Financial Markets

Highlights We conservatively estimate lost output from shutdowns and social distancing will equal $10 trillion, and we expect the jobs market to be permanently scarred. Inflation, even at 2 percent, is a pipe dream, which leads to three investment conclusions on a 1-year horizon: Overweight US T-bonds and Spanish Bonos versus German Bunds and French OATs. Any high-quality bond yield that can decline will decline. Overweight CHF/USD. The tightening yield spread will structurally favour the CHF, while the haven status of the CHF should prevent it from underperforming in periods of market stress. Overweight defensive equities (technology and healthcare) versus cyclical equities (banks and energy). This implies underweight European equities versus other markets. Fractal trade: Short Germany versus the UK. The recent outperformance of German equities is technically extended. Feature Chart of the WeekCredit Impulses Are Large, But The Hole In Output Is Much Larger Credit Impulses Are Large, But The Hole In Output Is Much Larger Credit Impulses Are Large, But The Hole In Output Is Much Larger Big numbers befuddle us. Hardly a day passes without someone listing the unprecedented global stimulus unleashed to counter the coronavirus forced shutdowns – the trillions in government spending promises, tax relief, loan guarantees, money supply growth, and central bank asset-purchases. The most optimistic estimates quantify the total stimulus at $15 trillion. This includes $7 trillion of loan guarantees plus increases in central bank balance sheets which do not directly boost demand. So the direct stimulus is closer to $7 trillion.1 Yet the size of the stimulus is meaningless until we quantify the massive hole in economic output that needs to be filled. Assuming no further large-scale shutdowns, we conservatively estimate that the hole will amount to 12 percent of world output, or $10 trillion. A $10 Trillion Hole In Output Last week, the UK’s Office for National Statistics (ONS) helped us to estimate the hole in output, because unusually the ONS calculates UK GDP on a monthly basis. Between February and April, when the UK economy went from fully open to full shutdown, UK GDP collapsed by 25 percent. This despite the UK having an outsized number of jobs suitable for ‘working from home.’ For a more typical economy, we estimate that a full shutdown collapses output by 30 percent (Chart I-2). Chart I-2A Full Shutdown Collapses Output By 30 Percent A Full Shutdown Collapses Output By 30 Percent A Full Shutdown Collapses Output By 30 Percent The next question is: how long does the full shutdown last? Assuming it lasts for three months, output would suffer a hole amounting to 7.5 percent of annual GDP.2  But in practice, the economy will not fully re-open after three months. Social distancing will persist until people feel confident that the pandemic is under control. An effective vaccine against Covid-19 is unlikely to be available for a year. So, even without government policy to enforce social distancing, many people will choose to avoid crowds and congregations for fear of catching the virus. The size of the stimulus is meaningless until we quantify the massive hole in economic output. This means that the sectors that rely on crowds and congregations – leisure and hospitality and retail trade – will be operating at half-capacity, at best. Given that these sectors generate 9 percent of GDP, operating at half-capacity will create an additional hole amounting to 4.5 percent of output. More worryingly, these two sectors employ 21 percent of all workers, so operating at sub-par will leave the jobs market permanently scarred.3 Combining the 7.5 percent existing hole with the 4.5 percent future hole, the full hole in economic output will amount to around 12 percent of annual GDP. As global GDP is worth around $85 trillion, this equates to $10 trillion.  Crucially though, our estimate assumes that a second wave of the pandemic will not force a new cycle of shutdowns. If it does, the hole will become even bigger. Don’t Be Fooled By Money Supply Growth The recent growth in broad money supply seems a big number. Since the start of the year, the outstanding stock of bank loans has increased by around $0.7 trillion in the euro area, and by $1 trillion in both the US and China (Chart I-3 and Chart I-4). This has boosted the 6-month credit impulses in all three economies. Indeed, the US 6-month credit impulse recently hit its highest value of all time, and the combined 6-month impulse across all three blocs equals around $2 trillion (Chart of the Week). Chart I-3Don't Be Fooled By Money Supply Growth In The Euro Area And The US... Don't Be Fooled By Money Supply Growth In The Euro Area And The US... Don't Be Fooled By Money Supply Growth In The Euro Area And The US... Chart I-4...And In ##br##China ...And In China ...And In China This 6-month credit impulse quantifies the additional borrowing in the most recent six-month period compared to the previous period. Ordinarily, a $2 trillion impulse would create a huge boost to demand. After all, the private sector does not usually borrow just to hold the cash in a bank. Yet in the coronavirus crisis this is precisely what has happened. While the shutdowns lasted, firms drew on existing bank credit lines to build up emergency cash buffers. Therefore, much of the money growth will not generate new demand. While the shutdowns lasted, firms drew on existing bank credit lines to build up emergency cash buffers.  To the extent that this cash is sitting idly in a firm’s bank account, the monetary velocity will decline. Meaning there will be a much-reduced transmission from credit impulses to spending growth. Furthermore, when the economy re-opens, many firms will relinquish the precautionary credit lines. There is no point holding cash in the bank when there are few investment opportunities. Hence, credit impulses will fall back – as seems to be the case right now in the US. QE: The Great Misunderstanding To repeat, big numbers befuddle us. They must always be put into context. No truer is this than when it comes to central bank asset-purchases. The great misunderstanding is that the act of central banks buying assets, per se, drives up those asset prices. Central banks act as lenders of last resort to solvent but illiquid banks and sovereigns. If there is ample liquidity in these markets – as is the case now – then the primary function of central bank asset-purchases is to set the term-structure of interest rates. In turn, the term-structure of global interest rates establishes the prices of $500 trillion of global assets. The prices of these assets are inextricably inter-connected and inter-dependent4 (Chart I-5). Chart I-5The Prices Of $500 Trillion Of Assets Are Inextricably Inter-Connected The Prices Of $500 Trillion Of Assets Are Inextricably Inter-Connected The Prices Of $500 Trillion Of Assets Are Inextricably Inter-Connected The great misunderstanding is that the act of central banks buying assets, per se, drives up those asset prices. Yet central banks set no price target for their asset-purchases. They leave that to the market. Moreover, in the context of the $500 trillion of inter-dependent asset prices, the $10-15 trillion or so of central bank asset-purchases to date constitutes chicken feed (Chart I-6). Hence, the mechanism by which asset-purchases work is through the signal they give to the $500 trillion market on the likely course of interest rate policy. This sets the term-structure of interest rates, which in turn sets the required return on all the $500 trillion of assets (Chart I-7). Chart I-6$10-15 Trillion Of QE Is Chicken Feed... $10-15 Trillion Of QE Is Chicken Feed... $10-15 Trillion Of QE Is Chicken Feed... Chart I-7...Compared To $500 Trillion Of Assets Priced By The Term-Structure Of Interest Rates ...Compared To $500 Trillion Of Assets Priced By The Term-Structure Of Interest Rates ...Compared To $500 Trillion Of Assets Priced By The Term-Structure Of Interest Rates As the ECB’s former Chief Economist, Peter Praet, explains: “There is a signalling channel inherent in asset purchases, which reinforces the credibility of forward guidance on policy rates. This credibility of promises to follow a certain course for policy rates in the future is enhanced by the asset purchases, as these asset purchases are a concrete demonstration of our desire (to keep policy rates at the lower bound.)” The credible commitment to keep policy rates near the lower bound for an extended period depresses bond yields towards the lower bound too. But once bond yields have reached their lower bound the effectiveness of central bank asset-purchases becomes exhausted. Three Investment Conclusions The main purpose of this report was to put the $7 trillion of direct stimulus dollars unleashed into the economy into a proper context. With lost output estimated at $10 trillion and the jobs market permanently scarred, inflation – even at 2 percent – is a pipe dream. Moreover, a second wave of the pandemic and a new cycle of shutdowns would inject a further disinflationary impulse. This leads to three investment conclusions on a 1-year horizon: Any high-quality bond yield that can decline – because it is not already near the -1 percent lower bound to yields – will decline. An excellent relative value trade is to overweight US T-bonds and Spanish Bonos versus German Bunds and French OATs (Chart I-8). Long CHF/USD is a win-win. The tightening yield spread will structurally favour the CHF, while the haven status of the CHF should prevent it from underperforming in periods of market stress. Overweight defensive equities versus cyclical equities, with technology correctly defined as defensive, not cyclical. The performance of cyclicals (banks and energy) versus defensives (technology and healthcare) is now joined at the hip to the bond yield (Chart I-9). This implies underweight European equities versus other markets. Chart I-8Bond Yields That Can Decline Will Decline Bond Yields That Can Decline Will Decline Bond Yields That Can Decline Will Decline Chart I-9The Performance Of Cyclicals Versus Defensives Is Joined At The Hip To The Bond Yield The Performance Of Cyclicals Versus Defensives Is Joined At The Hip To The Bond Yield The Performance Of Cyclicals Versus Defensives Is Joined At The Hip To The Bond Yield Fractal Trading System* The recent outperformance of German equities is technically extended. Accordingly, this week’s recommended trade is to go short Germany versus the UK, expressed through the MSCI dollar indexes. Set the profit target and symmetrical stop-loss at 5 percent. MSCI: Germany Vs. UK MSCI: Germany Vs. UK In other trades, long euro area personal products versus healthcare achieved its 7 percent profit target at which it was closed. The rolling 1-year win ratio now stands at 65 percent. When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated  December 11, 2014, available at eis.bcaresearch.com. Footnotes 1 Source: Reuters estimate. 2 A 30 percent loss in output for a quarter of a year (3 months) amounts to a 30*0.25 = 7.5 percent loss in annual output. 3 Using the weights of leisure and hospitality and retail trade in the US economy as a proxy for the global weights. 4 The $500 trillion of assets comprises: real estate $300 trillion, public and private equity $100 trillion, corporate bonds and EM debt $50 trillion, and high-quality government bonds $50 trillion.   Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading System   Cyclical Recommendations Structural Recommendations Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

Highlights High-Yield: Our analysis of current junk spread levels relative to likely economic outcomes leaves us inclined to maintain our current recommended positioning: Overweight Ba-rated bonds, underweight bonds rated B & below. Fed/Treasuries: There is no urgency for the Fed to provide more explicit forward rate guidance. The market has already taken on board the expectation that the funds rate will stay pinned at zero at least through the end of 2022. Investors should keep portfolio duration near benchmark but add tactical overlay positions: long TIPS versus nominal Treasuries, and steepeners along both the nominal and real yield curves. Securitizations: We recommend that investors continue to overweight Aaa-rated consumer ABS and CMBS, as both sectors offer attractive spreads and benefit from TALF. Despite the lack of Fed support, adding some non-Aaa consumer ABS exposure also makes sense. Investors should continue to avoid Agency MBS, where value has improved but prepayment risk remains high. Feature In case it wasn’t already obvious that the Fed will continue to act as a tailwind behind risky asset prices, Chair Powell made it abundantly clear at last week’s FOMC press conference. When asked about the risk of bubbles in financial markets, Powell’s response was to focus on the millions of unemployed workers and imply that it would be a dereliction of the Fed’s duties if it were to hold back on monetary stimulus because it thought asset prices were too high. Ironically, this strong statement of market support came the day before the S&P 500 fell 6% in a single session. Nonetheless, with the Fed providing such aggressive forward guidance on top of direct intervention in certain segments of the fixed income market, it behooves us to consider whether our recommended portfolio allocation is insufficiently aggressive. The Strong Performance Of Low-Rated Junk Chart 1Lower-Rated Junk Bonds Playing Catch-Up Lower-Rated Junk Bonds Playing Catch-Up Lower-Rated Junk Bonds Playing Catch-Up Within the high-yield corporate bond market we have been advising an overweight allocation to Ba-rated bonds but an underweight allocation to bonds rated B and below. The reasoning is that Ba-rated bonds are largely eligible for the Fed’s emergency lending facilities while lower-rated junk bonds are mostly left out in the cold.1 This positioning worked well throughout April and the first half of May, but lower-rated junk bonds have started to play catch-up during the past month (Chart 1). High-Yield Index Fundamentals To get a sense of whether we should extend our overweight recommendation to the B and below credit tiers, let’s first perform a valuation exercise on the entire high-yield index. In this exercise we consider current spread levels relative to likely economic outcomes. We set aside any impact from direct Fed intervention for the time being. Our analysis revolves around the High-Yield Default-Adjusted Spread (Chart 2). This valuation measure takes the junk index spread and subtracts default losses realized during the subsequent 12 month period. The spread’s historical average is around 250 bps, but it has occasionally dipped below zero during periods when default losses swamp the compensation offered by the index. Chart 2High-Yield Index Assessment: Default-Adjusted Spread High-Yield Index Assessment: Default-Adjusted Spread High-Yield Index Assessment: Default-Adjusted Spread The Default-Adjusted Spread also lines up very closely with 12-month excess returns (Chart 2, panel 2). A simple linear regression model of 12-month excess returns versus the Default-Adjusted Spread gives an R2 of 53% and tells us that the threshold between positive and negative excess returns is a Default-Adjusted Spread of 187 bps. That is, if the Default-Adjusted Spread is above 187 bps we should expect high-yield to outperform Treasuries, if it is below 187 bps we should expect high-yield to underperform. With that in mind, we can apply some quick figures to the current context. The High-Yield index option-adjusted spread is 611 bps. If we assume a default rate of 10% and recovery rate of 25% for the next 12 months, we get expected default losses of 750 bps and a Default-Adjusted Spread of -139 bps. We should expect Treasuries to outperform junk bonds in that scenario. Ba-rated bonds are largely eligible for the Fed’s emergency lending facilities while lower-rated junk bonds are mostly left out in the cold. We can also perform the same sort of analysis in reverse. If we target a Default-Adjusted Spread of 187 bps – the spread that is consistent with high-yield performing in line with Treasuries – and we also assume a recovery rate of 25%, then the current index spread gives us an implied 12-month default rate of 5.7% (Chart 2, bottom panel). That is, we should expect high-yield to outperform Treasuries during the next 12 months if the default rate comes in below 5.7%, and underperform if it is above 5.7%. There are a couple assumptions used in the above analysis that require clarification. First, we relied on a simple linear regression model to get the result that a Default-Adjusted Spread of 187 bps is consistent with junk bonds breaking even with Treasuries. This is not an entirely accurate depiction of the historical record. Table 1 shows a more complete picture of the historical linkage between the Default-Adjusted Spread and 12-month high-yield excess returns. Here, we see that junk bonds have actually outperformed duration-matched Treasuries 81% of the time when the Default-Adjusted Spread is between 150 bps and 200 bps, and 72% of the time when it is between 100 bps and 150 bps. Relative junk bond losses only become more likely than gains when the Default-Adjusted Spread is below 100 bps. Table 1The Default-Adjusted Spread & High-Yield Excess Returns No Holding Back No Holding Back Second, we assumed a 25% recovery rate when we calculated our implied default rate of 5.7%. This is low compared to the historical average, but we would argue that a low recovery rate assumption is appropriate in the current environment. We analyzed the main economic drivers of default and recovery rates in a recent Special Report and found that the recovery rate observed during an economic downturn is primarily driven by corporate balance sheet leverage heading into that downturn.2 Corporate balance sheets were carrying a lot