Equities

Highlights An analysis on Turkey is available on page 10. In the short term, EM share prices will likely continue searching for a direction as visibility is extremely low. Beyond the near term, an appropriate strategy for EM equity investors is buying breakouts and selling breakdowns. The forthcoming stimulus from China is not a surefire guarantee of an immediate cyclical recovery. Low and falling willingness to spend among Chinese consumers and enterprises could overwhelm the positive boost from the stimulus. Forecasting changes in willingness to spend is not straightforward. Elsewhere, we are recommending a new trade: Short Turkish banks / long Russian banks. Feature Chart I-1EM Vs DM Equities: The Path Of Least Resistance Is Down EM risk assets and currencies as well as China-related financial markets are facing higher than usual uncertainty. Not only are the magnitude and duration of the coronavirus shock to the mainland’s economy unknown, but also both the scale of China’s forthcoming stimulus and its multiplier are highly uncertain. How should investors navigate through such uncertainty? For EM equity investors, an appropriate strategy is buying breakouts and selling breakdowns. Presently, we maintain a neutral stance on the absolute performance of EM stocks. We initiated a long position on December 19 and closed it on January 30 to manage risks amid the coronavirus outbreak. For asset allocators, we continue to recommend underweighting EM within global equity and credit portfolios (Chart I-1). As to exchange rates, investors should stay short a basket of EM currencies versus the US dollar. The EM equity index and EM currencies have been in a trading range in the past 12 months (Chart I-2). In the short term, markets will likely continue searching for a direction as visibility is extremely low. Beyond the near term, however, EM share prices and currencies are unlikely to remain in a narrow trading range. They will either break out or break down. Which way the market swings is contingent on corporate profits and the business cycle. A Framework To Assess Shocks What framework should investors use to gauge economic and financial market outcomes? We recommend the following: When a system – in this case the Chinese economy – is hit by an external shock, its most likely trajectory depends on the duration and magnitude of the shock as well as the initial health of the system. If the system is balanced and robust, a moderate shock can certainly shake it, but will not knock it over. A V-shaped recovery is most likely in this case. By contrast, if the system is unbalanced and precarious, a measured tremor could produce an outsized negative impact. As a result, this economy is more likely to experience a U-shaped recovery. No one can gauge with any precision the impact of the coronavirus outbreak on China’s economy. The only thing we can assess is the health of the mainland economy prior to this exogenous shock. Beyond the near term, EM share prices and currencies are unlikely to remain in a narrow trading range. Which way the market swings is contingent on corporate profits and the business cycle. In this regard, we present the following analysis on both the economy’s cyclical condition and structural vitality: 1. Cyclically, China’s growth was ostensibly bottoming when the coronavirus outbreak occurred. The top panel of Chart I-3 illustrates that – at that time – the Chinese broad money impulse foreshadowed a revival in nominal industrial output from late 2019 until mid-2020. In the second half of this year, however, the same indicator projected renewed growth deterioration. Chart I-2EM Stocks And Currencies Are In A Trading Range: How Long Will It Last? Chart I-3Without The Coronavirus Outbreak, Chinese Recovery Would Have Been Muted And Short-Lived   Notably, the broad money impulse has often led the credit and fiscal spending impulse, and it currently signals a rollover in the latter sometime in the first half of 2020 (Chart I-3, bottom panel). Chart I-4EM Corporate Profits: Modest And Temporary Improvement Consistently, China’s narrow money growth had been projecting a muted and only temporary rebound in EM corporate profits – which are often driven by the Middle Kingdom’s business cycle – from late 2019 until the middle of 2020 (Chart I-4). Thereafter, EM profit growth was set to relapse anew. In short, even prior to the coronavirus outbreak, our indicators were signaling that any economic improvement on the back of the Chinese government’s 2018-19 stimulus would have been muted and short-lived from late 2019 until mid-2020. Hence, the negative shock from the public health emergency could end up nullifying the pending recovery. 2. Structurally, as we have written extensively, China has enormous credit and money excesses. The economy has become addicted to rampant money and credit creation. This, along with the misallocation of capital and the resulting growth in the number of zombie companies, makes the system vulnerable, even to moderate shocks. It is reasonable to assume that there are some companies that enjoy great financial health, some zombies that are unable to service their debt at all, and a certain number of enterprises that generate just enough cash flow to service their debt. While the coronavirus-induced downtrend in the economy will not materially change the financial status of healthy or zombie businesses, it will likely alter the financial standings of debtors that were on the proverbial edge. Assuming the unavoidable drop in cash flows due to the country’s sudden shutdowns, these debtors will struggle to service their debt. This will likely alter their short-to-midterm decision making. For example, if they were planning to expand their operations and hire more employees, these plans are likely to be shelved for now. Low and falling willingness among households to consume and among enterprises to invest and hire could overwhelm the positive boost from the stimulus. In short, the coronavirus-induced shutdowns are cutting into cash flows, but they do not in any way reduce debt burdens. Chart I-5 illustrates that debt servicing costs as a share of income for companies and households in China are among the highest in the world. Chart I-5China Has A High Debt Service-To-Income Ratio Notably, this measure for China is relative to nominal GDP while for other countries it is relative to disposable income. Disposable income is smaller than GDP as it takes into account taxes paid. Therefore, on a comparable basis, this ratio for China will be meaningfully higher than the one shown on Chart I-5. Bottom Line: Provided the Chinese economy is highly leveraged, it is reasonable to conjecture that the recovery following the adverse shock from the coronavirus will be U- rather than V-shaped. Stimulus: Yes. Multiplier: Unknown. It is a given that the Chinese authorities will inject more fiscal and monetary stimulus into the system. Nevertheless, the ultimate size of stimulus is unknown. So far, the following has been announced: On the monetary and credit side: A RMB300 billion re-lending quota to supply special low-cost funds to assist national commercial banks and local banks to provide preferential interest rate loans to key enterprises for epidemic prevention and control; On February 3, open market operation rates were cut by 10 basis points, and the key 7-day repo rate fell by 45 basis points; The People’s Bank of China injected liquidity1 via open market operations; The People’s Bank of China encouraged banks to lower lending costs for small and medium enterprises by 10% in some provinces. Critically, the banking regulatory authority has indicated it will allow an extension of the transition period for the implementation of the New Asset Management Regulation beyond 2020. Chart I-6Marginal Propensity To Spend Varies From Cycle To Cycle On the fiscal side: Additional local government debt quotas of RMB848 billion have been approved, on top of the previously authorized quota of RMB1 trillion in November 2019; the front-loaded debt quota will offer local governments more flexibility with their budgets and support growth via public investment; Cumulatively about RMB66 billion in supplementary funds has been deployed to support local governments and businesses, according to the Ministry of Finance; The authorities have delayed or partially waived taxes, social security fees, and government-owned rents for affected businesses; The government has instituted refunds of unemployment insurance premiums to enterprises who retain most employees in some cities; The central government will provide temporary interest rate relief (equivalent to 50% of the re-lending policy rate) on loans to key enterprises involved in the fight against the epidemic. However, stimulus in and of itself is not a sufficient condition on which to bet on a V-shaped recovery. Stimulus (or in the opposite scenario, tightening) does not always immediately entail an economic recovery (or on the flip side, a downturn). For one, policy stimuli always work with a time lag. In addition, the size of stimulus is still unknown. What’s more, the multiplier of the stimulus varies from cycle to cycle. Chart I-7Chinese Households Are Indebted We gauge the magnitude of any stimulus in China by observing money, credit and fiscal spending impulses. The multiplier is in turn contingent on economic agents’ (households and enterprises) propensity to spend. The impact of a large amount of stimulus can be offset by a low/falling marginal willingness to spend (a lower multiplier). Before the coronavirus outbreak, the marginal propensity to spend in China had improved slightly for households and had barely stabilized in the case of companies (Chart I-6). It is plausible to assume that a negative shock to confidence will likely dent both households’ and companies’ marginal propensity to consume. This is especially true since both economic agents are highly leveraged, as discussed above (Chart I-7). Finally, the leads and lags between the measures of stimulus like money impulses or credit and fiscal spending impulses and EM stocks in general and Chinese share prices in particular are not constant, as illustrated in Chart I-8 and Chart I-9. Chart I-8China: Share Prices And Money Impulse Chart I-9EM Stock Prices And China Credit And Fiscal Impulse   Bottom Line: Forthcoming stimulus is not a surefire guarantee of an immediate cyclical rally – neither for EM risk assets and currencies, nor for other China-related plays. This does not mean that a rally will not occur. Rather, gauging the timing and potential drawdown that precede it are almost impossible. The basis is that low and falling willingness among households to consume and among enterprises to invest and hire could overwhelm the positive boost from the stimulus. Unfortunately, forecasting changes in willingness to spend is not straightforward. Investment Strategy Chart I-10An Inconclusive Message From This Reliable Indicator We are currently neutral on EM stocks in absolute terms. We will be watching for market-based indicators to signal a breakout or breakdown and will adjust our strategy accordingly. One of our favorite indicators – the Risk-On /Safe-Haven currency ratio – is presently inconclusive (Chart I-10). Relative to DM, EM share prices broke to new lows last week as illustrated in Chart I-1 on page 1. We continue recommending an underweight position in EM within a global equity portfolio. Consistently, we are reiterating our long-standing short EM / long S&P 500 strategy. The US dollar’s technical profile is bullish (Chart I-11), which entails that its bull market is not yet over. We continue shorting an equally-weighted basket of BRL, CLP, COP, ZAR, KRW, IDR and PHP against the US dollar. We are also short the CNY versus the greenback on a structural basis. Within the EM currency space, we favor the MXN, RUB, CZK, THB and TWD. Finally, EM exchange rates hold the key to the performance of both EM local currency and US dollar bonds. Given our negative view on the currency, we are reluctant to chase the decline in domestic bond yields and narrowing spreads in the sovereign credit space (Chart I-12). Chart I-11The US Dollar Rally Is Intact Chart I-12EM: Local Bond Yields And Sovereign Spreads Are Too Low   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Turkey: Doubling Down On Unsound Policies Despite the steep drop in oil prices, Turkish stocks have failed to outperform the EM equity benchmark (Chart II-1). When a market fails to outperform amid a historically bullish backdrop, it is often a sign of trouble ahead. The basis for the decoupling between Turkey’s relative performance and oil prices is President Erdogan’s doubling down on populist and unorthodox macro policies. He is eager to boost growth at any cost. As a litmus test of aggressive expansionist policies, local currency broad money growth has already surged to 24% (Chart II-2). In brief, these overly expansionary policies will undermine the currency, lift inflation and lead to a further exodus of investors from the country’s financial markets. Chart II-1A Bearish Sign For Turkish Equities Chart II-2Turkey: Rampant Money Creation   Chart II-3Turkey: Booming Fiscal Spending First, the central bank has cut interest rates to below inflation. The outcome is negative policy rates in real terms. Moreover, the central bank has resumed plentiful liquidity provisioning to banks to prevent interbank rates from rising. Second, government expenditures are surging (Chart II-3). Ballooning government borrowing is largely being financed by commercial banks – i.e., the latter are involved in outright monetization of public debt (Chart II-4, top panel). Chart II-4Public Debt Monetization By Commercial Banks In the past two years, banks have purchased some TRY 250 billion of government bonds. This has boosted their share of holdings of government local currency bonds from 45% to 58% (Chart II-4, bottom panel). This has not only capped local bond yields, but also enormously expanded money supply. When a commercial bank purchases a bond from a non-bank entity, it creates a new deposit (broad money supply), as we discussed in November 29, 2018 report. The authorities have also announced tax cuts on various consumer goods in order to boost consumption. This is leading to a resurgence in consumer goods imports. In short, the trade balance is bound to widen again as domestic consumption resumes. Third, the government is forcing both state-owned and private banks to substantially boost credit flows to the economy. Last week, the AKP proposed a new banking bill that could force banks to fund large-scale projects. Further, the banking regulator is penalizing banks that fail to meet a “credit volume criteria’ by lowering the interest rate banks receive on their required reserves at the central bank. Crucially, the authorities are forcing banks to cut lending rates. Banks’ net interest rate margins have declined to all-time lows (Chart II-5). It will narrow further as they continue to cut lending rates, while holding deposit rates high to avoid flight from local currency deposits into US dollars. Banks, especially public ones, have dramatically accelerated their credit origination. This will lead to capital misallocation and potentially to non-performing loans (NPLs). On banks’ balance sheets, NPLs have been, and will remain, artificially suppressed. Neither banks nor regulators are incentivized to provision for potential loan losses.  