Financial Markets

Highlights Global Growth & Inflation: An increasing number of growth indicators worldwide are tracing out a “v”-shaped pattern from the COVID-19 recession. However, high unemployment and a lack of inflationary pressure will ensure that global monetary policies remain highly stimulative for some time. Duration:  Maintain a neutral duration stance in global fixed income portfolios, as the recent negative correlation between inflation expectations and real yields is likely to continue.  Stay overweight higher-yielding government bonds in the US, Canada and Italy versus core Europe and Japan.  Also, favor inflation-linked bonds over nominals - particularly in the US, Canada and euro area – as breakevens will continue drifting higher over the next 6-12 months. Corporate Credit: Maintain a neutral overall allocation to global spread product, focused on overweights in markets directly supported by central bank purchases (US investment grade corporates of maturities up to five years, US Ba-rated high-yield). Feature Today marks the midway point of what has already become one the most eventful years of our lifetimes. Investors have had to process multiple massive shocks: a global pandemic; a historically deep worldwide recession; and in the US, nationwide social unrest and a now politically vulnerable president.  Yet despite the severe economic shock and persistent uncertainties, financial market performance over the entire first six months of the year has not been terrible. The S&P 500 index is only down -5.5% year-to-date, while the NASDAQ index is up +10.5% over the same period. Meanwhile, the Barclays Global Aggregate benchmark fixed income index is up +3.9% so far in 2020 (in hedged US dollar terms).  In light of the magnitude of losses suffered by global equity and credit markets in February and March, those are impressive year-to-date returns. CHART OF THE WEEKA Tug Of War A Tug Of War A Tug Of War Falling government bond yields, driven lower by an aggressive easing of global monetary policies through rate cuts and quantitative easing (QE), have played a major role in driving the recovery in risk assets. With the number of global COVID-19 cases now accelerating rapidly once again, however, the odds are increasing that investors become more reluctant to drive equity and credit valuations even higher (Chart of the Week). At the halfway point of the calendar year, this is a good time to review our most trusted indicators, and current investment recommendations, for global government debt and corporate credit. Duration Allocation: A Non-Inflationary Growth Recovery – But With Higher Inflation Expectations Our current recommended overall global duration stance is NEUTRAL. Global growth has started to recover from the sharp COVID-19 recession.  Survey data like manufacturing and services purchasing managers indices (PMIs) have rapidly rebounded from the huge March/April drops, although most PMIs remain below the 50 level suggesting accelerating economic growth (Chart 2). While there is less timely “hard data” available due to reporting lags, there are signs of improvement in critical measures like US durable goods orders, which soared +15.8% in May after falling by similar amounts in both March and April.  Global realized inflation data remains very weak, however, with headline CPI flirting with deflation in most major develop economies.  Combined with still very high levels of unemployment, which will take years to return anywhere close to pre-COVID levels, the backdrop will keep central banks highly dovish for a long time. The US Federal Reserve has already signaled that the fed funds rate will remain near 0% until the end of 2022, while the Bank of Japan has said no rate hikes will happen before 2023 at the earliest. Our Global Duration Indicator, comprised of three elements - our global leading economic indicator and its diffusion index, along with the global ZEW measure of economic expectations - has already returned to pre-COVID levels (Chart 3).  This leading, directional indicator of bond yields suggests that the downward pressure on yields seen over the first half of 2020 is over.   Chart 2Growth, But Not Inflation, Is Recovering Growth, But Not Inflation, Is Recovering Growth, But Not Inflation, Is Recovering Chart 3Our Global Duration Indicator Says Bond Yields Will Bottom Out In H2/2020 Our Global Duration Indicator Says Bond Yields Will Bottom Out In H2/2020 Our Global Duration Indicator Says Bond Yields Will Bottom Out In H2/2020 However, it is far too soon to expect a big bond selloff, with nominal government bond yields now pulled in opposing directions by their real yield and inflation expectations components. As we discussed in last week’s report, our models for market-based inflation expectations indicate that breakevens derived from inflation-linked bonds are too low.1 Hyper-easy monetary policies from the Fed, ECB and other major central banks will help lift inflation expectations, especially with oil prices likely to continue rising over the next 12-18 months according to BCA’s commodity strategists.  Chart 4Higher Inflation Breakevens Should Eventually Help Steepen Yield Curves Higher Inflation Breakevens Should Eventually Help Steepen Yield Curves Higher Inflation Breakevens Should Eventually Help Steepen Yield Curves The rise in inflation breakevens already seen over the past three months in places like the US, Canada and Australia – combined with dovish forward guidance on future interest rates that has kept shorter-maturity bond yields anchored -  should have resulted in a bearish steepening of government bond yield curves.  Yet the differences between 10-year and 2-year yields across the major developed markets have gone sideways since the beginning of April, even as 10-year inflation breakevens have increased (Chart 4). This has also kept the overall level of nominal 10-year yields nearly unchanged over the same period; for example, the 10-year US Treasury yield is now at 0.64% compared to the 0.58% closing level seen back on April 1. An outcome of rising inflation expectations with stable nominal yields must mean that real bond yields have declined by nearly as much as breakeven inflation rates have increased.  That is exactly what has happened when looking at the actual real yield on 10-year inflation-linked bonds in the US, euro area, Canada, Japan, the UK and Australia. Using the US as an example, the 10-year inflation breakeven has increased +44bps since April 1, while the 10-year real yield has declined by -38bps. The decline in global real bond yields has coincided with the major central banks aggressively easing monetary policy, including large-scale purchases of government bonds.  This occurred even in countries that had not engaged in major QE programs before, like Australia and Canada. The sizes involved for the new QE purchases have been massive, given the significant increase in the size of central bank balance sheets in absolute terms and relative to GDP (Chart 5).  An outcome of rising inflation expectations with stable nominal yields must mean that real bond yields have declined by nearly as much as breakeven inflation rates have increased.   Chart 5Global QE Is Helping Drive Real Bond Yields Lower Global QE Is Helping Drive Real Bond Yields Lower Global QE Is Helping Drive Real Bond Yields Lower It is possible that the decline in real yields is due to other factors besides QE purchases, like markets pricing in structurally slower economic growth (and lower neutral interest rates) following the severe COVID-19 recession.  Or perhaps it is more fundamentally economic in nature, reflecting a surge in domestic savings at a time of falling investment spending.  The key takeaway for investors is that rising inflation expectations do not necessarily have to translate into higher nominal bond yields if the markets do not expect central banks to signal a need to tighten monetary policy in the near future, which would push real bond yields higher. For this reason, we continue to prefer structural allocations to inflation-linked bonds out of nominal government debt, rather than maintaining below-benchmark duration exposure in fixed income portfolios.  That is a position that benefits from both higher inflation breakevens and lower real yields, while still having the benefit of maintaining a neutral level of safe-haven duration exposure given the lingering uncertainties over the accelerating global spread of COVID-19. At the specific country level, we recommend overweighting inflation-linked bonds over nominals in the US, Italy and Canada where breakevens appear most cheap on our models. Bottom Line: Maintain a neutral duration stance in global fixed income portfolios, as the recent negative correlation between inflation expectations and real yields is likely to continue.  Stay overweight higher-yielding government bonds in the US, Canada and Italy versus core Europe and Japan.  Also, favor inflation-linked bonds over nominals - particularly in the US, Canada and euro area – as breakevens will continue drifting higher over the next 6-12 months. Corporate Credit Allocation: Keep Buying What The Central Banks Are Buying Our current recommended overall stance on global corporate credit is NEUTRAL. The same reflationary arguments underlying our recommended inflation-linked bond positions also help support our views on global corporate debt.  Aggressively easy monetary policies, combined with some recovery in global economic growth, will help minimize the risk premium on corporate debt.  Yield-starved investors will continue to have no choice but to look to corporate bond markets for income over the next 6-12 months. The same reflationary arguments under-lying our recommended inflation-linked bond positions also help support our views on global corporate debt.   The combined growth rate of the balance sheets for the major central banks (the Fed, ECB, Bank of Japan and Bank of England) has been a reliable leading indicator of excess returns for global investment grade and high-yield debt since the 2008 financial crisis (Chart 6). With that combined balance sheet now expanding at a 34% year-over-year pace after the ramp up of global QE, this suggests continued support for global corporate outperformance versus government bonds over the next year. Corporate debt is also benefitting from direct central bank purchases by the Fed, ECB and Bank of England. Unsurprisingly, the 2020 peak in US investment grade and high-yield corporate spreads occurred on March 20, literally the last trading day before the Fed announced its corporate bond purchase programs (Chart 7).  Chart 6Global QE Will Continue To Support Risk Assets Global QE Will Continue To Support Risk Assets Global QE Will Continue To Support Risk Assets Chart 7The Fed Has Removed The 'Left Tail' Risk Of US Credit The Fed Has Removed The 'Left Tail' Risk Of US Credit The Fed Has Removed The 'Left Tail' Risk Of US Credit   The Fed’s announced plan for its corporate bond buying was to have it focused on shorter maturity (1-5 year) investment grade credit.  Later, the Fed allowed the programs to buy high-yield ETFs while also allowing “fallen angel” debt of investment grade credits downgrade to junk to be held within the programs.  Since that announcement in late March, risk premiums for US corporate debt across all credit tiers and maturities have narrowed.  However, the limits of that broad-based spread tightening may have now been reached, as some of the dislocations in US corporate bond markets created by the global market rout in February and early March have now been corrected.  Chart 8Relative US Corporate Spread Relationships Have Normalized Relative US Corporate Spread Relationships Have Normalized Relative US Corporate Spread Relationships Have Normalized For example, the spread on the Bloomberg Barclays 1-5 year US investment grade index – a proxy for the universe of bonds the Fed is buying – has moved from a level 25bps above that of the 5-10 year US investment grade index, seen before the Fed announced its purchase programs, to 53bps below the longer maturity index (Chart 8, top panel). This is a more normal “slope” for that spread maturity curve relationship, in line with levels seen over the past decade. This suggests that additional spread tightening in US investment grade corporates may be more widespread across all maturities, even with the Fed still focusing its own purchases on shorter-maturity bonds. A similar dynamic is evident in the US high-yield universe.  The spread between the riskier B-rated and Caa-rated credit tiers to Ba-rated names has narrowed since late March to the lower bound of a rising trend channel in place since mid-2018 (bottom panel).  The market appears to be pricing in a structurally rising risk premium between lower-rated junk and higher-rated US high-yield debt – likely a sign of a US credit cycle that was already maturing before COVID-19. The implication going forward is that additional outperformance of lower-rated US junk bonds will be difficult to achieve. The market appears to be pricing in a structurally rising risk premium between lower-rated junk and higher-rated US high-yield debt – likely a sign of a US credit cycle that was already maturing before COVID-19.  European corporate debt has also been witnessing similar trends to those seen in the US.  Euro area investment grade corporate spreads have tightened alongside US spreads since the March 20 peak, but that trend has now stabilized given the recent uptick in market volatility measures like the VIX and VStoxx index (Chart 9).  The spread tightening in euro area high yield has also stalled, with spreads seeing a slight uptick alongside the recent increase in market volatility (Chart 10). Chart 9Global IG Spread Tightening Has Stalled Global IG Spread Tightening Has Stalled Global IG Spread Tightening Has Stalled Chart 10Have Global HY Spreads Bottomed? Have Global HY Spreads Bottomed? Have Global HY Spreads Bottomed? Given the renewed uncertainty over the accelerating number of global COVID-19 cases, hitting large US population areas in the US southern states and across the emerging economies, it will be difficult for global market volatility and credit spreads to return to even the recent lows, much less the pre-COVID levels. Thus, we continue to recommend a “selective” approach to global corporate bond allocations, based on valuations, while maintaining a neutral exposure to credit versus government bonds. Our preferred method for evaluating the attractiveness of credit spreads is to look at 12-month breakeven spreads, or the amount of spread widening that would make corporate bond returns equal to duration-matched government debt over a one-year horizon.  We compare those breakeven spreads to their own history to determine if the current level of credit spreads offer value, while adjusting for the underlying spread volatility backdrop. In the US, the 12-month breakeven spread for investment grade corporates is now less attractive than was the case back in March, now sitting at the long-run median level (Chart 11, top panel). The 12-month breakeven for US high-yield is much more attractive, sitting near the highest readings dating back to the mid-1990s (bottom panel).  Of course, this approach only looks at spreads relative to their volatility and does not incorporate credit risk, which is an obvious risk after the recent collapse in US economic growth. In other words, high-yield needs to offer very high 12-month breakeven spreads to be attractive in the current environment. In the euro area, 12-month breakevens for high-yield are only at long-run median levels, while the breakevens for investment grade are a bit more attractive sitting at the 65th percentile of its own history (Chart 12). Chart 11US Corporate Breakeven Spreads: HY Looks Attractive, But Beware Defaults US Corporate Breakeven Spreads: HY Looks Attractive, But Beware Defaults US Corporate Breakeven Spreads: HY Looks Attractive, But Beware Defaults Chart 12European Corporate Breakeven Spreads: Now At Median Levels European Corporate Breakeven Spreads: Now At Median Levels European Corporate Breakeven Spreads: Now At Median Levels Importantly, 12-month breakeven spreads in both the US and euro area, for investment grade and high-yield, have not fallen into the lower quartile rankings, even after the sharp tightening of spreads since late March. This is a sign the current rally in global corporates has more room to run, strictly from a spread compression perspective.  For high-yield credit, however, the risk of default losses coming after a short, but intense, recession must be factored into any assessment of valuation. Chart 13Default-Adjusted HY Spreads In The US & Europe Are Unattractive Default-Adjusted HY Spreads In The US & Europe Are Unattractive Default-Adjusted HY Spreads In The US & Europe Are Unattractive Looking at default-adjusted spreads – spread in excess of realized and expected credit losses – shows that the current level of junk spreads on both sides of the Atlantic offers little-to-no compensation for credit losses (Chart 13).  Default-adjusted spreads are already well below long-run median levels, but if a typical 10-12% recessionary default rate is applied, expected credit losses over the next twelve months will exceed the current level of spreads, thus ensuring negative excess returns on allocations to junk bonds versus government bonds. Tying it all together, our valuation metrics for corporates suggest the following recommended allocations: Overweight US investment grade corporates, but focused on the 1-5 year maturity range that is supported by Fed purchases Overweight US Ba-rated high-yield (also eligible for Fed holdings), while underweighting lower-rated B- and Caa-rated junk Neutral allocation to euro area investment grade Underweight euro area high-yield across all credit tiers This allocation is in line with our current allocations within our model bond portfolio, which are on pages 13-14. Bottom Line: Maintain a neutral overall allocation to global spread product, focused on overweights in markets directly supported by central bank purchases (US investment grade corporates of maturities up to five years, US Ba-rated high-yield).   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com   Footnotes 1  Please see BCA Research Global Fixed Income Strategy Weekly Report, “How To Play The Revival Of Global Inflation Expectations”, dated June 23, 2020, available at gfis.bcaresearch.com Recommendations Contagion Vs. Reflation: The Battle Of 2020 Rages On Contagion Vs. Reflation: The Battle Of 2020 Rages On Contagion Vs. Reflation: The Battle Of 2020 Rages On Contagion Vs. Reflation: The Battle Of 2020 Rages On Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Dear client, We are sending you our Quarterly Strategy Outlook today, where we outline our thoughts on the macro landscape and the direction of financial markets for the rest of the year and beyond. Next week, please join me for a webcast on Thursday, July 9 at 10:00 AM EDT (3:00 PM BST, 4:00 PM CEST, 10:00 PM HKT) where I will discuss the outlook. Best regards, Peter Berezin, Chief Global Strategist Highlights Markets will trade nervously over the coming weeks in response to the second wave of the pandemic and the looming US fiscal cliff. Nevertheless, we would “buy the dip” if global equities were to fall 5%-to-10% from current levels. While the pace of reopening will slow, there is little appetite for the sort of extreme lockdown measures that were implemented in March. The US Congress will ultimately extend fiscal support for households and firms. Around the world, both fiscal and monetary policy will remain highly accommodative, which should provide a supportive backdrop for stocks. Many institutional investors missed the rebound in stocks and are eager to get back in. High levels of “cash on the sidelines” will further buttress equities. Remain overweight stocks versus bonds on a 12-month horizon. Favor cyclical sectors over defensives and non-US stocks over their US peers. The US dollar has entered a bear market. A weaker greenback will boost commodity prices and EM assets. Global bond yields will rise modestly over the next few years. However, they will remain extremely low by historic standards. Bond yields will only surge once inflation reaches uncomfortably high levels. At that point, the equity bull market will end. Fortunately, this is unlikely to happen for at least three years. I. Macro And Markets Financial markets’ response to the pandemic has followed three distinct phases: Phase One: Hope and Denial. While equities did buckle on the news that a previously unknown coronavirus had emerged in China, they quickly recovered in the hope that the epidemic would be contained. Equities remained resilient even as the virus resurfaced in South Korea and Iran, prompting us to pen a report in February entitled “Markets Too Complacent About The Coronavirus.”1 Phase Two: The Wile E. Coyote Moment.2 The second phase began with the outbreak in Italy. Scenes of overflowing emergency rooms prompted governments to order all non-essential workers to stay home. The resulting decline in commerce caused equities to plummet. Credit spreads widened, while funding markets began to seize up (Chart 1). Phase Three: Recovery. With memories of the 2008 global financial crisis still fresh in their minds, policymakers sprung into action. The combination of massive monetary and fiscal easing helped stabilize financial markets. Risk assets received a further boost as the number of new cases in Italy, Spain, New York City and other hotspots began to decline rapidly in April (Chart 2). The hope that lockdown measures would be relaxed continued to power stocks in May and early June. Chart 1Echos Of The Global Financial Crisis Prompted A Powerful Policy Response Echos Of The Global Financial Crisis Prompted A Powerful Policy Response Echos Of The Global Financial Crisis Prompted A Powerful Policy Response Chart 2Sharp Decline Of New COVID-19 Cases In April Allowed Equities To Recover Third Quarter 2020 Strategy Outlook: Navigating The Second Wave Third Quarter 2020 Strategy Outlook: Navigating The Second Wave Fast forward to the present and things do not seem as straightforward. Despite today’s rally, global equities are still down 4.7% from their June 8th high. The key immediate question for investors is whether the recent bout of volatility marks the end of Phase Three or just a temporary pause in a new cyclical bull market for stocks. On balance, we lean towards the latter scenario. As we discuss in greater detail below, while we do think that the next few months will be more treacherous for investors due to a resurgence in the number of Covid cases in some countries, as well as uncertainty over how the looming US fiscal cliff will be resolved, we expect global equities to be higher 12 months from now. Stocks And The Economy Pundits such as Paul Krugman often like to recite the mantra that “the stock market is not the economy.” While there is some truth to that, equities still tend to track the ups and downs of the business cycle. This can be observed simply by looking at the strong correlation between the US ISM manufacturing index and the S&P 500 (Chart 3).  