of debt heading into the current recession, meaning that we should expect a lower-than-normal recovery rate. In fact, the current trailing 12-month recovery rate is 22%, below our assumed level. Table 2 shows what the Default-Adjusted Spread will be for the next 12 months under different default and recovery rate assumptions. We think that 25% is a reasonable recovery rate assumption and expect that the default rate will be somewhere between 9% and 12% during the next 12 months. At present, Moody’s baseline 12-month default rate forecast is 11.6%. Table 2Default-Adjusted Spread (BPs) Given Different Assumptions For Default And Recovery Rates No Holding Back No Holding Back Clearly, junk spreads do not offer adequate compensation for default losses in the economic environment we anticipate. This logic also extends to the individual B and Caa/C credit tiers when we look at them in isolation. A Focus On B-Rated & Below Junk Bonds Charts 3A and 3B show the historical linkage between Default-Adjusted Spreads and excess returns for those specific credit tiers, with forecasts plugged in for “mild”, “moderate” and “severe” default scenarios. All three scenarios use a recovery rate of 25%. The assumed default rate is 6% in the “mild” scenario, 9% in the “moderate” scenario and 12% in the “severe” scenario. Default-adjusted compensation is unattractive in all three cases. Chart 3AB-Rated Default-Adjusted Spread No Holding Back No Holding Back Chart 3BCaa/C-Rated Default-Adjusted Spread No Holding Back No Holding Back Bottom Line: Our analysis of current junk spread levels relative to likely economic outcomes leaves us inclined to maintain our current recommended positioning: Overweight Ba-rated bonds, underweight bonds rated B & below. The Fed’s support for the Ba credit tier will significantly limit default losses for those bonds, making current spread levels attractive. However, absent Fed intervention, junk spreads are already far too tight. Investors should avoid bonds rated B & below where issuers generally don’t benefit from the Fed’s emergency programs. No Rush For More Explicit Forward Guidance In addition to Chair Powell’s strong statement of support for risky assets, last week’s FOMC meeting brought us the committee’s updated interest rate projections. With only two exceptions, those projections revealed that all Fed policymakers expect to keep the fed funds rate at its current level at least until the end of 2022. There had been some expectation that the Fed might provide more explicit forward guidance for the funds rate. Something along the lines of the “Evans Rule” that was used during the last zero-lower-bound episode. For example, the Fed could pledge to not increase rates until the unemployment rate is below some specified threshold or inflation is above some specified threshold. Fed policymakers expect to keep the fed funds rate at its current level at least until the end of 2022. This sort of forward guidance would be useful if the Fed needed to convince markets about its commitment to keeping rates pinned near zero, but the market has already internalized that message. Notice in Chart 4 that expectations priced into the overnight index swap curve show no rate hikes through the end of 2022. The same goes for the median estimate from the New York Fed’s April 2020 Survey of Market Participants. Chart 4Fed Policymakers And Market Participants Agree: No Hikes Until 2023 Fed Policymakers And Market Participants Agree: No Hikes Until 2023 Fed Policymakers And Market Participants Agree: No Hikes Until 2023 More explicit forward rate guidance will likely be required in the future, when the market starts to price-in the eventual return of rate hikes. But for the time being, the Fed will probably be content to stay the course. Treasury Positioning The combination of the Fed’s strong commitment to zero interest rates and the risks to the 6-12 month economic outlook that we detailed in last week’s report make us inclined to maintain our recommended “At Benchmark” portfolio duration stance.3 However, we also recognize that yields are more likely to rise than fall in the coming months as the US economy re-opens and the economic data trend higher. For this reason, we advise holding several tactical overlay trades that will profit from rising bond yields: overweight TIPS versus nominal Treasuries, duration-neutral nominal curve steepeners, real yield curve steepeners. On TIPS, May’s CPI report showed a third consecutive month-over-month decline but the drop was far less severe than what was seen in March and April (Chart 5). This is a preliminary indication that we could already be passed the trough in inflation. The fact that trimmed mean CPI has not followed the core measure lower during the past few months is further evidence that inflation may not fall much more from its current level (Chart 5, bottom panel). If inflation has indeed bottomed, then our recommendation to favor TIPS over nominal Treasuries looks very good. We calculate that the current 1-year TIPS breakeven inflation rate is 0.1%, slightly below trailing 12-month headline CPI inflation (Chart 5, panel 2). Along the nominal Treasury curve, we continue to recommend favoring the 5-year bullet over a duration-matched 2/10 barbell. This position will profit from continued 2/10 yield curve steepening (Chart 6). We also recommend steepeners along the real yield curve. The real 2/10 slope has already steepened a lot (Chart 6, bottom panel), but has more room to run given that the 2-year cost of inflation compensation remains well below the 10-year cost (Chart 6, panel 3). Chart 5Is The Trough In Inflation Already##br## Behind Us? Is The Trough In Inflation Already Behind Us? Is The Trough In Inflation Already Behind Us? Chart 6Keep Steepeners Along Both The Nominal And Real Yield Curves Keep Steepeners Along Both The Nominal And Real Yield Curves Keep Steepeners Along Both The Nominal And Real Yield Curves Bottom Line: There is no urgency for the Fed to provide more explicit forward rate guidance. The market has already taken on board the expectation that the funds rate will stay pinned at zero at least through the end of 2022. Investors should keep portfolio duration near benchmark but add tactical overlay positions: long TIPS versus nominal Treasuries, and steepeners along both the nominal and real yield curves. Securitized Products Update Take Some Non-Aaa Risk In Consumer ABS, But Not In CMBS Since the Fed rolled out its emergency lending facilities in late-March, our spread product strategy has been to favor sectors that offer attractive spreads and that benefit from Fed support. This has meant owning Aaa-rated consumer ABS and CMBS, which are eligible for the Fed’s Term Asset-Backed Securities Loan Facility (TALF), and avoiding non-Aaa securitizations, which don’t qualify for Fed support. How has this worked out? Aaa-rated ABS and CMBS have both performed well since spreads peaked on March 23 (Chart 7). Within ABS, Aaa issues have beaten Treasuries by 390 bps since March 23 compared to 290 bps for non-Aaa securities. In CMBS, non-Aaa securities have lagged, losing 470 bps versus Treasuries since March 23 compared to gains of 810 bps for Aaa CMBS. As Chart 7 makes plain, no segments of either market have regained all of the ground that was lost during March’s blow-up. Chart 7Opportunities In Non-Aaa Consumer ABS, But Not In CMBS Opportunities In Non-Aaa Consumer ABS, But Not In CMBS Opportunities In Non-Aaa Consumer ABS, But Not In CMBS Going forward, we think it is wise to re-consider our strategy when it comes to consumer ABS. Specifically, we think investors should dip into non-Aaa ABS where we see potential for strong returns, even in the absence of Fed support. The reason for our optimism is that consumer credit losses will probably turn out to be significantly lower than many had feared in March. During the past two months, we learned that federal government stimulus actually caused real personal income to rise by 9% since February. Also, consumers have generally been able to keep up with their debt payments.4  According to data from TransUnion, the percentage of credit card and mortgage loans that are more than 30 days past due actually declined in April compared to March. For auto loans it only increased by 7 bps (Table 3). Further, the data show that households paid off significantly more of their credit card balances than usual in April, presumably because they received an influx of cash from the government but had fewer spending opportunities due to the quarantine. Table 3No Spike In Consumer Credit Delinquencies No Holding Back No Holding Back There remains a risk that Congress will delay passing further stimulus measures to keep consumers flush during the next few months. But we think enough stimulus will be delivered to prevent a significant default spike in credit cards and auto loans. Investors should add some exposure to non-Aaa consumer ABS. CMBS is a different story. The commercial real estate market is particularly challenged by the current environment. The office and retail sectors in particular were already facing structural headwinds from remote working and online shopping, respectively. The pandemic has accelerated the adoption of those trends. Not surprisingly, May’s CMBS delinquency rate saw its largest jump since 2017 and more delinquencies are certainly on the way (Chart 8). Chart 8Challenging Environment For CMBS Challenging Environment For CMBS Challenging Environment For CMBS Investors should continue to avoid non-Aaa CMBS. Continue To Avoid Agency MBS We have been advising an underweight allocation to Agency MBS because, even though the securities benefit from support through the Fed’s direct MBS purchases, value has been insufficiently attractive. That is starting to change. Agency MBS spreads widened considerably during the past month and are now very close to Aa-rated corporate bond spreads. They are also greater than Agency CMBS and Aaa ABS spreads (Chart 9). However, despite improving valuations, we remain concerned about risks in the MBS sector. Notice in the top 2 panels of Chart 9 that the MBS option-adjusted spread (OAS) has returned to 2012 levels, but the nominal spread (which is not adjusted for expected prepayment losses) remains quite low. This means that the prepayment loss assumption embedded in the current index OAS is much lower than it was in 2012. Is this reasonable? We estimate that 63% of the conventional 30-year MBS index is eligible for refinancing. In part, yes it is. Even with mortgage rates at all-time lows, we estimate that 63% of the conventional 30-year MBS index is eligible for refinancing. This is lower than what was seen in 2012 (Chart 10). However, we would also argue that mortgage rates have room to fall further Chart 9Agency MBS Spreads Have Widened Agency MBS Spreads Have Widened Agency MBS Spreads Have Widened Chart 10Prepayment Risk Is Elevated Prepayment Risk Is Elevated Prepayment Risk Is Elevated Despite having fallen to all-time lows, this year’s decline in the 30-year mortgage rate has been much smaller than what was seen in Treasury or MBS yields (Chart 10, bottom 3 panels). The 30-year mortgage rate could drop by another 50 bps and it would only restore typical primary and secondary mortgage spread levels. We estimate that a further 50 bps drop in the mortgage rate would increase the refinanceable share of the MBS index from 63% to 74% (horizontal dashed line in the second panel of Chart 10). This is below 2012 levels, but still leads us to the conclusion that the current index OAS understates the risk of prepayment losses. In summary, the Agency MBS OAS is starting to look more attractive but we are concerned that it embeds an overly optimistic prepayment loss assumption. Investors should maintain underweight allocations to Agency MBS. Bottom Line: We recommend that investors continue to overweight Aaa-rated consumer ABS and CMBS, as both sectors offer attractive spreads and benefit from TALF. Despite the lack of Fed support, adding some non-Aaa consumer ABS exposure also makes sense. Investors should continue to avoid Agency MBS, where value has improved but prepayment risk remains high. Appendix A: Buy What The Fed Is Buying The Fed rolled out a number of aggressive lending facilities on March 23. These facilities focused on different specific sectors of the US bond market. The fact that the Fed has decided to support some parts of the market and not others has caused some traditional bond market correlations to break down. It has also led us to adopt of a strategy of “Buy What The Fed Is Buying”. That is, we favor those sectors that offer attractive spreads and that benefit from Fed support. The below Table tracks the performance of different bond sectors since the March 23 announcement. We will use this to monitor bond market correlations and evaluate our strategy’s success. Table 4Performance Since March 23 Announcement Of Emergency Fed Facilities No Holding Back No Holding Back Footnotes 1 For more details on the Fed’s emergency lending facilities please see US Investment Strategy/US Bond Strategy Special Report, “Alphabet Soup: A Summary Of The Fed’s Anti-Virus Measures”, dated April 14, 2020, available at usbs.bcaresearch.com 2 Please see US Bond Strategy/Global Fixed Income Strategy Special Report, “Trading The US Corporate Bond Market In A Time Of Crisis”, dated March 31, 2020, available at usbs.bcaresearch.com 3 Please see US Bond Strategy Weekly Report, “Assessing Healthcare & Pharma Bonds In A Pandemic”, dated June 9, 2020, available at usbs.bcaresearch.com 4 For more details on the outlook for the US consumer please see US Investment Strategy Weekly Report, “So Far, So Good (How Markets Learned To Stop Worrying And Love Washington, DC)”, dated June 8, 2020, available at usis.bcaresearch.com   Ryan Swift US Bond Strategist rswift@bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Dear client, It was my pleasure to join Dhaval Joshi, BCA’s Chief European Investment Strategist, this past Friday June 12, 2020 on a webcast he hosted titled: “Sectors To Own, And Sectors To Avoid In The Post-Covid World”. You can access the replay of the lively webcast here, where Dhaval and I debate how investors should be positioned in different time horizons. I hope you will find it both insightful and informative. Kind Regards, Anastasios Highlights Portfolio Strategy While we cannot time the exact equity market top, our sense is that we are more than fairly valued at the current juncture and the equity market has entered a speculative phase; thus the risk/reward tradeoff is poor in the near-term. We are compelled to put the S&P home improvement retailers index (HIR) on our downgrade watch list and institute a stop at the 10% return mark in order to reflect softness in our HIR macro model, a hook down in existing home sales and a high profit growth bar that sell-side analysts have set for the coming year. Recent Changes Our rolling 10% stop got hit last Tuesday and we monetized 32% gains since the reinstatement of the long S&P oil & gas exploration & production / short global gold miners pair trade.1 Feature Equities briefly erased all losses for the year early last week, but the Fed’s June meeting lacked any additional easing measures and served as a catalyst for a much needed breather – the fifth 5.3-7.3% pullback since the March 23 bottom – as the week drew to a close. While extremely easy monetary and fiscal policies remain the key macro drivers for the SPX, any hiccups in passing a new fiscal spending bill once the money runs out on July 31, carry enough risk to short circuit the equity market’s momentum and result in a shakeout phase. Importantly, given the recent speculative overshoot in equities, the cyclical return potential has diminished, and that is cause for concern. The ongoing COVID-19 catalyzed recession that the NBER last week confirmed commenced in February, the “second wave” risk, a flare up in the US/Sino trade war and more recently, civil unrest have dominated the news flow. However in all this chaos, the November election has slowly moved into the background, especially the SPX return implications during the 4th year of a Presidency. Chart 1 shows the profile of the S&P 500 during Presidential Election calendar years, going back to the 1950s. The solid green line shows the historical mean, and shaded areas denote the 10th and 90th percentiles of SPX performance. If history rhymes, the average profile of these 17 iterations suggests that more cyclical gains are in store for the S&P 500. Chart 1Do Not Ignore… Do Not Ignore… Do Not Ignore… Nevertheless, before getting carried away, a word of caution is in order. As we highlighted last week, a Biden win represents a risk to the SPX’s euphoric rise from the March lows, and could serve as a catalyst for a much needed pullback (Chart 2).2 Thus, according to our analysis if the 90th percentile proves accurate, then the SPX could trace this lower bound and fall 640 points or 20% (Chart 1). This is a key tail risk to our cyclically sanguine equity market view. Chart 2…(Geo)Political Risks Exit Stage Right Exit Stage Right Turning over to the reopening of the economy, while the SPX has now discounted a near fully functioning economy for the rest of the year and beyond (bottom panel, Chart 3), fixed income investors are not in total agreement. In fact, the missing ingredient in giving the green light for equities is a selloff in the bond market, which financials/banks are currently sniffing out on the back of the reopening of the economy. Until fixed income investors get on the same page as equity investors, the SPX will remain on shaky ground (top panel, Chart 3). We first turned positive on the cyclical prospects of the equity market in mid-March3 and cemented our conviction in our March 23 report presenting 20 reasons to buy stocks.4 Since then, the SPX has rocketed higher by 1000 points and overshot our 3,000 SPX target that we recently derived from three