trend line, characterized by a series of higher highs and lows. Given this defense line has been tested (and broken), it could pin the S&P 500 around 2200-2400 (Chart I-6). A further drop of this magnitude is likely to unravel financial markets as stop losses are triggered and reinforced selling is supercharged. Non-US equity markets have a much higher concentration of cyclical stocks in their bourses. Thus, whenever cyclical sectors are underperforming defensives at the same time as non-US markets are underperforming US ones, it is a clear sign that the marginal dollar is rotating towards the US (in this case fixed income). During the latest downdraft, what has been clear is that cyclical (and non-US) markets have been underperforming from already oversold levels (Chart I-7A and Chart I-7B). As contrarian investors, we tend to view this development positively, but catching a falling knife before eventual capitulation can also be quite painful. Chart I-6A Break Below The Defense Line Is Bearish Chart I-7ANot A Bullish Configuration For Cyclical Currencies Chart I-7BNot A Bullish Configuration For Cyclical Currencies The 2015-2016 roadmap was instructive on when such a capitulation might occur. Even as the market was selling off, certain cyclical sectors such as industrials started to outperform defensives ones (Chart I-8). So far, it appears that selling pressure in cyclical markets have not yet been exhausted. Chart I-8Equity Market Internals Are Worrisome In commodity markets, the copper-to-gold and oil-to-gold ratios continue to head lower from oversold levels. Together with the fall in government bond yields, it signifies that the liquidity-to-growth transmission mechanism is impaired (Chart I-9). The speed and magnitude of the latest drop could signify capitulation, but since the European debt crisis there has been ample time to catch the upswings, since they tend to be powerful and durable. Earnings revisions continue to head lower across all markets. Bottom-up analysts are usually spot on about the direction or earnings. Not surprisingly, the downgrades have been driven by emerging markets, meaning that return on capital will be lower in cyclical bourses. Chart I-9Commodity Market Internals Are Worrisome A selloff in equity markets has tended to occur in cycles. The speed and intensity of the first selloff usually wipes out stale longs, especially those that bought close to the recent market peak. It is fair to assume with yesterday’s selloff that the process is near complete. The next wave comes from medium-term investors, making a judgment call on whether they are at the cusp of a recession. Unfortunately, this phase usually involves a cascading selloff with capitulation only evident a few weeks or months later. The fact that cheap and deeply oversold currencies like the Norwegian krone and Australian dollar are still falling suggests we are stepping into the second wave of selloffs. What remains peculiar about the dollar is that it continues to be whipsawed between relative fundamentals and sentiment. Bottom LIne: Equity market internals continue to suggest we have not yet hit a capitulation phase for pro-cyclical currencies. Stand aside on the DXY for now. On Interest Rates, The Euro, And Petrocurrencies Chart I-10The Bear Case For The US Dollar What remains peculiar about the dollar is that it continues to be whipsawed between relative fundamentals and sentiment. For example, interest rate differentials across much of the developed world have risen versus the dollar, in stark contrast with the drop in their exchange rates (Chart I-10). The risk is that as a momentum currency, a surge in the dollar triggers a negative feedback loop that tightens global financial conditions, reinforcing the same negative feedback loop. A few questions we have fielded this week have been in surprise to the rise in the euro. What has been remarkable is that the drop in Treasury yields has wiped out the carry from being long the dollar for a number of countries. For example, the German bund-US Treasury spread continues to collapse. The message is that at least initially, room for policy maneuvering remains higher at the Fed, which corroborates the market view of a disappointing European Central Bank meeting this week. A drop in oil prices is also a huge dividend on the European economy, which partly explains recent strength in the euro. Within this sphere of multiple moving parts, one key question is what to do with oil plays. Usually recessions are triggered by rising oil prices that impose a tax on the domestic economy. But rather, oil prices have fallen dramatically in recent weeks as the pseudo-alliance between Russia and OPEC appears to have broken down. Our commodity and geopolitical strategists believe that while some sort of resolution will ultimately be reached, the path of least resistance for oil prices in the interim is down, as market share wars are re-engaged.2 Risks to oil demand are now also firmly tilted to the downside. Oil demand tends to follow the ebb and flows of the business cycle. Transport constitutes the largest share of global petroleum demand, and the rising bans on travel will go a long