Insolvent banks can operate indefinitely so long as their shareholders and regulators allow it, and the central bank provides sufficient liquidity. This will most certainly be the case in Turkey in the years to come. Constraints in such a scenario are surging inflation and currency devaluation. Turkish authorities have whole-heartedly opted for these lax fiscal, monetary and bank regulatory policies. This entails that inflation and currency devaluation are unavoidable. Overly expansionary policies will undermine the currency, lift inflation and lead to a further exodus of foreign investors from the country’s financial markets. Lastly, surging wages and unit labor costs corroborate that inflationary pressures are genuine and rampant (Chart II-6). The minimum wage is set to increase by another 15% this year. Chart II-5Banks' Net Interest Margins At All Time Lows Chart II-6Turkey: Wages Are Surging   The government has been trying to regulate prices in the consumer sector by putting administrative price caps in place. Yet inflation remains persistently high in both goods and services sectors. Investment Recommendation Chart II-7Excessive Stimulus Is Bearish For The Lira The Turkish lira is again on a precipice. Only government intervention can temporarily prevent a major down leg. We are reiterating our underweight call on Turkish stocks within an EM equity portfolio. As a new trade, we are recommending a short Turkish banks / long Russian banks position. In contrast to Turkey, Russia’s macro policies have been, and remain, extremely orthodox. The new Russian government is poised to boost fiscal stimulus and the economy will accelerate with low inflation. We will discuss Russia in next week’s report. Finally, a surging fiscal and credit impulse in Turkey often leads to higher inflation and downward pressure on the currency (Chart II-7). As such, local currency government yields offer little protection at these levels against a depreciating currency. Therefore, investors should underweight the Turkish currency, local fixed-income and sovereign credit relative to their respective EM benchmarks. Andrija Vesic Research Analyst andrijav@bcaresearch.com   Footnotes 1     We published A Primer On Liquidity on January 16, 2020 illustrating that the linkages from liquidity provisions by central banks and both increased spending in the real economy and higher asset prices are ambiguous. Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights Chinese stocks made a comeback as soon as the speed of COVID-19 transmitting outside of the epicenter somewhat moderated. Inside the epicenter, the pandemic has not shown clear signs of easing, and could significantly prolong the region’s lockdown. Despite being a large manufacturing hub, Hubei-based companies represent relatively limited significance in China’s equity market. A protracted regional lockdown in Hubei may disrupt company-specific supply chains, but so far there is little evidence suggesting such disruptions will spill over to China’s broad equity market. Feature The stringent containment measures taken by China in its battle against the COVID-191  epidemic are indeed having economic consequences, both domestically and globally. However, the full extent of the repercussions remains to be seen. In the financial market, Chinese stocks regained significant ground following a sharp selloff when the financial markets reopened after an extended Chinese New Year holiday (Chart 1). The number of confirmed COVID-19 cases continues to rise. On the other hand, the number of new cases outside of Hubei province appears to have peaked on February 3rd and the official number within the province has plateaued (Chart 2). Chart 1Chinese Equities Rebounded Despite The Ongoing Epidemic Chart 2Has The Peak Arrived? Not Within The Epicenter The latest official data reinforces our view that the epidemic outside of Hubei is considerably less severe than within Hubei. While it is still too early to confirm that the number of new cases elsewhere in China has peaked, the epidemic in Hubei - particularly in Wuhan - is far from contained despite what the official data suggests. The near-collapsing municipal system in the epicenter leaves a large margin for error in recording and confirming the number of cases. The region’s strained medical resources also mean that the number of both new infections and fatalities may not reach a sustained peak in the weeks to come. Most cities in China’s 31 provinces and municipalities had partially resumed business activities by February 10, but we think that Hubei and especially Wuhan will likely remain in lockdown through the end of March, a month longer than scheduled by the provincial government. Will an extended lockdown of the Hubei province prevent a budding recovery in China’s economy from manifesting itself? In our view, the answer is no. And even in the case of a prolonged region-wide lockdown, our assessment is that the spillover effects from supply-chain disruptions in Hubei on the domestic equity market are unlikely to be significant. Quantifying The Potential Impact Of An Extended Lockdown In Hubei Hubei accounted for only 4.6% of China’s aggregate economy in 2019. If the majority of businesses in Hubei remain closed until March 20 and we assume no growth in the province in Q1 on an annual basis,2 it will shave 0.3 percentage points from China's total nominal growth in the quarter. Furthermore, if the manufacturing sector restarts production in Q2, but most activities in the service sector such as retail, hotel, transportation and real estate remain depressed, then China’s tertiary sector output growth in that quarter will be reduced by 0.4 percentage points. This will only reduce the country’s overall economic growth in Q2 by 0.2 percentage points. Hubei’s protracted but isolated lockdown will also have a minor impact on China’s overall financial market. Within the MSCI China Onshore Index, there are 16 Hubei-based companies representing only 1.2% of total market capitalization. In the offshore market, there are 14 listed companies registered in Hubei and their market value accounts for a mere 0.3% of the offshore MSCI China Index.3  Chart 3Chinese Equity Performance Rationally Reflects Economic Fundamentals So Far Given the small market capitalization of these Hubei-based companies, China’s index performance simply will not be affected on a fundamental basis by a longer shutdown of the province (Chart 3).   Bottom Line: We expect a more protracted shutdown of business in Hubei than is currently scheduled, which has the potential to weigh negatively on investor sentiment. But from a fundamental perspective, this will not derail the economic and stock market recoveries underway in China. Confirming Signals From The Equity Market Chart 4 shows that the relative performance of cyclicals versus defensives is improving in both China’s onshore and offshore markets, which suggests investors share our view that outbreak will subside to a Hubei-specific phenomenon, and that a longer-than-expected shutdown of the province is unlikely to threaten China's overall economic recovery. Chart 4Risk-On Sentiment Ticking Up Chart 5Auto And Tech Manufacturers Having Large Presence In Wuhan ​​​​​​​ Importantly, supply chain disruptions due to a shutdown of Hubei’s production plants have not had significant spillover effects on industry performance in China’s equity markets.  Hubei, and more specifically Wuhan-based manufacturers, is a manufacturing hub and key supplier in the automobile and electronic equipment industries (Chart 5). Despite the region’s significant manufacturing presence, Hubei-based manufacturers have relatively limited impact on the equity performance of their industry groups, both onshore and offshore: The stocks of Hubei-based automobile and tech companies have mostly been underperforming relative to their respective industries and the broad Chinese market. Nevertheless, these industries and their overall sectors have managed to outperform relative to the broad market, which indicates that the supply chain constraints have not spilled over to Chinese companies outside of Hubei.  For example, Dongfeng Motor Co., a leading state-owned auto manufacturer located in Hubei, is a key supplier for Nissan and Honda. Dongfeng represents 6% of the automobile and components industry in the MSCI China Index. Chart 6 shows that while Dongfeng has been underperforming the industry and the broad market since the onset of the COVID-19 epidemic, performance in the auto industry relative to the broad market picked up last week when the number of new cases in the epidemic peaked. This suggests that supply-chain constraints are limited to Dongfeng and Hubei, and the downside risks in the automobile and components industry elsewhere in China are abating. Hubei-based tech companies account for 5% of the technology, hardware, and equipment industry group in China’s onshore equity market. Due to production cuts and transportation constraints, four of the five companies listed in the MSCI China onshore index have significantly underperformed both the industry and the broad market since the start of the COVID-19 epidemic (Chart 7).  The only Hubei-based constituent in the sector that has had large gains is a company that produces thermal imaging systems, an equipment widely used in monitoring contagious diseases. But the company’s 1% weight in the industry equity group means the industry’s outperformance is mostly from gains in companies outside of Hubei.  This suggests that despite disruptions inside Hubei, China’s domestic supply chains in the tech industry are relatively agile with manufacturers outside of Hubei stepping in to fill production shortages. Chart 6Supply Disruptions In Hubei's Auto Sector Not Affecting China's Overall Auto Industry Performance Chart 7Flexible Supply Chains In China Domestic Tech Industry Help Offset Production Shortages In Hubei   Bottom Line: While it is too early to conclusively say that the risk of further contagion outside of Hubei has abated, we think the positive equity market performance over the past week is warranted.  The negative impact of supply-chain disruptions in Hubei on China’s domestic overall equity market and industry performance has been minor. Hence, in the case of a prolonged region-wide lockdown, we think the broad financial market implications will not be significant. Investment Conclusions Chart 8Chinese Stocks Are Still Priced At A Deep Discount We maintain our bullish view on Chinese stocks, both in the near term and in the next 6-12 months. Despite regaining considerable ground in the past week, onshore and offshore equities are still priced at deep discounts (Chart 8). Cities and regions outside of the Hubei epicenter have partially resumed business activities this week. This, coupled with a reduction in the number of new cases, should further boost investors’ confidence in the recovery of China’s economy and risk assets. The reopening of businesses in Hubei could be delayed as late as the end of March. While this will have a devastating impact on the region’s economy and corporate profits, the spillover effects will most likely be contained within the region and not derail China’s economy. In addition, for now the resilience at both China’s industry and broad level equity performance appears to be outweighing the risk of a longer-than-announced shutdown.   Jing Sima China Strategist jings@bcaresearch.com   Footnotes 1    Previously labeled as coronavirus or 2019-nCoV, the disease was officially named COVID-19 by the World Health Organization (WHO) on February 11, 2020. 2   We consider this an overestimate of the economic damage caused by the COVID-19 epidemic. Even though manufacturing activities can potentially grind to a halt, healthcare-related investment and consumption will likely skyrocket. 3   As of February 10, 2020, according to the MSCI. Cyclical Investment Stance Equity Sector Recommendations

What matters for stocks, aside from interest rates, is EPS growth. On that front, the Street continues to expect 10% profit growth for calendar 2020 which is a tall order according to our “Three EPS Scenarios” analysis in mid-January, warning that the SPX is still 8% overvalued as per our base case EPS and multiple scenario. The tech sector sits atop the contribution to earnings growth table and leads its peers by a wide margin. Health care and financials occupy the second and third spots. While these rankings are more or less in line with the sector profit and market cap weights, what stands out is the delta between the market cap and earnings weights (see Table). According to this valuation proxy, tech, consumer discretionary and real estate sectors are the most expensive, while financials, health care, and energy are the cheapest. Bottom Line: We remain underweight real estate and consumer discretionary, neutral on tech and overweight all three most undervalued sectors: financials, health care and energy. For more details, please refer to this Monday’s Weekly Report.