methods.5 While we cannot time the exact top and equities may have a bit more upside, our sense is that today, stocks are more than fairly valued and they have entered a speculative phase (Chart 4). Thus the risk/reward tradeoff in the near-term has shifted to the downside. Once these (geo)political risks get appropriately repriced via a higher risk premium, then the broad equity market will resume its cyclical upside march. Chart 3Bond Market Is Not Buying Stock Market’s Euphoria Bond Market Is Not Buying Stock Market’s Euphoria Bond Market Is Not Buying Stock Market’s Euphoria Chart 4Lots Of Good News Is Priced In Lots Of Good News Is Priced In Lots Of Good News Is Priced In This week we update one consumer discretionary subgroup and put it on our downgrade watch list. Put Home Improvement Retailers On Downgrade Alert We are putting the S&P home improvement retailers index (HIR) on downgrade alert and setting a stop at the 10% return mark in order to protect handsome gains for our portfolio since the mid-April overweight inception. HIR have catapulted to all-time highs both in absolute terms and relative to the broad market. Granted, this has been an earnings-led propulsion (top panel, Chart 5), however, we are uneasy that HD is a top ten holding in the S&P growth index (middle panel, Chart 5).6 Importantly, the first print in the real GDP release for Q1/2020 in late-April made for grim reading, with one notable exception: real residential investment. Business capex took it to the chin, but housing related outlays spiked over 20% on a quarter-over-quarter annualized basis, and signal that DIY same-store retail sales will likely prove resilient this summer (bottom panel, Chart 6). Chart 5An Earnings-Led Advance… An Earnings-Led Advance… An Earnings-Led Advance… Chart 6…Buttressed By Resilient Residential Investment… …Buttressed By Resilient Residential Investment… …Buttressed By Resilient Residential Investment… As a reminder, these Big Box retailers are highly levered to the ebbs and flows of residential investment and the latest GDP print should sustain the recent bid under S&P HIR prices (top & middle panels, Chart 6). Tack on the roughly $75/tbf jump in lumber prices since the early-April trough (not shown), and profits benefit from a dual lift: rising volumes and firming selling prices. The DIY avalanche is real and not likely to dissipate any time soon as a consequence of the coronavirus-induced working from home pervasiveness. Yet, HIR has run too far too fast and is due for a consolidation phase. One yellow flag is the recent fall in existing home sales, despite the all-time lows in mortgage rates brought back by the Fed’s ZIRP. The middle panel of Chart 7 shows that if the home sales decline continues in the summer months, then HIR sales will face stiff headwinds as remodeling activity suffers a setback. In addition, in previous recessions the inventory of homes for sale has surged, but at the current juncture only a small jump in inventories is visible (inventories shown inverted, top panel, Chart 7). Were that trend to gain steam, it could put downward pressure to high-flying HIR equities. Chart 7…But Soft Home Sales Are An Issue… …But Soft Home Sales Are An Issue… …But Soft Home Sales Are An Issue… Chart 8…And The Tick Down In Our HIR Model Is A Yellow Flag …And The Tick Down In Our HIR Model Is A Yellow Flag …And The Tick Down In Our HIR Model Is A Yellow Flag The industry’s net earnings revision ratio has climbed to multi-year highs and warns that analyst optimism is excessive, which is contrarily negative (bottom panel, Chart 7). Our macro driven HIR model does an excellent job in encapsulating all the moving parts and its recent tick down is worrisome (Chart 8). Nevertheless, given that this has been a profit-led advance, HIR have a large valuation cushion. The relative forward P/E is trading near a market multiple and below the historical mean (bottom panel, Chart 5). Netting it all out, we are compelled to put the S&P HIR index on our downgrade watch list and institute a stop at the 10% return mark in order to reflect softness in our HIR macro model, a hook down in existing home sales and a high profit growth bar that sell-side analysts have set for the coming year (middle panel, Chart 5). Bottom Line: While we remain overweight the S&P HIR index it is now on downgrade alert. We also set a stop at the 10% return mark in order to protect profits for our portfolio. Stay tuned. The ticker symbols for the stocks in this index are: BLBG: S5HOMI – HD, LOW.   Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com     Footnotes 1     Please see BCA US Equity Strategy Insight Report, “Pocketing Gains In Oil/Gold Pair Trade” dated June 10, 2020, available at uses.bcaresearch.com. 2     Please see BCA US Equity Strategy Weekly Report, “Don’t Turn A Blind Eye To Geopolitical Risks” dated June 8, 2020, available at uses.bcaresearch.com. 3    Please see BCA US Equity Strategy Weekly Report, “Inflection Point” dated March 16, 2020, available at uses.bcaresearch.com. 4    Please see BCA US Equity Strategy Weekly Report, “The Darkest Hour Is Just Before The Dawn” dated March 23, 2020, available at uses.bcaresearch.com 5    Please see BCA US Equity Strategy Weekly Report, “New SPX Target” dated April 20, 2020, and “Gauging Fair Value” dated April 27, 2020, available at uses.bcaresearch.com. 6    https://us.spindices.com/indices/equity/sp-500-growth#data-constituents   Current Recommendations Current Trades Strategic (10-Year) Trade Recommendations Exit Stage Right Exit Stage Right 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 relaxation of lockdown measures, along with mass protests over the past two weeks, have made a second wave of the pandemic more likely than not in many countries. Unlike during the first wave, most governments will not shutter their economies in response to a renewed spike in infection rates. For better or for worse, the “Sweden strategy” will become commonplace. As today’s stock market selloff illustrates, a second wave could significantly unnerve investors, especially since it is coming on the heels of a substantial rally in stocks. However, global equity prices will still rise over a 12-month horizon. Easy monetary policy, improving labor market conditions, and significant amounts of cash on the sidelines should allow the equity risk premium to decline, especially outside the US where valuations remain quite cheap. The US dollar has entered a cyclical bear market. This is especially positive for commodities, economically-sensitive equity sectors, and non-US stocks. Opening The Hatch Chart 1Governments Are Lifting Lockdown Restrictions A Second Wave Is Now The Base Case (But Stocks Will Eventually Shrug It Off) A Second Wave Is Now The Base Case (But Stocks Will Eventually Shrug It Off) Three months after the virus burst out of China, countries around the world are starting to relax lockdown measures. Our COVID-19 Government Response Stringency Index, created by my colleague Jonathan LaBerge and showcased in last week’s Global Investment Strategy report, has been on an easing course since May. A similar measure developed by Goldman Sachs broadly shows the same loosening pattern. Reflecting these developments, the Dallas Fed’s index of “mobility and engagement” has been slowly returning to normal (Chart 1). The reopening of economies is taking place despite limited success in containing the virus. While some countries have seen a considerable drop off in the number of new cases and deaths, others continue to experience an increase in both metrics (Chart 2). Globally, the number of new cases has begun to trend higher after remaining flat for most of April. The number of deaths — which lags new cases by about three weeks but is less vulnerable to statistical distortions caused by changes in testing prevalence — has also ticked higher after falling for nearly two months. Mass protests starting in Minneapolis and spreading to much of the western world have the potential to further increase the infection rate. As Jonathan noted last week, large gatherings have been an important vector of transmission for the virus. While the protests have occurred outdoors, many protestors did not wear masks while singing and shouting nor practise social distancing. Chart 2Globally, The Number Of New Cases and Deaths Has Started To Trend Higher Again A Second Wave Is Now The Base Case (But Stocks Will Eventually Shrug It Off) A Second Wave Is Now The Base Case (But Stocks Will Eventually Shrug It Off) A Risky Gambit How markets react to a second wave of the pandemic will depend a lot on how policymakers and the broader public respond. For better or for worse, the patience for continued lockdowns has waned. The US and a number of other countries appear to be moving towards the “Swedish model” of trying to keep a lid on the virus without imposing draconian lockdown restrictions. It is a risky gambit, especially in light of the jump in infections that Sweden has reported in the past two weeks. While some countries such as China and New Zealand, which have effectively eradicated the virus, can allow most activities – with the exception of international travel – to resume, others should arguably wait longer until they too have defeated the disease. As Professor Peter Doherty, renowned immunologist and co-recipient of the 1996 Nobel Prize for Medicine, discussed in a webcast with my colleague Garry Evans on Monday, significant progress has been made towards developing a vaccine for COVID-19. Opening up economies now could cause a lot of needless death before a vaccine becomes available. Near-Term Risks To Stocks… Chart 3Earnings Estimates Have Taken It On The Chin Earnings Estimates Have Taken It On The Chin Earnings Estimates Have Taken It On The Chin Even if governments continue opening up their economies despite rising infection rates, some people will increase the amount of social distancing they practise regardless of official recommendations. Airline, cruise ship, and restaurant stocks had rallied mightily off their March lows before giving up some of their gains over the past few days. If a second wave occurs, they will fall further. The rally in stocks linked to the reopening of the economy occurred alongside a retail investor speculative frenzy. In one of the more bizarre episodes in financial history, stocks of bankrupt or soon-to-be-bankrupt companies surged on Monday as novice day traders snapped up shares of companies that most institutional equity investors had left for dead. Meanwhile, earnings estimates have taken it on the chin (Chart 3). Many companies chose not to provide guidance for the second quarter, citing unprecedented uncertainty over the near-term business outlook. Since Q2 will be the worst quarter for economic growth, it will probably also be a very bad quarter for earnings. The prospect of a slew of poor earnings reports in July could further dent investor sentiment, exacerbating the stock market correction we have seen over the past few days. All this suggests that global equities could experience some further weakness over the next few months. …But Still Sticking With Our 12-Month Overweight To Equities Chart 4Economic Activity Has Started Rebounding Economic Activity Has Started Rebounding Economic Activity Has Started Rebounding Despite these short-term risks, we are not ready to abandon our cyclical overweight view on stocks. While many people have remarked that the equity market has diverged from the economy, in fact, the rebound in the stock market has tracked the peak in initial unemployment claims and the trough in current activity indicators quite closely (Chart 4). A second wave would certainly slow the economic rebound. However, it would probably not reverse it completely given that the mortality rate from the virus now appears to be somewhat lower than initially feared and an increasing number of medical treatments are becoming available. If output and employment keep rising, stocks are likely to trend higher. A Deep Hole This does not mean that everything will return to normal soon. Even though global growth appears to have bottomed in April, the level of employment remains at depression-like levels (Chart 5). About 12% of US workers are employed in the hospitality, restaurant, and travel sectors. A return to normalcy in those sectors will take several years at best. Nevertheless, the recovery will not be nearly as drawn out as the one following the Global Financial Crisis. The Congressional Budget Office expects that it will take another eight years for the US unemployment rate to fall back to 5% (Chart 6). That seems unduly pessimistic. Chart 5Employment Remains At Depression-Like Levels Employment Remains At Depression-Like Levels Employment Remains At Depression-Like Levels Chart 6CBO Projects The Unemployment Rate Will Fall Very Slowly CBO Projects The Unemployment Rate Will Fall Very Slowly CBO Projects The Unemployment Rate Will Fall Very Slowly Cyclical Versus Structural Unemployment Chart 7Residential Construction Accounted For Less Than 20% Of The Job Losses During The Great Recession A Second Wave Is Now The Base Case (But Stocks Will Eventually Shrug It Off) A Second Wave Is Now The Base Case (But Stocks Will Eventually Shrug It Off) Commentators like to talk about structural unemployment, but the truth is that large increases in joblessness usually reflect deficient labor demand rather than insufficient supply. For example, the decline in residential construction employment and related sectors accounted for less than one-fifth of the job losses during the Great Recession (Chart 7). You don’t have to fill a half-empty 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 elsewhere, whether it be at an Amazon distribution center or any number of manufacturing companies that will benefit from the repatriation of production back onshore. The shift in jobs from one sector to the next is not instantaneous, but it need not drag on for years either. Policy Will Stay Stimulative This is where the role of monetary and fiscal policy takes center stage. Despite the improving economic outlook, government bond yields have barely moved off their lows as investors have become increasingly convinced that central banks will keep rates at rock-bottom levels (Chart 8). This week’s FOMC meeting made it clear that the Fed has no intention of raising rates through 2022. “We’re not thinking about raising rates. We’re not even thinking about thinking about raising rates,” Fed Chairman Jerome Powell declared during his press conference. Granted, the zero lower bound has prevented yields from falling as much as they normally would. Fortunately, fiscal policy has stepped in to fill the void. Chart 9 shows that governments have eased fiscal policy much more this year than they did in 2008-09. If governments tighten fiscal policy prematurely like they did after the Great Recession, the recovery will indeed be sluggish. Such a risk cannot be ignored. BCA’s geopolitical team, led by Matt Gertken, has argued that Republican Senators will initially resist the proposed $3 trillion in new stimulus, until they are forced to act by a major new round of financial or social turmoil. Nevertheless, Matt thinks that the Republican Senate will ultimately buckle under the political pressure, knowing full well that a large dose of fiscal largess could prevent a Democratic sweep in November. Chart 8Yields Remain Close To Recent Lows Yields Remain Close To Recent Lows Yields Remain Close To Recent Lows Chart 9Will It Be Enough? A Second Wave Is Now The Base Case (But Stocks Will Eventually Shrug It Off) A Second Wave Is Now The Base Case (But Stocks Will Eventually Shrug It Off) Chart 10China Has Ramped Up Stimulus China Has Ramped Up Stimulus China Has Ramped Up Stimulus Outside the US, fiscal support shows little sign of being scaled back. Germany has pushed forward with additional stimulus, going so far as to propose a risk-sharing arrangement via the creation of an EU Recovery Fund. On Wednesday, the Japanese House of Representatives approved a draft supplementary budget of 32 trillion yen ($296 billion) providing additional funding for small businesses and medical workers. Jing Sima, BCA Research's chief China strategist, expects Chinese credit formation as a share of GDP to reach the highest level since 2009 and the budget deficit to widen to the largest on record (Chart 10). The upshot is that we may find ourselves in an environment over the next few years where global GDP and corporate profits are moving back to trend, while interest rates (and the implied discount rate used for valuing stocks) stay at very low levels. If profits return back to normal but interest rates do not, the surreal implication is that the pandemic could end up increasing the fair value of the stock market. Ample Cash On The Sidelines Stocks also have another factor working in their favor: huge amounts of cash on the sidelines (Chart 11). The combination of massive fiscal income transfers and low spending has led to a surge in private-sector savings. The US personal savings rate reached 33% in April, the highest on record. Reflecting this increase in savings, private sector bank deposits have ballooned (Chart 12). Chart 11Sizable Amount Of Dry Powder Sizable Amount Of Dry Powder Sizable Amount Of Dry Powder Chart 12Savings Have Spiked Amid Stimulus A Second Wave Is Now The Base Case (But Stocks Will Eventually Shrug It Off) A Second Wave Is Now The Base Case (But Stocks Will Eventually Shrug It Off)     Investors often talk about cash “flowing” in and out of the stock market. This is a somewhat misleading characterization. Setting aside the impact of corporate buybacks and public share offerings, the decision by one person to buy shares requires a corresponding decision by someone else to sell shares. The buyer of the shares loses some cash, while the seller gains some cash. On net, there is no inflow of cash into the stock market. Rather, what happens is that the price of shares adjusts to ensure that there is a seller for every buyer. If people feel that they have too much cash relative to the value of their equity holdings, they will bid up the price of stocks until enough sellers come forward. This will cause the amount of cash that people hold as a percentage of their total wealth to shrink, even if the dollar value of that cash remains the same. The process will only stop when the amount of cash that people hold is in line with their preferences. The amount of cash held in US money market funds and personal cash deposits has surged by $2.6 trillion since February. Despite the rally in equities, cash holdings as a percent of stock market capitalization remain near multi-year highs. This suggests that the firepower to fuel further increases in the stock market has not been exhausted. Start Of The Dollar Bear Market After peaking in March, the broad trade-weighted US dollar has weakened by 5.3%. The dollar is a countercyclical currency, meaning that it tends to move in the opposite direction of the global business cycle (Chart 13). While the dollar could strengthen temporarily in response to a second wave of the pandemic, global growth should continue to recover in the second half of the year provided that severe lockdown measures are not reintroduced. Stronger global growth will push the greenback lower. Chart 13The US Dollar Is A Countercyclical Currency The US Dollar Is A Countercyclical Currency The US Dollar Is A Countercyclical Currency Unlike last year, the dollar no longer has support 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 14). Chart 14The Dollar Has Been Losing Interest Rate Support The Dollar Has Been Losing Interest Rate Support The Dollar Has Been Losing Interest Rate Support A Weaker Dollar Will Support Non-US Stocks The combination of a weaker dollar and stronger global growth should disproportionately help the more cyclical sectors of the stock market, particularly commodity producers. 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 15). EM equities should fare well over the next 12 months.   Chart 15EM Stocks Are Very Cheap EM Stocks Are Very Cheap EM Stocks Are Very Cheap Peter Berezin Chief Global Strategist peterb@bcaresearch.com Global Investment Strategy View Matrix A Second Wave Is Now The Base Case (But Stocks Will Eventually Shrug It Off) A Second Wave Is Now The Base Case (But Stocks Will Eventually Shrug It Off) Current MacroQuant Model Scores A Second Wave Is Now The Base Case (But Stocks Will Eventually Shrug It Off) A Second Wave Is Now The Base Case (But Stocks Will Eventually Shrug It Off)