way in curbing consumption (Chart I-11). Balance-of-payment dynamics also tend to deteriorate during oil bear markets. Altogether, these forces combine to become powerful headwinds for petrocurrencies. A fall in oil prices tends to be bullish for the US dollar. This is because falling oil prices reduce government spending in oil-producing countries, which depresses aggregate demand and leads to easier monetary policy. Meanwhile, a fall in oil prices also implies falling terms of trade, which further reduces the fair value of the exchange rate. Balance-of-payment dynamics also tend to deteriorate during oil bear markets. Altogether, these forces combine to become powerful headwinds for petrocurrencies. Chart I-11Oil Demand Will Collapse Further Chart I-12Resell CAD/NOK NOK Will Outperform CAD We were stopped out of our long petrocurrency basket trade for a small loss of 0.9% (on the back of a positive carry). We are standing aside on this trade for now. We were also stopped out of our short CAD/NOK trade which we are reinstating this week. Further improvement in Canadian energy product sales will require not only rising oil prices, but an improvement in pipeline capacity and a smaller gap between Western Canadian Select (WCS) and Brent crude oil prices. With the US shale revolution grabbing production market share from both OPEC and non-OPEC producing countries, the divergence between the WCS (and WTI) price of oil versus Brent is likely to remain wide (Chart I-12). Rebuy NOK/SEK Our limit buy on long NOK/SEK was triggered at parity this week. Relative fundamentals, especially from an interest rate perspective, still favor the cross. The cross has approached an important technical level, with our intermediate-term indicator signaling oversold conditions. Should the NOK/SEK pattern of higher lows and higher highs in place since the 2015 bottom persist, we should be on the cusp of a reversal (Chart I-13). Interest rate differentials continue to favor the NOK over the SEK (Chart I-14). Meanwhile, Norway mainland GDP growth continues to outpace that of Sweden. Chart I-13Rebuy NOK/SEK Rebuy NOK/SEK Chart I-14A Yield Cushion The risk to this trade is that we have not yet seen a capitulation in oil prices. This will largely be driven by geopolitics. But given that the cross is already trading near the 2016 lows in oil prices, this has already largely been priced in. We are placing a tight stop at 0.94 to account for volatility in the coming weeks. Housekeeping Our short CHF/NZD trade briefly hit our stop loss of 1.75. We are reinstating this trade today, with a new entry level of 1.74 and a stop-loss of 1.76. We were also stopped out of our short USD/NOK trade, and we will look to rebuy the krone in the near future. Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Please see Foreign Exchange Strategy Weekly Report, titled “Are Competitive Devaluations Next?”, dated March 6, 2020, available at fes.bcaresearch.com. 2 Please see Commodity & Energy Strategy Special Report, titled “Russia Regrets Market-Share War?”, dated March 12, 2020, available at ces.bcaresearch.com. Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the US have been positive: Nonfarm payrolls increased by 275 thousand and average hourly earnings grew by 3% year-on-year in February. The NFIB business optimism index ticked up to 104.5 in February. Core CPI grew by 2.4% year-on-year from 2.3% in February. The DXY index appreciated by 0.8% this week. Core inflation has consistently printed at or above 2% for the last two years, but with inflation expectations plunging to new lows, the February print is likely to mark an intermediate-term high in CPI. As a counter-cyclical currency, the DXY is likely to continue getting a bid in the near term, even if we get more aggressive stimulus from the Fed. Report Links: Are Competitive Devaluations Next? - March 6, 2020 The Near-Term Bull Case For The Dollar - February 28, 2020 On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area have been mixed: GDP grew by 1% year-on-year in Q4 2019, from 0.9% in Q3. The Sentix investor confidence index plummeted to -17.1 from 5.2 in March. Industrial production grew by 2.3% month-on-month in January from a contraction of 1.8% in December. The euro appreciated by 0.5% against the US dollar this week. The European Central Bank (ECB) kept rates unchanged at its Thursday meeting but implemented measures that support bank lending to small and medium-sized enterprises and injected liquidity through longer-term refinancing operations. The ECB also introduced additional net asset purchases of EUR 120 billion until the end of the year. This will help ease financial conditions in the euro area, but until global demand picks up, the exodus of capital from cyclical European stocks could continue.   