Highlights Portfolio Strategy Receding interest in the coronavirus epidemic, rising demand prospects, a looming profit turnaround and compelling valuations, all signal that it no longer pays to be bearish the S&P hotels index. Lift exposure to neutral. An historical parallel with chemicals industry regulation suggests that the path of least resistance is lower for the S&P interactive media & services industry. Recent Changes Lock in gains of 20% and augment the S&P hotels index to neutral. Table 1 Feature Equities ripped higher last week as the coronavirus scare subsided, the Senate acquitted President Trump and the PBoC and the Fed sustained the liquidity injections. From a macro perspective, bond yields have served as a suspension for the SPX, absorbing the economic shock and catapulting the broad equity market to fresh all-time highs. The usual suspects, tech stocks, led the charge as lower interest rates equate to higher multiples. Keep in mind that the SPX is trading near an eighteen-year high on a forward P/E ratio basis (Chart 1). Such investor complacency is worrisome, especially given the persistently soft economic backdrop. Importantly, the latest GDP release revealed that net exports had the largest contribution to real output growth – trumping even PCE – on the back of a collapse in imports (second & third panels, Chart 2). Chart 1Flush Liquidity Chart 2Net Exports Jump Is A Yellow Flag In fact, the quarter-over-quarter plunge in real imports is the steepest since the GFC, and on a par with both the 9/11 induced recession in the early-2000s and the Savings & Loan recession in the early-1990s (top panel, Chart 3). Historically, when imports crest they are a precursor of recession (bottom panel, Chart 3). While this may be a one quarter blip in the data as a result of the trade war, we will continue to closely monitor the US trade balance. Meanwhile, consumer outlays are also decelerating, corroborating last quarter’s real imports collapse (bottom panel, Chart 2). If this pillar of economic strength gives way in the coming quarters, it will stoke up recession fears anew and vindicate the bond market’s message. Ultimately, what matters for stocks, aside from interest rates, is EPS growth. On that front, the Street continues to expect 10% profit growth for calendar 2020 which is a tall order according to our analysis in mid-January, warning that the SPX is still 8% overvalued as per our base case EPS and multiple scenario.1 Chart 3Imports Flashing Red Chart 4Sector Contribution To 2020 SPX EPS GrowthChart 4 shows the sector contribution to profit growth for this year. The tech sector sits atop the table and leads its peers by a wide margin (Table 2). Health care and financials occupy the second and third spots. While these rankings are more or less in line with the sector profit and market cap weights, what stands out is the delta between the market cap and earnings weights (Table 2). Table 2Sector EPS And Market Cap Weights According to this valuation proxy, real estate, tech and consumer discretionary sectors are the most expensive, while energy, health care and financials are the cheapest (Table 2). As a reminder we remain neutral tech, and underweight both real estate and consumer discretionary, and overweight all three undervalued sectors: energy, health care and financials. This week we book gains and lift to neutral a niche consumer discretionary sub sector that the coronavirus epidemic has badly bruised, and update our view on the largest communication services sub-group. Crystalize Gains And Upgrade Hotels To Neutral Google trends data shows that peak interest in the coronavirus was registered on January 26 in China, January 30 in the US and one day later globally (Chart 5). These trends may change in the coming weeks, but it appears that the initial fears and interest on the coronavirus are quickly subsiding, highlighting that the worst may likely be behind us with regard to fear mongering. Thus, we are compelled to lift the hard-hit S&P hotels index to neutral and cement gains of 20% since inception. While Chinese, global and US outputs will likely take a hit in Q1, subsequently recover in Q2 in the aftermath of the epidemic and only Q3 will come in as a clean quarter, the beating down of this niche consumer discretionary sub-group is overdone. Macro headwinds are turning into mild tailwinds. Last week the ISM non-manufacturing report rebounded smartly, and consumer confidence remains resilient. The implication is that it no longer pays to be bearish the S&P hotels index (top & middle panels, Chart 6). Tack on our vibrant industry demand indicator underscoring that the two-year bear market will likely go on hiatus (bottom panel, Chart 6). Chart 5Risks Receding Chart 6Upbeat Demand A number of other indicators we track send a similar message. Relative retail sales are rebounding with discretionary sales reclaiming the upper hand (top panel, Chart 7). While overall PCE is decelerating (bottom panel, Chart 2), relative consumer outlays on hotels is picking up momentum signaling that the bar for positive relative profit surprises is low (middle panel, Chart 7). Importantly, almost all of the negative coronavirus news flow is likely reflected in the roughly 25% forward P/E discount to the broad market that the index is changing hands at. If the coronavirus epidemic is petering out, then such undervaluation is no longer warranted (bottom panel, Chart 7). Importantly, our S&P hotels EPS growth model does an excellent job in encapsulating all these moving parts and is currently signaling that relative profit growth is slated to turn the corner in the coming quarters (Chart 8). Chart 7Grim News Is Priced In Chart 8Model Points To A Turnaround Netting it all out, receding interest in the coronavirus epidemic, rising demand prospects, a looming profit turnaround and compelling valuations, all signal that it no longer pays to be bearish the S&P hotels index. Beyond the risk of a resurgence in the coronavirus epidemic, what prevents us from upgrading all the way to an above benchmark allocation is a challenging profit margin backdrop. Chart 9 highlights that not only are industry CEOs showing no restraint with respect to labor additions, but also lodging inflation is now contracting. Taken together, there are rising odds that the S&P hotels index may suffer from a profit margin squeeze (bottom panel, Chart 9). Netting it all out, receding interest in the coronavirus epidemic, rising demand prospects, a looming profit turnaround and compelling valuations, all signal that it no longer pays to be bearish the S&P hotels index. Bottom Line: Lift the S&P hotels index to neutral and lock in gains of 20% since inception. The ticker symbols for the stocks in this index are: BLBG S5HOTL – MAR, CCL, HLT, RCL, NCLH. Chart 9Margin Squeeze Is A Risk Regulation Is Coming While most mega cap tech stocks had a better-than-expected Q4 earnings season, GOOGL and FB were left behind. We reiterate our underweight stance in the S&P interactive media & services index (we still consider them tech stocks) which serves as a great hedge to our overweight S&P software index. As a reminder we remain underweight this communications services subgroup on a cyclical basis, and since mid-December also on a secular ten-year time horizon.2 Regulation is a powerful force. President Trump is only slightly favored for reelection and there is bipartisan support to toughen anti-trust regulation, which his own Department of Justice has pursued. Republican Senator of Missouri Josh Hawley has spearheaded the assault on tech companies from the right wing, while leading Democratic presidential contenders represent the push from the left wing. Indeed, if the Democrats take power, they are likely to enact a federal privacy law following in the footsteps of California and the European Union. Such a law would face court battles but would ultimately have popular tailwinds: corporate protectionism, wealth inequality, and social demands for privacy across the political spectrum. Looking back to the early- and mid-twentieth century with regard to US government regulation aimed at protecting the consumer is instructive. What catches our attention are the Biologics Control Act, the Pure Food and Drug Act and the Toxic Substances Control Act. The first two acts affected the pharmaceutical and food industries and the third act the chemicals industry. While we do not have sector data dating back to the early 1900s, we have chemicals equity prices since 1958. The Toxic Substances Control Act of 1976 dealt a blow to chemical equity prices in absolute and relative terms (Chart 10). In fact, investments in chemical stocks were dead money for a whole decade until 1985 when they broke out in absolute terms and troughed in relative terms (Chart 10). New regulation will cast a shadow over the S&P interactive media & services index. This is true especially if a privacy law is passed, but even if it is postponed or shot down by the Supreme Court, companies will have to contend with a higher regulatory burden in order to comply with California’s and Europe’s privacy laws. Beyond the threat of privacy regulation protecting the consumer, the monopolistic power these companies exert will also come under the microscope. While we doubt the government will break up these two companies given their industry dominance, and the need to maintain international competitiveness,3 anti-monopoly probes clearly pose a big risk. This is true even under a GOP administration. During times of inequality, especially during recessions, governments will seek popularity by punishing scapegoats. The firms that are the chief beneficiaries of the business cycle will be the first in line for scrutiny. Keep in mind, Ronald Reagan’s Republican administration broke up “Ma Bell” into seven regional “Baby Bells” on January 1, 1984. Interestingly, AT&T also had the largest market capitalization in the S&P 500 in 1982. What concerns us the most is a forced sale of “crown jewel” assets as the result of a court ruling in an anti-monopoly suit. This would jeopardize the companies’ ecosystems. Imagine if Alphabet were forced to divest their Google Marketing Platform (old DoubleClick) and Google Ads, or YouTube or Google Cloud. Facebook could be forced to sell WhatsApp or Instagram. Chart 10Regulation Hurts Stocks Chart 11Risks Are Neither Reflected In Profit Estimates… All of these risks pose a threat to EPS growth and still sky-high industry profit margins. Importantly, relative profit growth is climbing at a 13% rate (middle panel, Chart 11) and coupled with the drubbing in 10-year Treasury yields, have pushed valuations to overshoot territory. As we went to print the S&P interactive media & services index was trading at a 34% forward P/E premium to the broad market (Chart 12). Similarly on a forward P/E/G ratio basis this industry is trading at roughly a 30% premium to the SPX (bottom panel, Chart 12). In sum, an historical regulatory parallel with chemicals industry regulation suggests that the path of least resistance is lower for the S&P interactive media & services industry. Over the past year profit margins have been narrowing as costs have been creeping up for the industry, but are still more than twice the level of SPX margins (second panel, Chart 13). If federal regulation puts a price on consumer data in the coming years, especially through direct legislation, then this added cost will squeeze industry profit margins and dent profitability. Chart 12…Nor In Pricey Valuations Chart 13Margin Compression Looms The chief constraint on US government regulation is the desire to maintain international competitiveness in a world of great power competition, in which US rivals attempt to promote their own tech companies globally. However, neither colonialism nor the Cold War stopped earlier anti-monopoly crusades. Politicians primarily court domestic constituencies with such pursuits. Regulators would have to set the terms of any breakup with various interests in balance, but the point is that even a limited breakup that does not mortally wound the company would still come as a negative shock at first. In sum, an historical regulatory parallel with chemicals industry regulation suggests that the path of least resistance is lower for the S&P interactive media & services industry. Bottom Line: Stay underweight S&P interactive media & services index both on a cyclical and structural ten-year time horizon. The ticker symbols for the stocks in this index are: BLBG S5INMS – GOOGL, GOOG, FB, TWTR.   Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com Matt Gertken Geopolitical Strategist mattg@bcaresearch.com   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 Special Report, “Top US Sector Investment Ideas For the Next Decade” dated December 16, 2019, available at uses.bcaresearch.com. 3     Please see BCA US Equity Strategy Special Report, “Is The Stock Rally Long In The FAANG?” dated August 1, 2018, and Geopolitical Strategy Special Report, “Surviving A Breakup: The Investor's Guide To Monopoly-Busting In America,” dated March 20, 2019, available at uses.bcaresearch.com and gps.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Stay neutral cyclicals over defensives (downgrade alert) Favor value over growth Favor large over small caps (Stop 10%)