Highlights Historically, when global growth picks up, the yen weakens. But this is less likely in an environment where global yields remain anchored at low levels. Meanwhile, there is rising risk that consumption in Japan will remain muted. This will limit any pickup in domestic inflation. A modest rise in real rates will lead to a self-reinforcing upward spiral for the yen. That said, cheap yen valuations will buffet Japanese exports. Go short USD/JPY with an initial target of 100. Feature Chart I-1Higher Volatility, Higher Yen An Update On The Yen An Update On The Yen The powerful bounce in global markets since the March lows is at risk of a bigger technical correction. As we enter the volatile summer months, it may only require a small shift in market sentiment to trigger this reversal. The yen has tended to strengthen when market volatility rises (Chart I-1). Should this happen, it will provide the necessary catalyst for established long yen positions. On the other hand, if risk sentiment stays ebullient, the yen will surely weaken on its crosses but can still strengthen vis-à-vis the dollar. This places short USD/JPY bets in an enviable “heads I win, tails I do not lose too much” position. Growth And Monetary Policy Like most other economies, Japan entered a recession in the first quarter of this year, with GDP contracting at a 2.2% annualized pace. For the private sector, this is the worst growth rate since the Fukushima crisis in 2011. This is particularly significant, since the structural growth rate of the economy has fallen below interest rates. Going back to Japan’s lost decades, where private sector GDP growth averaged well below nominal rates (due to the zero bound), it is particularly imperative that Japan exits this liquidity trap in fast order (Chart I-2). A strong yen back then, on the back of deficient domestic demand, led to a self-fulfilling deflationary spiral. Chart I-2The Story Of Japan In One Chart The Story Of Japan In One Chart The Story Of Japan In One Chart The Bank of Japan began to acknowledge this problem with the end of the Heisei era1  last year. For example, with the BoJ owning almost 50% of outstanding JGBs, the supply side puts a serious limitation on how much more stimulus the BoJ can provide. The yen has become extremely sensitive to shifts in the relative balance sheets between the Federal Reserve and the BoJ. If the BoJ continues to purchase securities at the current pace, then the rate of expansion in its balance sheet will severely lag behind the Fed, and could trigger a knee-jerk rally in the yen (Chart I-3). Chart I-3The Yen And QE The Yen And QE The Yen And QE Inflation And The 2% Target The US is a much more closed economy than Japan, and has not been able to maintain a 2% inflation rate since the Global Financial Crisis. This makes the BoJ’s target of 2% a pipe dream for any timeline in the near future. There are three key variables the authorities pay attention to for inflation: Core CPI, the GDP deflator and the output gap. All three indicators point towards deflationary pressures, with the recent slowdown in the global economy exacerbating the trend. In fact, since the financial crisis, prices in Japan have only been able to really rise during a tax hike (Chart I-4). Always forgotten is that the overarching theme for prices in Japan is a rapidly falling (and ageing) population, leading to deficient demand. The overarching theme for prices in Japan is a rapidly falling (and ageing) population, leading to deficient demand. More importantly, almost 50% of the Japanese consumption basket is in tradeable goods, meaning domestic inflation is as much driven by the influence of the BoJ as it is by globalization. Even for domestically-driven prices, an ageing demographic that has a strong preference for falling prices is a powerful conflicting force. For example, over the years, a strong voting lobby has been able to advocate for lower telecom prices, which makes it difficult for the BoJ to re-anchor inflation expectations upward (Chart I-5). Chart I-4Japan CPI At A Glance Japan CPI At A Glance Japan CPI At A Glance Chart I-5Strong Deflationary Pressures In Japan Strong Deflationary Pressures In Japan Strong Deflationary Pressures In Japan Meanwhile, the BoJ understands that it needs domestic banks to expand the credit intermediation process if any inflation is to take hold. Unfortunately, the yield curve control strategy and negative interest rates have been anathema for Japanese net interest margins and share prices (Chart I-6). This puts the BoJ in a precarious balance between trying to stimulate the economy further and biting the hand that will feed a pickup in inflation. Chart I-6Point Of No Return For Japanese Banks? Point Of No Return For Japanese Banks? Point Of No Return For Japanese Banks? Japanese Consumption And Fiscal Policy The consumption tax hike last year delivered a severe punch to aggregate demand in Japan. COVID-19 has dealt a fatal blow. In prior episodes of the tax hikes, it took around three to four quarters for growth to eventually bottom. This suggests that a protracted slowdown in Japanese consumption is a fait accompli (Chart I-7). Foreign and domestic machinery orders are slowing, employment growth has gone from over 2% to free fall and the availability of jobs relative to applicants has reversed a decade-long rising trend. The Abe government has passed an additional 117 trillion yen of fiscal stimulus. With overall fiscal announcements near 40% of GDP, could this fully plug the spending gap? Not quite. The consumption tax hike last year delivered a severe punch to aggregate demand in Japan.  First, as is usually the case with Japanese stimulus announcements, the timeframe is uncertain for when the funds will be deployed. It could be one year or ten years. Chart I-7A V-Shaped Recovery Might Stall A V-Shaped Recovery Might Stall A V-Shaped Recovery Might Stall Chart I-8More Jobs, More Savings More Jobs, More Savings More Jobs, More Savings Second, Japanese consumption has been quite weak for some time. Despite relatively robust economic conditions since the Fukushima disaster, Japanese consumption has trended downward. The reason is that government spending triggered a rise in private savings, because of expectations of higher taxes. In other words, the savings ratio for workers has surged. If consumers were not willing to spend prior to COVID-19 due to Ricardian equivalence,2  they are unlikely to do so with much higher fiscal deficits (Chart I-8). Some of the government’s outlays will certainly go a long way to boosting aggregate demand, since the fiscal multiplier tends to be much larger in a liquidity trap. This will especially be the case for increased social security spending such as child education, construction activity or the move towards promoting cashless transactions (with a tax rebate). However, there are important near-term offsets. In particular, the postponement of the Olympics will continue to be a drag on Japanese construction activity, and the labor (and income) dividend from immigration has practically vanished. The important tourism industry that faced sudden death will only recover slowly. This suggests a much more protracted recovery in many nuggets of Japanese activity. The Yen As A Safe Haven Real interest rates are already higher in Japan, well before any of the above factors began to meaningfully generate a deflationary impulse. As such, the starting point for yen long positions is already favorable (Chart I-9). Real interest rates are already higher in Japan, well before any of the above factors began to meaningfully generate a deflationary impulse. With global growth bottoming, a continued rise in global equity markets is a key risk to our scenario. However, if inflows into Japan accelerate on cheap equity valuations, the propensity of investors to hedge these purchases will be much less today, given how cheap the yen has become. This is especially important since in an era of rising budget deficits, balance of payments dynamics can resurface as the key driver of currencies. This suggests the negative yen/Nikkei correlation will continue to weaken, as has been the case in recent quarters. Chart I-9Real Rates And The Yen Real Rates And The Yen Real Rates And The Yen Chart I-10USD/JPY And DXY Are Positively Correlated USD/JPY And DXY Are Positively Correlated USD/JPY And DXY Are Positively Correlated As a low-beta currency, our contention is that the yen will surely weaken on its crosses, but could strengthen versus the dollar. The yen rises versus the dollar not only during recessions, but during most episodes of broad dollar weakness (Chart I-10). This places short USD/JPY trades in an envious “heads I win, tails I do not lose too much” position.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 The Heisei era refers to the period of Japanese history corresponding to the reign of Emperor Akihito from 8 January 8th, 1989 until his abdication on April 30th, 2019. 2 Ricardian equivalence suggests in simple terms that public sector dissaving will encourage private sector savings. 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 robust: Nonfarm payrolls increased by 2.5 million in May after declining by a record 20.7 million in April. This was better than expectations of an 8 million job loss. The unemployment rate fell from 14.7% to 13.3%. The NFIB business optimism index increased from 90.9 to 94.4 in May. Headline consumer price inflation fell from 0.3% to 0.1% year-on-year in May. Core inflation fell from 1.4% to 1.2%. Initial jobless claims increased by 1542K for the week ended June 5th. The DXY index fell by 1.3% this week. On Wednesday, the Fed left interest rates unchanged, with a signal that rates might not be increased before the end of 2022. The Fed also stated that it will maintain the current pace of Treasuries and mortgage-backed securities purchases, at minimum. 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 improving: The Sentix investor confidence index improved from -41.8 to -24.8 in June. Employment increased by 0.4% year-on-year in Q1. GDP contracted by 3.1% year-on-year in Q1. The euro appreciated by 1.2% against the US dollar this week. At an online seminar held this week, Isabel Schnabel, member of the executive board of the ECB, noted that "evidence is increasingly pointing towards a protracted impact of the crisis on both demand and supply conditions in the euro area and beyond" and that the current PEPP remains appropriate in de aling with the global recession. 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 coincident index fell from 88.8 to 81.5 in April. The leading economic index also decreased from 85.1 to 76.2. The current account surplus shrank from ¥1971 billion to ¥262.7 billion in April. Annualized GDP fell by 2.2% year-on-year in Q1. Machine tool orders plunged by 52.8% year-on-year in May, following a 48.3% decrease the previous month. The Japanese yen appreciated by 2.6% against the US dollar this week. According to a Bloomberg survey, the majority of economists believe that the BoJ has done enough to cushion the economy, and expect the BoJ to leave current monetary policy unchanged next week. We continue to recommend the yen as a safe-haven hedge, especially given a possible second wave of COVID-19. 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: Halifax house prices increased by 2.6% year-on-year in May. Retail sales surged by 7.9% year-on-year in May, up from 5.7% the previous month. GfK consumer confidence was little changed at -36 in May. The British pound rose by 1% against the US dollar this week. On Wednesday, BoE governor Andrew Bailey noted that easing lockdown restrictions has been fueling a recovery in the UK, which could be faster than previously anticipated. Our long GBP/USD and short EUR/GBP positions are 4% and 0.2% in the money, respectively. 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 mixed: The NAB business confidence index increased from -45 to -20 in May. The business conditions index also ticked up from -34 to -24. The Westpac consumer confidence index increased from 88.1 to 93.7 in June. Home loans declined by 4.8% month-on-month in April, down from a 0.3% increase the previous month. That said, expectations were for a fall of 10%. AUD/USD was flat this week. While the RBA has other options in its policy toolkit to combat the global recession, negative interest rates is still on the table and hasn't been totally ruled out. We remain positive on the Australian dollar both against the US dollar and the New Zealand dollar due to cheap valuations and increasing Chinese stimulus. 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 mixed: Manufacturing sales declined by 1.7% quarter-on-quarter in Q1, down from a 2.8% increase the previous quarter. ANZ business confidence increased from -41.8 to -33 in June. The activity outlook index also ticked up from -38.7 to -29.1. The New Zealand dollar appreciated by 0.8% against the US dollar this week. RBNZ's Deputy Governor Geoff Bascand said that house prices in New Zealand could fall by 9-10% or even worse. Besides disrupting exports and imports for a trade-reliant country like New Zealand, the global health crisis is also likely to further reduce immigration to New Zealand, curbing housing demand. 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: The unemployment rate ticked up from 13% to 13.7% in May, versus expectations of a rise to 15%, but this was due to a  rise in the participation rate from 59.8% to 61.4%. Average hourly wages increased by 10% year-on-year in May. Net employment increased by 289.6K, up from a 1994K job loss the previous month. Housing starts increased by 193.5K in May, up from 166.5K the previous month.  The Canadian dollar fell by 0.2% against the US dollar this week. The labor market has seen some recovery in May with the gradual easing of COVID-19 restrictions and re-opening of the economy. Employment rebounded and absences from work dropped. Notably, Quebec accounts for nearly 80% of overall employment gains in May. 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 There was scant data out of Switzerland this week: FX reserves increased from CHF 801 billion to CHF 816 billion in May.  The unemployment rate increased from 3.1% to 3.4% in May, lower than the expected 3.7%. The Swiss franc appreciated by 2.3% against the US dollar this week, reflecting a flight back to safety amid concerns over political risks and a second wave of COVID-19. While the euro has been strong recently and EUR/CHF touched 1.09, the franc has lost most of those gains. We are lifting our limit buy on EUR/CHF to 1.055 on expectations we are in a run-of-the-mill correction.  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 mixed: Manufacturing output shrank by 1.6% month-on-month in April.  PPI fell by 17.5% year-on-year in May. Headline consumer prices increased by 1.3% year-on-year in May, up from 0.8% the previous month. Core inflation also increased from 2.8% to 3% in May. The Norwegian krone fell by 1.5% against the US dollar this week. The recent OPEC meeting over the weekend concluded that all members agreed to the extension to curb oil production. We believe that oil prices will continue to recover, and recommend to stay long the Norwegian krone. 