Chart 3Strong Correlation Between Economic Growth And Stocks Strong Correlation Between Economic Growth And Stocks Strong Correlation Between Economic Growth And Stocks As happened in 2009 and during prior downturns, stocks bottomed this year at roughly the same time as leading economic indicators such as initial unemployment insurance claims peaked (Chart 4). Chart 4Equities Bottomed This Year At Around The Same Time As Leading Economic Indicators Peaked Equities Bottomed This Year At Around The Same Time As Leading Economic Indicators Peaked Equities Bottomed This Year At Around The Same Time As Leading Economic Indicators Peaked Will the economic data continue to improve, allowing equities to move higher? In the past, recoveries following exogenous shocks have tended to be more rapid than those following recessions that arose from endogenous problems. The pandemic would seem to qualify as an exogenous shock. Temporarily furloughed workers have accounted for the vast majority of the increase in US unemployment this year (Chart 5). As lockdown measures are relaxed, the hope is that most of these workers will return to their jobs. Chart 5Temporarily Laid Off Workers Account For The Vast Majority Of The Increase In US Unemployment This Year Temporarily Laid Off Workers Account For The Vast Majority Of The Increase In US Unemployment This Year Temporarily Laid Off Workers Account For The Vast Majority Of The Increase In US Unemployment This Year Bumps In The Road Nevertheless, the recovery will be a bumpy one. In the near term, the main barrier will be the virus itself. Globally, the number of new cases has been trending higher since early May. The number of deaths has also reaccelerated (Chart 6). In the US, the epicenter of the pandemic has shifted from the Northeastern tri-state corridor to the southern states. Florida, Texas, and Arizona have been particularly hard hit. Contrary to President Trump’s claims, more testing does not explain the rise in case counts. As Chart 7 shows, the fraction of tests coming back positive has actually been trending higher in all three states. Chart 6Globally, The Number Of New Cases Has Been Trending Higher Since Early May, While The Number Of Deaths Has Moved Off Its Recent Lows Third Quarter 2020 Strategy Outlook: Navigating The Second Wave Third Quarter 2020 Strategy Outlook: Navigating The Second Wave Chart 7Fraction Of Tests Coming Back Positive Has Been Moving Higher In Certain States Third Quarter 2020 Strategy Outlook: Navigating The Second Wave Third Quarter 2020 Strategy Outlook: Navigating The Second Wave It did not have to be this way. The evidence suggests that the widespread use of masks could have kept the virus at bay while still allowing most economic activities to resume (Chart 8). Unfortunately, the question of whether to wear a mask, like almost everything else in the US, has become another front in the culture war. Chart 8Masks On! Third Quarter 2020 Strategy Outlook: Navigating The Second Wave Third Quarter 2020 Strategy Outlook: Navigating The Second Wave Mask wearing is much more common in China and the rest of east Asia, which is one key reason why the region has suffered far fewer casualties than elsewhere. Hence, a second wave is likely to be much more muted there. Western Europe, Australia, and New Zealand should also remain largely unscathed going forward. Luckily, treatment options have improved over the past few months, as medical professionals have learned more about the virus. Hospitals have also built up capacity to deal with an influx of patients. Another less well recognized development is that protocols have been put in place to protect residents in long-term care facilities. In Canada, more than 80% of COVID deaths have occurred in nursing homes. All this suggests that while a second wave will weigh on global growth over the coming months, we are unlikely to see the sort of broad-based economic dislocations experienced in March. A Structural Break Even if a second wave does not turn out to be as disruptive as the first, it probably will be several years before spending in the sectors most affected by the virus returns to pre-pandemic levels. Indeed, there is a chance that some sectors may not ever fully recover. The technology to work from home was in place before the pandemic began. Many workers chose not to do so because they did not want to be the odd ones out. The pandemic may have nudged society to a new equilibrium where catching a red-eye flight to attend a business meeting becomes more the exception than the rule, while working from home is seen as perfectly acceptable (and safer) than going to the office. If that happens, there will be, among other things, less business travel going forward, as well as less demand for office space. Such a transformation could end up boosting productivity down the road by allowing companies to slash overhead costs and unnecessary expenses. However, it will impose considerable near-term dislocations, particularly for airlines, hotels, commercial real estate operators and developers, and associated lenders to these sectors. The Role Of Policy It would be unwise for policymakers to try to prevent the shift of capital and labor towards sectors of the economy where they can be more efficiently deployed. However, policy can and should smooth the transition. Chart 9Residential Construction Accounted For Less Than 20% Of The Job Losses During The Great Recession Third Quarter 2020 Strategy Outlook: Navigating The Second Wave Third Quarter 2020 Strategy Outlook: Navigating The Second Wave Most of the suffering during recessions comes in the form of collateral damage. For example, more than 80% of the jobs lost during the Great Recession were outside the residential real estate sector (Chart 9). One does not have to fill a half-empty swimming pool through the same pipe from which the water escaped. As long as there is enough demand throughout the economy, workers who lose their jobs will likely find new jobs in other sectors. This is where the role of monetary and fiscal policy takes center stage. Central banks moved quickly to ease monetary policy as soon as the pandemic began. Unfortunately, with rates already quite low in most countries, there was only so much that conventional monetary policy could achieve. The Federal Reserve, which had more scope to cut rates than most, brought the fed funds rate down 150 bps to a range of 0%-to-0.25%. As helpful as this action was, it fell well short of the more than five percentage points in easing that the Fed has delivered, on average, during past recessions (Chart 10). Chart 10Fed Easing Has Fallen Short This Time Around Fed Easing Has Fallen Short This Time Around Fed Easing Has Fallen Short This Time Around With conventional monetary policy constrained by the zero lower bound, central banks turned to unconventional tools, the most important of which were asset purchases, lending backstops, and forward guidance. These tools blurred the line between fiscal and monetary policy. To some extent, this was by design. By offering to buy government debt in unlimited quantities and at extremely low rates, central banks incentivized governments to run larger budget deficits. Even if one excludes loan guarantees, governments have eased fiscal policy by an extraordinary degree this year (Chart 11). The G7 as a whole has delivered 11.7% of GDP in fiscal stimulus, compared to 4% of GDP in 2008-10. In China, we expect the credit impulse to reach the highest level since the Global Financial Crisis, and the budget deficit to hit the highest level on record (Chart 12).  Chart 11Fiscal Stimulus Is Greater Today Than It Was During The Great Recession Third Quarter 2020 Strategy Outlook: Navigating The Second Wave Third Quarter 2020 Strategy Outlook: Navigating The Second Wave Chart 12China Has Opened The Spigots China Has Opened The Spigots China Has Opened The Spigots   Fiscal Austerity? Don’t Bet On It The recovery following the Great Recession was hampered by the decision of many governments, including the US, Germany, and Japan, to tighten fiscal policy prematurely, despite a lack of pressure from bond markets to do so. While a repeat of such an outcome cannot be excluded, we think it is quite unlikely. Politically, stimulus remains very popular (Table 1). Unlike during the housing bust, there has been little moral handwringing about bailing out households and firms that “don’t deserve it.” Thus, while the US faces a daunting fiscal cliff over the next two months – including 3% of GDP in expiring Paycheck Protection Program funding and over 1% of GDP in expanded unemployment benefits and direct payments to individuals – we expect Congress to ultimately take action to avert most of the cliff. Table 1There Is Much Public Support For Fiscal Stimulus Third Quarter 2020 Strategy Outlook: Navigating The Second Wave Third Quarter 2020 Strategy Outlook: Navigating The Second Wave This will probably involve rolling over some existing programs and supplanting others with new measures such as increased aid to state and local governments. The same pattern is likely to be repeated globally. II. Long-Term Focus: Inflation And The Fiscal Hangover The combination of large budget deficits and falling output has caused the ratio of government debt-to-GDP to explode. The IMF now expects net government debt to reach 132% of GDP in advanced economies in 2021, up from an earlier estimate of 104% made last October (Chart 13). What will happen to all that debt? The answer partly hinges on what happens to the neutral rate of interest, or more precisely, the difference between the neutral rate and the trend growth rate of the economy. The neutral rate of interest is the interest rate that is consistent with full employment and stable inflation. When policy rates are above the neutral rate, unemployment will tend to rise, and vice versa. Most estimates of the neutral rate, such as those produced by the widely used Laubach-Williams model, suggest that it is currently quite low — certainly lower than the potential growth rate of most economies (Chart 14). Theoretically, when GDP growth exceeds the interest rate the government pays on its borrowings, the debt-to-GDP ratios will eventually converge to a stable level, even if the government keeps running a huge budget deficit.3 Chart 13Ratio Of Government Debt-To-GDP Is Exploding Higher On The Back Of Large Budget Deficits And Falling Output Government Debt Levels Have Surged In The Wake Of The Pandemic Ratio Of Government Debt-To-GDP Is Exploding Higher On The Back Of Large Budget Deficits And Falling Output Government Debt Levels Have Surged In The Wake Of The Pandemic Ratio Of Government Debt-To-GDP Is Exploding Higher On The Back Of Large Budget Deficits And Falling Output Chart 14The Neutral Rate Is Lower Than The Potential Growth Rate In Most Economies Third Quarter 2020 Strategy Outlook: Navigating The Second Wave Third Quarter 2020 Strategy Outlook: Navigating The Second Wave   The catch is that this “stable” level of the debt-to-GDP ratio could turn out to be very high. This would leave the government extremely vulnerable to any future change in interest rates. Specifically, if at some point the neutral rate were to rise above the trend growth rate of the economy – and the central bank were to align policy rates with the new higher neutral rate – the government’s borrowing costs would soar. The government would then need to cut spending and/or increase in taxes to make room for additional interest payments.4  The Inflation Solution What if highly indebted governments refuse to tighten fiscal policy? At that point, they would either have to: 1) allow debt levels to spiral out of control; 2) default on the debt; or 3) lean on their central banks to keep rates low. The first two options are unlikely to be politically feasible, implying that the third one would be chosen. By definition, the third option would entail keeping policy rates below their neutral level, or in other words, keeping monetary policy more stimulative than is necessary to maintain full employment and stable inflation. Eventually, this would result in rising inflation. In theory, the increase in inflation can be temporary and limited. Rising consumer prices will lift nominal GDP, causing the ratio of debt-to-GDP to decline. Once the ratio shrinks by enough, central banks could raise interest rates to a suitably high level in order to bring inflation back down. Unfortunately, in practice, the whole process of driving inflation up in order to erode the real value of a government’s bond obligations could be quite destabilizing. This would be especially the case if, as is likely, a period of high inflation leads to a significant repricing of inflation expectations. Long-Term Inflation Risk Is Underpriced Chart 15Long-Term Inflation Expectations Remain Very Depressed Third Quarter 2020 Strategy Outlook: Navigating The Second Wave Third Quarter 2020 Strategy Outlook: Navigating The Second Wave Investors are not too worried that inflation will accelerate anytime soon. The CPI swap market expects inflation to remain subdued for decades to come (Chart 15). This could turn out to be an erroneous assumption. While central banks do not want inflation to get out of hand, they would be happy for it to increase from current levels. After all, they have been obsessing about the zero-lower bound constraint for the better part of two decades. If inflation is, say, 4% going into a downturn, central banks could cut nominal rates to zero, taking real rates to -4%. That would be quite stimulative. Such a deeply negative real rate would not be achievable if inflation were running at 1% going into a downturn.  As noted above, heavily indebted governments would also prefer higher inflation to higher interest rates. The former would erode the real value of debt, while the latter would require that tax dollars be diverted from social program to bondholders. The Neutral Rate May Rise The catch is that for inflation to rise, the neutral rate has to increase well above current policy rates. Will that happen? Our guess is that such an outcome is more likely than most investors believe. For one thing the neutral rate itself depends on the stance of fiscal policy. Looser fiscal policy will generate more demand in the economy. Since one can think of the neutral rate as the interest rate that equalizes aggregate demand with aggregate supply, this implies that larger budget deficits will increase the neutral rate. If, as seems likely, we are entering an era where political populism promotes big budget deficits, this makes it more likely that economies will, at some point, overheat. Savings Glut May Dissipate The structural forces that have depressed the neutral rate over the past few decades could also abate, and perhaps even reverse course. Take the example of demographics. Starting in the mid-1970s, the ratio of workers-to- consumers – the so-called “support ratio” – began to steadily increase as more women entered the labor force and the number of dependent children per household declined (Chart 16). An increase in the number of workers relative to consumers is equivalent to an increase in the amount of production relative to consumption. A rising support ratio is thus deflationary. More recently, however, the global support ratio has begun to decline as baby boomers leave the labor force in droves. Consumption actually increases in old age once health care spending is included in the tally (Chart 17). As populations continue to age, the global savings glut could dissipate, pushing up the neutral rate of interest in the process. Chart 16The Ratio Of Workers-To-Consumers Is Now Falling The Ratio Of Workers-To-Consumers Is Now Falling The Ratio Of Workers-To-Consumers Is Now Falling Chart 17As Populations Continue To Age, The Global Savings Glut Will Dissipate As Populations Continue To Age, The Global Savings Glut Will Dissipate As Populations Continue To Age, The Global Savings Glut Will Dissipate Meanwhile, globalization, a historically deflationary force, remains on the backfoot. The ratio of global trade-to-output has been flat for over a decade (Chart 18). Globalization took a beating from last year‘s trade war, and is taking another bruising from the pandemic, as more companies relocate production back home in order to gain greater control over their supply chains. It is possible that newfangled technologies will allow companies to cut costs, thereby helping them to bring down prices. But, so far, this remains more a hope than reality. As Chart 19 shows, productivity growth in the major economies remains abysmal. Weak supply growth would slow income gains, potentially leading to a depletion of excess savings. Chart 18The Ratio Of Global Trade-To-Output Has Failed To Rise For Over A Decade The Ratio Of Global Trade-To-Output Has Failed To Rise For Over A Decade The Ratio Of Global Trade-To-Output Has Failed To Rise For Over A Decade Chart 19Productivity Growth In The Major Economies Remains Abysmal Productivity Growth In The Major Economies Remains Abysmal Productivity Growth In The Major Economies Remains Abysmal   Social Unrest Continued social unrest could further disrupt the supply side of the economy. Violent crime has already spiked in a number of major US cities,5 just as it did five years ago in the aftermath of demonstrations in cities such as Baltimore and St. Louis (the US homicide rate rose 23% between 2014 and 2016, partly because police pulled out of many troubled neighbourhoods6). Markets generally ignored the social unrest back then, and they may do so again over the coming months. However, if recent developments herald the beginning of an extended crime wave, this could have momentous implications for asset markets. The number of people institutionalized in prisons and mental hospitals dropped dramatically during the 1960s. This corresponded with a sharp increase in the homicide rate (Chart 20). As violent crime soared, equity valuations dropped. Inflation also accelerated, hurting bondholders in the process (Chart 21). If a country cannot credibly commit to protecting its citizens, it is reasonable to wonder if it can credibly commit to maintaining price stability. Chart 20Dramatic Drop In Institutionalizations During The 1960s Corresponded With A Sharp Increase In The Homicide Rate Third Quarter 2020 Strategy Outlook: Navigating The Second Wave Third Quarter 2020 Strategy Outlook: Navigating The Second Wave Chart 21Rising Homicide Rates Coincided With A Drop In Equity Valuations And Higher Inflation In The 1970s Rising Homicide Rates Coincided With A Drop In Equity Valuations And Higher Inflation In The 1970s Rising Homicide Rates Coincided With A Drop In Equity Valuations And Higher Inflation In The 1970s As we discuss in greater detail below, the implication is that the long-term outlook for stocks and bonds is unlikely to be as rosy as the cyclical (3-to-12 month) outlook. III. Investment Implications For Now, Buy The Dip As anyone who has watched a horror movie knows, that scariest part of the film is the one before the monster is revealed. No matter how good the makeup or set design, our imaginations can always fathom something much more frightening than Hollywood can