Highlights The coronavirus is a real threat for the global economy and financial markets: We expect that the epidemic will be contained before it takes too much of a bite out of global output, but it has become the biggest market wild card. We are watching for a peak in new infections as a tell for when markets may move on from it. Earnings season was once again a ho-hum affair: S&P 500 earnings per share are on track to post 2% growth in 4Q19, about three percentage points above downwardly revised estimates. Profit margin contraction was in line with the previous three quarters. The biggest banks don’t see any immediate signs of credit problems, … : Net charge-off and non-performing loan ratios remain very low and the banks don’t see borrower performance worsening any time soon. … and think an uptick in business confidence is overdue: The banks’ calls occurred before the coronavirus broke out, but every management team saw the easing of trade tensions as a prelude to a pickup in corporate confidence. While We Were Out Chart 1Risk Off, Everywhere But Stocks We last published a Weekly Report on January 6th, and the ensuing five weeks have been anything but boring. The US assassinated Iran’s foremost military leader, escalating the two nations’ conflict; and the coronavirus burst forth in China’s ninth-largest city, sparking worldwide concerns. The VIX awakened, Treasury yields slid, crude oil swooned and the dollar surged, but the S&P 500 only declined 3% trough to peak, and now sits 2-3% above its January 6th close (Chart 1). The coronavirus is a significant threat to the global economy and global markets, and geopolitical tensions have escalated, but the underpinning of our market views has not changed. We continue to view monetary policy as the critical swing factor for financial markets and the macro cycles that influence them. Assuming the coronavirus or another exogenous event does not tip over the US economy, the next recession will not begin until monetary policy settings turn restrictive. Nothing that has happened since the beginning of year has changed our view that the Fed is almost certain not to hike rates before its November meeting, and we think it is unlikely that it will do so at all in 2020. As long as monetary policy remains accommodative, the economy will keep expanding, the equity bull market will roll on, and spread product will continue to generate excess returns over Treasuries and cash. When China Gets Locked Down It has long been said that when the US sneezes, the rest of the world catches a cold. Conversely, challenges in the rest of the world often fail to leave much of a mark on the US. Should US investors really be that concerned about a virus outbreak in China? The answer is yes, despite the S&P 500’s surge last week. There is no such thing as full-on decoupling, even for the US. The US may respond to global events with a longer lag than more export-oriented economies, but they eventually have an impact. Investors should bear in mind that the S&P 500 is considerably more attuned to global conditions than the domestic economy, given that more than a third of its revenues come from abroad. The coronavirus outbreak has turned into the main source of market uncertainty and is the largest risk to our bullish view on global growth and risk assets. For now, our base case is that the global growth recovery will be delayed, though we expect growth will pick up later this year, provided that the outbreak begins to recede by the end of March. That base case is heavily data-dependent, however, subject to the disease’s course and the Chinese government’s response. From a market perspective, tracking the number of new infections may provide a window on investor sentiment. In 2003, the bottom in equities coincided with the peak in the number of new SARS infections (Chart 2). However, a direct analogy between 2003 and 2020 may underplay the impact on growth. China exerts a lot more influence on the global economy than it did at the turn of the millennium (Table 1). A turn in investor sentiment may not be enough to support risk assets in the face of a significant growth headwind. Chart 2Infections Peak, Market Troughs Table 1China’s Importance Now And In 2003 Since it entered the World Trade Organization in 2001, China has grown from being the sixth-largest economy to the second, trailing only the US. It now accounts for 16% of global GDP in dollar terms. Its total imports of goods and services – the main growth transmission mechanism from China to the rest of the world – currently account for 13.5% of global trade, three times its 2002 share. The scale of the Chinese government response is also very different. While the SARS epidemic caused relatively mild disruptions to the travel and retail sectors, quarantines have put some areas in total lockdown, placing meaningful elements of the country’s overall production on indefinite hold. That’s bad enough from a domestic perspective, but it could swiftly lead to a sharp reduction in global manufacturing output if it derails global supply chains that depend on Chinese-produced components. Last week, Hyundai idled a production line in South Korea for lack of essential China-sourced parts, and Fiat Chrysler has warned that it might have to close a European factory in two to four weeks if critical Chinese suppliers are not able to operate. China exerts considerably more influence on the global economy today than it did in 2003.  Extended quarantines will have a readily observable impact. Chart 3Services Now Account For A Majority Of Chinese Output Moreover, this time around the outbreak coincided with the Lunar New Year celebration, when spending on services is usually elevated. Services engender less pent-up demand than durable goods; while demand for durables may merely be deferred until the epidemic is contained, demand for services is much more likely to be destroyed. Nonmanufacturing sectors’ increasing importance in the Chinese economy (Chart 3) implies that relative to 2003, less "lost" spending will be made up later. Using SARS’ impact on Chinese GDP to support a back-of-the-envelope estimate, our Global Investment Strategy colleagues judge that the coronavirus could zero out Chinese growth in the first quarter. Our Global Fixed Income Strategy service estimates that major country sovereign bonds are pricing in two months of lost Chinese growth. The prospect of a stagnant two to three months could well force policymakers to focus exclusively on encouraging growth. They have already signaled they will pull forward some scheduled infrastructure investments, and our China strategists note that 2020 is policymakers’ deadline for meeting their target to double GDP over the decade. Bottom Line: The coronavirus outbreak is a serious threat to the global economy and financial markets, but we do not expect that it will induce a US recession or S&P 500 bear market. The Same Old Earnings Song-And-Dance Chart 4A Typical Quarter With 305 of the companies in the S&P 500 having reported earnings through last Thursday’s open, the fourth quarter appears to be nearly exactly like the first three quarters. Earnings growth was nothing to write home about, but it’s tracking to be a few percentage points better than expected when the big banks kicked off reporting season (Chart 4). Revenue growth continues to be in step with nominal global GDP growth, but profit margins are contracting at about the same rate that they did in the first three quarters (Chart 5). The source of the margin contraction remains a mystery, and unraveling it is near the top of our research to-do list. Chart 5The Incredible Shrinking Profit Margin Earnings don't matter much in the near term, but they've been good enough to allay the undercurrent of worry that was a prominent feature of the equity market all of last year. We have previously written about earnings’ limited effect on equity prices.1 In the near term, moves in the S&P 500 exhibit little to no correlation with either earnings growth or the magnitude of earnings beats. Earnings do matter in the long term, and the uneventful 4Q19 reports at least suggest that stocks give no indication of falling off their currently projected path. As has been the case throughout 2019, the bears’ worst fears failed to come to pass in the fourth quarter. Once the coronavirus is contained, accommodative monetary conditions should help keep them at bay in 2020, as well. Follow The Money The big banks reported their fourth quarter earnings in mid-January, and the market reaction suggested their torrid fourth quarter run has fully played out, at least until long yields perk up again. Our review of their earnings calls is not meant to tell us anything about bank stocks, however. We review the calls to gain some insight into the lending market and where it might be headed, seeking color on banks’ willingness to lend, consumers’ and businesses’ appetite for credit, borrower performance, and the banks’ bottom-up perspective on the economy. This time around, we also wanted to hear if the brand-new CECL (Current Expected Credit Loss) loan-loss provisioning standard could constrain lending. 4Q19 Big Bank Beige Book As a group, the banks were constructive on the economy.2 They agree that the consumer is in fine fettle, and they see signs that corporate confidence is returning as trade tensions recede. Overall loan growth has dipped to 4% on a year-over-year basis (Chart 6), while corporate and industrial (C&I) loan growth has contracted on a thirteen-week basis (Chart 7). The C&I contraction is not a sign that corporations are circling the wagons, however, it’s simply that they’ve turned to the corporate bond market instead (Chart 8). Businesses seeking credit generally have access to all they want at tight spreads, given the paucity of yield in the ZIRP/NIRP era. Chart 6Overall Bank Lending Is Decelerating, ... Chart 7... And C&I Lending Is Contracting, ... Chart 8... But The Bond Market Is Capable Of Picking Up The Slack Positive operating leverage was a mantra that all of the management teams recited. Branch footprints are being rationalized, and the biggest banks are successfully automating manual tasks and driving mundane activity to websites and apps and away from branches and ATMs. Shrinking branch counts could intensify the pressure at the margin for retail landlords, and automation could squeeze bank head counts. Every bank grew deposits faster than loans, furnishing them with dry powder for future lending, and padding their holdings of Treasury and agency securities in the meantime. Households And Businesses [S]entiment on the corporate side appears to be looking better. We’re going to be signing [the Phase I] trade agreement with China today, … and the US-Mexico-Canada agreement is well on its way. So I think that some of that uncertainty that might have been impacting discretionary spend on the commercial side of the equation has been alleviated. [W]e feel pretty good. (Dolan, USB CFO) Every bank cited trade tensions as a drag on corporate confidence last year, and pointed to USMCA and the Phase 1 agreement with China as a sign that it will rebound. [T]he US consumer remains in very strong shape, … from a credit perspective, sentiment, [and] spending, [and] obviously [the] labor market is very strong[.] [C]apital spending is still a bit soft, but sentiment is … certainly better than it was six months ago. [B]roadly speaking, [we have a] constructive outlook as we’re heading into 2020[.] (Piepszak, JPM CFO) [T]hroughout the year, we saw … a lot of things out there that [were] driving uncertainty, be it the lack of the China trade deal, USMCA, Brexit, Hong Kong and … now … the horizon looks like some of those things may clear[,] … and we [may] get a bit more action out of the C-suite. [T]he [capital markets] backlog looks pretty good[,] … [a]nd the forward calendar [does, too]. (Corbat, C CEO) [C]ustomers [in our consumer business] are coming off a strong [spending] finish in 2019. In addition, there’s good loan demand, … result[ing] from good employment levels and growing wages. We saw solid loan demand in our commercial client base throughout the year, [though it] moderated in the second half of the year as worries about global economic uncertainty … dragged on. Today we see some resolution of those issues and that combined with continued consumer strength leads us to expect to see businesses continue their solid activity and we’re hearing more optimism. All this provides a great backdrop[.] (Moynihan, BAC CEO) Borrower Performance Overall credit quality indicators in our commercial portfolio remained strong with our fourth quarter internal credit grades at their strongest levels in two years. Non-accrual loans … in the fourth quarter [were at] their lowest level in over ten years. (Shrewsberry, WFC CFO) [Credit quality metrics] show … that asset quality remained strong in [consumer and commercial] categories. (Donofrio, BAC CFO) [C]redit quality was stable in the fourth quarter. … The ratio of non-performing assets … improved linked quarter and year-over-year. (Dolan, USB) [CLO is] still an asset class that we feel comfortable with the risk/reward … in spite of where we are in the cycle[.] (Shrewsberry, WFC) [There’s nothing] we’re overly concerned about [in our own loan portfolio], given how [conservatively] we manage [lending], but we’re certainly paying attention to leveraged lending. We’re certainly paying attention to energy with respect to natural gas prices, we’re certainly looking at retail … malls. (Donofrio, BAC) CECL Impacts We would expect provisions to be a little higher than net charge-offs in 2020 due to CECL. … All else equal, [the new increased provision] would lower our Common Equity Tier 1 capital ratio by roughly 20 basis points[, but we have a sizable capital buffer, and the capital charge] is phased in … evenly through 2023. (Donofrio, BAC CFO) [I]t’s fair to say, under CECL, [that] you could have incremental volatility [of provisioning expenses]. [But] incremental volatility would [not] be material for us. … It’s just timing [of expense recognition, not any increase in expenses.] (Piepszak, JPM) [A]t this point, it’s not likely that [CECL would] change our appetite for longer-duration consumer loans[.] … [I]t hasn’t caused anything to drop below a hurdle level that says to us, we need to either meaningfully reprice it or … [consider] whether [we want to be] in the business. (Shrewsberry, WFC) Investment Implications Chart 9US Data Have Also Weighed On Yields The coronavirus outbreak is a serious threat, but its very seriousness is likely to provoke Chinese policy responses that may better ensure a turnaround once it can be brought under control. Our view is subject to the real-time course of events on the ground, but our base case is that the business cycle and the bull markets in risk assets remain intact, even if they may sputter here and there until the epidemic is brought to heel. While we acknowledge that economic data have been spotty, and the decline in Treasury yields has not solely been a function of coronavirus fears (Chart 9), we think that yields are near the bottom of their likely 2020 range and have more scope to rise than fall from current levels. We continue to recommend below-benchmark duration positioning. We also continue to recommend that investors remain at least equal weight equities in balanced portfolios and at least equal weight spread product within bond portfolios. We would relish the chance to buy an S&P 500 dip to 3,000 if it were to occur when the coronavirus threat appeared to be manageable.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Jennifer Lacombe Senior Analyst JenniferL@bcaresearch.com Footnotes 1 Please see the November 11, 2019 US Investment Strategy Weekly Report, "Why Bother With Earnings?" available at usis.bcaresearch.com. 2 The calls were all held before the coronavirus outbreak.