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 mixed: Household consumption plunged by 10% year-on-year in April. The current account surplus increased from SEK 43.2 billion to SEK 80.6 billion in Q1. Headline consumer prices recovered from a 0.4% year-on-year decline to flat in May. The Swedish krona increased by 0.6% against the US dollar this week. Sweden is benefitting economically from a less stringent Covid-19 agenda. With very cheap valuations, we remain short EUR/SEK and USD/SEK. 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 US dry gas production – the gas traded on futures exchanges and consumed by firms and households – is expected to fall ~ 2.5% this year to 89.7 bcf/d.  Consumption will be down ~ 4% to 74.3 bcf/d.  High carryout stocks from a warmer-than-normal winter mean US natgas storage will be at a record 4 TCF by November.  This is close to demonstrated peak capacity of 4.3 TCF. We expect US benchmark Henry Hub futures prices to average $2.00/MMBtu in 2H20, assuming a normal winter (Chart of the Week).  This is slightly lower than current futures’ levels.  A deeper round of demand destruction from a second wave of COVID-19 remains a risk to commodities generally.  Our base case assumes accommodative policy globally will spur a recovery in gas demand next year.  This will push benchmark US prices into the $2.25-$2.50/MMBtu range, which also is below the level futures currently are trading. Weather-related risk is peaking right now.  The early start to the hurricane season will keep demand for storage gas elevated into October.  Local-distribution companies will be planning for normal winter temperatures, which would be colder than last year. Feature Our modeling, shown in the Chart of the Week, leads us to expect natgas futures to average $1.92/MMBtu and $2.22/MMBtu this year and next, respectively. US natgas prices will recover slowly in 2H20 and pick up steam in 2021 as demand recovers and LNG export growth resumes. However, we do not expect prices to rally to the extent futures currently are pricing in, nor as much as the US EIA expects. The NYMEX benchmark natgas futures, which call for delivery of pipeline quality dry gas at Henry Hub, LA, were on track to average close to $2.00/MMBtu this year and $2.64/MMBtu next year earlier this week.1 The EIA, for its part, is forecasting $2.04/MMBtu and $3.08/MMBtu for 2020 and 2021, respectively. Our modeling, shown in the Chart of the Week, leads us to expect natgas futures to average $1.92/MMBtu and $2.22/MMBtu this year and next, respectively. Our natgas price models use the EIA’s fundamental inputs – supply, demand and working gas storage levels – and temperature and financial variables to explain and forecast prices, including 10-year average heating-degree days, and US Treasury rates. Chart of the WeekUS Natgas Prices Recover Slowly US Natgas Prices Recover Slowly US Natgas Prices Recover Slowly On the supply side, the rate of growth in US natgas production started rolling over in 4Q19, well before COVID-19 was even an issue for the market. A warmer-than-normal winter last year weakened prices sufficiently to cause natgas production in the US shales to roll over from a high of 86 billion cubic feet per day (bcf/d) in 4Q19, to 84 bcf/d in the first five months of 2020. Shales account for ~ 90% of total US gas production. In and of itself, this is a relatively small impact, reflecting more the unintended inventory accumulation following last winter. Shale-Gas Production Rolls Over The decade-long shale-gas production surge led by the Marcellus formation in the US Appalachian Mountain region and, more recently, the Permian basin in Texas, which together account for ~ 60% of US gas production, ended – for the time being – in 4Q19 (Chart 2). Total natgas production in the Lower 48 states rose 11% in 2019 to 95.6 bcf/d, and is expected to fall ~ 2% this year to 93.7 bcf/d. Chart 2Shale-Gas Production Rolled Over Following A Warm 2019-20 Winter Natgas Prices Will Recover Slowly Natgas Prices Will Recover Slowly Natgas production is sensitive to the level of US short-term rates. The financial variables in our model indicate natgas production is sensitive to the level of US short-term rates, which the Fed has been maintaining at low levels since the Global Financial Crisis (GFC) to battle disinflation. Natgas is a derived demand – it is used to heat buildings and generate electricity, e.g. – so anything that lifts demand will benefit supply (Chart 3). In our modeling, we find natgas production is an explanatory variable for natgas consumption, but not vice versa, suggesting that the supply side is aggressively pricing to meet demand, and increase market share at the expense of coal-fired generation (Chart 4). Chart 3US Natgas Production, Consumption Are Sensitive to US Treasurys US Natgas Production, Consumption Are Sensitive to US Treasurys US Natgas Production, Consumption Are Sensitive to US Treasurys Chart 4Low Rates Accelerate Coal's Market Share Loss To Natgas Low Rates Accelerate Coal's Market Share Loss To Natgas Low Rates Accelerate Coal's Market Share Loss To Natgas Shale-gas production also is being weakened in the US by the collapse in oil prices, particularly in the Permian basin, where associated natural gas output has been surging (Chart 5).2 Close to 500 Bcf of natural gas was flared in the Bakken and Permian plays.3 This means the collapse in crude-oil prices on net is lowering CO2 emissions associated with flaring in Texas and North Dakota.4 Chart 5Associated Gas Production Falls As Crude Oil Prices Weaken Associated Gas Production Falls As Crude Oil Prices Weaken Associated Gas Production Falls As Crude Oil Prices Weaken Chart 6Warm Winter Destroys Natgas Demand Warm Winter Destroys Natgas Demand Warm Winter Destroys Natgas Demand Gas Consumption Growth Slows The US EIA expects working gas in storage to reach 4 TCF, a record, by the start of the heating season in November. Gas consumption was hammered by a much warmer-than-average winter last year (Chart 6). This left the level of working gas in storage at ~ 2 TCF by the end of March 2020, when the heating season ended (Chart 7). Natgas working storage has continued to increase every month since, and now stands just below 3 TCF, according to the EIA’s latest estimate. The US EIA expects working gas in storage to reach 4 TCF, a record, by the start of the heating season in November. The latest estimate of demonstrated peak storage capacity is 4.26 TCF, which raises the possibility a warm winter this year could lead to a full-storage event.5 Should this happen, markets would begin pricing the probability – not the possibility – of negative natural gas prices in more than just local markets lacking pipeline takeaway capacity or sufficient storage to accommodate local supply and demand imbalances. Chart 7US Working Gas In Storage Continues To Build Toward 4 TCF Natgas Prices Will Recover Slowly Natgas Prices Will Recover Slowly Negative natgas prices would further exacerbate the risk of more sharp curtailments in oil and gas capex – in addition to the $400 billion projected by the International Energy Agency (IEA) last month, which would cut shale-oil and -gas capex by 50%.6 This could set up a huge rally in hydrocarbons generally, oil and gas in particular, should it occur. Beware Disorderly Gas Markets As US natgas working storage fills going into the winter heating season, markets will once again be watching to see if the CFTC and CME are capable of maintaining orderly terminations of trading under physical-market stress, which a full-storage event certainly qualifies as. At the end of April, we noted the disorderly termination of trading in WTI futures delivering in May to Cushing, OK, was among the proximate causes of futures falling to -$40.32/bbl – that’s $40.32/bbl below $0.00/bbl – prior to the contract going off the board. Partly, we contend, this was the result of a failure of the US Commodity Futures Trading Commission (CFTC) and the CME Group, which operates WTI crude oil and Henry Hub natgas futures markets, to ensure only bona fide hedgers with the capacity to make or take delivery of the physical commodity being traded via futures contracts were left in the market as these contracts went to delivery. As US natgas working storage fills going into the winter heating season, markets will once again be watching to see if the CFTC and CME are capable of maintaining orderly terminations of trading under physical-market stress, which a full-storage event certainly qualifies as. Another failure to ensure an orderly termination of trading would add another impediment to sourcing capital for oil and gas producers – many producers chose to or are forced to hedge – which would exacerbate a tightening of supply in the medium term (2 to 3 years hence). Bottom Line: We expect natgas futures delivering to Henry Hub, LA, to average $1.92/MMBtu and $2.22/MMBtu this year and next, respectively, based on our proprietary models using fundamental and financial explanatory variables. Upside risks to the forecast are a stronger-than-expected demand recovery, which sees residential, commercial, industrial and electric-generation demand reviving sharply. A global pick-up that increased demand for LNG also would rally US gas prices sharply. To the downside, another round of demand destruction from a second wave of the COVID-19 pandemic would press prices lower. As US working gas in storage increases, the risks of a full-storage event rises. This will force market participants to price in a higher probability of negative prices, which also would have a deleterious impact on capex and, thus, future supplies.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Hugo Bélanger Associate Editor Commodity & Energy Strategy HugoB@bcaresearch.com Fernando Crupi Research Associate Commodity & Energy Strategy FernandoC@bcaresearch.com     Commodities Round-Up Energy: Overweight US shale E&P companies are bringing back some of their shut-in production as WTI prices remain above $35/bbl. According to Rystad Energy, more than 300k b/d of previously shut-in production is already coming back online as of June. Nonetheless, rig count remains at its lowest level since 2009 and prices are not high enough to incentivize additional drilling. Our estimates suggest the return of shut-in production will pale compared to the drop in production from natural decline rates over the coming months. Base Metals: Neutral In its June Global Economic Prospects, the World Bank revised its emerging market and developing economies real GDP growth estimates for 2020 to -2.5%, a 6.6pp downward revision from its January 2020 projections. On the other hand, China’s credit numbers continue to move up, reaching 30% of nominal GDP in May (Chart 8). Going forward, the recovery in base metals hinges on the speed at which the stimulus reaches the real economy. On average, it takes somewhere between 4 to 9 months for metals to react to surges in China’s TSF. Precious Metals: Neutral Gold prices traded between $1,675/oz and $1,760/oz since April. Our fair-value model suggests prices could trade slightly below this range (Chart 9). However, risks of renewed US-China tensions are rising rapidly, which could keep gold well-bid. BCA Research’s China Investment strategists believe these risks will reach new height over the summer as pressure on Trump’s election campaign intensifies.7 Mounting geopolitical risks could hurt risk assets and benefit gold as a hedge against equity volatility. Ags/Softs:  Underweight July Ethanol futures have shown substantial strength in the past two months, but the outlook remains gloomy. With over 30% of US fuel ethanol plants being idled during the pandemic, as prices and margins increase, an increase in supply is likely.  Gasoline demand might have less room to grow as most individuals keep working from home. Supporting this is EIA’s STEO outlook which sees the ethanol market oversupplied in 2020, with consumption expected to average 800k b/d in 2020 and production to average 880k b/d. Chart 8Chinese Credit Growth To Rise Chinese Credit Growth To Rise Chinese Credit Growth To Rise Chart 9Gold Slightly Above Fair Value Gold Slightly Above Fair Value Gold Slightly Above Fair Value     Footnotes 1     Pipeline-quality dry natural gas has had all impurities (metals, sulfur compounds, etc.) and non-methane liquids removed so that its heat content is ~ 1,010 BTUs per cubic foot. The NYMEX futures taken to delivery at Henry Hub, LA, require physical gas to meet the specifications “set forth in the FERC-approved tariff of Sabine Pipe Line Company.” 2     TThe correlation between US natgas and oil prices declined substantially since 2009. Our model, based on WTI prices and 10-year US treasury yields only, suggests Henry Hub prices’ elasticity to changes in oil prices dropped by more than 50% post-GFC. On the other hand, US yields are now much closely related to natural gas prices. The disconnection between Henry Hub and WTI prices is largely a result of the large increase in shale gas and associated gas production. Strong oil prices –which are determined globally – incentivized higher output by US E&Ps. This led to a surge in the volume of associated gas in an already saturated domestic gas market. 3    Please see Lingering Oil-Demand Weakness Will Fade, which we published November 21, 2019, and discusses flaring in the Permian and Bakken basins. 4    Please see "U.S. oil fields flared and vented more natural gas again in 2019: data" published by reuters.com February 3, 2020. 5    Please see Underground Natural Gas Working Storage Capacity published by the EIA May 29, 2020, for additional detail. 6    Please see The Covid-19 crisis is causing the biggest fall in global energy investment in history, published by the IEA May 27, 2020. The Agency notes, “… after the Covid-19 crisis brought large swathes of the world economy to a standstill in a matter of months, global investment is now expected to plummet by 20%, or almost $400 billion, compared with last year.” Oil and gas investment is projected to fall more than 30%. 7     Please see BCA Research's China Investment Strategy Report entitled Watch Out For A Second Wave (Of US-China Frictions) published June 10, 2010, available at cis.bcaresearch.com.   Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Trade Recommendation Performance In 2020 Q1 Natgas Prices Will Recover Slowly Natgas Prices Will Recover Slowly Commodity Prices and Plays Reference Table Trades Closed In 2020 Summary of Closed Trades Natgas Prices Will Recover Slowly Natgas Prices Will Recover Slowly  

Please note that yesterday we published Special Report on Egypt recommending buying domestic bonds while hedging currency risk. Today we are enclosing analysis on Hungary, Poland and Colombia. I will present our latest thoughts on the global macro outlook and implications for EM during today’s webcast at 10 am EST. You can access the webcast by clicking here. Yours sincerely, Arthur Budaghyan Hungary Versus Poland: Mind The Reversal Conditions are set for the Hungarian forint to outperform the Polish zloty over the coming months. We recommend going long the HUF against the PLN. Hungarian opposition parties criticized the government about the considerable depreciation in the forint. As a result, we suspect that political pressure from Prime Minister Viktor Orban led monetary authorities to alter their stance since April. Critically, the main architect of super-dovish monetary policy Marton Nagy resigned from the board of the central bank on May 28. In line with tighter liquidity, interbank rates have risen above the policy rate. This is marginally positive for the forint. The Hungarian central bank (NBH) tweaked its monetary policy in April after the currency had plunged to new lows against the euro, underperforming its Central European counterparts. The NBH widened its policy rate corridor by hiking the upper interest band to 1.85% and keeping the policy rate at 0.90%. The wider interest rate corridor makes it more costly for commercial banks to borrow reserves from the central bank. Hence, such liquidity tightening is positive for the forint. For years, Hungary was pursuing a super-easy monetary policy and consumer price inflation rose to 4% (Chart I-1). With the NBH keeping interest rates close to zero, real rates have plunged well into negative territory (Chart I-2, top panel). Chart I-1Hungary: Inflation Could Pause For Now Hungary: Inflation Could Pause For Now Hungary: Inflation Could Pause For Now Chart I-2Hungary Vs. Poland: Real Rates Reversal Is Coming Hungary Vs. Poland: Real Rates Reversal Is Coming Hungary Vs. Poland: Real Rates Reversal Is Coming     In brief, the central bank has been behind the inflation curve. As a result, the forint has been depreciating against both the euro and its central European peers. In such a situation, the key to reversal in the exchange rate trend would be the monetary authority’s readiness to raise real interest rates. The NBH has made a small step in this direction. Going forward, the central bank will be restrained in its quantitative easing (QE) program and will not augment it any further. So far, QE uptake has been slow: around half out of the available HUF 1,500 billion has been tapped by commercial banks and corporates. Importantly, the NBH announced its intention to sterilize its government and corporate bond purchases. Already, the commercial banks excess reserves at the central bank have fallen to zero, which suggests that liquidity is no longer abundant in the banking system (Chart I-3). In line with tighter liquidity, interbank rates have risen above the policy rate. This is marginally positive for the forint. Hungarian authorities have become more cognizant of the economic and financial risks associated with their ultra-accommodative policies. For instance, they initiated a clampdown on real estate speculation, which is leading to dwindling real estate prices. This will lead to a decline in overall inflation expectations and, thereby, lift