create. COVID-19 is a deadly disease, much deadlier than the common flu. But, at this point, it is a “known known.” The next few weeks will bring news reports of overflowing emergency rooms in some US states, delayed reopenings, and increased talk of renewed lockdowns. The knee-jerk reaction among investors will be to sell stocks. While that was the right trade in March, it may not be the right trade today, at least not for very long. Chart 22Betting Markets Now Expect Joe Biden To Become President Third Quarter 2020 Strategy Outlook: Navigating The Second Wave Third Quarter 2020 Strategy Outlook: Navigating The Second Wave At this point, we know how the movie will end. As was the case during the first wave, the latest outbreak will be brought under control through a combination of increased voluntary social distancing and the cessation of activities that are known to significantly contribute to the spread of the disease (allowing bars and nightclubs to reopen was, as many predicted, a huge mistake). Likewise, while the next few weeks could see plenty of posturing among politicians in Washington, the end result will be a deal to avert most of the fiscal cliff. Investors who run for the hills now will end up making the same mistake as those who jettisoned stocks every time the debt-ceiling issue came to the fore in the past. Panicking about the outcome of November’s US presidential election would also be unwise. Yes, if Joe Biden wins and the Democrats take control of the Senate, then Trump’s corporate tax cuts would be in jeopardy. A full repeal would reduce S&P 500 EPS by about 12%. However, the betting markets are already expecting the Democrats to win the White House and Senate (Chart 22). Thus, some of this risk is presumably already priced in. Moreover, it is possible that the Democrats only partially reverse the corporate tax cuts, focusing more on closing some of the more egregious loopholes in the tax code. And even if corporate tax rates do rise, spending would likely rise even more, resulting in a net increase in fiscal stimulus. Lastly, a Biden presidency would result in less trade tension with China, which would be a welcome relief for equity investors. Are Stocks Already Pricing In A Benign Scenario? Chart 23Earnings Optimism Driven By Tech And Health Care Third Quarter 2020 Strategy Outlook: Navigating The Second Wave Third Quarter 2020 Strategy Outlook: Navigating The Second Wave Bottom-up estimates foresee S&P 500 earnings returning to 2019 levels next year. Does this mean that Wall Street analysts are banking on a V-shaped recovery? Not quite. Outside of the health care and technology sectors, EPS is still expected to be down 9% next year relative to 2019 (Chart 23). Globally, earnings estimates are still fairly downbeat. This suggests that analysts are expecting more of a U-shaped recovery. Of course, what matters to investors is not so much what analysts expect but what the market is pricing in. Given that the S&P 500 is down only 4% year-to-date, have investors gotten ahead of themselves? Again, it is not clear that they have. The value of the stock market does not simply depend on expected earnings growth. It also depends on the discount rate one uses to calculate the present value of future earnings. In a world of exceptionally low interest rates, the contribution from earnings far out into the future to this present value calculation is almost as important as the path of earnings over the next year or two. Provided that the pandemic does not permanently impair the supply-side of the economy, the impact on earnings should be transitory. In contrast, if long-term bond yields are any guide, the impact on the discount rate may be longer lasting. The 30-year US TIPS yield, a proxy for long-term real rate expectations, has fallen by 76 basis points since the start of the year, representing a significant decline in the risk-free component of the discount rate (Chart 24). If we put together analysts’ expectations of a temporary decline in earnings with the observed decline in real bond yields, what we get is an increase in the fair value of the S&P 500 of about 15% since the start of the year (Chart 25). Chart 24The 30-Year TIPS Yield Is Pointing To A Significant Decline In The Risk-Free Component Of The Discount Rate The 30-Year TIPS Yield Is Pointing To A Significant Decline In The Risk-Free Component Of The Discount Rate The 30-Year TIPS Yield Is Pointing To A Significant Decline In The Risk-Free Component Of The Discount Rate Admittedly, the notion that there could be a temporary decline in corporate earnings but a permanent decline in bond yields sounds contradictory. However, it need not be. Imagine a situation where the pandemic does permanently reduce private demand, but that this is fully counteracted by looser monetary policy and increased fiscal stimulus. The result would be the same level of GDP but a lower interest rate.7 As odd as it sounds, this suggests that the pandemic might have increased the fair value of the stock market. Chart 25The Present Value Of Earnings: A Scenario Analysis Third Quarter 2020 Strategy Outlook: Navigating The Second Wave Third Quarter 2020 Strategy Outlook: Navigating The Second Wave Lots Of Cash On The Sidelines Chart 26Lots Of Savings Slushing Around Lots Of Savings Slushing Around Lots Of Savings Slushing Around The combination of surging government transfers and subdued household spending has resulted in a jump in personal saving. Accumulated US personal savings totalled $1.25 trillion in the first five months of the year, up 123% from the same period last year. Much of that money has made its way into savings deposits and money market funds (Chart 26). As a share of stock market capitalization, US cash holdings currently stand at 51%, up nearly 12 percentage points from the start of the year. Looking at it differently, if the ratio of cash holdings-to-stock market capitalization were to return to January 1st levels, stocks would have to rise by about 30%. Retail Bros Versus The Suits Thanks to a steady flow of income from Uncle Sam, plenty of spare time, zero brokerage commissions, and a lack of opportunities for sports betting, the popularity of day trading has surged (Chart 27). It would be easy to dismiss the rise of the “retail bros” as another comical, and ultimately forgettable, chapter in financial history. That is what most have done. Not us. The late 1990s stock market bubble was as much a consequence of the boom in day trading as the cause of it. That boom lasted for more than four years, taking the S&P 500 to one record high after another. The current boom has lasted less than four months. It may have much further to run. Chart 27Day Trading Is Back In Style These Days Day Trading Is Back In Style These Days Day Trading Is Back In Style These Days Keep in mind that every time an institutional investor sells what they regard as overpriced shares to a retail trader, the institutional investor is left with excess cash that must be deployed elsewhere in the stock market. Buying begets buying. Then there are the hedge funds. Brokerages like Robinhood make much of their money by selling order flow data to hedge funds, who then trade on this information. This activity probably lifts prices by enhancing liquidity and reinforcing the price momentum generated by retail trades.  One would also be remiss not to point out that the mockery levelled at retail traders has an aura of hypocrisy to it. The average mutual fund underperforms its benchmark, even before fees are included. As we discussed before, this is not because active managers cannot outperform the market.8 It is because most don’t even bother to try. In contrast to retail traders, a large fraction of institutional investors did not participate in the stock market recovery that began in late March. According to the latest BoA Merrill Lynch Survey, fund managers were still more than one sigma underweight stocks and nearly one sigma overweight cash in June. Along the same vein, speculators increased short positions in S&P 500 futures contracts soon after stocks rallied, paring them back only recently (Chart 28). As of last week, bears exceeded bulls by 25 percentage points in the AAII survey (Chart 29). When positioning is underweight equities and sentiment is bearish, as it is today, stocks are more likely to go up than down.   Chart 28Speculators Still Net Short S&P 500 Futures Contracts Speculators Still Net Short S&P 500 Futures Contracts Speculators Still Net Short S&P 500 Futures Contracts Chart 29Many Investors Are Bearish On Stocks Many Investors Are Bearish On Stocks Many Investors Are Bearish On Stocks The bottom line is that stocks could fall another 5%-to-10% from current levels to about 2850 on the S&P 500 and 68 on the ACWI ETF but are unlikely to go much lower, as investors start to anticipate a peak in the number of new cases and a deal to maintain adequate levels of fiscal support. Start Of The Dollar Bear Market A weaker dollar should also help global equities (Chart 30). After peaking in March, the broad trade-weighted US dollar has fallen by 4.4%. Unlike last year, the dollar no longer benefits from higher US interest rates. Indeed, US real rates are below those of many partner countries due to the fact that US inflation expectations are generally higher than elsewhere (Chart 31). Chart 30A Weaker Dollar Should Also Help Global Equities A Weaker Dollar Should Also Help Global Equities A Weaker Dollar Should Also Help Global Equities Chart 31The Dollar Has Been Losing Interest Rate Support The Dollar Has Been Losing Interest Rate Support The Dollar Has Been Losing Interest Rate Support The dollar is a countercyclical currency, meaning that it tends to move in the opposite direction of the global business cycle (Chart 32). If global growth recovers over the coming quarters, the dollar should weaken. The negative pressure on the dollar may be amplified by the fact that the second wave of the pandemic seems likely to affect the US more than most other large economies. Chart 32The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency Commodities And Commodity Currencies To Benefit Once fears of a second wave abate, the combination of stronger global growth, infrastructure-intense Chinese stimulus, and a weaker dollar will also boost commodity prices (Chart 33). BCA’s commodity strategists remain particularly fond of oil. They expect demand to pick up gradually this year, with supply continuing to be curtailed by shut-ins among US producers and production discipline from OPEC and Russia. Their latest projections foresee WTI and Brent prices rising more than 50% above current market expectations in 2021 (Chart 34). Chart 33Commodity Prices Usually Rise When The Dollar Weakens Commodity Prices Usually Rise When The Dollar Weakens Commodity Prices Usually Rise When The Dollar Weakens Chart 34Oil Prices Are Expected To Recover Oil Prices Are Expected To Recover Oil Prices Are Expected To Recover Higher oil prices will be particularly beneficial to currencies such as the Norwegian krone, Canadian dollar, Mexican peso, Colombian peso, and Malaysian ringgit. A Weaker Dollar Will Support Non-US Stocks Stronger global growth, a weaker dollar, and higher commodity prices will disproportionately help the more cyclical sectors of the stock market (Chart 35). Since cyclical stocks tends to be overrepresented outside the US, non-US equities should outperform their US peers over the next 12 months. A weaker dollar will also reduce the local-currency value of dollar-denominated debt. This will be especially helpful for emerging markets. Despite the recent rally, the cyclically-adjusted PE ratio for EM stocks remains near historic lows (Chart 36). EM equities should fare well over the next 12 months. Chart 35Cyclical Sectors Should Outperform Defensives As Global Growth Recovers Cyclical Sectors Should Outperform Defensives As Global Growth Recovers Cyclical Sectors Should Outperform Defensives As Global Growth Recovers Cyclical Sectors Should Outperform Defensives As Global Growth Recovers Cyclical Sectors Should Outperform Defensives As Global Growth Recovers Chart 36EM Stocks Are Cheap Third Quarter 2020 Strategy Outlook: Navigating The Second Wave Third Quarter 2020 Strategy Outlook: Navigating The Second Wave Chart 37Non-US Stocks Look Cheaper Than Their US Peers In Both Absolute Terms And In Relation To Bond Yields Non-US Stocks Look Cheaper Than Their US Peers In Both Absolute Terms And In Relation To Bond Yields Non-US Stocks Look Cheaper Than Their US Peers In Both Absolute Terms And In Relation To Bond Yields Chart 38Expected Earnings Recovery: US Lags Slightly Behind Third Quarter 2020 Strategy Outlook: Navigating The Second Wave Third Quarter 2020 Strategy Outlook: Navigating The Second Wave More broadly, non-US stocks look quite attractive in both absolute terms and in relation to bonds compared to their US peers (Chart 37). They are also unloved. In the BofA Merrill Lynch survey mentioned above, equity managers are heavily overweight the US, despite the fact that consensus earnings estimates point to a slightly faster recovery in EPS outside the United States (Chart 38). Thus, earnings trends, valuations, and sentiment all currently favor non-US stocks. Bond Yields To Stay Subdued… For Now It will probably take a couple of years for the unemployment rate in the G7 to fall to pre-pandemic levels. It will likely be another year or two before labor markets tighten to the point where inflation takes off. And, as discussed above, even if inflation does rise, central banks will be slow to raise rates both because they want higher inflation and because governments will pressure them to keep rates low in order to avoid having to redirect tax revenue from social programs to bondholders. All this suggests that short-term rates could remain depressed across much of the world until the middle of the decade. Chart 39Corporate Debt Metrics Among Publicly-Traded Issuers Are Worrisome Corporate Debt Metrics Among Publicly-Traded Issuers Are Worrisome Corporate Debt Metrics Among Publicly-Traded Issuers Are Worrisome Yield curves will steepen marginally over the next few years as global growth recovers and long-term bond yields rise in relation to short-term rates. In absolute terms, however, long-term yields will remain low. An initial bout of higher inflation will not be enough to lift long-term yields to a significant degree given the ability of central banks to cap yields via the threat of unlimited bond purchases – something that Japan and Australia are already doing. Yields will only rise substantially when central banks start feeling uneasy about accelerating inflation. As noted above, that point is probably still 3-to-5 years away. But, when it does come, it will be very painful for bondholders and equity holders alike. Not Much Scope For Further Spread Compression Spreads are unlikely to widen much in a low-rate, higher growth environment. Nevertheless, one should acknowledge that spreads are already low and corporate debt levels were quite elevated going into the recession, especially among companies with publicly-traded bonds (Chart 39). As such, while we generally favor a pro-risk stance over the next 12 months, we would recommend only benchmark exposure to high-yield credit. Within that category, we would favor consumer credit or corporate credit. We would especially shy away from credit linked to urban office and brick-and-mortar retail shopping, given the unfavorable structural shifts in those sectors.  Gold Is Still Worth Owning Chart 40Real Price Of Gold Is Elevated Relative To Its Long-Term History Real Price Of Gold Is Elevated Relative To Its Long-Term History Real Price Of Gold Is Elevated Relative To Its Long-Term History Lastly, a few words on gold. We upgraded our view on gold in late March. A weaker dollar will boost gold prices over the next 12 months, while higher inflation down the road makes gold an attractive hedge. Yes, the real price of gold is elevated relative to its long-term history (Chart 40). However, gold prices were distorted during most of the 20th century as one country after another abandoned the gold standard. The move to fiat money eliminated the need for central banks to hold large amounts of gold, which reduced underlying demand for the commodity. Had this move not happened, the real price of gold – just like the price of other real assets such as property and art – would have risen substantially. Thus, far from being above their long-term trend, gold prices could still be well below it. Our full suite of tactical, cyclical, and structural market views are depicted in the matrix below. Peter Berezin Chief Global Strategist peterb@bcaresearch.com   Footnotes 1  Please see Global Investment Strategy Weekly Report, “Markets Too Complacent About The Coronavirus,” dated February 21, 2020. 2  For those unfamiliar with Saturday morning cartoons, Wile E. Coyote is a devious and scheming Looney Tunes cartoon character usually depicted unsuccessfully attempting to catch his prey, the Road Runner. Wile E. Coyote is outwitted each time by the fast-running bird, but fails to learn his lesson and tries anew. One popular gag involves the coyote running off a cliff, stopping mid-air to look down, only to realize that there is no more road beneath him. 3 This is a tricky point to grasp, so it might be helpful to think through an example. Suppose that government debt is 100 and GDP is also 100. Let us assume that the interest rate is 1%, trend growth is 3%, and the government wishes to run a primary budget deficit of 5% of GDP (the primary deficit is the deficit excluding interest payments). It does not matter if the interest rate and growth are expressed in nominal terms or real terms, as long as we consistently use one or the other. Initially, the debt-to-GDP ratio is 100%. The following year, debt increases to 100+5+100*0.01=106, while GDP rises to 103. Hence, the debt-to-GDP ratio jumps to 106/103=102.9%. The debt-to-GDP ratio will keep rising until it reaches 250%. At that point, debt-to-GDP will stabilize. To see why, go back to the original example but now assume that debt is 250 while GDP is still 100. The following year, debt increases to 250+5+250*0.01=257.5, while GDP, as in the first example, rises to 103. 257.5 divided by 103 is exactly 250%. 4 The standard equation of debt sustainability, which we derived in Box 1 of the Global Investment Strategy Weekly Report titled “Is There Really Too Much Government Debt In The World?”, says that the ratio of government debt-to-GDP will be stable if the primary budget balance (expressed as a share of GDP), p, is equal to the debt-to-GDP ratio (D/Y) multiplied by the difference between the interest rate and the growth rate of the economy, that is, p=D/Y (r-g). When p>D/Y (r-g), debt-to-GDP will fall. When, p<D/Y (r-g), debt-to-GDP will rise. Note that the higher the debt-to-GDP ratio is at the outset, the more the primary budget surplus would need to increase in response to a rise in interest rates.  5 Please see Ashley Southall and Neil MacFarquhar, “Gun Violence Spikes in N.Y.C., Intensifying Debate Over Policing,” The Wall Street Journal, dated June 23, 2020; “Gun Violence Soars in Minneapolis,” WCCO/CBS Minnesota, dated June 22, 2020;  and Tommy Beer, “18 People Were Murdered In Chicago On May 31, Making It The City’s Single Deadliest Day In 60 Years,” Forbes, dated June 8, 2020. 6 Please see “Baltimore Residents Blame Record-High Murder Rate On Lower Police Presence,” npr.org, dated December 31, 2017. 7 For economics aficionados, one can model this as a permanent inward shift of the IS curve and permanent outward shift of the LM curve which leaves the level of GDP unchanged but results in lower equilibrium interest rate. 8 Please see Global Investment Strategy Special Report, “Quant-Based Approaches To Stock Selection And Market Timing,” dated November 9, 2018. Global Investment Strategy View Matrix Third Quarter 2020 Strategy Outlook: Navigating The Second Wave Third Quarter 2020 Strategy Outlook: Navigating The Second Wave Current MacroQuant Model Scores Third Quarter 2020 Strategy Outlook: Navigating The Second Wave Third Quarter 2020 Strategy Outlook: Navigating The Second Wave

Rising Short-Term Risks Rising Short-Term Risks The SPX remains in churning mode, consolidating the massive gains since the March 23 lows. Easy fiscal and monetary policies are still the dominant macro themes underpinning markets, and thus any letdown in either loose policies poses a threat to the 1000 point three-month SPX run-up (bottom panel). Importantly, correlations have gone vertical of late with the CBOE’s implied correlation index – gauging the S&P 500 constituents’ pairwise correlations – surging to 70% (implied correlation index shown inverted, top panel). This is cause for concern as it has historically been a precursor to SPX pullbacks. Typically, stocks move in tandem, especially during risk off phases when everything becomes one big macro trade. Bottom Line: Odds are high that stocks will be range bound this summer. Beyond that, on a cyclical 9-12 month time horizon we remain constructive on the return prospects of the broad market. Please refer to this Monday’s Weekly Report for more details.