Highlights The coronavirus is likely to cut global growth in half (from 3.3% to 1.7%) during the first quarter of 2020. Investors should brace for a slew of profit warnings over the coming weeks from companies with significant operations in China. The near-term economic data is also likely to disappoint. Provided the virus is contained (admittedly a big if), economic activity should recover quickly in the second quarter, leaving global growth about 0.3 percentage points lower for the year as a whole. We should have a better sense of who the Democratic presidential candidate will be by mid-March, by which time more than 60% of the delegates will have been awarded. We continue to recommend an overweight stance on global equities over a 12-month horizon, but do not have a strong conviction about the near-term direction of global bourses given the risks around the virus and the Democratic nomination. Green Shoots Delayed Coming into 2020, we expected global growth to accelerate thanks to the lagged effects of last year’s decline in bond yields, an improvement in the global manufacturing inventory cycle, diminished Brexit and trade war risks, and ongoing policy stimulus out of China. Consistent with this prediction, the manufacturing ISM surged this week, with the forward-looking new orders-to-inventories ratio rising to the highest level in 10 months. The non-manufacturing ISM also surprised on the upside, as did factory orders in December. To top it off, ADP employment rose by 291k in January, well above the consensus estimate of 157k. In the euro area, the manufacturing and services PMIs were both revised higher in January. The future output component of the euro area manufacturing PMI rose to 59.8, the highest level since August 2018. The Swedbank Swedish manufacturing PMI jumped to 51.5, easily topping the consensus estimate of 47.6. We have generally found that the Swedish manufacturing PMI leads the global PMI by one or two months. Meanwhile, the UK composite PMI hit a 16-month high. The Coronavirus: Gauging The Economic Impact Unfortunately, the outbreak of the coronavirus is likely to depress global growth over the next couple of months, and possibly longer if the brewing crisis is not contained. During the SARS epidemic in 2003, Chinese growth fell from 10.8% in Q1 to 5.5% in Q2 on a seasonally-adjusted quarter-over-quarter annualized basis – a decline of 5.3 percentage points – only to snap back to 14.7% in Q3. Given that trend growth in China is currently about 5%-to-6%, growth could grind to a halt in the first quarter of this year, if the SARS experience is any guide. This would bring the year-over-year GDP growth rate down to 4%-to-4.5%. While zero growth on a quarter-over-quarter basis in Q1 may sound dire, keep in mind that this would simply leave real output at the same level as in Q4 of last year. Considering the disruptions presently facing the Chinese economy, a prediction of zero quarterly growth could actually prove to be too optimistic. The outbreak of the coronavirus is likely to depress global growth over the next couple of months, and possibly longer if the brewing crisis is not contained. China now accounts for 16% of global GDP on a US dollar basis, compared to 4% in 2003. Thus, a 5.5 percentage-point decline in Chinese growth would arithmetically shave about 0.16*5.5=0.9 percentage points off of global growth. In addition, there will be spillovers from weaker Chinese growth to the rest of the world. Global goods exports to China stand at about 2.5% of world GDP compared to 0.9% of GDP in 2003 (Chart 1). Chinese import growth is about twice as volatile as GDP growth (Chart 2). Thus, a 5.5 percentage-point decline in Chinese GDP in Q1 would reduce global exports to China by 2*0.055*2.5=0.27% of GDP. Chart 1Chinese Demand Has Expanded Over The Years Chart 2Imports Are More Volatile Than Domestic Production China’s service imports will also decline, mainly due to a sharp drop in Chinese tourists travelling abroad. Overseas spending by Chinese residents rose from 0.05% of world GDP in 2007 to 0.33% of GDP in 2018. If tourist arrivals end up falling by 70% during the first quarter, this would shave a further 0.7*0.33=0.23 percentage points from global growth.   On top of all this, there will probably be some multiplier effects from weaker Chinese growth on domestic spending. For example, a decline in Chinese tourism will reduce the income of hotel proprietors and their employees, leading to lower outlays by local residents. For an economy such as Thailand, where Chinese tourist spending accounts for over 3% of GDP, this effect is likely to be substantial. We subjectively pencil in an additional 0.2 percentage-point hit to Q1 global growth from this multiplier effect. As Chart 3 shows, this gives a total hit to growth of 1.6% in Q1. Going into this year, the IMF expected global growth to average 3.3% in 2020. This implies that growth could fall by half the IMF’s projected pace in the first quarter before recovering during the rest of the year. Chart 3Chinese GDP Growth Will Plunge In Q1, But Should Recover In The Remainder Of 2020 Provided The Coronavirus Outbreak Is Contained Uncertainties Abound These estimates are subject to a large margin of error. On the positive side, the impact on global growth might be mitigated by the fact that most of the categories (aside from tourism) in which the Chinese are cutting back spending are in the service sector, and hence have relatively low import content. In addition, China is likely to further bolster policy stimulus in response to the crisis. The People’s Bank of China has injected additional liquidity into money markets, cut the 7-day repo rate, and indicated that it will further lower lending rates. Regulators have delayed the introduction of new rules and regulations in the financial sector. We also expect the authorities to boost fiscal spending, especially on health care, where China lags behind most other countries (Chart 4). Chart 4China: Public Spending On Health Care Has Room To Catch Up On the negative side, the rising share of services in the Chinese economy means that some of the spending lost in Q1 will not be recouped during the rest of the year (unlike in the case of durable goods, there is little pent-up demand for say, restaurant meals). There is also a risk that spending outside China will decline if confidence drops and people begin to hunker down and save more. This is a particular risk in Japan where at least 30 people have contracted the virus (compared to zero during the SARS outbreak) and consumer confidence remains weak following the consumption tax hike. Lastly, global supply chains that rely on Chinese-produced components could be severely disrupted, leading to a downdraft in global manufacturing output. Needless to say, the impact of the outbreak depends critically on how long the epidemic lasts and how broad-based it ends up being. Our baseline assumption is that the outbreak will subside by the end of March. If that happens, growth will rebound in the remainder of the year, as occurred during the SARS episode. This will limit the overall hit to growth in 2020 to about 0.3 percentage points. As of now, the news is mixed. While the total number of new infections has dipped over the past two days in Hubei, where the outbreak originated, the trend in the province still appears to be on the upside. More encouragingly, the number of new infections seems to be stabilizing elsewhere in China and remains at very low levels in the rest of the world (Chart 5). From a markets perspective, tracking the number of new infections is important because it helped mark a bottom in stocks during the SARS outbreak (Chart 6). Chart 5The Number Of New Cases Seems To Be Stabilizing Outside Of The Epicenter Chart 6Stocks Bottomed As The SARS Infection Rate Was Peaking If the coronavirus follows a limited transmission path like MERS did, which did not spread much beyond the Middle East and South Korea, then worries about a pandemic will quickly abate. However, it is too early to make such a confident pronouncement, especially since this particular virus appears to be spreading more easily than either MERS or SARS. As such, we regard the risks to our GDP growth projection as tilted to the downside. Meanwhile, another potential risk is rising to the fore… The Democrats' B-List The Democratic presidential nomination is turning out to be a battle among four B’s: Bernie, Biden, Buttigieg, and Bloomberg. The big story from the Iowa caucus is how well Pete Buttigieg did and how poorly Joe Biden performed. Both Biden and Buttigieg are moderates. However, Biden fares much better in head-to-head polls against Trump than other Democratic challengers, including Buttigieg (Chart 7). Hence, anything that hurts Biden helps Trump. Chart 7For Now, Biden Is Trump’s Biggest Threat The impact on the stock market would be small if either Biden or Buttigieg were to end up in the White House next year. While both of these Democrats have expressed an interest in reversing at least part of the Trump tax cuts, neither would be as hawkish on trade as Trump. For investors, this makes it a bit of a wash. What would clearly hurt the stock market is if Bernie Sanders were to become the next US president. Sanders brings a lot of baggage to the race, including having campaigned for the far-left Socialist Workers Party in the 1980s, while also honeymooning in Moscow at a time when Soviets had thousands of nuclear missiles pointed at the US. Yet, despite his checkered past, the Vermont senator has still beaten Trump in 48 of the last 53 head-to-head polls tracked by Realclearpolitics over the past 12 months. The reality is that the US is moving leftward on a variety of cultural and economic issues (Chart 8). This is unlikely to change anytime soon given the firm grip the left has over academia and most of the media (Charts 9A & B). All this benefits leftist candidates such as Bernie Sanders and Elizabeth Warren. Chart 8The US Is Moving To The Left Chart 9AMany More Democrats Than Republicans In US Colleges Chart 9BThe Vast Majority Of Journalists Are Left-Leaning Battle Of The Billionaires This brings us to Mike Bloomberg. According to PredictIt, Bloomberg is now the second most likely candidate to emerge as the Democratic nominee after Bernie Sanders (Chart 10). Bloomberg’s nationwide polling numbers are quite poor, but unlike the other candidates, he has enough wealth to stay in the race for as long as he wants to. Chart 10Bloomberg As The Dark Horse? Bloomberg can also do something the other candidates cannot: stage an independent bid for the White House. Bloomberg’s allegiance to the Democratic Party is fairly tenuous. He governed New York City as a Republican, after all. If Bernie Sanders emerges as the Democratic nominee, Bloomberg could try to run up the middle as the “moderate choice.” Granted, Bloomberg has promised to support whoever the Democratic nominee ends up being. But here is the irony: the best thing that Bloomberg could do for Sanders is run as an independent. According to BCA’s geopolitical team, Bloomberg would take more voters from Trump than he would from Sanders.1 Whether Bloomberg will try to sabotage Trump in order to help Sanders remains to be seen. Ideologically, Bloomberg is probably closer to Trump than he is to Sanders. However, the two billionaires hate each other, and this could ultimately prove to be the deciding factor. Investment Conclusions The short-term outlook for risk assets remains murky. It is too early to relax about the coronavirus. Even if the outbreak is contained, a lot of economic damage has already been done. Investors should brace for a slew of profit warnings over the coming weeks from companies with significant operations in China. The near-term economic data is also likely to disappoint. Then there are the US elections. We bucked the consensus view in 2015/16 by predicting that Donald Trump would become President. At the moment, however, we do not have a strong feeling about the outcome of this year’s contest. This is in contrast to many market participants who see a Trump victory as a foregone conclusion. At a recent Goldman conference, 87% of attendees expected President Trump to be re-elected.2  Our conversations with clients have revealed a similar bias. The S&P 500 has moved in lockstep with Trump’s chances of being re-elected (Chart 11). If Trump’s prospects begin to fade, while Bernie Sanders wins in New Hampshire and Nevada and outperforms in South Carolina, risk assets could suffer. Chart 11An Uncanny Correlation Why, then, not turn bearish on stocks now? One reason, as noted above, is that global growth should pick up later this year provided the coronavirus is contained. Stocks generally outperform bonds when growth is accelerating (Chart 12). Equity risk premia also remain quite high, which gives stocks a cushion of support (Chart 13). Chart 12Stocks Usually Outperform Bonds When Global Growth Is Accelerating Chart 13Relative Valuations Favor Stocks All this leaves us in the somewhat uncomfortable position of continuing to advocate an overweight stance towards equities over a 12-month horizon, without having a strong view about the short-term direction for global bourses.   Matters should be clearer by mid-March. Super Tuesday takes place on March 3rd. By March 17th, more than 60% of the Democratic delegates will have been awarded (Appendix Table 1). There should also be more clarity on the coronavirus outbreak by then too. At that point, we will reassess both our short-term and medium-term views on equities and other assets. Peter Berezin Chief Global Strategist peterb@bcaresearch.com   Appendix Table 1Next Stops For The Democrat Caravan     Footnotes 1    Please see Geopolitical Strategy Weekly Report, “After Iowa And Impeachment? Questions From The Road,” dated February 7, 2020. 2   Theron Mohamed, “A Goldman Sachs client poll finds 87% expect Trump to win the next election,” Business Insider (January 17, 2020). Global Investment Strategy View Matrix MacroQuant Model And Current Subjective Scores   Strategic Recommendations Closed Trades