expected real interest rates. The open nature of Hungary’s economy – whereby exports of goods and services constitute 85% of GDP - makes it much more sensitive to pan-European tourism and manufacturing cycles. With the collapse in its manufacturing and tourism revenues, wage growth in Hungary is bound to decelerate rapidly (Chart I-4). Chart I-3Hungary: Central Bank Has Drained Liquidity Hungary: Central Bank Has Drained Liquidity Hungary: Central Bank Has Drained Liquidity Chart I-4Economic Growth: Hungary Is More Vulnerable Than Poland Economic Growth: Hungary Is More Vulnerable Than Poland Economic Growth: Hungary Is More Vulnerable Than Poland   Rapidly deteriorating wage and employment dynamics reduces the odds of an inflation breakout anytime soon. This will cool down inflation and, thereby, increase real rates on the margin. The central bank in Poland will stay super accommodative while the National Bank of Hungary will be a bit less aggressive. Bottom Line: Although this monetary policy adjustment does not entail the end of easy policy in Hungary, generally, it does signal restraint on the part of monetary authorities resulting from a much reduced tolerance for currency depreciation. This creates conditions for the forint to outperform. Poland In the meantime, Polish monetary authorities have switched into an ultra-accommodative mode. Recent policy announcements by the National Bank of Poland (NBP) represent the most dramatic example of policy easing in Central Europe. Such a policy stance in Poland will produce lower real rates than in Hungary, which is negative for the Polish zloty against the forint. The NBP is set to finance the majority of a new 11% of GDP fiscal spending program enacted by the government amid the COVID-19 lockdowns. This amounts to de-facto public debt and fiscal deficit monetization. The latter will not be sterilized unlike in Hungary and will therefore lead to an excess liquidity overflow in the banking system. The Polish central bank has cut interest rates by 140 bps to 10 bps since March. Pushing nominal rates down close to zero has produced more negative real policy rates than in Hungary (Chart I-2, top panel on page 2). Also, Polish prime lending rates in real terms have fallen below those in Hungary (Chart I-2, bottom panel). Chances are that inflation in Poland will also prove to be stickier than in Hungary due to the minimum wage raise at the beginning of the year and very aggressive fiscal and monetary stimulus since the pandemics has erupted (Chart I-5). Critically, the Polish economy is much less open than Hungary’s, and it is therefore less vulnerable to the collapse of pan-European manufacturing and tourism. This will ensure better employment and wage conditions in Poland. All in all, Poland’s final demand outperformance, versus Hungary, will contribute to a higher rate of inflation there. Bottom Line: The central bank in Poland will stay super accommodative while the National Bank of Hungary will be a bit less aggressive. This is producing a U-turn in both countries’ nominal and relative real interest rates, which heralds a reversal in the HUF / PLN cross rate (Chart I-6). Chart I-5Polish Inflation Will Be Sticker Than In Hungary Polish Inflation Will Be Sticker Than In Hungary Polish Inflation Will Be Sticker Than In Hungary Chart I-6Go Long HUF / Short PLN Go Long HUF / Short PLN Go Long HUF / Short PLN   Investment Strategy For Central Europe A new trade: go long the HUF versus the PLN. Take a 3% profit on the short HUF and PLN / long CZK trade. Close the short IDR / long PLN trade with a 20% loss. Downgrade central European bourses (Polish, Czech and Hungarian) from an overweight to a neutral allocation within the EM equity benchmark. Lower for longer European interest rates disfavor bank stocks that dominate central European bourses. Andrija Vesic Associate Editor andrijav@bcaresearch.com Colombia: Continue Betting On Lower Rates Colombia has been badly hit by two shocks: the precipitous fall in oil prices and the strict quarantine measures to constrain the spread of the COVID-19 outbreak. An underwhelming fiscal stimulus in response to the lockdowns will further weigh on private demand. An underwhelming fiscal stimulus in response to the lockdowns will further weigh on private demand. We have been recommending receiving 10-year swap rates in Colombia since April 23rd and this strategy remains unchanged: While oil prices seem to have rebounded sharply, they will remain structurally low (Chart II-1). The Emerging Markets Strategy team's view is that oil prices will average $40 per barrel this year and next.1 After the recent rally, chances of further upside in crude prices are limited. Chart II-1A Long-Term Perspective On Oil Prices A Long-Term Perspective On Oil Prices A Long-Term Perspective On Oil Prices Table II-1Colombia’s Fiscal Package Is The Lowest In The Region Hungary Versus Poland; Colombia Hungary Versus Poland; Colombia Colombia's high sensitivity to oil prices is particularly visible via its current account balance. Indeed, Colombia’s net crude exports cover as much as 50% of the current account deficit, such that low oil prices severely affect the currency and produce a negative income shock for the economy. Fiscal policy remains unreasonably tight, especially in the face of the global pandemic. The government’s fiscal response plan amounts to only a meagre 1.5% of GDP. This is low not only compared to advanced economies but also to the rest of Latin America (Table II-1). Moreover, President Duque’s administration has been running the tightest fiscal budget in almost a decade, with the primary fiscal balance reaching 1% of GDP before the pandemic. The country’s COVID-19 response has been fast and effective. Colombia has managed to achieve the lowest amount of infections and deaths among major economies in Latin America (Chart II-2). Chart II-2COVID-19 Casualties Across Latin America COVID-19 Casualties Across Latin America COVID-19 Casualties Across Latin America Duque’s administration has taken a pragmatic approach to handling the pandemic by enforcing strict lockdowns and banning international and inter-municipal travel since late March, only three days after the country’s first casualty. Further, the nationwide confinement measures have been extended until July 1st, with particularly stringent rules applying to major cities. These have helped the country avoid a nation-wide health crisis, but they will engender prolonged economic pain. Regarding monetary stimulus, the central bank (Banrep) has cut interest rates by 150 basis points since March of this year. It also embarked on the first and largest QE program in the region. Banrep has committed to purchase 12 trillion pesos worth of government and corporate securities (amounting to a whopping 8% of GDP). Consumer price inflation is falling across various core measures and will drop below the low end of Banrep’s target range (Chart II-3). This will push the central bank to continue cutting rates. Despite the monetary easing, nominal lending rates are still restrictive. Real lending rates (deflated by core CPI) remain elevated at 7% (Chart II-4). Chart II-3Colombia: Inflation Will Fall Below Target Colombia: Inflation Will Fall Below Target Colombia: Inflation Will Fall Below Target Chart II-4Colombia: Real Lending Rates Are Still High Colombia: Real Lending Rates Are Still High Colombia: Real Lending Rates Are Still High Chart II-5The Colombian Economy Was Already Under Pressure The Colombian Economy Was Already Under Pressure The Colombian Economy Was Already Under Pressure Importantly, there has not been an appropriate amount of credit support and debt waving programs for SMEs, as there has been in many other countries. Given that SMEs employ a large share of the workforce, and that household spending accounts for about 70% of GDP, consumer spending and overall economic growth will contract substantially and be slow to recover. Employment rates had already been contracting, and wage growth downshifting, before the pandemic started (Chart II-5). Household income is now certainly in decline as major cities are in full lockdown and economic activity is frozen. Investment Recommendations Even though we are structurally positive on the country due to its orthodox macroeconomic policies, positive structural reforms, and low levels of debt among both households and companies, we maintain a neutral allocation on Colombian stocks within an EM equity portfolio. This bourse is dominated by banks and energy stocks. The lack of both fiscal support and bank loan guarantees amid the recession means that banks will carry the burden of ultimate losses. They will suffer materially due to loan restructuring and defaults. For fixed income investors, we reiterate our call to receive 10-year swap rates and recommend overweighting local currency government bonds versus the EM domestic bond benchmark. The yield curve is steep and real bond yields are elevated (Chart II-6). Hence, long-term interest rates offer great value. Additional monetary easing, including quantitative easing, will suppress yields much further. Chart II-6A Great Opportunity In Colombian Rates A Great Opportunity In Colombian Rates A Great Opportunity In Colombian Rates Chart II-7The COP Has Depreciated Considerably The COP Has Depreciated Considerably The COP Has Depreciated Considerably   We are upgrading Colombia sovereign credit from neutral to overweight within an EM credit portfolio. General public debt (including the central and state governments) stands at 59% of GDP. Conservative fiscal policy and the central bank’s large purchases of local bonds will allow the government to finance itself locally. Presently, 40% of public debt is foreign currency and 60% local currency denominated. As a result, sovereign credit will outperform the EM credit benchmark. In terms of the currency, we recommend investors to be cautious for now. Even though the peso is cheap (Chart II-7), another relapse in oil prices or a potential flare up in social protests could cause further downfall in the currency. Juan Egaña Research Associate juane@bcaresearch.com   1 This differs from the view of BCA’s Commodities and Energy Strategy service. We believe structural forces such as the lasting decline in air travel and commuting will impede a recovery in oil demand while, at the same time, US shale production will rise again considerably if crude prices rise and remain well above $40   Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

  In a webcast this Friday I will be joined by our Chief US Equity Strategist, Anastasios Avgeriou to debate ‘Sectors To Own, And Sectors To Avoid In The Post-Covid World’. Today’s report preludes five of the points that we will debate. Please join us for the full discussion and conclusions on Friday, June 12, at 8:00 AM EDT (1:00 PM BST, 2:00 PM CEST, 8.00 PM HKT).   Highlights Technology is behaving like a Defensive. Defensive versus Cyclical = Growth versus Value. Growth stocks are not a bubble if bond yields stay ultra-low. The post-Covid world will reinforce existing sector mega-trends. Sectors are driving regional and country relative performance. Fractal trade: Long ZAR/CLP.   Chart of the WeekSector Defensiveness/Cyclicality = Positive/Negative Sensitivity To The Bond Price Sector Defensiveness/Cyclicality = Positive/Negative Sensitivity To The Bond Price Sector Defensiveness/Cyclicality = Positive/Negative Sensitivity To The Bond Price 1. Technology Is Behaving Like A Defensive How do we judge an equity sector’s sensitivity to the post-Covid economy, so that we can define it as cyclical or defensive? One approach is to compare the sector’s relative performance with the bond price. According to this approach, the more negatively sensitive to the bond price, the more cyclical is the sector. And the more positively sensitive to the bond price, the more defensive is the sector (Chart I-1).   On this basis the most cyclical sectors in the post-Covid economy are, unsurprisingly: energy, banks, and materials. Healthcare is unsurprisingly defensive. Meanwhile, the industrials sector sits closest to neutral between cyclical and defensive, showing the least sensitivity to the bond price. The tech sector’s vulnerability to economic cyclicality appears to have greatly reduced. The big surprise is technology, whose high positive sensitivity to the bond price during the 2020 crisis qualifies it as even more defensive than healthcare. This contrasts sharply with its behaviour during the 2008 crisis. Back then, tech’s relative performance was negatively correlated with the bond price, defining it as classically cyclical. But over the past year, tech’s relative performance has been positively correlated with the bond price, defining it as classically defensive (Chart I-2 and Chart I-3). Chart I-2In 2008, Tech Behaved Like ##br##A Cyclical... In 2008, Tech Behaved Like A Cyclical... In 2008, Tech Behaved Like A Cyclical... Chart I-3...But In 2020, Tech Is Behaving Like A Defensive ...But In 2020, Tech Is Behaving Like A Defensive ...But In 2020, Tech Is Behaving Like A Defensive This is not to say that the big tech companies cannot suffer shocks. They can. For example, from new superior technologies, or from anti-oligopoly legislation. However, the tech sector’s vulnerability to economic cyclicality appears to have greatly reduced over the past decade. 2. Defensive Versus Cyclical = Growth Versus Value If we reclassify the tech sector as defensive in the 2020s economy, then the post mid-March rebound in stocks was first led by defensives. Cyclicals took over leadership of the rally only in May. Moreover, with the reclassification of tech as defensive, the two dominant defensive sectors become tech and healthcare. But tech and healthcare are also the dominant ‘growth’ sectors. The upshot is that growth versus value has now become precisely the same decision as defensive versus cyclical (Chart I-4). Chart I-4Defensive Versus Cyclical = Growth Versus Value Defensive Versus Cyclical = Growth Versus Value Defensive Versus Cyclical = Growth Versus Value 3. Growth Stocks Are Not A Bubble If Bond Yields Stay Ultra-Low Some people fear that growth stocks have become dangerously overvalued. There is even mention of the B-word. Let’s address these fears. Yes, valuations have become richer. For example, the forward earnings yield for healthcare is down to 5 percent; and for big tech it is down to just over 4 percent. This valuation starting point has proved to be an excellent guide to prospective 10-year returns, and now implies an expected annualised return from big tech in the mid-single digits. Yet this modest positive return is well above the extremes of the negative 10-year returns implied and delivered from the dot com bubble (Chart I-5). Chart I-5Big Tech Is Priced To Deliver A Positive Return, Unlike In 2000 Big Tech Is Priced To Deliver A Positive Return, Unlike In 2000 Big Tech Is Priced To Deliver A Positive Return, Unlike In 2000 Moreover, we must judge the implied returns from growth stocks against those available from competing long-duration assets – specifically, against the benchmark of high-quality government bond yields. If bond yields are ultra-low, then they must depress the implied returns on growth stocks too. Meaning higher absolute valuations (Chart I-6 and Chart I-7). Chart I-6Tech's Forward Earnings Yield Is Above The Bond Yield, Unlike In 2000 Tech's Forward Earnings Yield Is Above The Bond Yield, Unlike In 2000 Tech's Forward Earnings Yield Is Above The Bond Yield, Unlike In 2000 Chart I-7Healthcare's Forward Earnings Yield Is Above The Bond Yield, Unlike In 2000 Healthcare's Forward Earnings Yield Is Above The Bond Yield, Unlike In 2000 Healthcare's Forward Earnings Yield Is Above The Bond Yield, Unlike In 2000 In the real bubble of 2000, big tech was priced to return 12 percent (per annum) less than the 10-year T-bond. Whereas today, the implied return from big tech – though low in absolute terms – is above the ultra-low yield on the 10-year T-bond. If bond yields are ultra-low, then they must depress the implied returns on growth stocks too. The upshot is that high absolute valuations of growth stocks are contingent on bond yields remaining at ultra-low levels. And that the biggest threat to growth stock valuations would be a sustained rise in bond yields. 4. The Post-Covid World Will Reinforce Existing Sector Mega-Trends If a sector maintains a structural uptrend in sales and profits, then a big drop in the share price provides an excellent buying opportunity for long-term investors. This is because the lower share price stretches the elastic between the price and the up-trending profits, resulting in an eventual catch-up. However, if sales and profits are in terminal decline, then the sell-off is not a buying opportunity other than on a tactical basis. This is because the elastic will lose its tension as profits drift down towards the lower price. In fact, despite the sell-off, if the profit downtrend continues, the price may be forced ultimately to catch-down. This leads to a somewhat counterintuitive conclusion. After a big drop in the stock market, long-term investors should not buy everything that has dropped. And they should not buy the stocks and sectors that have dropped the most if their profits are in major downtrends. In this regard, the post-Covid world is likely to reinforce the existing mega-trends. The profits of oil and gas, and of European banks will remain in major structural downtrends (Chart I-8 and Chart I-9). Conversely, the profits of healthcare, and of European personal products will remain in major structural uptrends (Chart I-10 and Chart I-11). Chart I-8Oil And Gas Profits In A Major ##br##Downtrend Oil And Gas Profits In A Major Downtrend Oil And Gas Profits In A Major Downtrend Chart I-9Bank Profits In A Major ##br##Downtrend European Banks Profits In A Major Downtrend Bank Profits In A Major Downtrend European Banks Profits In A Major Downtrend Bank Profits In A Major Downtrend Chart I-10Healthcare Profits In A Major Uptrend Healthcare Profits In A Major Uptrend Healthcare Profits In A Major Uptrend Chart I-11Personal Products Profits In A Major Uptrend Personal Products Profits In A Major Uptrend Personal Products Profits In A Major Uptrend   5. Sectors Are Driving Regional And Country Relative Performance Finally, sector winners and losers determine regional and country equity market winners and losers. Nowadays, a stock market’s relative performance is predominantly a play on its distinguishing overweight and underweight ‘sector fingerprint’. This is because major stock markets are dominated by multinational corporations which are plays on their global sectors, rather than the region or country in which they have a stock market listing. It follows that when tech and healthcare outperform, the tech-heavy and healthcare-heavy US stock market must outperform, while healthcare-lite emerging markets (EM) must underperform. It also follows that the tech-heavy Netherlands and healthcare-heavy Denmark stock markets must outperform. Sector mega-trends will shape the mega-trends in regional and country relative performance. Equally, when energy and banks underperform, the energy-heavy Norway and bank-heavy Spain stock markets must underperform. (Chart I-12 and Chart I-13). These are just a few examples. Every stock market is defined by a sector fingerprint which drives its relative performance.  