Dear Client, There will be no US Equity Insights from July 1-3 inclusive, as the US Equity team will be on vacation for the week. Our regular publication schedule will resume on Monday July 13, 2020 with our Weekly Report. Happy Independence Day.  Kind Regards, Anastasios Highlights Portfolio Strategy Odds are high that stocks will move laterally in Q3, digesting the massive gains since the March 23 lows. Beyond that, on a cyclical 9-12 month time horizon we remain constructive on the return prospects of the broad market. On all three key profit fronts – price of credit, loan growth and credit quality – banks are starting to show signs of stress. Tack on the potential dividend cuts/suspensions and we were compelled to downgrade exposure to neutral. A dearth of M&A deals, a steep fall in margin debt and declining equity flows into mutual funds and exchange traded funds and potential dividend cuts/suspensions enticed us to trim exposure in the S&P investment banks & brokers index to neutral. Recent Changes Last Tuesday we downgraded the S&P banks and S&P investment banks & brokers indexes to neutral. These two moves also pushed the S&P financials sector weighting to neutral.1 Feature The SPX remains in churning mode, consolidating the massive gains since the March 23 lows. Easy fiscal and monetary policies are still the dominant macro themes underpinning markets, and thus any letdown in either loose policies poses a threat to the 1000 point three-month SPX run-up (bottom panel, Chart 1). Importantly, correlations have gone vertical of late with the CBOE’s implied correlation index – gauging the S&P 500 constituents’ pairwise correlations – surging to 70% (implied correlation index shown inverted, second panel, Chart 1). This is cause for concern as it has historically been a precursor to SPX pullbacks. Typically, stocks move in tandem, especially during risk off phases when everything becomes one big macro trade. Similarly, two Fridays ago we highlighted that the VIX and the S&P 500 were becoming positively correlated.2 The 20-day moving correlation between these two assets is shooting higher, approaching positive territory. Since late-2017 every time this correlation has hit the inflection point near the zero line, stocks has subsequently suffered a sizable setback (Chart 2). Chart 1Short-Term Downdraft Risks Are Rising Short-Term Downdraft Risks Are Rising Short-Term Downdraft Risks Are Rising Chart 2Watch SPX/VIX Correlation Watch SPX/VIX Correlation Watch SPX/VIX Correlation Tack on the public’s renewed interest in COVID-19 according to Google trends search results, and the odds are high that stocks will be range bound this summer (top panel, Chart 1). Beyond that, on a cyclical 9-12 month time horizon we remain constructive on the return prospects of the broad market. Turning over to profits on the eve of earnings season, our four-factor macro EPS growth model for the SPX has tentatively troughed at an extremely depressed level (Chart 3). Our SPX EPS estimate for next calendar year remains near $162/share which we consider trend EPS and was last hit both in 2018 and 2019.3 Chart 3Our EPS Growth Model Has Troughed Our EPS Growth Model Has Troughed Our EPS Growth Model Has Troughed Moreover, drilling beneath the surface, this week Table 1 updates the sector and subgroup EPS growth expectations. First we rank the GICS1 sectors and then within each sector we rank the subsectors, both times by absolute 12-month forward EPS growth using I/B/E/S/ data (see second columns, Table 1). The third columns in Table 1 show the sector growth rate relative to the SPX. Table 1Identifying S&P 500 Sector EPS Growth Leaders And Laggards Drilling Deeper Into Earnings Drilling Deeper Into Earnings The final columns highlight the trend in relative growth. In more detail, they compare the current relative growth rate to that of three months ago: a positive sign indicates an upgrade in analysts’ relative estimates and a negative sign a downgrade in analysts’ relative estimates. Tech, health care and communication services occupy the top ranks with positive EPS growth expectations, while financials, real estate and energy are forecast to contract in the coming 12 months and have fallen at the bottom of the table. Table 2Sector EPS And Market Cap Weights Drilling Deeper Into Earnings Drilling Deeper Into Earnings Given that the tech sector has the highest profit weight in the SPX roughly 23% projected for next year (Table 2) it has really helped the broad market’s profit growth recovery (Chart 4). As a reminder, we continue to employ a barbell portfolio approach and prefer defensive (software and services) to aggressive tech (hardware and equipment). On the flip side, financials have the third largest profit weight roughly 16% in the S&P 500, trailing tech and health care, and pose a big threat to overall SPX profits next year, especially if there are any hiccups with the reopening of the economy (Table 2). Worrisomely, investors are not voting with their feet and are doubting that financials profits will deliver as the market cap weight relative to the profit weight stands at negative 540bps.  Last Tuesday we downgraded the S&P financials sector to a benchmark allocation via trimming the S&P banks and S&P investment banks & brokers indexes to neutral and this week we delve into more details on these two early cyclical subgroups. Chart 4Earnings Finding Their Footing Earnings Finding Their Footing Earnings Finding Their Footing Downgrade Banks To Neutral… We were compelled to downgrade the S&P banks index to neutral last Tuesday in advance of the Fed’s stress test results. There are high odds that a number of banks will cut/suspend dividend payments in coming quarters in line with the Fed’s guidance in the latest round of stress test, especially if profits take a big hit as we expect. As a reminder, dividends are paid out below-the-line. Beyond the Fed’s stress tests and rising political risks,4 yellow flags are waving on all three key bank profit drivers, namely the price of credit, loan growth and credit quality. First, it is disconcerting that bank relative performance has really not taken the yield curve’s steepening cue and has negatively diverged as we showed last week.5 The year-to-date plummeting 10-year yield is weighing heavily on relative share prices (top panel, Chart 5). The transmission mechanism to bank profits of this lower price of credit is via the net interest margin (NIM) avenue (third panel, Chart 5). NIMs will remain under downward pressure as long at the 10-year Treasury yield stays suppressed owing to the Fed’s immense b/s expansion. The rising likelihood of yield curve control could keep interest rates on the long end of the curve depressed for a number of years similar to what happened between 1942 and 1951. Second, on the credit growth front news is equally worrisome. The widening in the junk spread signals loan growth blues in the quarters ahead (second panel, Chart 6). Despite the initial knee jerk reaction, primarily by corporations, of tapping existing C&I credit lines and causing a surge in bank credit growth, bankers are not willing to extend credit according to the latest Fed Senior Loan Officer survey (third panel, Chart 6). The same survey revealed that banks are reporting lower demand for credit across the board, warning that future loan growth will be anemic at best, especially given the collapse in our economic impulse indicator (bottom panel, Chart 6). Chart 5Bank Yellow Flags Waving Bank Yellow Flags Waving Bank Yellow Flags Waving Chart 6Loan Growth Will Suffer Loan Growth Will Suffer Loan Growth Will Suffer Finally, with regard to credit quality, delinquency and charge-off rates are all but certain to spike in the coming months. The third panel of Chart 7 highlights that historically all these credit quality gauges are lagging. However, the near vertical climb in the unemployment rate recently and persistently high continuing unemployment benefit claims near 20mn signal that non-performing loans (NPLs) are slated to soar in the back half of 2020 (bottom panel, Chart 7). True, the recent $2tn+ fiscal package is acting as a Band-Aid solution by putting money in unemployed consumers’ pockets, but when the money runs out on July 31, the going will get tough especially if Congress does not pass a new fiscal package. In addition, there are “extend and pretend” clauses in the existing relief package especially on the residential mortgage front that aim to help homeowners make ends meet. But, the longer workers stay out of the labor force the higher the chances that their skills atrophy making it difficult for them to return to work. As a result, foreclosure risk is on the rise. While residential real estate loans are no longer the largest category in bank loan books they still comprise a respectable 21% of total loans or $2.3tn, a souring housing market could spell trouble for banks (Chart 8). Chart 7Deteriorating Credit Quality Will Sink Profits Deteriorating Credit Quality Will Sink Profits Deteriorating Credit Quality Will Sink Profits Chart 8Housing Arrears Are A Risk Housing Arrears Are A Risk Housing Arrears Are A Risk Already, residential mortgage delinquencies are rising and in May surged to the highest level since November 2011 according to Bloomberg. 4.3mn residential real estate borrowers are in arrears (this delinquency count includes borrowers with forbearance agreements who missed payments) and “more than 8% of all US mortgages were past due or in foreclosure” according to Black Night Inc., a property information service. Tack on the shattering consumer confidence and the consumer loan category (credit card, auto and student debt) is also under risk of severe credit quality deterioration (fourth panel, Chart 7). The commercial real estate (CRE) side of loan books is also likely to bleed. Anecdotes where landlords are demanding past due rent payment from tenants are mushrooming, at a time when the same landlords refuse to service their loan obligations. According to TREPP, CMBS delinquencies are skyrocketing across different REIT lines of business. Importantly, CRE loans add up to $2.4tn on commercial bank balance sheets or roughly 22% of total loans. Encouragingly, in Q1 banks started to aggressively provision for steep credit losses with commercial bank loan loss reserves now climbing just shy of $180bn according to the latest FDIC Quarterly Banking Profile (second panel, Chart 7). This figure is almost twice as high as noncurrent loans and represents a healthy reserve coverage ratio. However, our fear is that if history at least rhymes NPLs will sling shot higher (bottom panel, Chart 7) rendering loan loss reserves insufficient. Putting this provisioning number in context, according to the Fed’s most adverse stress test scenarios banks’ losses could spring to $700bn: “In aggregate, loan losses for the 34 banks ranged from $560bn to $700bn”.6 As a result, banks will have to further provision for futures losses and thus take an additional hit to profitability. Our bank earnings growth model does an excellent job in capturing all these moving parts and warns of a contraction in profit in the back half of the year (bottom panel, Chart 9). Nevertheless, before getting too bearish on banks, there two key offsetting factors. Relative valuations are bombed out, signaling that most of the bad news is likely reflected in prices (bottom panel, Chart 5). Finally, technicals are also extremely oversold. The second panel of Chart 5 shows that relative momentum is as bad as it gets. Netting it all out, on all three key profit fronts – price of credit, loan growth and credit quality – banks are starting to show signs of stress and compel us to downgrade exposure to neutral. Chart 9Dividend Cuts Are Looming Dividend Cuts Are Looming Dividend Cuts Are Looming …And Move To The Sidelines On Investment Banks & Brokers The S&P investment banks & brokers (IBB) group has a similar investment profile to the S&P banks index. But, given its more cyclical nature it typically oscillates violently around banks’ relative performance. Thus last Tuesday, we were also compelled to move to the sidelines on this higher beta financials subgroup.7 The COVID-19 accelerated recession has not only mothballed potential M&A deals that were in the works, but also a number of previously announced deals have been canceled. In addition, the outlook for M&A is grim, at least until the dust really settles from the coronavirus pandemic (second panel, Chart 10), weighing heavily on the sector’s profit prospects. While “Robinhood” (retail investor) trading stories abound, margin debt remains moribund and continues to contract, despite the V-shaped recovery in all major US stock markets since the March 23 lows (third panel, Chart 10). This coincident indicator speaks volumes in the near term direction of the broad market and any sustained contraction in trading related debt uptake will likely dent IBB profitability. According to the American Association of Individual Investors bullish retail investors have been absent from this quarter’s massive stock market rally and equity mutual fund and exchange traded fund flows corroborate this message (fourth panel, Chart 10). With regard to cyclicality, IBB are extremely quick to prune labor in times of duress and aggressively add to headcount during expansions. Recent trimming of IBB input costs signal that this industry is retrenching as it is trying to adjust cost structures to lower revenue run rates (bottom panel, Chart 10). Chart 10Diminishing Activities Are Profit Sapping Diminishing Activities Are Profit Sapping Diminishing Activities Are Profit Sapping Related to the cyclical nature of the IBB industry, an accelerating stock-to-bond ratio has been synonymous with relative share outperformance and vice versa. In early June we turned cautious on the broad market’s near-term return prospects primarily on the back of rising (geo)political risks. The implication is that a lateral move in the broad market would push down the S/B ratio and weigh on relative share prices (Chart 11). However, there are some offsets that prevent us from turning outright bearish on this niche early-cyclical group. First relative valuations are extremely alluring. On a price-to-book basis IBB traded recently at 0.8x in absolute terms and at a steep 68% discount to the broad market (bottom panel, Chart 12). Chart 11Move To The Sidelines On This Highly Cyclical Industry Move To The Sidelines On This Highly Cyclical Industry Move To The Sidelines On This Highly Cyclical Industry Chart 12Some Positive Offsets Some Positive Offsets Some Positive Offsets Second, volatility has gone haywire since late-February and it remains elevated with a VIX reading still north of 30. This is a fertile environment for IBB trading desks and should translate into higher profits (second panel, Chart 12). Third, equity trading volumes have exploded. True, volumes spike on downdrafts, but they have remained at an historically high level recently underscoring that IBB trading desk should be minting money (third panel, Chart 12). Adding it all up, a dearth of M&A deals, a steep fall in margin debt and declining equity flows into mutual funds and exchange traded funds and potential dividend cuts/suspensions compelled us to trim exposure in the S&P investment banks & brokers index to neutral. Bottom Line: Downgrade the S&P banks index to neutral for a loss of 32.4% since inception. Trim the S&P investment banks & brokers index to neutral for a loss of 24% since inception. These moves also push the S&P financials sector to a benchmark allocation. The ticker symbols for the stocks in these indexes are: BLBG S5BANKX – JPM, BAC, C, WFC, USB, TFC, PNC, FRC, FITB, MTB, KEY, SIVB, RF, CFG, HBAN, ZION, CMA, PBCT, and BLBG S5INBK – GS, MS, SCHW, ETFC, RJF, respectively.   Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com     Footnotes 1    Please see BCA US Equity Strategy Insight Report, “Unresponsive” dated June 23, 2020, available at uses.bcaresearch.com. 2    Please see BCA US Equity Strategy Insight Report, “Tales Of The Tape” dated June 19, 2020, available at uses.bcaresearch.com. 3    Please see BCA US Equity Strategy Weekly Report, “Gauging Fair Value ” dated April 27, 2020, and BCA US Equity Strategy Special Report, “Debunking Earnings” dated May 19, 2020, both available at uses.bcaresearch.com. 4    Please see BCA US Equity Strategy Insight Report, “Unresponsive” dated June 23, 2020, available at uses.bcaresearch.com. 5    Ibid. 6    https://www.federalreserve.gov/newsevents/pressreleases/bcreg20200625c.htm 7    Please see BCA US Equity Strategy Insight Report, “Unresponsive” dated June 23, 2020, available at uses.bcaresearch.com.   Current Recommendations Current Trades Strategic (10-Year) Trade Recommendations Drilling Deeper Into Earnings Drilling Deeper Into Earnings Size And Style Views June 3, 2019 Stay neutral cyclicals over defensives (downgrade alert)  January 22, 2018 Favor value over growth April 28, 2020  Stay neutral large over small caps  June 11, 2018 Long the BCA Millennial basket  The ticker symbols are: (AAPL, AMZN, UBER, HD, LEN, MSFT, NFLX, SPOT, TSLA, V).