Report Links: On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 On Money Velocity, EUR/USD And Silver - October 11, 2019 Japanese Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan have been negative: The current account surplus increased to JPY 612.3 billion from JPY 524 billion while the trade balance went into a deficit of JPY 985.1 billion from a surplus of JPY 120.7 billion in January. Machine tool orders contracted by 30.1% year-on-year in February. The outlook component of the Eco Watchers survey plummeted to 24.6 from 41.8. The Japanese yen appreciated by 2.2% against the US dollar this week. An increase in foreign investments boosted the current account surplus, helping offset the deficit in goods trade. The government announced a package totaling JPY 430.8 billion to support financing for small businesses squeezed by the virus. The sharp rally in the yen could begin to garner discussions from both the MoF and BoJ on further actions. Report Links: The Near-Term Bull Case For The Dollar - February 28, 2020 Building A Protector Currency Portfolio - February 7, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the UK have been negative: GDP growth was flat month-on-month in January. Industrial production contracted by 2.9% year-on-year in January, from a contraction of 1.8% the previous month. The total trade balance shrank to GBP 4.2 billion from GBP 6.3 billion in January. The British pound depreciated by 2.2% against the US dollar this week. The Bank of England (BoE) responded to the Covid-19 shock with an emergency rate cut of 50 basis points. This dovetailed with the government’s announcement of a GBP 30 billion stimulus package financed largely by additional borrowing. With the policy rate at 0.25%, the BoE has ruled out negative rates so further easing will likely come in the form of QE if rates go to zero. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 A Few Trade Ideas - Sept. 27, 2019 United Kingdom: Cyclical Slowdown Or Structural Malaise? - Sept. 20, 2019 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia have been negative: The Westpac consumer confidence index fell to 91.9 from 95.9 in February, a five-year low. National Australia Bank business confidence decreased to -4 from -1 while business conditions fell to 0 from 2 in February. Home loans grew by 3.1% month-on-month in January, from 3.6% the previous month. The Australian dollar depreciated by 3.9% against the US dollar this week. The Australian government joined other economies in announcing a stimulus package worth more than $15 billion that includes an extension of asset write-offs and measures to protect apprenticeships across the country. Reserve Bank of Australia Deputy Governor Debelle confirmed that the bank would consider quantitative easing if necessary. Report Links: On AUD And CNY - January 17, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 A Contrarian View On The Australian Dollar - May 24, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand have been negative: Manufacturing sales grew by 2.7% quarter-on-quarter in Q4 2019. The preliminary ANZ business confidence numbers plummeted to -53.3 from -19.4 in March. Export intentions, at -21.5, hit an all-time low in March. Electronic card retail sales grew by 8.6% year-on-year in February, picking up from 4.2% in January. The New Zealand dollar depreciated by 1.9% against the US dollar this week. The government is planning a business continuity package that will be ready in coming weeks. Reserve Bank of New Zealand Governor Orr stated that the bank would consider unconventional policy such as negative rates, interest rate swaps, and large scale asset purchases only if policy rates hit the effective zero bound. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Place A Limit Sell On DXY At 100 - November 15, 2019 USD/CNY And Market Turbulence - August 9, 2019 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada have been mixed: Average hourly earnings grew by 4.3% year-on-year and 30.3 thousand new jobs were added to the Canadian economy in February. Imports fell to CAD 49.6 billion, exports fell to CAD 48.1 billion, and the deficit in international merchandise trade swelled to CAD 1.47 billion in February.  The Ivey PMI decreased to 54.1 from 57.3 on a seasonally-adjusted basis in February. The Canadian dollar depreciated by 3% against the US dollar this week. The petrocurrency sold off as oil plunged in its biggest decline since the Gulf War in 1991. Exports of motor vehicles and energy products were down, contributing to the widening deficit. Supply and demand factors are bearish for oil, which will put a floor under our long EUR/CAD trade. Report Links: The Loonie: Upside Versus The Dollar, But Downside At The Crosses Updating Our Balance Of Payments Monitor - November 29, 2019 Making Money With Petrocurrencies - November 8, 2019 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 There were scant data out of Switzerland this week: The unemployment rate remained flat at 2.3% in February. Foreign currency reserves increased to CHF 769 billion from CHF 764 billion in February while total sight deposits ticked up to CHF 598.5 billion from CHF 503.6 billion in the week ended March 6.   