Chart I-12Sector Relative Performance Drives... Sector Relative Performance Drives... Sector Relative Performance Drives... Chart I-13...Regional And Country Relative Performance ...Regional And Country Relative Performance ...Regional And Country Relative Performance If sector mega-trends continue, they will also shape the mega-trends in regional and country relative performance – favouring those stock markets that are heavy in growth stocks and light in old-fashioned cyclicals. Please join the webcast to hear the full debate and conclusions. Fractal Trading System*  This week’s recommended trade is to go long the South African rand versus the Chilean peso. Set the profit target and symmetrical stop-loss at 5 percent. In other trades, long Spanish 10-year bonds versus New Zealand 10-year bonds achieved its 3.5 percent profit target at which it was closed. And long Australia versus New Zealand equities is approaching its 12 percent profit target. The rolling 1-year win ratio now stands at 63 percent. Chart I-14ZAR/CLP ZAR/CLP ZAR/CLP   When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated  December 11, 2014, available at eis.bcaresearch.com.   Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading System   Cyclical Recommendations Structural Recommendations Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields   Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations  

Highlights Volatility strategies are a useful tool for asset allocators. They can be used for both alpha generation and risk mitigation, but they have to be managed properly within a fund’s total risk management framework. Dedicated tail-risk hedging can reduce volatility, but can be very costly depending on the holding period. Short volatility strategies can generate alpha, but can also incur large losses when volatility spikes. Long volatility and also relative-value volatility strategies are much better alpha generators. A simple and easy-to-implement rule-based dynamic hedging strategy using short-term VIX futures reduces equity portfolio risk significantly without sacrificing return. The Sensational Headlines The COVID-19 pandemic-induced financial market volatility has put two major pension funds in the proverbial spotlight. First, CalPERS was questioned about its October 2019 decision to unwind its tail-risk hedging program that would have generated a payoff of more than US$1 billion during the March equity market selloff.1 Then, AIMCo was said to have lost over C$3 billion in its short volatility program, and was also forced to shut the program down.2 With such high-profile stories making the rounds, it is not surprising that we have received questions about tail-risk hedging and volatility strategies from many clients: Should long-term investors hedge tail risk? Is short volatility not a suitable strategy for pension funds? What are the efficient ways to manage large drawdowns? Chart 1The High Profile Failures: Not Uncommon The High Profile Failures: Not Uncommon The High Profile Failures: Not Uncommon Before we attempt to answer these questions, we want to first point out that tail-risk hedging and short-volatility strategies are negatively correlated, as shown in Chart 1, panel 1. It is normal for short-volatility strategies to suffer large drawdowns when tail-hedging strategies make handsome gains in periods of extreme financial market stress. This is largely due to the nature of volatility. As shown in panel 2 in Chart 1, VIX futures curves are normally in contango (the far-month contract is higher than the near-month contract), so a plain-vanilla short position in VIX futures benefits from positive rolling yields, while a plain-vanilla long position suffers from negative rolling yields. When VIX spikes, however, the futures curve turns into large backwardation (the far-month contract is lower than the near-month contract) in a fast and furious fashion, hence the large insurance-like payoff. The short-volatility and tail-hedge indexes in Chart 1 are from CBOE Eurekahedge, which has a suite of volatility indexes. As shown in Table 1, these indexes track the average performance of hedge funds that employ various volatility strategies, including tail-risk volatility, long volatility, short volatility and relative-value volatility. Table 1CBOE Eurekahedge Volatility Hedge Fund Indexes* Demystifying Tail-Risk Hedging And Volatility Strategies Demystifying Tail-Risk Hedging And Volatility Strategies   The performance statistics of these indexes are shown in Table 2. It is clear that not all volatility strategies are created equal. Below, we explore in more detail how these strategies should be used. Table 2CBOE Eurekahedge Volatility Index Performance Statistics Demystifying Tail-Risk Hedging And Volatility Strategies Demystifying Tail-Risk Hedging And Volatility Strategies Tail-Risk Hedging Is Not Free Tail-risk hedging has been in the news of late, given the unprecedently sharp drop in equities in February and March and also the untimely decision by CalPERS to unwind its tail-risk hedging program last October. So, what is tail-risk-hedging exactly? How does it work? Tail-risk hedging strategies aim to profit from large drawdowns in risky assets. Unlike the traditional approach of diversification that reduces the weighting of risky assets (for example, a 60-40 equity-bond portfolio is less risky than a 100% equity portfolio), tail-risk hedging attempts to allocate a small percentage of capital, say 3-5%, to a specially designed insurance-like payoff, while maintaining exposure to the risky asset. As such, tail-risk hedging is like buying an insurance policy against a catastrophic event. The premiums paid may or may not be recouped, depending on how likely it is that a catastrophic event may occur and how long one has held the insurance policy. The Universa Tail Fund is one of the two tail-risk funds that CalPERS made the untimely decision to redeem. The fund returned 3,600% in March alone, and 4,440% in the first quarter of 2020. As well, according to reports, a portfolio with 96.7% in the S&P 500 and 3.3% in Universa’s tail-risk fund would effectively have mitigated the S&P 500’s large loss in March, and would have also produced a compounded return of 11.5% since March 2008 versus 7.9% for the S&P 500.3  The performance of the Universa Tail Fund seems to be very different from the average hedge fund in this category, as shown in Table 2 and Chart 1. The CBOE Eurekahedge Tail Risk Hedge Fund index is an average of eight hedge funds that employ tail-risk strategies to achieve capital appreciation during periods of market stress. Since December 2007, when the index started, it has had two outsized monthly gains: 37.5% in March 2020 and 27.5% in August 2011, when MSCI US equities lost 12.7 and 5.5%. However, such benefit is very costly from a long-term perspective because the index has generated an annualized loss of 2.5%, even through April 2020. Its arithmetic average during the period is about -1.6%. To better understand why Universa has been doing so much better than the “average” tail risk hedge fund, we replicate a stylized exercise by Universa published in October 2017.4 The only difference is that we use the MSCI US equity total return index instead of the S&P 500 index. The payoff structure of 9 to 1 means that when the MSCI US calendar year return is less than -15%, the hedge would generate a return of 900%. In other years, insurance premium is not recouped at all, i.e. there is a loss of 100%. The original exercise by Universa designed such a payoff structure because it aimed to have an average payoff of zero in the period from 1996 to 2016. As shown in Chart 2, the biggest advantage of the tail-hedged portfolio (97% MSCI US + 3% Insurance) is its much smoother return stream, with a standard deviation of 12.9% compared to 17.7% for the unhedged MSCI US equity portfolio based on calendar year returns from 1970 to 2020 (as of March for 2020). Also, the skew is improved to -0.1 from -0.7. In terms of return, however, it is highly variable depending on the period chosen. The hedged portfolio outperformed the MSCI US total return index by about 70 basis points annualized from 1996 to 2016, consistent with the result from the original exercise by Universa.5 Outside this period, however, the average return of the payoff stream really depends on how often US equities fall below -15% yearly. In the 50-year period from December 1969 to December 2019, the average return of the insurance payoff was -20%, and the tail-hedged program underperformed MSCI US by 26 basis points annualized. Chart 2Universa Exercise Replica* For 12/1969 - 3/2020 Demystifying Tail-Risk Hedging And Volatility Strategies Demystifying Tail-Risk Hedging And Volatility Strategies This simple stylized exercise shows that both the starting point to initiate the tail-risk hedge and the length of time to hold the hedge are very important for a tail-risk hedge to work, not to mention generate spectacular results. Like a catastrophic insurance policy, a tail hedge should not be considered as a stand-alone strategy but as a hedge to the underlying portfolio. It is critical to design the right payoff structure, which in turn requires a view on how often a large drawdown will likely happen in the forecast period. It also takes special skill to find the right instruments to implement such a payoff structure and manage it accordingly. As we will show in the section on page 9, a dynamic approach is needed to ensure the hedge is on only when it’s needed to reduce cost. In fact, Universa did mention about using extreme valuation as one indicator to identify periods with high likelihood of downside risks.6 It also locked in a massive gain in March 2020,7 another indication of the “dynamic nature” of tail-hedging management. Bottom Line: From a long-term perspective, tail-risk hedge does not significantly improve compound returns, but it does reduce volatility significantly. Unless an investor has the skill to dynamically manage a hedge program, passively holding a tail-risk hedge can be costly in terms of return, even though it does improve risk-adjusted returns. Is A Short-Volatility Strategy Suitable For Pension Funds? The CBOE Eurekhedge Short Volatility index lost 20.8% in the first four months of 2020, in which March was the worst month in its history since December 2004, with a loss of 15.8%, while April was the best month with a gain of 9.3%. The annualized return since December 2004, however, has been 5.4%, and 73% of monthly returns have been in positive territory (Table 2). On the other hand, AIMCo had to shut down its volatility trading program in March because of its large $3 billion loss, or about 2.5% of its $119 billion of AUM. It is not known why a small volatility program was allowed to lose more than the fund’s total full-year value-add target. Chart 3Volatility Measures: Implied Vs. Realized VOLATILITIES: IMPILED VS REALIZED VOLATILITIES: IMPILED VS REALIZED There are different ways to short volatility. One is to sell options on the underlying assets. This approach, however, is also impacted by the price level of the underlying assets. VIX futures, as shown in Chart 1, panel 2, are a way to bet on the change in implied volatility. Another way to short volatility is via variance swaps, which bet on the change between realized variance at the expiry of the swap and the strike variance, which is set according to both historical variance and implied variance.8 Because variance is the square of volatility, the payoff of a variance swap is convex, i.e. when volatility spikes up, a short seller loses more money than when volatility decreases. As shown in Chart 3, VIX, the implied volatility, peaked on March 16, and realized volatility peaked on March 27. However, the difference between realized and implied volatility did not peak until April 6, and remained positive through the end of April. As such, a short volatility program via variance swaps would have experienced severe mark-to-market losses daily from mid-March to early April, even though equities bottomed on March 23.   However, such a spike happened in 2008 as well. Any back-test would have included such an occurrence in 2008. Granted, the magnitude of the current spike is larger than that in 2008, but it reversed quickly down to the 2008 level. We may never know why AIMCo’s short volatility program suffered such outsized losses. The only guess is that it may have used variance swaps, and the embedded leverage made the size of the program not appropriate for the total fund. Bottom Line: Short volatility can be a useful tool for alpha generation. The key, however, is risk management. It should be properly sized within the overall risk management framework of the total fund. Volatility As An Asset Class? Tail-risk hedging using volatility is too costly in general, while shorting volatility outright can be disastrous. Some argue that investors should not have anything to do with volatility strategies. On the other hand, other investors treat volatility as an asset class for both alpha generation and risk mitigation. Chart 4 shows the CBOE Eurekahedge Relative-Value Volatility index and the Long-Volatility index together with the MSCI US equity index, and Bloomberg Barclays US aggregate bond index and US Treasury index. The relative-value volatility index can be long, short, or neutral on volatility (Table 1). As shown in Table 2, it has achieved an annualized return of 7.6%, only 60 basis points less than MSCI US equity return of 8.2%, but much higher than the 4.3% and 4.5% respective return from Bloomberg Barclays US Treasury index and aggregate bond index in the period from December 2004 to April 2020. Its standard deviation of 3.9% is much lower than the MSCI US (14.7%) and very close to Treasurys (4.1%) and aggregate bonds (3.2%). For this specific period, in fact, this index even has a much better risk-return profile than a typical 60/40 US equity/aggregate-bond portfolio, which scores a 7.1% annualized return with 8.9% standard deviation. With almost zero correlation to both stocks and bonds, this index serves as an ideal addition to a balanced equity-bond portfolio (Chart 5). Chart 4Volatility As An Asset Class VOLATILITY AS AN ASSET CLASS VOLATILITY AS AN ASSET CLASS Chart 5Relative-Value Vol Strategy Improves The Performance Of A 60/40 Equity/Bond Portfolio Demystifying Tail-Risk Hedging And Volatility Strategies Demystifying Tail-Risk Hedging And Volatility Strategies The challenge, however, is that this index is an average of 35 hedge funds that employ relative-value or opportunistic-volatility strategies that can be long, short, or neutral on implied volatility.9 Because of this, capacity constraints for investors to get into those funds may exist, which could produce diverging performances. Even the long-volatility strategy (Chart 4, panel 2), which in theory suffers negative rolling yields when the VIX is in a normal range, has generated a 5% annualized return. It has a negative correlation of 0.46 with MSCI US equities, comparable to the negative correlation of 0.5 between the Tail-Risk index and MSCI US. Given the much better statistics of this index compared to the Tail-Risk index, it should be a less costly alternative to the Tail-Risk Hedge index (Table 2). To illustrate how these two strategies work to mitigate downside risk in the MSCI US equities, we compare a series of portfolios that allocate from 0-100% of capital to MSCI US and 100-0% to the two volatility strategies, respectively. As shown in Chart 6, the long-volatility strategy is a much better risk mitigator to the MSCI US equities index than the tail-hedge strategy at all levels of allocations for the period from January 2008 to April 2020.  Chart 6Risk Mitigation Using Long Vol Vs. Tail-Risk Hedge Demystifying Tail-Risk Hedging And Volatility Strategies Demystifying Tail-Risk Hedging And Volatility Strategies Dynamic Hedging Using VIX Futures The CBOE Eurekahedge volatility indexes are based on average returns of the funds in each index. They are not investable. Also, hedge funds in these indexes may have capacity issues to accommodate large investors. In this section we run a simple rule-based hedging strategy using VIX futures to illustrate how investors can use volatility strategies in-house as an alternative tool to mitigate risk. We use the S&P VIX short-term futures index for this exercise, because it can be easily replicated in-house. This index is constructed based on rolling daily 5% of the front-month contract to the second-month contract. This means the index always has one month to expiry. It also means that daily rolling averages out the rolling yield for any given month.  