Highlights The highly uncertain backdrop calls for taking less near-term risk: It may be boring, but it’s only prudent for asset allocators to limit risk exposures when the distribution of economic and public health outcomes is so unusually wide. The US reported record daily COVID-19 infections last Wednesday and Thursday: Several southern and western states that led the way in easing social distancing measures are now experiencing record-high infection rates. Some states are pausing their reopening plans, and the recovery may be more drawn out than expected. Bank stocks sold off after the stress tests, but we’re still a fan of the SIFIs: The year-over-year increases in projected losses weren’t that large, and we still think the SIFIs will suffer smaller credit losses than the market expects. Feature Neutral is dull, neither hot nor cold, neither here nor there, and recommending a benchmark equity weighting in a balanced portfolio makes us restless. We see an equity equal weight as no more than a temporary pause while we wait for the balance between risk and reward to shift enough to merit an underweight or an overweight. When conditions are unusually uncertain, however, we recognize that staying within sight of the shore is prudent. Investors should only take risks when they judge that they will be adequately compensated for doing so. The IMF titled last week’s update to its World Economic Outlook, in which it lowered its 2020 global GDP growth forecast to -4.9% from April’s -3%, “A Crisis Like No Other, An Uncertain Recovery.” As the 1918-19 influenza outbreak is the only global public health threat approaching COVID-19 in terms of its seriousness and its reach, investors have to proceed without a ready basis of comparison. Six months after its emergence, there is still a great deal that we don’t know about the virus. It remains uncertain if developed economies have the hospital capacity and resource stockpiles to combat it, though many emerging economies clearly do not. Modeling the economic impact is further complicated by human vagaries. Public officials can make careful plans for the phased relaxation of activity restrictions, but there is no guarantee that the populace will abide by them. Clusters of unmasked patrons enjoying takeout service on the sidewalk outside the lower Manhattan bars that are open suggest that even likely Democratic voters are as tired of social distancing as the attendees packing the seats at the president’s recent rallies. It turns out that there is something that both sides can agree on, after all. The unpredictability of how well citizens will take direction can go the other way, as well. Just as steadily declining infection rates emboldened people to emerge from their cocoons sooner than officials wished, they may be reluctant to quit them even after officials sound the all-clear signal. As our European Investment Strategy colleagues have noted, economic activity in Sweden, which imposed barely any virus restrictions, was just as weak as it was in neighboring countries that sharply limited movement. The takeaway is that government officials may not have all that much say over how citizens change their behavior amidst a pandemic. There is a possibility, then, that even if officials become comfortable with fully reopening the economy, participants may balk at returning to some corners of it. Officials might throw a party, only to find that very few people will come. The bottom line is that economic conditions are still extremely uncertain, and we will remain in our tactically neutral limbo until we get some clarity about the virus’ path or until equity prices move significantly. Ready Or Not, Here We Come US equities stumbled last week as new COVID-19 infections staged a comeback, with the 7-day moving average rising for 13 straight days and counting (Chart 1). Increases in infections are an inevitable consequence of the expiration of temporary stay-at-home orders that stymied transmission by keeping people apart. The locus has begun to shift from a still largely limited New York City to the southern and western states that were among the first to reopen their economies. As infection rates surged beyond Gotham, the US set consecutive daily infection records last Wednesday and Thursday. Chart 1US Daily New Infections Limbo Limbo We reiterate that rising cases are no surprise. It is a certainty that more people will contract a communicable disease once large swaths of the population are released from quarantine. But the sharp increases in cases may inspire investors to ask some uncomfortable questions. The lockdowns were meant to buy time for officials to design a testing, tracing and isolation framework that other countries have successfully wielded to short-circuit the spread of the virus. Did the United States use that time to build a workable framework? If not, are conditions materially different than they were in March, when stay-at-home orders began to be issued? The testing process continues to be beset by snags. The US is now capable of administering half a million tests a day, according to health officials’ testimony before Congress last week, and they expect capacity to triple by the fall. That capacity is fragmented across several small labs and testing facilities, however, and it can take as much as a week to obtain results, hampering attempts to isolate those who test positive. The absence of a central authority to direct resources where they’re most needed as new nodes emerge undermines the aggregate national capabilities.1 Turnabout Is Fair Play New York City quickly became the global epicenter once the pandemic entered the United States on account of its density, its residents’ reliance on public transportation and its position as an international crossroads. Counties across the entire metropolitan area, stretching into New Jersey and Connecticut, suffered high per-capita infection rates. Nowhere else in the US needed lockdown measures more than New York City, and it only entered the second stage of a four-stage phased re-opening last week. Other states, observing how the virus besieged New York in March and April, imposed restrictions on New York residents traveling to their states, fearing that they could potentially spread the virus far and wide. The rise in infection rates isn't surprising, but its steepness might cause investors to revisit their virus assumptions. The shoe is now on the other foot. New York has steadily reduced its new infection rate for two months and its 7-day moving average of new infections is just one-fifteenth of its early April peak (Chart 2, top panel). It is now nervously eyeing states suffering new outbreaks, and it announced 14-day quarantine measures for visitors from nine states – Alabama, Arizona, Arkansas, Florida, North Carolina, South Carolina, Texas, Utah and Washington – last week. The visitor quarantines are a voluntary measure, and thus likely to have little practical effect, but they highlight the way that several states that have reopened are seeing sharply rising per-capita infection rates relative to the entire country. Alabama’s stay-at-home order ended on April 30th. Its relative per-capita infection rate began to rise immediately (Chart 3, bottom panel). Its 7-day moving average of new infections has since experienced three surges, with the last and most potent causing it to more than double across nine days from June 8th to June 16th (Chart 3, top panel). That span included four consecutive days of record infections. Chart 2New York Daily New Infections Limbo Limbo Chart 3Alabama Daily New Infections Limbo Limbo Arizona’s outbreak has been remarkably swift. Its stay-at-home order expired on May 15th, and both its 7-day moving average of new infections (Chart 4, top panel) and its relative per-capita infection rate (Chart 4, bottom panel) inflected sharply higher fourteen days later. The former series has risen sixfold since residents regained their ability to circulate freely outside of their homes. Arkansas did not have a statewide stay-at-home order, but several measures to slow the virus’ spread were imposed. Restaurants re-opened with capacity limits on May 11th, and by month’s end Arkansas’ 7-day moving average of new infections (Chart 5, top panel) and its relative per-capita infection rate (Chart 5, bottom panel) had begun to inflect sharply higher. Chart 4Arizona Daily New Infections Limbo Limbo Chart 5Arkansas Daily New Infections Limbo Limbo The story is similar across the rest of the states subject to New York’s quarantine. Stay-at-home orders end, stores, bars and restaurants reopen, and infection rates surge with a lag of about two weeks. Florida and Texas, the two most populous states on New York’s list, fit the general pattern, though the rate at which their infections has grown has been striking. Last Wednesday, Florida topped its previous single-day new infection record by 36%2 (Chart 6, top panel), while Texas surpassed its daily high by 30% (Chart 7, top panel). Chart 6Florida Daily New Infections Limbo Limbo Chart 7Texas Daily New Infections Limbo Limbo What’s That Have To Do With The Price Of Stocks In New York? Some of the increase in infection rates is surely a function of more widely available testing. An assessment of what increased state infection rates mean for the course of the virus in any individual state or the entire country is beyond the scope of this report, not to mention our qualifications. Our intention is simply to assess whether US equities are vulnerable to the rising state case counts. We think they could be. Combined daily new infections in Florida and Texas now exceed New York's worst levels in the first half of April. We have previously written that the political will for social distancing measures has dissipated. For many state and local leaders, a return to lockdowns is not an option, and both Missouri’s and Texas’ governors have said as much, in no uncertain terms. There must be an infection level, however, that would force their hands, no matter the depth of their personal opposition. On Thursday, Texas’ governor halted any further easing of restrictions and signed an order suspending elective procedures at hospitals in the counties encompassing Austin, Dallas, Houston and San Antonio, all the while reiterating that rolling back reopening measures was a last resort.3 A resurgence in infection rates isn’t an investment concern per se, but it could become one if it encourages state and/or municipal authorities to reinstitute strict social distancing measures or freeze steps toward reopening local economies. There is also a potential threat to consumer confidence, which could be much harder to combat. Reopening an economy too soon could produce a more persistent drag than locking it down for too long. Premature easing that leads to a widely observed surge in infections may make individuals wary of leaving their homes lest they encounter the virus. Hasty measures meant to unshackle economic activity could backfire by sapping confidence that takes a long time to restore. The bottom line is that the combination of virus risks and an elevated forward earnings multiple keeps us from changing our neutral tactical stance to overweight. We are not inclined to underweight stocks, however, unless the S&P 500 approaches its all-time high around 3,400, given the potential for a positive virus surprise and individual and institutional investors’ ample cash holdings. Over a one-year horizon, we remain overweight equities as we do not see the pandemic exerting a permanently negative impact on corporate earnings. SIFI Bank Update The Fed released the results of its annual Dodd-Frank Act Stress Tests (DFAST) after the close last Thursday. The verdict was decidedly mixed. Investors and the financial media were keenly focused on the fate of bank dividends, and while the Fed did not forbid dividend payments, it capped third-quarter distributions at the lesser of a bank’s second-quarter dividend payment or the average of its trailing four-quarter earnings. It also said it would not allow any share repurchases in the third quarter, extending the largest banks' voluntary buyback pause. Among the SIFIs, Wells Fargo (WFC) is most likely to be constrained by the dividend cap, but its stock, lagging the rest of its peers’, already discounted that possibility. Our thesis that the SIFI banks will not incur credit losses as large as the market expects is still intact, provided Congress doesn’t abandon pandemic-stricken businesses, state and local governments or the unemployed in its follow-up to the CARES Act. The Fed's stress tests highlighted the many risks the banking system still faces, but we stand behind our call to overweight the SIFIs. If Congress plays its part, reserve builds roughly equivalent to half of the credit losses projected under the severely adverse scenario should prove to be more than sufficient. Table 1 updates the table we created after first quarter earnings releases to assess the adequacy of each bank’s loan-loss reserves. It shows that the total projected stress-test losses for the SIFIs are just 8.6% larger than they were in 2019, with only JP Morgan (JPM) facing a material increase in its loan-loss rate. A modest increase in maximum projected losses suggests only a modest increase in future provisions, and we still believe that another two quarters of provisions equivalent to the first quarter’s will be enough for each bank ex-WFC, which continues to look under-provisioned alongside its peers. Table 1Loan-Loss Reserves Vs. Updated Stress Test Projections Limbo Limbo Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 Kliff, Sarah, “Arizona ‘Overwhelmed’ With Demand for Tests as U.S. System Shows Strain,” New York Times, June 25, 2020. https://www.nytimes.com/2020/06/25/upshot/virus-testing-shortfall-arizona.html 2 As we went to press Friday afternoon, Florida announced over 8,900 new cases, 60% above Wednesday's high. 3 As we went to press Friday afternoon, the governor had just issued an order closing all Texas bars.

Running Ahead Of Itself Running Ahead Of Itself The market gapped to fresh recovery highs in early June, but the Fed’s June meeting that lacked any additional easing measures, undermined the overshoot phase since the March 23 lows. In fact, once the Fed had to ease off the QE gas pedal, the market almost immediately paused for breath (bottom panel). In addition, the recent news flow has not helped speculators, as interest in COVID-19 is on the rise anew (google search shown inverted, top panel). While there is uncertainty with regard to how many of the rising infections will lead to actual deaths, we doubt the global economy will come to a screeching halt again. Nevertheless, these marginally negative developments as well as the increase in (geo)political risks that we have been flagging since the June 8 Weekly Report can serve as a catalyst for a consolidation phase in the broad market at least until the November Presidential election. Bottom Line: While we remain cautious on the prospects of the broad equity market in the near-term, our bullish thesis remains intact on a cyclical 9-12 month time horizon.  