The Swiss franc appreciated by 0.7% against the US dollar this week. The franc was driven by safe-haven flows at the beginning of the week but sold off as the market posted a tentative rally. Sight deposit and reserve data suggest the Swiss National Bank (SNB) intervened to keep EUR/CHF above the key 1.06 level. The ECB’s decision to hold rates will take some pressure off the SNB. Report Links: On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 Portfolio Tweaks Before The Chinese New Year - January 24, 2020 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway have been negative: Headline CPI grew by 0.9% from 1.8% while the core figure grew by 2.1%, slowing from 2.9%, in February. Manufacturing output contracted by 1.4% month-on-month in January. The PPI contracted by 7.4% year-on-year in February, deepening the contraction of 3.9% the previous month. The Norwegian krone depreciated by 8.2% against the US dollar this week. As expected, the currency was hit hard by tumbling oil prices. The government is set to present emergency measures which will target bankruptcies and layoffs in sectors hit hard by Covid-19, such as airlines, hotels, and parts of the manufacturing industry. There may also be scope for the government to directly stimulate demand in the oil industry. Report Links: Building A Protector Currency Portfolio - February 7, 2020 On Oil, Growth And The Dollar - January 10, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2   There were scant data out of Switzerland this week: The current account surplus shrank to SEK 39 billion from SEK 65 billion in Q4 2019. The Swedish krona depreciated by 3% against the US dollar this week. The Swedish government announced a SEK 3 billion supplementary budget bill to combat the shock from Covid-19, in addition to preexisting tax credits and an extra SEK 5 billion promised to local authorities in the upcoming spring mini-budget. Riksbank Governor Ingves emphasized the need to maintain liquidity via more generous terms for loans to banks or direct purchases of securities. A rate cut, however, does not seem to be on the table. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019 Balance Of Payments Across The G10 - February 15, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

The SPX collapsed on Monday in a mini-crash, reminiscent of the 20% October 1987 Black Monday crash. True, in 1987 the stock market fell 20% in a single day, but it is equally painful when the S&P 500 drops roughly 20% in 13 trading days, erasing 52 weeks of gains. While the equity market is extremely oversold and a short-term bounce is likely, we doubt a V-shaped SPX recovery looms similar to what prevailed following the 20% peak-to-trough December 2018 drawdown. Instead, 1987 (see chart), 2011, 2015/16 and early-2018 are the closest parallels we could think of, when the market had to digest those tremors over a three-to-six month troughing period. We deem the current equity market bottoming process will play out over the next two quarters leaving investors plenty of time to commence deploying long-term capital. Bottom Line: Stay patient before putting cash to work on a 9-12 month horizon, and for additional analysis please look forward to reading our upcoming Monday weekly report.  ​​​​​​​

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

  Highlights China should fare a global recession better than most G20 economies, given its large domestic market and powerful policy response. China is likely to frontload a large portion of its multi-year infrastructure investment projects to this year. We project a near 10% increase in infrastructure investments in 2020. While at the moment we do not have high conviction in the absolute trend in Chinese stock prices, we think Chinese equities will still passively outperform global benchmarks in a global recession. Feature Chart 1A Black Monday Triggered By A "Perfect Storm" Investors are now pricing in a global recession, triggered by a worsening COVID-19 epidemic outside of China and a full-blown price war in the oil market. Global stocks tumbled by 7% on Monday March 9 while the US 10-year Treasury yield dropped to a record low (Chart 1).  This extreme volatility reflects investors’ inability to predict how the epidemic will evolve or how long the oil price war will persist. If growth in the US and other major economies turns negative, then China’s disrupted supply side in Q1 will be met with weaker global demand in Q2 and even Q3. While our visibility is limited on the predominantly medically- or politically-oriented crisis, what we have conviction in forecasting at this point is that the Chinese economy will weather the storm better than most G20 economies. China’s policy response and the recovery in domestic demand will more than offset weaknesses from external demand. Thus Chinese stocks will likely outperform global benchmarks in the next 3 months and over a 6-12 month span, even though the absolute trend in both Chinese and global stock prices remains unclear over both these time horizons. A One-Two Punch In a recessionary scenario affecting the entire global economy, China would receive a one-two punch through shocks to both supply and demand tied to the COVID-19 outbreak and shrinking global demand. However, while a global recession would impact China’s export growth, it would not have the kind of bearing on China’s aggregate economy as it did in either 2008/2009 or 2015/2016. The reason is that the Chinese economy is less reliant on exports