Highlights Trump's odds are still only around 55%. Biden remains the frontrunner in the Democratic primary election, albeit a weak one. Sanders brings forward the risk to this view. Evidence does not suggest that Trump would beat Sanders in a landslide. Bloomberg’s “moment” is arriving but Biden and Buttigieg must fall for him to win. The Democrats will likely avoid a contested convention. If they don’t, Trump benefits. Expect equity volatility in the near term. The market must clear the coronavirus and Democratic primary hurdles before it can rally sustainably. Feature Chart 1China: Bad News, Then Stimulus Boost Over the past week we visited clients in New York and Toronto and debated a range of intriguing questions. The coronavirus impact was top of mind. The outbreak will delay the Chinese economic rebound we expected in the first quarter. It also reinforces one of our key geopolitical views on Chinese policy: bad news will be followed by good news in the form of increased stimulus (Chart 1). The problem is that this is good news for the second half of the year at best, while the near term is extremely murky. After the virus, the US election cycle was clearly the greatest source of policy uncertainty. Because clients asked so many questions on this topic, we devote this report to the election. We still expect US equity volatility in the near term. Aren’t Trump’s Odds Of Reelection Better Than 55%? No. Clients hardly raised an eyebrow this time when we argued that President Trump was favored to win reelection – a stark turnaround from just three months ago, when many believed that his goose was cooked. So much has the climate changed that many clients now argue that Trump’s odds have reached 70% and he is likely to win by a landslide. But that is going too far – according to the data. Certainly Trump is coming off a string of successes. So far this year he has deterred Iran, struck trade deals with the US’s top trading partners – China, Canada, and Mexico – and been acquitted of impeachment articles (Chart 2). The Republican-led Senate resisted a last-ditch effort to admit witnesses and prolong the impeachment trial, and few Republicans defected in the final vote.1 Chart 2Trump Acquittal: Political Constraints In Action Chart 3Trade Deals, Impeachment Boosted Trump Approval Trump’s approval rating hit its all-time high just as the Senate voted to acquit (Chart 3). The impeachment process backfired on the Democrats, a point corroborated by the recent shift in the public’s party identification that puts the Republicans right alongside the Democrats after a period in which they trailed (Chart 4). Just before his acquittal, the president delivered a State of the Union Address in which he rattled off a catalogue of record-setting, late-cycle economic statistics. Meanwhile the Democrats suffered a debacle at their first primary election, the Iowa caucus, when a rushed attempt to improve their digital savvy in the electoral process resulted in a software malfunction that delayed the announcement of election tallies. Nevertheless, the ballot is nine months away and the path to reelection is fraught with danger. First, President Trump has not yet proven that he can keep his approval rating in the upper 40s, let alone over 50%. A true game changer would be cracking 50% on a sustainable basis. If Trump slips beneath the 46% of the vote he received in 2016 his odds fall back toward 50%. Assuming the economy rebounds he cannot afford to slip much below his stable range of 43% and still win, according to the model. Second, the manufacturing sector is only just poking its head out of the woods, leaving the critical swing states of Michigan, Pennsylvania, and Wisconsin hanging in the balance, albeit with positive news (Chart 5). Chart 4More Voters Identify As Republican Post-Impeachment Chart 5US Manufacturing Rebounding, But Watch For Virus Hit Our quantitative election model suggests the election is too close to call. Technically the model shows Trump slipping beneath the threshold for victory for the first time since we unveiled it in November (Chart 6). The reason is that the leading economic indicators in Wisconsin and especially Pennsylvania took a turn for the worse in December. These indicators are forward-looking – they predict the 6-month growth rate of the state coincident indexes, which include nonfarm payroll employment, average hours worked in manufacturing by production workers, the unemployment rate, and wage and salary disbursements deflated by the consumer price index. Chart 6Quantitative Election Model Shows Election A Toss Up Chart 7Pennsylvania Job Growth A Risk To Trump Of course, the state leading indicators also tend to be heavily revised in subsequent prints, which can make our model volatile. Month-on-month total employment growth from the Bureau of Labor Statistics corroborates the shaky status of Pennsylvania, but not Wisconsin (Chart 7). This slight shift in our model from a Trump win to a Trump loss does not change our overall election forecast, which has a qualitative overlay. The point is that Trump is still skating on thin ice, the US manufacturing sector.2 Going forward, the US and global economy should continue improving, especially in the second half of the year. The demand shock emanating from the coronavirus outbreak in China should be temporary. The eventual rebound in Chinese demand combined with the lagged effect of China’s new stimulus measures will benefit US manufacturing states. The manufacturing sector’s woes are still a clear and present danger for Trump. Bottom Line: Trump is still favored but his odds of winning are still only 55% qualitatively. The election will remain a major source of uncertainty throughout the year. Investors need to be prepared for either outcome. Volatility is also frontloaded due to the coronavirus shock to the global economy. Is Biden Still The Frontrunner? Yes. Former Vice President Joe Biden bombed in the Iowa caucus, the first of the Democratic Party’s primary elections, coming in fourth place behind South Bend Mayor Pete Buttigieg, Vermont Senator Bernie Sanders, and Massachusetts Senator Elizabeth Warren. He barely beat the sensible but uninspiring Minnesota Senator Amy Klobuchar (Chart 8). Chart 8Iowa: Buttigieg Surged, Biden Slumped Chart 9Biden Still The Democrats’ Frontrunner Traditionally Iowa delivers a polling boost to the victor, since it goes first and attracts attention disproportionate to its size. But this year the first-comer effect is largely moot because of the reporting debacle. Both Buttigieg’s win and Biden’s loss have been drowned out. This is consolation for Biden because he is far more competitive in later states than Buttigieg – he is in fact still the (weak) frontrunner in national polling (Chart 9). Biden also continues to lead our back-of-the-envelope projection of the delegates who will be pledged to candidates at the end of the primary election season on June 6 in Washington, DC. True, Biden is lined up for a plurality at best, not a majority. There are still plenty of “other” delegates to be redistributed, which could leave Biden in the dust if his polling breaks down due to a loss of momentum in the early states (Chart 10A). Nevertheless the centrist “lane” now has a commanding lead over the progressive lane for the first time in the race, creating our base case in which Biden wins a plurality of votes that translates into winning the nomination (Chart 10B). Chart 10ABiden Leads Back-Of-Envelope Delegate Count For Democratic Nomination Chart 10BCentrists Lead Back-Of-Envelope Delegate Count For Democratic Nomination If Biden continues to underperform his polling in New Hampshire and Nevada then he could stumble into a huge disappointment in South Carolina, his bulwark, on February 29 (Chart 11). As the first southern state, South Carolina is the bellwether for Super Tuesday, March 3, when about 35% of the delegates are up for grabs, 54% of which are southern (Chart 12). Anything that shakes Biden’s substantial lead in South Carolina sets him up for failure overall and pushes Sanders into the frontrunner position. Chart 11Biden’s Bulwark Is South Carolina Chart 12Biden’s ‘Southern Strategy’ Should Pay On Super Tuesday Sanders would then face an emerging centrist in the shape of Buttigieg or Bloomberg. (Or Warren will pivot to the center.) Aside from Biden’s lead in the national polling, and many of the southern and Midwestern states, he continues to benefit from a tailwind in that he is the more “electable” or competitive candidate against Trump. Head-to-head polls continue to bear this out (Chart 13). These polls will congeal around almost any candidate once he or she becomes the de facto nominee, but over the past year Biden has performed far better than any of the others. Chart 13Biden Beats Trump Head-To-Head In Every Swing State (So Far) Bottom Line: Anyone who wants to show their electability against Trump must first prove it by dethroning Biden. This could happen in February if Bernie Sanders generates runaway momentum in the early primaries, so the equity market faces major election risk imminently. Is A Sanders Nomination Suicide For The Democrats? Not Necessarily. Chart 14Sanders Generating Momentum In Early Primaries Sanders is only slightly less likely to win the Democratic nomination than Biden. He is clearly capable of doing so – he rivals Biden in the nationwide polling and surpasses him in the early states. Strong finishes in New Hampshire and Nevada are expected and could generate momentum that lasts through Super Tuesday and beyond (Chart 14). Ideologically Sanders is not unthinkable for most Democrats – the average Democrat is shifting to the left of the political spectrum (Chart 15). Most Biden supporters say Sanders is their second choice (Chart 16). Voters are interested in electability, so if Sanders can prove that he is more electable than Biden, voters will flock to him. Chart 15Democrats More Liberal Than In The Past Chart 16Biden Voters Support … Sanders! Thus the question of Sanders is more about the general election than the primary. “Movement candidates” like Alf Landon, Barry Goldwater, and George McGovern have racked up some of the most humiliating defeats in the history of US elections. The self-described democratic socialist Bernie Sanders has some of the defining traits – he has a movement, he is ideologically “pure” and outside the mainstream, and his nomination is a gamble on whether his youthful supporters’ enthusiasm will carry over to the general public. It is plausible that the Democratic Party could choose Sanders out of a desire to fight populist fire with fire, only to find that Trump overwhelmingly benefits from the stigma of socialism in the swing states. Sanders could still win the nomination and even the White House. So far, however, the evidence does not bear out this interpretation. The aforementioned Chart 13 shows that Sanders is second only to Biden against Trump. It is notable that he outperformed Hillary Clinton versus Trump in 2016 (Chart 17). He is specifically competitive against Trump in the Midwest swing states because of his ability to compete for the vote of the blue-collar worker. Thus he has a viable path to winning the Electoral College: the Clinton 2016 states plus Michigan, Pennsylvania, and Wisconsin. Biden’s primary advantage, by this measure, is that he is also competitive in Florida as well as the Midwest, which broadens his Electoral College options. And while Sanders captivates the youth, Biden appeals to African Americans and moderates who turn out to vote more reliably (Chart 18). Chart 17Sanders Outperformed Hillary Versus Trump Chart 18Biden’s Supporters Have Higher Turnout Ultimately presidential elections are referendums on the incumbent party. Since World War II, incumbent parties have lost because of major shifts in the economic, social, or international context that discredit the current administration and drive voters to demand “regime change.” Sitting presidents strengthen the incumbent party and have only lost in a recessionary environment (1980, 1992) or a massive scandal (1976). And Trump’s scandal has been neutralized, for now, due to his acquittal in the Senate. Unless Trump suffers from a faltering economy, a policy humiliation at home or abroad, or a third party candidate who splits the Republican vote, he is unlikely to be discomfited. By the same token, if major changes occur, Sanders will be as good as or even better than Biden at riding the wave of disenchantment with the ruling party and its figurehead. PredictIt, the online betting site, currently puts Sanders at 29% chance of winning the White House, while Biden stands at 7%. Both are underrated given our assessment that Trump’s odds of election still stand at 55% and that he is only likely to fall as a result of economic weakness or an unforeseen policy humiliation. As things stand, either Biden or Sanders would see their chance of winning the White House rise toward 45% if they won the nomination. If Sanders wins the nomination, yet