Highlights Should the DXY fail to breach below 92 in the coming months, momentum will be a risk to our short dollar positions. Another risk is valuation. The trade-weighted dollar is expensive, but not overly so. It is not especially expensive versus the euro and some commodity currencies. A post-COVID-19 world in which global economies become more closed could also hurt short dollar positions. Maintain a barbell strategy, being long a basket of the cheapest currencies (SEK and NOK) together with some safe havens (JPY). This should insulate portfolios over what could become a more volatile summer. Feature Chart I-1The Dollar And Markets The Dollar And Markets The Dollar And Markets The breakdown in the dollar since March is still facing some skepticism, even internally at BCA. As a reserve currency, the dollar tends to do well during periods of heightened uncertainty. With a clear risk of a second COVID-19 infection wave, and with equity markets up strongly from their lows, odds are that volatility could rise in the near term. Renewed geopolitical tensions between China and the US as well as the upcoming US presidential election are also sources of risk. Historically, the dollar has tended to rise with both increasing equity and geopolitical risk premia (Chart I-1). The key question is whether any near-term bounce in the dollar is technical in nature, or represents the resumption of the bull market. While the dollar is a countercyclical currency, it has also been in a bull market since 2011, notwithstanding the growth upcycles that took place during that period. Through a series of technical, valuation, and macroeconomic charts, we will explore the key risks to our dollar-bearish view as well as potential signposts to see if we are spot on in our thinking. The Long-Term Technical Profile Is Bullish Chart I-2The Dollar And Cycles The Dollar And Cycles The Dollar And Cycles The dollar is a momentum currency, and so tends to move in long cycles. Moreover, in recent history, these cycles have tended to last around eight to 10 years, coinciding with the NBER definition of business cycles. The dollar bear market of the 1980s entered its capitulation phase with the 1990s recession. Similarly, the dollar bull market of the late ‘90s ended with the 2001 recession. The Great Recession in 2008 and subsequently cascading crises from the Eurozone to Japan in 2010-2011 ended the bear market run in the dollar from 2001. If the past is prologue, then the pandemic recession of 2020 may also be signaling an end to the dollar’s decade-long bull run. There is also an economic reason for the decade-long run in dollar cycles. This is the time it usually takes to build and subsequently unwind imbalances in the US economy. In a closed economy, savings must equal investment. However, in open economies, investors usually require a cheaper exchange rate (or higher interest rates) to fund rising deficits, just as they require a higher IRR to fund projects with risky cash flows. This has been the story for the US dollar since the 1980s (Chart I-2). Of course, dollar transition phases can be quite volatile, and the risk to this view is that the dollar bear story could be one for 2022 rather than 2020. However, it is also noteworthy that dollar tops are generally V-shaped, while bottoms are more saucer-shaped. The reason is that the Federal Reserve is usually at the center of a dollar peak, in its decisiveness to ease monetary conditions quite aggressively. At bottoms, the dollar is typically already sufficiently cheap that it does not pose headwinds to the US economy. The pandemic recession of 2020 may also be signaling an end to the dollar’s decade-long bull run. If the DXY can easily break through  the 92-94 zone, this will technically end the bull market in place since 2011, as the powerful upward-sloping channel, in place since then, will be breached (Chart I-3). On the sentiment side of things, conditions remain bullish, which is positive from a contrarian perspective. Professional forecasters often tend to be  adaptive, with a Bloomberg survey expecting the DXY to be flat by year end, but hitting 92 only in 2022 (Chart I-4). More importantly, they tend to miss important turning points in the greenback. Chart I-3A Technical Profile For DXY A Technical Profile For DXY A Technical Profile For DXY Chart I-4The Dollar And Forecasters The Dollar And Forecasters The Dollar And Forecasters The Dollar Is Not Overly Expensive The valuation picture for the dollar is more nuanced, and is our biggest source of risk. The dollar is clearly expensive versus currencies such as the Swedish krona and Norwegian krone, but on a trade-weighted basis, the dollar is only one standard deviation above our fair-value model. This still makes the dollar pricey, but not to the extent of previous peaks, that have tended to occur around two standard deviations above fair value (Chart I-5). Our long-term fair value model has two critical inputs – the productivity gap between the US and its trading partners as well as real bond yield differentials. Rising productivity ensures a country can pursue non-inflationary growth. This lifts the neutral rate of interest in the country, raising the long-term fair value of its exchange rate. The Bloomberg survey expects the DXY to be flat by year end, but hitting 92 only in 2022. Since 2010, the productivity gap between the US and its trading partners has been flat, but there is reason to believe this gap will start to roll over. For one, fiscal largesse could crowd out private investment. But more importantly, as my colleague Ellen JingYuan He of BCA’s Emerging Market Strategy reckons, productivity gains in countries like China could start to pick up as it becomes a world leader in innovation (Chart I-6). This will allow real bond yields outside the US to remain high. Chart I-5The Dollar Is Expensive The Dollar Is Expensive The Dollar Is Expensive Chart I-6US Relative Productivity May Decline US Relative Productivity May Decline US Relative Productivity May Decline The key point is that valuation alone is not a sufficient catalyst for dollar short positions, which is a risk to the view. This is especially the case versus commodity currencies and the euro. That said, there are still some currencies trading below or near two standard deviations from their mean relative to the US dollar. This includes the NOK, SEK, and to a certain extent the GBP (Chart I-7). We remain long these currencies in our portfolio. Chart I-7ASome G10 Currencies Are Very Cheap Some G10 Currencies Are Very Cheap Some G10 Currencies Are Very Cheap Chart I-7BSome G10 Currencies Are Very Cheap Some G10 Currencies Are Very Cheap Some G10 Currencies Are Very Cheap   Post COVID-19 Behavior Could Be Dollar Bullish A post COVID-19 world in which global economies become more closed could hurt the bearish dollar view. This is because when global growth is rebounding, more cyclical economies benefit from this growth dividend, and as such capital tends to gravitate to their respective economies. This is aptly illustrated with consumption being a much larger share of GDP in the US compared to exports (Chart I-8). A move towards more domestic production will hurt the capital flows that have tended to dictate the dollar’s countercyclical nature. A post COVID-19 world in which global economies become more closed could hurt the bearish dollar view.  Chart I-9 shows that dollar strength throughout most of March can be partly  explained by the relative resilience of the US economy, in part driven by a late start to state-wide shutdowns. With economies outside the US now reopening, PMIs abroad have recovered at a faster pace. Once the initial snapback phase has been established, differentiation among economies will then begin Chart I-8The US Economy Will Benefit From De-Globalization The US Economy Will Benefit From De-Globalization The US Economy Will Benefit From De-Globalization Chart I-9Relative Growth And ##br##The Dollar Relative Growth And The Dollar Relative Growth And The Dollar More importantly, in a post COVID-19 world, “platform” companies that can virtually leverage their technology and expertise across borders are replacing “brick and mortar” businesses that need both shipping lanes and ports to remain open. For example, will demand for autos ever recover to pre-crisis levels, when one can video conference rather than drive for two hours to the office? In general terms, if deep value stocks cannot find a way to improve their return on capital, flows into these markets (heavily represented outside the US), will dwindle. This will be a key risk to the dollar bearish view (Chart I-10).   Chart I-10Deep Value And The Dollar Deep Value And The Dollar Deep Value And The Dollar That said, manufacturing renaissances do happen. Asia, for example, remains at the core of both robotic and semiconductor manufacturing, which are redefining the production landscape. And over the long term, valuations do matter – and the starting point for US equities is unfavorable. Strategy And Housekeeping We continue to recommend a barbell strategy. Hold a basket of the cheapest currencies such as the NOK, SEK, and the GBP, along with some safe havens. Our list of trades is printed on page 9. We were stopped out of our short gold/silver position and are reinstating that trade today. While gold does better than silver during market riots, the ratio is 100:1, which is the most overvalued it has been in over a century. Once retail participation gains hold of cheap silver prices, which usually occurs during latter parts of precious metal bull markets, the move could be explosive. We remain long the pound, but are respecting our stop on our short EUR/GBP position that was triggered last week. Valuation supports the pound but politics will increase near-term volatility. We are raising our limit sell to 0.92, which has provided tremendous resistance since the referendum in 2016. Finally, the correction in energy prices is providing an interesting entry point for both the NOK/SEK cross and petrocurrencies. We remain oil bulls on the back of a pickup in global demand. This should lead to the outperformance of energy stocks, benefiting inflows into the CAD, NOK, RUB, MXN, and COP.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 Recent data in the US have been mostly positive: The Markit manufacturing PMI rebounded to 49.6 from 39.8 in June. The services PMI and composite PMI both increased to 46.7 and 46.8, respectively. The Chicago Fed National Activity index increased from -17.89 to 2.61 in May. Existing home sales fell by 9.7% month-on-month in May. However, new home sales surged by 16.6% month-on-month. Initial jobless claims increased by 1480K for the week ended June 19th, higher than the expected 1300K. The DXY index increased by 0.34% this week. Recent data have shown some improvement in the economy, supported by the reopening and Fed’s unprecedented relief measures. We remain cautiously bearish on the US dollar. Please refer to our front section this week for a checklist of risks to the bearish dollar view. Report Links: DXY: False Breakdown Or Cyclical Bear Market? - June 5, 2020 Cycles And The US Dollar - May 15, 2020 Capitulation? - April 3, 2020 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Recent data in the euro area have been mostly positive: The Markit manufacturing PMI increased from 39.4 to 46.9 in June. The services PMI increased to 47.3 from 30.5 and the composite PMI ticked up from 31.9 to 47.5. The current account surplus shrank from €27.4 billion to €14.4 billion in April. Consumer confidence slightly improved from -18.8 to -14.7 in June. The euro fell by 0.5% against the US dollar this week. The ECB decided to offer euro loans against collateral to central banks outside the euro area during the pandemic. Besides, the Eurosystem repo facility for central banks (EUREP) will remain available until the end of June 2021. Report Links: On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 On Money Velocity, EUR/USD And Silver - October 11, 2019 Japanese Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data in Japan have been negative: The manufacturing PMI fell from 38.4 to 37.8 in June. The coincident index fell from 81.5 to 80.1 in April, while the leading economic index ticked up from 76.2 to 77.7. The All Industry Activity Index fell by 6.4% month-on-month in April. The Japanese yen depreciated by 0.5% against the US dollar this week. The BoJ Summary of Opinions released this week pointed out that Japan’s economy has been in an extremely severe downturn and the recovery is likely to be longer and slower. Moreover, the BoJ has expressed concerns that Japan might slip back into deflation. We are long the yen as portfolio insurance. Report Links: The Near-Term Bull Case For The Dollar - February 28, 2020 Building A Protector Currency Portfolio - February 7, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data in the UK have been positive: The Markit manufacturing PMI increased from 40.7 to 50.1 in June. The services PMI also soared from 29 to 47. Retail sales fell by 13.1% year-on-year in May. However, it increased by 12% compared to the previous month.  The British pound fell by 0.7% this week. Last week, the MPC voted unanimously to keep the current rate unchanged at 0.1%. The Committee also voted by a majority of 8-1 for the Bank to increase government bond purchases by another £100 billion, bringing the total purchases to £745 billion. However, governor Andrew Bailey also indicated in a Bloomberg Opinion article on Monday that the Bank might take measures to reduce the BoE’s swollen balance sheet, indicating the £100 billion might be the last should conditions improve. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 A Few Trade Ideas - Sept. 27, 2019 United Kingdom: Cyclical Slowdown Or Structural Malaise? - Sept. 20, 2019 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Recent data in Australia have been positive: The manufacturing PMI increased from 44 to 49.8 in June. The services PMI soared from 26.9 to 53.2, bringing the composite PMI up to 52.6 in June. The Australian dollar initially rose against the US dollar, then fell, returning flat this week. During an online panel discussion this week, the RBA Governor Lowe warned about the long-lasting impact of the COVID-19. More importantly, he said that at the current level close to 0.7, the Australian dollar is not overvalued against the US dollar, even though a lower currency would support exports and push the inflation back to target. Report Links: On AUD And CNY - January 17, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 A Contrarian View On The Australian Dollar - May 24, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 Recent data in New Zealand have been negative: Exports declined by 6.1% year-on-year to NZ$5.4 billion in May, mainly due to lower sales in logs, fish, machinery and equipment. In contrast, exports of dairy products increased by 4.5% year-on-year. Imports slumped by 25.6% year-on-year, led by lower purchases of vehicles and petroleum products. The trade surplus fell to NZ$ 1.25 billion in May from NZ$ 1.34 billion in April. However, this compares favorably with a trade deficit of NZ$ 175 million in the same month last year. The New Zealand dollar fell by 0.6% against the US dollar this week. On Wednesday, the RBNZ held its interest rate unchanged at 0.25% as widely expected and maintained its current pace of QE. However, the Bank sounded quite dovish and indicted that it is ready to further ease policy whenever needed. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Place A Limit Sell On DXY At 100 - November 15, 2019 USD/CNY And Market Turbulence - August 9, 2019 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Recent data in Canada have been positive: Preliminary data shows that retail sales rebounded by 19.1% month-on-month in May, following a 26.4% decrease the previous month. The Canadian dollar depreciated by 0.7% against the US dollar this week. In his first speech as Bank of Canada Governor this week, Tiff Macklem warned that the recovery might be longer than expected, and indicated that the Bank needs a quick response and targeted containment to fight possible future waves of COVID-19 and another round of a broad-based shutdown. Report Links: More On Competitive Devaluations, The CAD And The SEK - May 1, 2020 A New Paradigm For Petrocurrencies - April 10, 2020 The Loonie: Upside Versus The Dollar, But Downside At The Crosses Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Recent data in Switzerland have been positive: The ZEW expectations index rose from 31.3 to 48.7 in June. Money supply (M3) surged by 2.5% year-on-year in May. Total sight deposits increased to CHF 680.1 billion from CHF 679.5 billion for the week ended June 19th. The Swiss franc appreciated by 0.2% against the US dollar this week. The SNB Quarterly Bulletin in Q2 was released this week and it showed that while government loans have been helpful to support the economy, the declines in profit margins were exceptionally severe. Moreover, a further appreciation of the Swiss franc remains a downside risk for a small open economy like Switzerland. Report Links: On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 Portfolio Tweaks Before The Chinese New Year - January 24, 2020 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Recent data in Norway have been negative: The unemployment rate increased to 4.2% in April from 3.6% the previous month. The Norwegian krone fell by 1% against the US dollar this week, along with lower oil prices. Last week, the Norges Bank left its interest rate unchanged at 0% and signaled that the rates are set to remain at current levels over the next few years. Report Links: A New Paradigm For Petrocurrencies - April 10, 2020 Building A Protector Currency Portfolio - February 7, 2020 On Oil, Growth And The Dollar - January 10, 2020 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Recent data in Sweden have been positive: Consumer confidence increased from 77.7 to 84 in June. The Swedish krona appreciated by 1.2% against the US dollar this week. As one of the few countries without strict lockdown measures, Sweden’s business sectors are showing budding signs of recovery in May and June, according to a company survey by the central bank. However, most companies believe that the recovery would take at least 9 months or longer. On another note, the Riksbank has been testing its digital currency e-krona and might be the first central bank to implement the wide use of digital currency. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019 Balance Of Payments Across The G10 - February 15, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