than it was in 2015 and considerably less than in 2008 (Chart 2). Domestic demand is now dominant, accounting for more than 80% of China’s economy, meaning that the country is less vulnerable to reductions in global demand. Chart 2The Chinese Economy Is Much Less Reliant On Exports Chart 3Global Economy Showing Reflation Signs Before COVID-19 Our current assessment is that the shocks from the virus epidemic and oil price rout on global demand will be brief.Global manufacturing and trade were on a path to recovery prior to the crisis (Chart 3). China’s external and domestic demand rebounded sharply in December and likely have improved even further until late January when the COVID-19 outbreak took hold in China (Chart 4). Even though China’s trade figures in the first two months of 2020 were distorted by COVID-19 (Chart 5),1 a budding recovery in both China’s domestic and global demand before the outbreak suggests the epidemic should disrupt rather than completely derail the global economy. Moreover, a rebound in trade following the crisis will likely be powerful, as the short-term disruption in business activities will lead to a sizable buildup in manufacturing orders. A rebound in trade following the crisis will likely be powerful. Chart 4Chinese Exports Likely To Have Improved Further Until COVID-19 Hit Chart 5Chinese Demand Likely To Pick Up Sharply In Q2   Bottom Line: China’s export growth will moderate if the virus outbreak prolongs and substantively weakens the global economy. However, the demand shock should have a relatively minor impact on China’s aggregate economy and the subsequent recovery should be robust. Infrastructure Investment Comes To Rescue, Again Chart 6Substantial Acceleration In Infrastructure Investment Likely In 2020 Infrastructure investment in China will likely ramp up significantly in 2020, which will mitigate the influence on the domestic economy from both COVID-19 and slowing global growth. The message from the March 4th Politburo Standing Committee2 chaired by President Xi Jinping further supports our view, that Chinese policymakers are committed to a major increase in infrastructure investment in 2020. Our baseline projection suggests a near 10% increase in infrastructure investment growth in 2020 (Chart 6). Local governments’ infrastructure investment plans for the next several years amount to about 34 trillion yuan.3 While local government budget and bond issuance will be approved at the annual National People’s Congress, which is delayed due to the epidemic, we have high conviction that a significant portion of the planned spending will be frontloaded this year. A significant portion of the multi-year infrastructure projects will likely be moved up to this year. In the first two months, local governments have frontloaded 1.2 trillion yuan worth of bonds, including nearly 1 trillion yuan of special-purpose bonds (SPBs). The consensus forecasts a total of 3-3.5 trillion yuan of SPBs to be issued in 2020, a 30% jump from 2019. Given tightened restrictions on the use of SPBs, we expect that 50% of the bonds will be invested in infrastructure projects, up from about 25% from 2019. This should contribute to about 10-15% of infrastructure spending in 2020. We are likely to also see significant additional funding channels to support infrastructure spending this year: Debt-swap program: With the aggressive easing by the PBoC in recent weeks, there is a high probability that another round of debt-swap program will materialize this year – a form of fiscal stimulus similar to the debt-to-bond swap program that the Chinese government initiated during the 2015-2016 cycle (Chart 7).  As we pointed out in our report dated July 24, 2019, the Chinese authorities were formulating another round of local government off-balance-sheet debt swaps, which we estimated would be about 3-4 trillion.4 What was absent back then was a concerted effort from the PBoC to equip commercial banks with the required liquidity and further lower policy rate (Chart 8). Both monetary and policy conditions are now ripe for such a program to be rolled out. Chart 7Money Supply Likely To Pick Up Strongly At The Onset Of Substantial Stimulus Chart 8Monetary Conditions Are Ripe For Major Money Base Expansion   Construction bond issuance: Borrowing through local government financing vehicles (LGFV) has climbed since the second half of last year. This follows two years of tightened regulations on local government borrowing. Net issuance of urban construction investment bonds (UCIB) reached 1.2 trillion in 2019, nearly doubling the amount from a year earlier. A total of 457 billion yuan in UCB has already been issued in the first two months of 2020, which indicates that the authorities are further relaxing LGFV borrowing.  