events all play to Trump’s favor such that he wins resoundingly, Sanders will forever after be seen as confirming the curse of the “movement candidate.” Yet under those circumstances Biden would likely have met the same fate. Bottom Line: Investors would be wrong to buy risky assets on a Sanders nomination in the belief that it guarantees Trump’s victory. Clinching the nomination sharply – and mathematically – increases any candidate’s chance of winning the White House. A Sanders White House in turn would be a paradigm shift in US politics: the first left-wing populist president. He would threaten a major increase in economically significant regulation even if no legislation were passed and as such would weigh on corporate profits and animal spirits. As a result, we expect volatility in the near term, since Sanders’s best hope is to build momentum now, unseat Biden, and then fend off Biden’s centrist replacements. Even if Sanders is only successful for a brief period in Q1, the market will have to discount the higher probability of a progressive populist in the Oval Office. What About Mayor Bloomberg? Show Us The Votes, Not Just The Money. Billionaire former New York Mayor Michael Bloomberg is a notable challenger both to other Democrats and to Trump based on the fact that his aggressive advertising campaign is producing some results in opinion polling – as it would for anyone given the volume! He is polling just ahead of Buttigieg and thus is first in line to benefit if Sanders knocks off Biden (Chart 19). Chart 19Bloomberg Benefits If Biden Falls Chart 20Biden Beats Bloomberg In Big Primaries However, Bloomberg’s attempt to pole-vault over the early states and rack up big wins in March is untested. Moreover the data do not yet reflect the elite optimism about Bloomberg’s chances. First, Biden will be harder to knock off than the consensus holds. He has a strong base in the South, he still leads in many Midwestern states, unlike Iowa, while Bloomberg’s base is the Northeast, where he has to split votes with most of the other candidates (including Biden). Looking ahead to March, Biden is beating Bloomberg in all of the key states where Bloomberg’s strategy requires a win (Chart 20). While Biden beats Trump head-to-head in the swing states, Bloomberg loses to Trump in most of them. This reflects Biden’s electability, a tailwind in the primaries (Chart 21). Bloomberg also has the worst favorability among voters – although admittedly Trump once held that distinction (Chart 22). Chart 21Trump Beats Bloomberg In Swing States Chart 22Trump And Biden More Favorable Than Bloomberg Hence Bloomberg can emerge as the leading centrist or establishment candidate if Biden crumbles, and Buttigieg fails to replicate his Iowa success, but not before then. Otherwise his significance lies in that he could become a dark horse candidate at a contested Democratic National Convention in July – say if the leading progressive candidates prove capable of blocking Biden’s nomination but not securing their own. Bloomberg may be waiting in the wings for just such a moment. Bloomberg could also act as the grand spoiler of the election should he decide to run as an independent candidate in November. Ostensibly his candidacy would hurt the Democrats, especially if they choose a candidate who suffers from the taint of socialism. However, contrary to popular wisdom, a strong third party candidate is historically a negative sign for the incumbent.3 Third party candidacies are only strong if the general public is dissatisfied – and when the public is dissatisfied it swings heavily against the incumbent party. Thus on the whole a large third party vote would tend to hurt Trump in 2020, just as it helped him in 2016 (by hurting the incumbent party). The fact that Bloomberg was formerly a Republican reinforces his risk to Trump – like the independently wealthy Ross Perot in 1992, he could produce a Democratic victory by splitting the conservative vote.4 Remember that 9-10% of Republicans believed that Trump should have been removed from office, according to impeachment polls over the past six months. If the economy holds up, this third party challenge is less likely to succeed, but it is still a risk. Such an outcome is far from assured and the Democratic Party would vilify Bloomberg for fear of him stealing votes from the Democratic candidate, especially if the occasion of his independent run were the nomination of a “socialist” like Sanders. Thus far Bloomberg claims he and his billions will support the Democratic Party’s nominee. Bottom Line: If Bloomberg’s intention were solely to unseat Trump, then he should have spent, or will spend, his billions waging a vigorous third party candidacy. On the contrary, by seeking the nomination of one of the two major parties, he apparently seeks to become president of the United States. In doing so he may weaken Biden and thus help Sanders. But we will not know the effect until we can observe his performance in actual elections, which he starts contesting in March. Nevertheless the big surprise of 2020 could well be an independently wealthy candidate capable of stealing enough votes from Trump to erase his very fine margins in the swing states. Bloomberg or someone else could play this role. Will There Be A Contested Convention? Probably Not. A contested convention – or its cousin, the “brokered convention” – is a situation in which the Democratic Party must decide its presidential nominee at its national convention, having failed to do so through the primary elections. Democratic delegates are awarded proportionately to the popular vote, unlike the Republican primary system which features many winner-take-all states. Several candidates each earning less than a third of the popular vote can continue struggling without any one of them hitting the “jackpot” and surging ahead. If none of the candidates has a majority of pledged delegates – or even a strong plurality – at the conclusion of the primaries on June 6 then the candidates will have to negotiate a solution. Otherwise they will show up in Milwaukee on July 13 for a chaotic four days in which the party delegates would have to hold a series of votes, on live television, to determine the nominee. The last time the Democrats had a contested convention was 1952, when they voted for three rounds; the Republicans saw a shorter-lived contest in 1976. In today’s context, in which a left-wing populist could win the nomination, such an unpredictable and arcane process would present a source of uncertainty for investors throughout June and July. A contested convention is more likely than usual because the party has four, possibly five viable candidates if we count Bloomberg. Biden, Bloomberg, and Sanders all have the financial ability to persist over the long haul. Yet with Buttigieg having won in Iowa and polling well in New Hampshire, he remains in the race, as does Warren, assuming they keep meeting the minimum threshold of 15% of the vote needed to receive delegates. So why isn’t a contested convention likely? Because there is a clear constraint: it would be a train wreck for the party. It would prolong divisions over ideology, it would exhaust everyone’s coffers (except Bloomberg’s), it would send a picture of a party in disarray to the general public (much like the Iowa caucus debacle), and it would deprive the party of months in which the de facto nominee could challenge President Trump. The bad press and divisiveness would actually increase Trump’s chances of winning. In the wake of the impeachment backfire, the candidates will be more attuned to these risks. Instead, with a common enemy, it is more likely that candidates will be pressured to drop out of the race once it is clear they cannot win. Democrats will bind together to pick a nominee – a contested convention helps Trump. Chart 23Iowans Want A Winner, Not A Platform Democratic voters are primarily concerned with beating President Trump – this has been confirmed in polling at the Iowa caucus (Chart 23). Therefore several candidates have a basis for sacrificing their own presidential bid. In exchange those who drop out will be offered cabinet positions, which they will sell as a political “dream team” against Trump’s small circle of loyalists and family members. The risk is that insurgent progressive candidates defy the party leadership and refuse to bow out. While Buttigieg is young and can live to fight another day, neither Sanders nor Warren will drop out easily if they think they still have a chance of winning the presidency. These two are also unlikely to cooperate with each other to consolidate the left-wing bloc. Bottom Line: Multiple competitive candidates make it possible that instead of bandwagoning around the candidate with a plurality – likely Biden – no candidate will have a commanding plurality of pledged delegates by June 6. If that is the case then expect the candidates to negotiate a solution prior to the convention. If a solution cannot be found, a contested convention will reflect a deeply divided party and hence imply higher odds of President Trump’s reelection, other things being equal. Investment Conclusions Investors can look at the three options as follows. Biden, Buttigieg, or Bloomberg would be a “known known,” a moderate Democratic whose policies would largely seek to restore and solidify those of the Obama administration. However, we still see this as negative for equities because of the increase in regulation that would ensue plus the high chance that victory would also bring the Senate and thus give rise to a more progressive policy shift than the consensus expects. Chart 24Centrists Outperformed In Iowa Trump is a “known unknown,” an unorthodox and aggressive president whose tactics have become familiar but whose approach is globally disruptive and would be more so in a second term relatively free of electoral constraints. We expect any melt-up in equities before or after a Trump win to be a sell signal given our base case that Trump’s reelection means Trade War II. Sanders or Warren would be an “unknown unknown,” the first-ever left-wing populist to take the White House. Above we show this is not at all improbable if one of them wins the nomination – which itself is about a 35% probability. The same odds apply to the Senate as under Biden, although moderate Democrats there would act as a constraint on a progressive pushing revolutionary legislation. Still, a progressive populist would be a generational paradigm shift in US policy and would justify a bear market. Where is the median voter? In the primary election, the Iowa caucus results reinforce the national trend suggesting that the median voter prefers a centrist or establishment candidate (Chart 24). If Biden falters, either Buttigieg or Bloomberg will take up the slack. Nevertheless the risk of a Sanders success is imminent and therefore we expect volatility to be frontloaded this year, especially in February but also possibly in March if Sanders does a bang-up job on Super Tuesday. In the general election, polling consistently shows that the economy is the most salient issue for voters in 2020. This plays to President Trump’s favor. Health care is usually ranked second, which plays to the Democrats’ favor. However, a recent open-ended poll by Morning Consult suggests that security issues have supplanted health care as the second-highest voter concern, which would reinforce Trump’s position (Chart 25). Further economic deterioration would not only undermine Trump’s approval on his handling of the economy but would also increase concern over health care, since insurance is tied to employers. So this is a critical risk to Trump in wobbly swing states like Pennsylvania. Chart 25Median Voter Focused On Economy, Trump’s Strong Suit We maintain that Trump is slightly favored with 55% odds. But our mathematical model highlights how close of a call the election is, at least until the manufacturing sector and broader economy durably rebound. Investors need to be prepared for either electoral outcome, which means hedging against sectors under bipartisan scrutiny such as Big Pharma and Big Tech. Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com Footnotes 1 Senator Mitt Romney of Utah, no fan of President Trump, voted to convict him of the charge of abuse of power but not of obstruction of Congress. 2 This is the second time Wisconsin has switched across the threshold in our model since November – all else equal, a 0.01% increase in the state’s leading index would move it back to the Republicans. 3 See Allan J. Lichtman, Predicting The Next President (New York: Rowman & Littlefield, 2016), 30-31. 4 Alternately he could ensure a Trump victory by producing an Electoral College tie! Demographic projections of the US electorate in 2020 by Robert Griffin, Ruy Teixeira, and William H. Frey show that a 2020 election in which voters behave exactly as they did in 2016, except that the third party vote normalizes from 5.7% (2016) to 1.7% (2012), would produce an Electoral College tie of 269-269 votes. Obviously this would be a Black Swan event. And the fact that electors in the college can be “faithless” to the candidate that their state elected complicates such projections. Nevertheless the result would be an extraordinary House of Representative vote according to state delegations in which Trump would emerge as the victor and the legitimacy of the election would be contested and debated once again. See "America’s Electoral Future: Demographic Shifts and the Future of the Trump Coalition," April 2018, brookings.edu.