  Highlights In the short run, extreme policy uncertainty is problematic for risk assets. In the long run, gargantuan fiscal and monetary stimulus continues to support cyclical trades. Equity volatility always increases in the lead-up to US presidential elections. Trump has a 35% chance of reelection. The US-China trade deal is intact for now but the risk of a strategic crisis or tariffs is about 40%. Our Turkish GeoRisk Indicator is lower than it should be based on Turkey’s regional escapades. Feature US equities fell back by 2.6% on June 24 as investors took notice of rising near-term risks to the rally. With gargantuan global monetary and fiscal stimulus, we expect the global stock-to-bond ratio to rise over the long run (Chart 1). However, we still see downside risks prevailing in the near term related to the pandemic, US politics, geopolitics, and the rollout of additional stimulus this summer. Chart 1Risk-On Phase Continues - But Risks Mounting Risk-On Phase Continues - But Risks Mounting Risk-On Phase Continues - But Risks Mounting Chart 2Policy Uncertainty Hitting Extremes Policy Uncertainty Hitting Extremes Policy Uncertainty Hitting Extremes Global economic policy uncertainty is skyrocketing – particularly due to the epic the November 3 US election showdown. Yet Chinese policy uncertainty remains elevated and will rise higher given that the pandemic epicenter now faces an unprecedented challenge to its economic and political order. China’s economic instability will increase emerging market policy uncertainty (Chart 2). Only Europe is seeing political risk fall, yet Trump’s threats of tariffs against Europe this week highlight that he will resort to protectionism if his approval rating does not benefit from stock market gains, which is currently the case. The COVID-19 outbreak is accelerating in the US in the wake of economic reopening and insufficient public adherence to health precautions and distancing measures. The divergence with Europe is stark (Chart 3). Authorities will struggle to institute sweeping lockdowns again, but some states are tightening restrictions on the margin and this will grow. Chart 3US COVID-19 Outbreak Volatility And Mediterranean Quarrels (GeoRisk Update) Volatility And Mediterranean Quarrels (GeoRisk Update) The divergence between daily new infection cases and new deaths in the US, as well as countries as disparate as Sweden and Iran, is not entirely reassuring. The US is effectively following Sweden’s “light touch” model. Ultimately COVID is not much of a risk if deaths are minimized – but tighter social restrictions will frighten the markets regardless (Chart 4). President Trump’s election chances have fallen under the weight of the pandemic – followed by social unrest and controversy over race relations. But net approval on handling the economy is holding up well enough (Chart 5). Chart 4Divergence In New Cases Versus New Deaths Volatility And Mediterranean Quarrels (GeoRisk Update) Volatility And Mediterranean Quarrels (GeoRisk Update) Chart 5Trump’s Lifeline Is The Economy Volatility And Mediterranean Quarrels (GeoRisk Update) Volatility And Mediterranean Quarrels (GeoRisk Update) Our subjective 35% odds of reelection still seem appropriate for now – but we will upgrade Trump if the financial and economic rebound is sustained while his polling improves. His approval should pick up in the face of a collapse of law and order, not to mention left-wing anarchists removing or vandalizing historical monuments to America’s Founding Fathers and some great public figures who had nothing to do with the Confederacy in the Civil War. Equity volatility will increase ahead of the US election. Chart 6Volatility Always Rises Before US Elections Volatility Always Rises Before US Elections Volatility Always Rises Before US Elections Equity volatility always increases in the lead up to modern American elections (Chart 6) and this year’s extreme polarization, high unemployment, and precarious geopolitical environment suggest that negative surprises could be worse than usual, notwithstanding the tsunami of stimulus. So far this year the S&P 500 is tracing along the lower end of its historical performance during presidential election years. This is consistent with a change of government in November, unless it continues to power upward over the next four months – typically a change of ruling party requires a technical correction on the year. Our US Equity Strategist, Anastasios Avgeriou, also expects the market to begin reacting to political risk – and he precisely timed the market’s peak and trough over the past year (Chart 7). We suspect that the positive correlation between the S&P and the Democratic Party’s odds of a full sweep of government is spurious. The reason the S&P has recovered is because of the economic snapback from the lockdowns and the global stimulus. The reason the odds of a Blue Wave election have surged is because the pandemic and recession decimated Trump and the Republicans. Going forward, the market needs to do more to discount a Democratic sweep. At 35%, this scenario is underrated in Chart 8, which considers all possible presidential and congressional combinations. Standalone bets put the odds of a Blue Wave at slightly above 50%. We have always argued that the party that wins the White House in 2020 is highly likely to take the Senate. Chart 7Market At Risk Of Election Cycle Market At Risk Of Election Cycle Market At Risk Of Election Cycle Chart 8Market Will Soon Worry About 'Blue Wave' Market Will Soon Worry About 'Blue Wave' Market Will Soon Worry About 'Blue Wave' True, the US is monetizing debt and this will push risk assets higher regardless over the long run. But if former Vice President Joe Biden wins the presidency, he will create a negative regulatory shock for American businesses, and if his party takes the Senate, then corporate taxes, capital gains taxes, federal minimum wages, liability insurance, and the cost of carbon (implicitly or explicitly) will all rise. The market must also reckon with the possibility that Trump is reelected or that he becomes firmly established as a “lame duck” and thus takes desperate measures prior to the election. His threat to impose tariffs on Europe this week underscores our point that if Trump’s approval rating stays low, despite a rising stock market, then the temptation to spend financial capital in pursuit of political capital will rise. This will involve a hard line on immigration and trade. Bottom Line: Tactically, there is more downside. Strategically, we remain pro-cyclical. Stimulus Hiccups This Summer One reason we have urged investors to buy insurance against downside risks this month is because of hurdles in rolling out the next round of fiscal stimulus. The four key drivers of the global growth rebound are liquidity, fiscal easing (Chart 9), an enthusiastic private sector response, and the large cushion of household wealth prior to the crisis. This is according to Mathieu Savary – author of our flagship Bank Credit Analyst report. Mathieu argues that it will be harder for investors to overlook policy uncertainty after the stimulus slows, i.e. the second derivative of liquidity turns negative. Chart 9Gargantuan Fiscal Stimulus Volatility And Mediterranean Quarrels (GeoRisk Update) Volatility And Mediterranean Quarrels (GeoRisk Update) The massive increase in budget deficits and the quick recovery in activity amid reopening have reduced politicians’ sense of urgency. We fear that the stock market will have to put more pressure on lawmakers to force them to provide more largesse. Ultimately they will do so – but if they delay, and if delay looks like it is turning into botching the job, then markets will temporarily panic. Why are we confident stimulus will prevail? In the United States, fiscal bills have flown through Congress despite record polarization. Democrats cannot afford to obstruct the stimulus just to hurt the economy and the president’s reelection chances. Instead they have gone hog wild – promoting massive spending across the board to demonstrate their fundamental proposition that government can play a larger and more positive role in Americans’ lives. Their latest proposal is worth $3 trillion, plus an infrastructure bill that nominally amounts to $500 billion over five years. President Trump, for his part, was always fiscally profligate and now wants $2 trillion in stimulus to fuel the economic recovery, thus increasing his chances of reelection as voters grow more optimistic in the second half of the year. He also wants $1 trillion in new infrastructure spending over five years. Yet Republican Senators are dragging their feet and offering only a $1 trillion package. In the end they will adopt Trump’s position because if they do not hang together, they will all hang separately in November. The debate will center on whether the extra $600 in monthly unemployment benefits will be continued (at a cost of $276bn in the previous Coronavirus Aid, Relief, and Economic Security Act). Republicans want to tie benefits to returning to work, since this generous subsidy created perverse incentives and made it more economical for many to stay on the dole. There will also be a debate over whether to issue another round of direct cash checks to citizens ($290bn in the CARES Act). Republicans want to prioritize payroll tax cuts, again focusing on reducing unemployment (Chart 10). Chart 10US Fiscal Stimulus Breakdown Volatility And Mediterranean Quarrels (GeoRisk Update) Volatility And Mediterranean Quarrels (GeoRisk Update) Our US bond strategist, Ryan Swift, has shown that the cash handouts present a substantial fiscal “cliff.” Without the original one-time stimulus checks, real personal income would have fallen 5% since February, instead of rising 9% (Chart 11). If Republicans refuse to issue a new round of checks, yet the extra unemployment benefits stay, then over $1 trillion in income will be needed to fill the gap so that overall personal income will end up flat since February. In other words, an ~8% increase in income less transfers from current levels is necessary to prevent overall personal income from falling below its February level. China and the EU will eventually provide more largesse. Republican Senators will capitulate, but the process could be rocky and the market should see volatility this summer. China may also be forced to provide more stimulus in late July at its mid-year Politburo meeting – any lack of dovishness at that meeting will disappoint investors. European talks on the Next Generation recovery fund could also see delays (though they are progressing well so far). Brexit trade deal negotiations pose a near-term risk. There is also a non-negligible chance that the German Constitutional Court will raise further obstructions with the European Central Bank’s quantitative easing programs on August 5. European risks are manageable on the whole, but the market is not discounting much (Chart 12). Chart 11Will Congress Takeaway The Money Tree? Will Congress Takeaway The Money Tree? Will Congress Takeaway The Money Tree? Bottom Line: We expect the S&P 500 to trade in a range between 2800 and 3200 points during this period of limbo in which risks over pandemic response and political risks will come to the fore while the market awaits new stimulus measures, which may not be perfectly timely. Chart 12European Risks Are Getting Priced European Risks Are Getting Priced European Risks Are Getting Priced Has The Phase One China Deal Failed Yet? President Trump’s threat this week to slap Europe with tariffs, if it imposes travel restrictions on the US over the coronavirus, points to the dynamic we have highlighted on the more consequential issue of whether Trump hikes broad-based tariffs on China, and/or nullifies the “Phase One” trade deal. Our sense is that if Trump is doing extremely poorly, or extremely well, in terms of opinion polls and the stock market, then the roughly 40% odds of sweeping punitive measures of some kind will go up (Diagram 1). Cumulatively we see the chance of a major tariff hike at 40%. Diagram 1Decision Tree: Risk Of Significant Trump Punitive Measures On China In 2020 Volatility And Mediterranean Quarrels (GeoRisk Update) Volatility And Mediterranean Quarrels (GeoRisk Update) White House trade czar Peter Navarro’s comments earlier this week, suggesting that the Phase One trade deal was already over, prompted Trump to tweet that he still fully supports the deal. Negotiations between Secretary of State Mike Pompeo and Chinese Politburo member Yang Jiechi also nominally kept the lid on tensions. However, China may need to depreciate the renminbi to ease deflationary pressures on its economy – and this would provoke Trump to retaliate (Chart 13). Chart 13Chinese Depreciation Would Provoke Trump Chinese Depreciation Would Provoke Trump Chinese Depreciation Would Provoke Trump We have always argued against the durability of the Phase One trade deal. Investors should plan for it to fall apart. Judging by our China GeoRisk Indicator, investors are putting in a higher risk premium into Chinese equities (Chart 14). They are also doing so with Korean equities, which are ultimately connected with US-China tensions. Only Taiwan is pricing zero political risk, which is undeserved and explains why we are short Taiwanese equities. After China’s imposition of a controversial national security law in Hong Kong and America’s decision to prepare retaliatory sanctions, reports emerged that Chinese authorities ordered state-owned agricultural traders to halt imports of soybean and pork – and potentially corn and cotton. These reports were swiftly followed by others that highlighted that state-owned Chinese firms purchased at least three cargoes of US soybeans on June 1, in spite of China’s decision to stop imports.1 Thus this aspect of the deal has not yet collapsed. But we would emphasize that the constraints against a failure of the deal are not prohibitive this year. The $200 billion worth of additional Chinese imports over 2020-2021 promised in the deal included $32 billion worth of additional US farm purchases – with at least $12.5 billion in 2020 and $19.5 billion in 2021 over 2017 imports of $24 billion. However, to date, US agricultural exports to China suggest that China may not even meet 2017 levels (Chart 15). Chart 14GeoRisk Indicators Show Rising Risk GeoRisk Indicators Show Rising Risk GeoRisk Indicators Show Rising Risk Chart 15Trade Deal Durability Still Shaky Volatility And Mediterranean Quarrels (GeoRisk Update) Volatility And Mediterranean Quarrels (GeoRisk Update) Soybeans account for roughly 60% of US agricultural exports to China. While Chinese imports are up so far this year relative to 2019, they remain well below pre-trade war levels. Although lower hog herds on the back of the African Swine Flu and disruptions caused by COVID-19 may be blamed, they are not the only cause of subdued purchases. The share of Chinese soybean imports coming from the US is also still below pre-trade war levels (Chart 16). Chart 16China Still Substituting Away From US Volatility And Mediterranean Quarrels (GeoRisk Update) Volatility And Mediterranean Quarrels (GeoRisk Update) New Chinese regulation requiring documents assuring food shipments to China are COVID-19 free adds another hurdle – China already banned poultry imports from Tyson Foods Inc. plants. Although the US’s share of China’s pork imports has picked up significantly, it will not go far toward meeting the trade deal requirements. China’s pork purchases from the US were valued at $0.3 billion in 2017, while soybean imports came in at $14 billion. Bottom Line: Trump’s only lifeline at the moment is the economy which pushes against canceling the US-China deal. But if he becomes a lame duck – or if exogenous factors humiliate him – then all bets are off. The passage of massive stimulus in the US and China removes economic constraints to conflict. Will Erdogan Overstep In Libya? We have long been bearish on Turkey relative to other emerging markets due to President Tayyip Erdogan’s populist policies, which erode monetary and fiscal responsibility and governance. Turkey’s intervention in Libya has marked a turning point in the Libyan civil war. The offensive to seize Tripoli on the part of General Khalifa Haftar of the Tobruk-based Libyan National Army (LNA) has been met with defeat (Map 1). Map 1Libya’s Battlefront Is Closing In On The Oil Crescent Volatility And Mediterranean Quarrels (GeoRisk Update) Volatility And Mediterranean Quarrels (GeoRisk Update) Foreign backing has enabled the conflict. Egypt, the UAE, Saudi Arabia, and Russia are the Libyan National Army’s main supporters, while Turkey and Qatar support Prime Minister Fayez al-Sarraj of the UN recognized Government of National Accord (GNA). The GNA’s successes this year can be credited to Turkey, which ramped up its intervention in Libya, even as oil prices collapsed, hurting Haftar and his supporters. Now the battlefront has shifted to Sirte and the al-Jufra airbase – the largest in Libya – and is closing in on the eastern oil-producing crescent, which contains over 60% of Libya’s oil. The victor in Sirte will also have control over the oil ports of Sidra, Ras Lanuf, Marsa al-Brega, and Zuwetina. With all parties eying the prize, the conflict is intensifying. Tripoli faces greater resistance as its forces move east. Egyptian President Abdel Fattah al-Sisi’s June 6 ceasefire proposal, dubbed the Cairo Initiative, was rejected by al-Sarraj and Turkey. Instead, the Tripoli-based government wants to capture Sirte and al-Jufra before coming to the table. The recapturing of oil infrastructure would bring back some of Libya's lost output (Chart 17). Nevertheless, OPEC 2.0 is committed to keeping oil markets on track to rebalance, reducing the net effect of a Libyan production increase on global supplies. However, the GNA’s swift successes in the West may not be replicable as it moves further East, where support for Haftar is deeper and where the stakes are higher for both sides. This is demonstrated by the GNA’s failed attempt to capture Sirte on June 6. The battlefront is now at Egypt’s red line – GNA control of al-Jufra would pose a direct threat to Egypt and is thus considered a border in Egypt’s national security strategy. A push eastward risks escalating the conflict further by drawing in Egypt militarily. In a televised speech on June 20, al-Sisi threatened to deploy Egypt’s military if the red line is crossed. The statement was interpreted by Ankara as a declaration of war, raising the possibility that Egypt will go to war with Turkey in Libya. On paper, Egypt’s military is up to the task. Its recent upgrades have pulled up its ranking to ninth globally according to the Global Fire Power Index, surpassing Turkey’s strength in land and naval forces (Chart 18). However, while Turkey’s military has been active in other foreign conflicts such as in Syria, Egypt’s army is untested on foreign soil. Its most recent military encounter was the 1973 Yom Kippur War. Even after years of fighting, it has yet to declare victory against terrorist cells in the Sinai Peninsula. Thus Egypt’s rusty forces could face a protracted conflict in Libya rather than a swift victory. Chart 17GNA/Turkish Success Would Revive Libyan Oil Production Volatility And Mediterranean Quarrels (GeoRisk Update) Volatility And Mediterranean Quarrels (GeoRisk Update) Chart 18Egypt Is Militarily Capable … On Paper Volatility And Mediterranean Quarrels (GeoRisk Update) Volatility And Mediterranean Quarrels (GeoRisk Update) Other constraints may also deter al-Sisi from following through on his threat: Other Arab backers of the Libyan National Army – the UAE and Saudi Arabia – are unlikely to provide much support as their economies have been hammered by low oil prices. Egypt’s own economy is in poor shape to withstand a protracted war, with public debt on an unsustainable path. Not coincidentally, Egypt faces another potential military escalation to its south where it has been clashing with Ethiopia over the construction of the Grand Ethiopian Renaissance Dam on the Blue Nile. The dam will control Egypt’s water supply. The latest round of negotiations failed last week. While Cairo is hoping to obtain a bilateral agreement over the schedule for filling the dam, Addis Ababa has indicated that it will begin filling the dam in July regardless of whether an agreement is reached. Al-Sisi’s response to the deadlocked situation has been to request an intervention by the UN Security Council. However, as the July filling date nears, the Egypt-Ethiopia standoff risks escalating into war. For Egypt, there is an urgency to secure its future water supplies now before Ethiopia begins filling the dam. And while resolving the Libyan conflict is also a matter of national security – Egypt sees the Libyan National Army as a buffer between its porous western border and the extremist elements of the GNA – the risks are not as pressing. Thus a military intervention in Libya would distract Egypt from the Ethiopian conflict and risk drawing it into a war on two fronts. Moreover, Egypt generally, and al-Sisi in particular, risk losing credibility in case of a defeat. That said, Egypt has high stakes in Libya. A GNA defeat could annul the recent Libya-Turkey maritime demarcation agreement – a positive for Egypt’s gas ambitions – and eliminate the presence of unfriendly militias on its Western border. Thus, if the GNA or GNA-allied forces kill Egyptian citizens, or look as if they are capable of utterly defeating Haftar on his own turf, then