We think that net UCIB issuance could reach 1.5 trillion this year, a 25% increase compared with last year. Chart 9More Room To Widen Government Budget Deficit Government budget:  Funding from the central and local governments budgets accounts for about 15% of overall infrastructure financing. We think that the government budget deficit will likely expand by about 2% of GDP in 2020. As Chart 9 shows, this figure is a conservative estimate compared with the 3%+ widening in the budget deficit during the 2008 and 2015 easing cycles. Bottom Line: Fiscal efforts to support the economy will significantly escalate this year. Monetary conditions and policy directions have already paved the way for a 2015-2016 style credit expansion. We expect infrastructure investment to rise to about 10% in 2020 compared with 2019. Will The RMB Join The Devaluation Club? The RMB appreciated by more than 1% against the USD in the past week, fanned by the expectation that China will have a faster recovery than other countries. The latest round of interest rate cuts by central banks around the world also pushed yield-seeking investors to RMB assets (Chart 10). Still, it is highly unlikely that the PBoC will allow the RMB to continue to appreciate at this rate. When other economies are in a competitive currency devaluation cycle, a strong RMB will generate deflationary headwinds for China’s economy and will partially offset the PBoC’s easing efforts (Chart 11). Chart 10Too Much Too Fast? Chart 11A Strong RMB Will Choke Off PBoC's Easing Efforts If the upward pressure in the RMB persists, then Chinese policymakers will be more inclined to expand the money base. Chart 12PBoC Likely To Rapidly Expand Its Balance Sheet Again We do not expect the PBoC to follow the US Federal Reserve and chase its policy rate even lower.  However, if the upward pressure in the RMB persists, then Chinese policymakers will be more inclined to expand the money base. This further raises the probability that local government debt-swap programs will develop this year (Chart 12). The government may allow financial institutions to extend or swap maturing local government off-balance sheet debt with bank loans that carry lower interest rates and longer maturities. Or, it will simply move the debt to the PBoC’s balance sheet. Bottom Line: If upward pressure in the RMB endures, the PBoC will likely expand its balance sheet and make more room to buy local government debt, but it is unlikely to aggressively cut interest rates. Investment Conclusions Chart 13Chinese Stocks Will Likely Continue To Outperform, Even In A Global Recession Our recent change in view5 concerning the willingness of Chinese authorities to “stimulate the economy at all costs” meant that Chinese stocks were likely to outperform the global benchmarks in a rising equity market.  In a global recessionary, which is now a fait accompli, Chinese leadership’s willingness to stimulate the economy will only intensify. China’s large domestic economy also makes the country less vulnerable to a global demand shock. At this point in time we do not have high conviction in the absolute trend in either Chinese or global stock prices, as their near-term performance is predominantly driven by a medically- and politically-oriented crisis. However, as we expect the Chinese economy to outperform in a global recession, our overweight call on Chinese equities remains intact on both a 3-month and 12-month horizon, in relative terms (Chart 13).   Jing Sima China Strategist jings@bcaresearch.com   Footnotes 1    China had postponed January’s data release and instead, has combined the first two months of the year. 2   “We should select investment projects; strengthen policy support for land use, energy use, and capital; and accelerate the construction of major projects and infrastructure that have been clearly identified in the national plan.” http://cpc.people.com.cn/n1/2020/0305/c64094-31617516.html?mc_cid=2a979… 3   https://m.21jingji.com/article/20200306/504edc15217322ab37337da2ca35a49e.html?[id]=20200306/nw.D44010021sjjjbd_20200306_9-01.json  4   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 5   Please see China Investment Strategy Weekly Report "China: Back To Its Old Economic Playbook?," dated February 26, 2020, available at cis.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations

There is a lot of uncertainty that reverberates through the equity markets and the dust has yet to settle down from Monday’s big crack. Small caps (similar to weak balance sheet stocks, middle panel) have cratered for three reasons: First, they are massively indebted as the bottom panel of the chart shows not only in absolute terms, but also compared with their large cap brethren. Second, small caps have been mired in earnings deflation for a while and the looming recession now aggravates the fall in these high beta stocks. Finally, small caps have a large weighting in financials in general and small regional banks in particular. As such, the recent double whammy of the oil price collapse and bond yield plunge has wreaked havoc in small cap indexes. We have been cyclically avoiding small caps and instead preferring large caps since mid-2018 and late-last year we also added this size preference to our high-conviction call list as a modest hedge to most other high-conviction calls that were levered to higher interest rates. Today, from a portfolio risk management perspective, we are instituting a trailing stop at the 10% return mark in order to protect gains. Bottom Line: Stick with the large cap bias for a while longer.