Underweight The S&P chemicals bear market has entered its third year and we remain underweight this capital intensive basic materials subgroup. China macro dominates the direction of US chemical equities. Chinese authorities continue to ease monetary policy and are injecting liquidity in the banking system by slashing the reserve requirement ratio (RRR). The recent coronavirus epidemic almost guarantees further easing via the RRR channel. Such a monetary setting should eventually stabilize the economy. However, until a turnaround is evident, US chemical stocks will continue to follow down the path of the Chinese RRR (top panel). The Australian currency, which is hyper-sensitive to China’s growth, further corroborates that Chinese economic activity remains soft (second panel). Simultaneously, the resilient US dollar will continue to weigh on the competitiveness of US chemical exporters (bottom panel). Bottom Line: Stay underweight the S&P chemicals index. The ticker symbols for the stocks in this index are: BLBG S5CHEM – LIN, APD, ECL, SHW, DD, DOW, PPG, CTVA, LYB, IFF, CE, FMC, EMN, CF, ALB, MOS.

Special Report

In lieu of the next weekly report I will be presenting the quarterly webcast ‘What Are The Most Attractive Investments In Europe?’ on Monday 17 February at 10.00AM EST, 3.00PM GMT, 4.00PM CET, 11.00PM HKT. As usual, the webcast will take a TED talk format lasting 18 minutes, after which I will take live questions. Be sure to tune in. Dhaval Joshi Feature The recent coronavirus scare seems to have added a fresh deflationary impulse into the world economy, at a time that central banks are already struggling to achieve and maintain inflation at the 2 percent target. Begging the question: will central banks’ ubiquitous ultra-loose monetary policy ever generate inflation? The answer is yes, but not necessarily where the central banks desire it. Universal QE, zero interest rate policy (ZIRP), and negative interest rate policy (NIRP) have already created rampant inflation. The trouble is that it is in the wrong place. Rather than showing up in consumer price indexes it is showing up in sky-rocketing asset prices. Feature Chart Ultra-Low Bond Yields Have Created The Greatest Asset-Price Inflation Of All Time Feature ChartUltra-Low Bond Yields Have Created The Greatest Asset-Price Inflation Of All Time The Greatest Asset-Price Inflation Of All Time Since 2014, ultra-loose monetary policy has boosted the valuation of equities by 50 percent. But that’s the small fry. The really big story is that ultra-loose monetary policy has boosted the value of the world’s real estate from $180 trillion to $300 trillion (Chart I-2).1 Chart I-2Ultra-Low Bond Yields Have Boosted The Value Of The World’s Real Estate By $120 Trillion Just pause for a moment to digest those numbers. In the space of a few years the value of the world’s real estate has surged by $120 trillion, equivalent to one and half times the world’s $80 trillion GDP. Moreover, it is a broad-based boom encompassing not just Europe, but North America and Asia too. Now add in the surge in equity prices, as well as other risk-assets such as private equity, corporate bonds and EM debt and the rise in wealth conservatively equals at least two times world GDP. To the best of our knowledge, there is no other time in economic history that asset prices have risen so broadly and by so much as a multiple of world GDP in such a short space of time. Making this the greatest asset-price inflation of all time. Yet central banks seem unmoved. To add insult to injury, Europe’s central banks do not even include surging owner-occupied housing costs in their consumer price indexes. This seems absurd given that the costs of maintaining owner-occupied housing is one of the largest costs that European households face. Europe’s central banks do not include surging owner-occupied housing costs in their consumer price indexes. Including owner-occupied housing costs would lift European inflation closer to 2 percent, eliminating the need for QE and negative interest rates. But its omission has kept measured inflation artificially low (Chart I-3), forcing European central banks to double down on their ultra-loose policies. Which in turn lifts risk-asset prices even further, and so the cycle of asset-price inflation continues. Chart I-3Using The US Definition Of Inflation, The ECB Wouldn't Need Ultra-Loose Policy European QE has spawned other major imbalances. Germany, as the largest shareholder of the ECB, now owns hundreds of billions of ‘Italian euro’ BTPs that the ECB has bought. But given the fragility of Italian banks, the Italians who sold their BTPs to the ECB deposited the cash they received in German banks. Hence, Italy now owns hundreds of billions of ‘German euro’ bank deposits. This mismatch between Germans owning Italian euro assets and Italians owning German euro assets combined with other mismatches across the euro area constitutes the Target2 banking imbalance, which now stands at a record €1.5 trillion. It means that, were the euro to ever break up, the biggest casualty would be Germany (Chart I-4). Chart I-4ECB QE Has Taken The Target2 Banking Imbalance To An All-Time High Meanwhile, the US Federal Reserve, to its credit, does include surging owner-occupied housing costs in its measure of consumer prices. As a result, US inflation has been closer to the 2 percent target enabling the Fed to tighten policy when the ECB had to loosen policy. This huge divergence between euro area and US monetary policies, stemming from different treatments of owner-occupied housing costs, has depressed the euro/dollar exchange rate and thereby spawned yet another major imbalance: the euro area/US bilateral trade surplus which now stands at an all-time high. Providing President Trump with the perfect pretext to start a trade war with Europe, should he desire (Chart I-5).  Chart I-5ECB QE Has Taken The Euro Area/US Trade Surplus To An All-Time High What Caused The Greatest Asset-Price Inflation Of All Time? Why did the past decade witness the greatest asset-price inflation of all time? The answer is that universal QE, ZIRP, and NIRP took bond yields to the twilight zone of the lower bound (Chart I-6). At which point, the valuation of all risky assets undergoes an exponential surge. Chart I-6The Past Decade Was The Decade Of Universal QE Understand that when bond yields approach their lower bound, bonds become extremely risky assets because their prices take on an unattractive ‘lose-lose’ characteristic. As holders of Swiss government bonds discovered last year, prices can no longer rise much in a rally, but they can collapse in a sell-off (Chart I-7). Chart I-7At Low Bond Yields, Bonds Become Much Riskier The upshot is that all (long-duration) assets become equally risky, and the much higher prospective returns offered on formerly more risky assets – such as real estate and equities – collapses to the feeble return offered on now equally-risky bonds. Given that valuation is just the inverse of the prospective return, this means that the valuation of risk assets undergoes an exponential surge. When bond yields approach their lower bound, bonds become extremely risky assets because their prices take on an unattractive ‘lose-lose’ characteristic.  An obvious question is: which valuation measure best predicts this depressed prospective return offered on equities? Most people gravitate to price to earnings (profits), but earnings are highly problematic – because even if you cyclically adjust them, they take no account of structurally high profit margins. The trouble is that earnings will face a headwind when profit margins normalise, depressing prospective returns. For this reason, price to earnings missed the valuation extreme of the 2007/2008 credit bubble and should be treated with extreme caution as a predictor of prospective returns (Chart I-8). Chart I-8Price To Earnings Missed The 2007/2008 Valuation Extreme A much more credible assessment comes from price to sales – or equivalently, market cap to GDP at a global level (Chart I-9). This is because sales are quantifiable, unambiguous, and undistorted by profit margins. Using these more credible prospective returns, we can now show that the theory of what should happen to risk-asset returns (and valuations) at ultra-low bond yields and the practice of what has actually happened agree almost perfectly (Feature Chart). Chart I-9Price To Sales (Or Global Market Cap To GDP) Is The Best Predictor Of Prospective Return Some Investment Conclusions It is instinctive for investors to focus first and foremost on the outlook for the real economy. After all, the evolution of the $80 trillion global economy drives company sales and profits. But the value of the world’s real estate, at $300 trillion, dwarfs the economy. Public and private equity adds another $100 trillion, while other risk-assets such as corporate bonds and EM debt add at least another $50 trillion. So even on conservative assumptions, risk-assets are worth $450 trillion – an order of magnitude larger than the world economy. Now combine this with the overwhelming evidence that risk-asset valuations are exponentially sensitive to ultra-low bond yields. A relatively modest rise in yields that knocked 20 percent off risk-asset valuations would mean a $90 trillion loss in global wealth. Even a 10 percent decline would equate to a $45 trillion drawdown. Could the $80 trillion economy sail through such declines in wealth? No way. Such setbacks would constitute a severe deflationary headwind, and likely trigger the next recession. Hence, though equities are preferable to bonds at current levels, a 50-100 bps rise in yields – were it to happen – would be a great opportunity to add to bonds. Meanwhile, the record high Target2 euro area banking imbalance means that the biggest casualty of the euro’s disintegration would not be Italy. It would be Germany. As all parties have no interest in such a mutually assured destruction, investors should go long high-yielding versus low-yielding euro area sovereign bonds. Finally, the record high euro area/US trade surplus is a political constraint to a much weaker euro versus the dollar. In any case, the ECB is close to the practical limit of monetary policy easing, while the Fed is not. Long-term bond investors should prefer US T-bonds versus German bunds or Swiss bonds. Long-term currency investors should prefer the euro versus the dollar. Fractal Trading System*  This week’s recommended trade is long EUR/CHF. As this currency cross has relatively low volatility, the profit target and symmetrical stop-loss is set at a modest 1 percent. In other trades, short NZD/JPY achieved its profit target, while long US oil and gas versus telecom reached the end of its 65-day holding period in partial loss having reached neither its profit target nor its stop-loss. The rolling 1-year win ratio now stands at 61 percent. Chart I-10EUR/CHF When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com.   Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1 Source: Savills World Research. The last data point is $281 trillion at the end of 2017, but we conservatively estimate that the value has increased to above $300 trillion in the subsequent two years. 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