it would be a prompt for intervention. Meanwhile Turkey’s regional influence and foreign policy assertiveness is growing – and at risk of over-extension. Erdogan’s interests in Libya stem from both economic and strategic objectives. In addition to benefitting from oil and gas rights and rebuilding contracts, Ankara’s strategy is in line with its pursuit of greater regional influence as set out in the Mavi Vatan, its current strategic doctrine.2 There are already rumors of Turkish plans to establish bases in the recently captured al-Watiya air base and Misrata naval base. This would be in addition to Ankara’s bases in Somalia and in norther Iraq. Erdogan is partly driven into these foreign policy adventures to distract from his domestic challenges and keep his support level elevated ahead of the 2023 general election (Chart 19). However, his growing assertiveness threatens to alienate European neighbors and NATO allies, which have so far played a minimal role in the Libyan conflict yet have important interests there. For now, the western powers seem focused on countering Russian intervention in Libya and the broader Mediterranean. Prime Minister al-Sarraj and General Stephen Townsend, head of US Africa Command (AFRICOM), met earlier this week and reiterated the need to return to the negotiating table and respect Libyan sovereignty and the UN arms embargo, with a focus on stemming Russian interference. However, Turkish relations with the West may take a turn for the worse if Erdogan oversteps. Turkey continues to threaten Europe with floods of refugees and immigrants if its demands are not met. This pressure will grow due to the COVID-19 crisis, which will ripple across the Middle East, Africa, and South Asia. Ankara also continues to press territorial claims in the Mediterranean Sea, ostensibly for energy development.3 Turkey has recently clashed with Greece and France on the seas. In sum, the Libyan conflict is intensifying as it moves into the oil crescent. The Turkey-backed GNA will face greater resistance in Sirte and al-Jufra, even assuming that Egypt does not follow through on its threat of intervening militarily. Erdogan’s foreign adventurism will provoke greater opposition in Libya and elsewhere among key western powers, Russia, and the Gulf Arab states. Bottom Line: The implication is that a deterioration in Turkey’s relationship with the West, military overextension, and continued domestic economic mismanagement will push up our Turkey GeoRisk Indicator, which is a way of saying that it will weigh on the currency (Chart 20). Chart 19Erdogan’s Fear Of Opposition Drives Bold Policy Volatility And Mediterranean Quarrels (GeoRisk Update) Volatility And Mediterranean Quarrels (GeoRisk Update) Chart 20Foreign And Domestic Factors Will Push Up Turkish Risk Foreign And Domestic Factors Will Push Up Turkish Risk Foreign And Domestic Factors Will Push Up Turkish Risk Stay short our “Strongman Basket” of emerging market currencies, including the Turkish lira. Investment Takeaways We entered the year by going strategically long EUR-USD, but closed the trade upon the COVID-19 lockdowns. We have resisted reinitiating it despite the 5% rally over the past three months due to extreme political risks this year, namely the US election and trade risks. Trump’s threat of tariffs on Europe this week highlights our concern. We will wait until the election outcome before reinstituting this trade, which should benefit over time as global and Chinese growth recover and the US dollar drops on yawning twin deficits. Throughout this year’s crisis we have periodically added cyclical and value plays to our strategic portfolio. We favor stocks over bonds and recommend going long global equities relative to the US 30-year treasuries. We are particularly interested in commodities that will benefit from ultra-reflationary policy and supply constraints due to insufficient capital spending. This month we recommend investors go long our BCA Rare Earth Basket, which features producers of rare earth elements and metals that can substitute for Chinese production (Chart 21). This trade reflects our macro outlook as well as our sense that the secular US-China strategic conflict will heat up before it cools down. Chart 21Position For An Escalation In The US-China Conflict Position For An Escalation In The US-China Conflict Position For An Escalation In The US-China Conflict   Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com   Roukaya Ibrahim Editor/Strategist Geopolitical Strategy RoukayaI@bcaresearch.com Footnotes 1 Please see Karl Plume et al, "China buys U.S. soybeans after halt to U.S. purchases ordered: sources," Reuters, June 1, 2020. 2 The Mavi Vatan or “Blue Homeland Doctrine” was announced by Turkish Admiral Cem Gurdeniz in 2006 and sets targets to Turkish control in two main regions. The first region is the three seas surrounding it – the Mediterranean Sea, Aegean Sea, and Black Sea with the goal of securing energy supplies and supporting Turkey’s economic growth. The second region encompasses the Red Sea, Caspian Sea and Arabian Sea where Ankara has strategic objectives. 3 Ankara’s gas drilling activities off Cyprus have been a form of frequent provocation for Greece and Cyprus. Ankara has also stated that it may begin oil exploration under a controversial maritime deal with Libya as early as August. Section II: Appendix : GeoRisk Indicator China China: GeoRisk Indicator China: GeoRisk Indicator Russia Russia: GeoRisk Indicator Russia: GeoRisk Indicator UK UK: GeoRisk Indicator UK: GeoRisk Indicator Germany Germany: GeoRisk Indicator Germany: GeoRisk Indicator France France: GeoRisk Indicator France: GeoRisk Indicator Italy Italy: GeoRisk Indicator Italy: GeoRisk Indicator Canada Canada: GeoRisk Indicator Canada: GeoRisk Indicator Spain Spain: GeoRisk Indicator Spain: GeoRisk Indicator Taiwan Taiwan: GeoRisk Indicator Taiwan: GeoRisk Indicator Korea Korea: GeoRisk Indicator Korea: GeoRisk Indicator Turkey Turkey: GeoRisk Indicator Turkey: GeoRisk Indicator Brazil Brazil: GeoRisk Indicator Brazil: GeoRisk Indicator Section III: Geopolitical Calendar

US Dollar Bear Market... US Dollar Bear Market... In this Monday’s Special Report, we examined which S&P 500 GICS1 sectors have historically benefited from a falling greenback. Currently, piling evidence suggests that the path of least resistance will be lower for the US dollar. Looking at structural (five years+) dynamics, swelling twin deficits emit a bearish USD signal. In more detail, prior to COVID-19 outbreak, the US twin deficits were estimated to gradually rise towards the 7.5% mark (top panel), but now the US Congressional Budget Office (CBO) estimates that the US fiscal deficit alone will be approximately 11% of nominal GDP for 2020 if not higher. In other words, the recent pandemic has exacerbated already structurally bearish dynamics for the US dollar. Switching gears from a structural to a medium term horizon (2-3 years), BCA’s four-factor macro model, is sending an unambiguous bearish message regarding the greenback’s fate (middle panel). Finally, on a short-term time horizon, the USD is lagging the money multiplier by approximately 3 months. The COVID-19 catalyzed recession and resulting money printing will likely exert extreme downward pressure on the US dollar (bottom panel).  

Please note that yesterday we published Special Report titled Do Not Overlook China’s Innovation Drive. Please click on it to access it. Today, we publish analysis on Brazil and Ukraine.   Chart I-1Brazilian Share Prices And Commodity Prices Move In Tandem Brazilian Share Prices And Commodity Prices Move In Tandem Brazilian Share Prices And Commodity Prices Move In Tandem A FOMO (fear-of-missing-out) mania has pushed equity prices higher around the world. Brazilian stocks, currency and credit markets, likewise, have been staging a rebound. There is evidence that in Brazil equity purchases by local investors have been driving up share prices.1 The absolute performance of Brazilian share prices and the exchange rate trend will likely depend on commodities prices and a global rally in risk assets (Chart I-1). In relative terms, Brazilian financial markets will underperform their EM counterparts because of the following: Brazil is on track for its worst economic contraction in the past century following the deep recession of 2014-2016 (Chart I-2). This is the first nominal GDP contraction in Brazil. Growth was feeble even before the pandemic struck, but the COVID-19 lockdowns were the last nail in the coffin for the economy. Given that Brazil has not been able to control the spread of the virus – having hit another high in daily new infections last Friday – major cities will be forced to maintain social distancing measures for longer, delaying a recovery in consumer and business confidence. Chart I-2The Level Of Economic Activity In Real And Nominal Terms The Level Of Economic Activity In Real And Nominal Terms The Level Of Economic Activity In Real And Nominal Terms Table I-1Brazil's Fiscal Package Is The Largest In The Region Brazil: Is The Worst Behind Us? Brazil: Is The Worst Behind Us?   While Brazil has deployed the largest COVID-19 fiscal package in the region (Table I-1), its economic recovery will lag behind the majority of EM and DM countries. State-sponsored loans have not been reaching small and micro businesses, which employ over half of the working force. Moreover, informal workers amount to about 20% of the country’s total population, and they also have not been receiving any economic benefits other than a $120 US dollar monthly stipend. Household income growth was subdued during the 2017-2019 recovery. To support their living standards, families were aggressively borrowing before the pandemic (Chart I-3, top panel). Now, with their income contracting and household debt servicing costs above 20% of disposable income, consumer loan defaults will mushroom (Chart I-3, bottom panel). Chart I-4 shows that non-performing loans (NPL) for households are rising as a share of total consumer loans. Chart I-3Household Income, Credit And Debt Service Household Income, Credit And Debt Service Household Income, Credit And Debt Service Chart I-4Mushrooming Consumer Delinquencies Mushrooming Consumer Delinquencies Mushrooming Consumer Delinquencies   The private banks’ NPL provisions are set to surge due to rising defaults. Consumer loans make up 53% of private banks’ non-earmarked (non state-directed) lending. Chart I-5 shows that bank share prices are highly correlated with the annual change in provisions (shown inverted). Hence, the further rise in provisions will continue undermining bank share prices. We published a Special Report on Brazilian banks on March 31 and their outlook remains dismal. Besides, facing high credit risks, private banks have tightened credit standards and loan origination is plummeting, further hurting the economy. The sheer size of the fiscal stimulus and the historic nominal GDP contraction will push the gross public debt-to-GDP ratio well above 100% by end-2020. As discussed in our previous reports,2 and provided local currency interest rates remain above nominal GDP growth, public debt is on an unsustainable trajectory (Chart I-6). Chart I-5Do Not Chase Brazilian Bank Stocks Do Not Chase Brazilian Bank Stocks Do Not Chase Brazilian Bank Stocks Chart I-6Government Bond Yields Are Well Above Nominal GDP Growth Government Bond Yields Are Well Above Nominal GDP Growth Government Bond Yields Are Well Above Nominal GDP Growth   Chart I-7The Social Security Deficit Is Widening The Social Security Deficit Is Widening The Social Security Deficit Is Widening The only way to stabilize the public debt-to-GDP ratio in Brazil is via the central bank conducting substantial quantitative easing, i.e. monetary authorities purchasing local government bonds. This will push local bond yields much lower and over time boost nominal GDP growth. With interest rate on government debt below nominal GDP growth over several years, the condition of public debt sustainability will be achieved. However, this amounts to monetization of public debt and, if carried on a large scale, it will suffocate the exchange rate – the currency would depreciate a lot. Furthermore, the projected BRL 800 billion (11% of GDP) in savings from the infamous pension reform will be impossible to achieve. Chart I-7 shows that the social security deficit has widened since March due to the shortfall in revenues. Given social security revenues are derived from taxes on workers and businesses, this deficit will continue to increase as employment and wages collapse while pension payouts remain fixed. Finally, the political situation is in disarray and a presidential impeachment might be inevitable. President Bolsonaro has become even more radical and is in conflict with various branches of power. Meanwhile, corruption and electoral fraud investigations against him and his allies continue to develop. The key risk to our negative view is as follows: One could argue that investors have lost faith in the Bolsonaro administration and are actually looking forward to his removal from office. Hence, the escalating political crisis culminating in Bolsonaro’s impeachment would be bullish for financial markets. This is a valid perspective given Vice-president Mourão – who has the backing of the army and adheres to a more centrist view on a wide range of issues - would assume the presidency in the case of impeachment. He would maintain orthodox economic policies and cooperate with Congress. This kind of thinking from investors might be taking its cues from the political dynamics and market actions in early 2016, when Brazilian markets bottomed seven months before then President Dilma Rousseff was impeached. Brazil is on track for its worst economic contraction in the past century following the deep recession of 2014-2016. In addition, the long-term political outlook for Brazil might be turning positive. The quite popular ex-Justice Minister Sergio Moro hinted last week that he could run in the 2022 presidential race. While he did not explicitly announce his candidacy, he stated that he wants to “participate” in the public debate by presenting a pro-market and anti-corruption alternative to Bolsonaro. If Moro runs, he will likely win given his enormous popularity. His victory will be accordingly cheered by international and domestic investors as he would run on a platform of structural reforms. Chart I-8The Brazilian Real Is Only Modestly Cheap The Brazilian Real Is Only Modestly Cheap The Brazilian Real Is Only Modestly Cheap Nevertheless, in the near term Bolsonaro will try to maintain his grip on power as long as he can. Foreseeing the risk of impeachment, he has strengthened his ties with the big coalition of small centrist parties in Congress. For now, it is not clear if Congress will vote for his removal. Importantly, the more radical and autocratic Bolsonaro becomes in a bid to save his presidency, the higher the odds of Economy Minister Paulo Guedes resigning. This was the case with the Ministers of Health and Justice and the Secretary of the Treasury. The latter was a key figure in drafting economic reforms. If Guedes resigns, it will send shockwaves throughout the nation’s financial markets. Bottom Line: Continue underweighting Brazilian equities and fixed income within their respective EM universes. We took profits on our short BRL/long USD position on June 4th due to tactical considerations. Investors should consider shorting the BRL again. The BRL is somewhat but not very cheap (Chart I-8). Juan Egaña Research Associate juane@bcaresearch.com Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Ukraine: An Opportunity In Bonds Is Still Present Investors should stay long local currency government bonds and continue overweighting the nation’s sovereign credit within the EM sovereign credit universe. Ukraine is pursuing prudent fiscal policy under the auspices of the IMF. With the government refraining from announcing a large-scale fiscal spending package amid the COVID-19 outbreak, its fiscal overall and primary deficits will widen to 8% and 4% of GDP, respectively. In particular, the increase in healthcare and social spending will be partially offset by both a reduction in discretionary spending and a cap on public wages. Such a conservative policy approach is negative for growth but will result in lower inflation and a stable exchange rate. Critically, a prudent fiscal policy will allow the central bank to cut interest rates. Both headline and core consumer price inflation are well below the lower end of the central bank’s target band (Chart II-1). Nominal wage growth is heading toward zero and will probably deflate by the end of this year (Chart II-2). Falling domestic demand will ensure that any rise in inflation due to currency depreciation will be modest. Chart II-1Inflation Is Undershooting Inflation Is Undershooting Inflation Is Undershooting Chart II-2Wage Growth Is Subdued! Wage Growth Is Subdued! Wage Growth Is Subdued!   As a result of considerable disinflation, real interest rates are still very high. Elevated real rates warrant large interest rate cuts by the central bank. Deflated by core consumer inflation, the real policy rate is 8% and the real lending rate is 12% for companies and over 30% for consumer credit (Chart II-3). A conservative policy approach is negative for growth but will result in lower inflation and a stable exchange rate. High real rates will entice foreign portfolio capital. Chart II-4 demonstrates that foreign investors have reduced their holdings of local bonds from $5.2 billion at the end of 2019 to $3.75 billion currently. Given the very low real rates worldwide, Ukraine is one of few markets offering high real rates with decent macro policies, at least in the medium term. Chart II-3Elevated Real Rates Warrant More Rate Cuts By CB Elevated Real Rates Warrant More Rate Cuts By CB Elevated Real Rates Warrant More Rate Cuts By CB Chart II-4Foreign Inflows Could Resume Foreign Inflows Could Resume Foreign Inflows Could Resume   With regard to the balance of payments, the recently announced $5 billion IMF loan should help ease short-term funding for the country. The 18-month arrangement will provide the immediate disbursement of $2.1 billion with a second disbursement of $0.7 billion expected by the end of September after the IMF program review. Importantly, plummeting imports and relatively resilient exports will narrow the current account deficit (Chart II-5). Exports should remain supported by food exports, which represents close to 40% of overall exports. Besides, the central bank also carries $25 billion in foreign exchange reserves, which compares with $18 billion in foreign funding requirements for 2020 (Chart II-6). So far, the central bank has refrained from selling foreign exchange reserves but might do so if the currency depreciates significantly. Chart II-5Current Account Will Balance Soon Current Account Will Balance Soon Current Account Will Balance Soon Chart II-6Foreign Funding Requirements Are Covered By FX Reserves Foreign Funding Requirements Are Covered By FX Reserves Foreign Funding Requirements Are Covered By FX Reserves   Bottom Line: We continue to recommend holding 5-year local currency government bonds currently yielding 11%. Even though moderate currency depreciation cannot be ruled out, on a total return basis domestic bonds will deliver decent returns to foreign investors in the next 6-12 months.  EM fixed income investors should continue overweighting domestic bonds and sovereign US dollar credit within respective EM portfolios. Andrija Vesic Associate Editor andrijav@bcaresearch.com     Footnotes 1     Investors ignore triple crisis and bet on equities 2     Please see Emerging Markets Strategy Countries In-Depth "Brazil: Deflationary Pressures Warrant A Weaker BRL," dated November 28, 2019 available at ems.bcaresearch.com Please see Emerging Markets Strategy Countries In-Depth "Brazil: Just Above "Stall Speed"," dated September 27, 2019 available at ems.bcaresearch.com   Equities Recommendations Currencies, Credit And Fixed-Income Recommendations