The rule is simple: invest in the short-term volatility futures only when the VIX is outside its normal range. Since its inception in 1990, the VIX average is about 20. To test how different thresholds and rebalancing frequencies work, we test four different VIX thresholds: 25, 30, 35 and 40 with both weekly and monthly rebalances. The rebalance rule is: if the VIX is greater than a threshold at the end of one period, then in the next period, 5% of the fund is allocated to the S&P short-term VIX futures index and 95% is allocated to MSCI US. Otherwise 100% goes to MSCI US equities. For comparison, we also run a static hedge that has 5% in VIX futures and 95% in the MSCI US index.  The monthly rebalanced results are quite interesting, as shown in Table 3 and Chart 7: Table 3Dynamic Hedging Using VIX Futures Demystifying Tail-Risk Hedging And Volatility Strategies Demystifying Tail-Risk Hedging And Volatility Strategies Chart 7Dynamic Hedging Works DYNAMIC HEDGING WITH VIX FUTURES DYNAMIC HEDGING WITH VIX FUTURES Despite a terrible risk-return profile on its own, VIX futures can be a good risk mitigator when the hedge is put on only when the VIX is above a certain threshold.  Even though the 60-40 wins in terms of risk-adjusted return, dynamically hedged portfolios have better returns than both the 60-40 and US equities. The results are also robust when we do a weekly rebalance. Three conclusions can be drawn from Charts 8A and 8B, and Chart 9: Chart 8ADynamic Hedging – Monthly Rebalance DYNAMIC HEDGE-MONTHLY REBALNCE DYNAMIC HEDGE-MONTHLY REBALNCE Chart 8BDynamic Hedging – Weekly Rebalance DYNAMIC HEDGE-WEEKLY REBALNCE DYNAMIC HEDGE-WEEKLY REBALNCE     Chart 9Simple But Robust Dynamic Hedging Demystifying Tail-Risk Hedging And Volatility Strategies Demystifying Tail-Risk Hedging And Volatility Strategies   Hedging reduces volatility significantly. The lower the VIX threshold is, the larger the volatility reduction in the hedged portfolio compared to the unhedged. Hedging also improves average returns, albeit at a smaller scale compared to the reductions in volatility. Depending on the rebalancing frequency, the return improvement differs. For the monthly rebalance, the best VIX threshold lies between 30-35; for the weekly rebalance, the best is when the VIX threshold is at 30. Hedging is not needed all the time because volatility is within a normal range most of the time. Even when it spikes, it does not stay high for an extended period of time. Bottom Line: A simple rule-based dynamic hedging approach using VIX futures can substantially improve an equity portfolio’s risk-return profile by decreasing volatility significantly without sacrificing return. In a low interest rate environment, dynamic hedging using VIX futures can be a good alternative to a 60-40 equity-bond mix.   Xiaoli Tang Associate Vice President xiaoliT@bcaresearch.com   Footnotes 1  https://www.institutionalinvestor.com/article/b1l65mvpw5xpts/The-Inside-Story-of-CalPERS-Untimely-Tail-Hedge-Unwind 2 https://www.institutionalinvestor.com/article/b1l9c8n9lgdj1r/AIMCo-s-3-Billion-Volatility-Trading-Blunder 3 https://www.bloomberg.com/news/articles/2020-04-08/taleb-advised-universa-tail-risk-fund-returned-3-600-in-march 4 https://www.universa.net/UniversaResearch_SafeHavenPart1_RiskMitigation.pdf 5  https://www.universa.net/UniversaResearch_SafeHavenPart1_RiskMitigation.pdf 6 https://www.universa.net/UniversaResearch_SafeHavenPart2_NotAllRisk.pdf 7 https://www.bloomberg.com/news/articles/2020-04-08/taleb-advised-universa-tail-risk-fund-returned-3-600-in-march 8  https://en.wikipedia.org/wiki/Variance_swap 9 https://www.eurekahedge.com/Indices/CBOE-Eurekahedge-Volatility-Indexes-Methodology  

Highlights Egypt’s balance of payments have deteriorated materially due to both the crash in oil prices and the global pandemic. The country’s foreign funding requirements in 2020 are high and the currency is under depreciation pressures. Unless domestic interest rates are brought considerably lower, the nation’s public debt is on an unsustainable trajectory. Hence, Egypt needs to reduce local interest rates substantially and rapidly. And in so doing, the central bank cannot control or defend the exchange rate. The latter is set to depreciate. Investors should buy Egyptian local currency bonds while hedging their currency exposure. Feature The Central Bank of Egypt (CBE) is depleting its foreign exchange (FX) reserves to defend the currency (Chart I-1). As the CBE’s foreign exchange reserves diminish, so will its ability to support the currency. As such, the Egyptian pound will likely depreciate in the next 6-9 months. Interestingly, despite being a net importer of energy, many of Egypt’s critical macro parameters are positively correlated with oil prices (Chart I-2). Egypt is in fact deeply integrated in the Gulf oil-economy network via trade and capital flows. In other words, Egypt is a veiled play on oil. Chart I-1The CBE Has Been Defending The Currency The CBE Has Been Defending The Currency The CBE Has Been Defending The Currency Chart I-2Egypt: A Veiled Play On Oil Egypt: A Veiled Play On Oil Egypt: A Veiled Play On Oil   Although oil prices have rallied sharply recently, the Emerging Markets Strategy team believes upside is limited and that oil prices will average about $40 over the next three years.1  In addition, local interest rates that are persistently above 10% are disastrous for both Egypt’s domestic demand and public debt sustainability. Egypt’s current account balance strongly correlates with oil prices because of the strong interlinkages that exist between Egypt and the oil-exporting Gulf countries. To preclude a vicious cycle in both the economy and public debt, the CBE should reduce interest rates materially and rapidly. Therefore, higher interest rates cannot be used to defend the exchange rate. Balance Of Payments Strains Egypt’s balance of payments (BoP) dynamics have deteriorated and the probability of a currency devaluation has risen: Current Account: The current account deficit – which stood at $9 billion and 3% of the GDP as of December 2019 – is widening significantly due to the plunge in oil prices this year (Chart I-2, top panel). Egypt’s current account balance strongly correlates with oil prices because of the strong interlinkages that exist between Egypt and the oil-exporting Gulf countries. The latter have been hard hit by the twin shocks of the coronavirus pandemic and the oil crash. First, Egypt’s $27 billion in annual remittances are drying up (Chart I-2, bottom panel). The majority of these transmittals come from Egyptian workers working in Gulf countries. Second, Egypt’s tourism industry – which brings in $13 billion in annual revenues or 4% of GDP – has collapsed due to the pandemic. Tourist arrivals from Middle Eastern countries – which makeup 20% of total tourist arrivals into Egypt – will diminish substantially due to both the pandemic and the negative income shock that the Gulf economies have experienced (Chart I-3). Third, Egyptian exports are in freefall (Chart I-4, top panel). Not only is this due to the freeze in global trade, but also because the country’s exports to the oil-leveraged Arab economies have taken a massive hit. The latter make up 25% of Egypt’s total goods shipments. Chart I-3Egypt: Tourism Is Linked To Oil Prices Egypt: Tourism Is Linked To Oil Prices Egypt: Tourism Is Linked To Oil Prices Chart I-4Exports Revenues Swing With Oil Prices Exports Revenues Swing With Oil Prices Exports Revenues Swing With Oil Prices   Furthermore, since 2019 Egypt has been increasingly exporting natural gas. The collapse in gas prices has probably already wiped out a large of chunk its natural gas export revenues (Chart I-5). Chart 6 exhibits the structure of Egypt’s exports of goods and services. Energy, tourism and transportation constituted 67% of total exports in 2019. Chart I-5Gas Export Revenues Are At Risk Gas Export Revenues Are At Risk Gas Export Revenues Are At Risk Chart I-6Egypt: Structure Of Goods & Services Exports Egypt: A Veiled Oil Play Egypt: A Veiled Oil Play Chart I-7Exports Are Shrinking Amid Resilient Imports Exports Are Shrinking Amid Resilient Imports Exports Are Shrinking Amid Resilient Imports Finally, while export revenues have plunged, imports remain resilient (Chart I-7). Critically, 26% of Egypt’s imports are composed of essential and basic items such as consumer non-durable goods, wheat and maize. Consumption of these staples and goods are less sensitive to business cycle oscillations. Therefore, the nation’s current account deficit has ballooned. A wider current account deficit needs to be funded by foreign inflows. With foreign investors reluctant to provide funds, the CBE has lately been financing BoP by depleting its foreign exchange reserves (Chart I-1, on page 1). Foreign Funding Requirements: Not only is Egypt facing a massively deteriorating current account deficit, but the country also carries large foreign funding debt obligations (FDO). FDOs are the sum of debt expiring in the next 12 months, and interest as well as amortization payments over the next 12 months. FDOs due in 2020 were $24 billion.2 In turn, Egypt’s total foreign funding requirements (FFR) – which is the sum of FDOs and the country’s current account deficit – has risen to $33 billion.3 Importantly, this FFR amount is based on the current account for 2019 and, thereby, does not take Egypt’s deteriorating current account deficit into consideration – as discussed above. Meanwhile, the central bank has net FX reserves of only $8 billion.4 If the monetary authorities continue to fund FFR of $33 billion in 2020 to prevent the pound from depreciating, the CBE will soon run out of its net FX reserves. Overall, Chart I-8 compares Egypt to the rest of the EM universe: with respect to (1) exports-to-FDO on the x-axis and (2) foreign exchange reserves-to-FFR on the y-axis. Based on these two measurements, Egypt is among the most vulnerable EM countries in terms of the balance of payments as it has the lowest FX reserves-to-FFR ratio and a low export-to-FDO ratio as well. Chart I-8Egypt Is One Of The Most Exposed EM Countries To Currency Depreciation Egypt: A Veiled Oil Play Egypt: A Veiled Oil Play Chart I-9FDI Inflows Are Set To Diminish FDI Inflows Are Set To Diminish FDI Inflows Are Set To Diminish Foreign Funding of Private Sector: Egypt will struggle to attract private-sector foreign inflows to meet its large FFR amid this adverse regional economic environment and the likely renewed relapse in oil prices in the months ahead. FDI inflows are set to drop (Chart I-9). The oil & gas sector has been the largest recipient of FDI inflows recently (around 55% in 2019 according to the central bank). The crash in both crude oil and natural gas prices will therefore ensure that FDIs into this sector will dry up. Besides, overall FDI inflows emanating from Gulf countries are poised to shrink substantially.5 Chart I-10The Egyptian Pound Is Once Again Expensive The Egyptian Pound Is Once Again Expensive The Egyptian Pound Is Once Again Expensive Foreign Funding of Government: With FDI inflows diminishing, the Egyptian government has once again been forced to approach the IMF for assistance. The country managed to secure $8 billion in assistance from the IMF ($2.8 billion in May and $5.2 in June). This has ameliorated international investor confidence in Egypt. Indeed, the country raised $5 billion by issuing US dollar-denominated sovereign bonds in May. Egypt is now seeking another $4 billion from other international lenders. Crucially, assuming Egypt manages to get the $4 billion loan, which would allow it to raise a total of $17 billion, Egypt would still be short on foreign funding to finance its $33 billion in FFR. Therefore, the currency will come under pressure of devaluation. As we argue below, the nation’s public debt sustainability is in jeopardy unless local currency interest rates are brought down substantially. This can only happen if the currency is allowed to depreciate. Consistently, foreign investors might be unwilling to lend to Egypt until interest rates are pushed lower and the country’s public debt trajectory is placed back on a sustainable path. Finally, the Egyptian pound has once again become expensive according to the real effective exchange rate (REER) which is based on both consumer and producer prices (Chart I-10). Bottom Line: Egypt is facing sharply slowing foreign inflows due to both the crash in oil prices and the global pandemic. This is occurring amid increased FFRs. Meanwhile, the CBE’s net FX reserves are insufficient to defend the exchange rate. Public Debt Sustainability The BoP strains discussed above are forcing the CBE to keep interest rates high to prevent the currency from depreciating. Yet the country’s public debt is on a dangerous path due to elevated interest rates. In turn, without currency devaluation that ultimately allows local interest rates to drop dramatically, the sustainability of Egypt’s public debt will worsen considerably. The BoP strains discussed above are forcing the CBE to keep interest rates high to prevent the currency from depreciating. Yet the country’s public debt is on a dangerous path due to elevated interest rates. To start, Egypt’s public debt stands at 97% of GDP – local currency and foreign currency debt account for 79% and 18% of GDP respectively (Chart I-11, top panel). Chart I-12 illustrates that interest payments on public debt is already using up 60% of government revenue and stands at 10% of GDP. Chart I-11Egypt: Public Debt Profile Egypt: Public Debt Profile Egypt: Public Debt Profile Chart I-12The Government's Interest Payments Are Unsustainable The Government's Interest Payments Are Unsustainable The Government's Interest Payments Are Unsustainable   Therefore, if the CBE keeps interest rates at the current level, then the government will continue to pay high interest on its debt. Generally, two conditions need to be met to ensure public debt sustainability in any country (i.e., to ensure that the public debt-to-GDP ratio does not to surge). Nominal GDP growth needs to be higher than government borrowing costs. The government needs to run persistently large primary fiscal surpluses. Chart I-13Egypt: Nominal GDP Growth And Government Borrowing Costs Egypt: Nominal GDP Growth And Government Borrowing Costs Egypt: Nominal GDP Growth And Government Borrowing Costs Regarding the first condition, nominal GDP growth was already dangerously close to the level of Egypt’s government borrowing costs even before the pandemic hit Egypt (Chart I-13). With the pandemic, both domestic demand and exports have plunged. Consequently, nominal GDP is likely close to zero while local currency borrowing costs are above 10%. So long as nominal GDP growth remains below borrowing costs, the public debt sustainability will continue to deteriorate. As to the second condition, Egypt only started running primary fiscal surpluses in 2018 as it implemented extremely tight fiscal policy by cutting non-interest expenditures (Chart I-14). However, that was only possible because economic growth was then strong. As growth has slumped, government revenue is most likely shrinking. Chart I-14Egypt Only Recently Started Running A Primary Fiscal Surplus Egypt Only Recently Started Running A Primary Fiscal Surplus Egypt Only Recently Started Running A Primary Fiscal Surplus Tightening fiscal policy amid the economic downturn will be ruinous. Cutting non-interest expenditures further will depress the already weak economy, drying up both nominal GDP and government revenues even more. This will bring about a vicious economic cycle. Needless to say, the latter option is politically unviable. The most feasible option to ensure sustainability of public debt dynamics is to bring down domestic interest rates considerably. Lower local interest rates will reduce interest expenditures on its domestic debt and will either narrow overall fiscal deficit or free up space for the government to spend elsewhere, boosting much needed economic growth. Meanwhile lower interest rates will boost demand for credit and revive private-sector domestic demand. Provided Egypt’s public debt has a short maturity profile, lower interest rates will reasonably quickly feed into lower interest payments for the government. This means that lower interest rates could reasonably quickly feed to lower interest payments for the government. Importantly, there is a trade-off between the exchange rates and interest rates. Lowering interest rates entail currency depreciation. According to the impossible trinity theory, a central bank facing an open capital needs to choose between controlling interest rates or the exchange rate, it cannot control both simultaneously. As such, if the Central Bank of Egypt opts to bring down local interest rates, while keeping the capital account reasonably open, it needs to tolerate a weaker currency amid its ongoing BoP strains. Bottom Line: Public debt dynamics are treading on a dangerous path. Egypt needs to bring down local interest rates down substantially and rapidly. And in so doing, the CBE cannot control and defend the exchange rate. Devaluation Is Needed All in all, the Egyptian authorities are facing a tight tradeoff: (1) either they continue to defend the currency at the expense of depressing the economy and worsening public debt dynamic, or (2) they tolerate a one-off currency devaluation which would allow the monetary authorities reduce interest rates aggressively. The latter will help stimulate economic growth and make public debt sustainable. Specifically, if the Central Bank of Egypt opts for defending the currency from depreciation, it will need to tolerate much higher interest rates for a long period of time. The CBE would essentially need to deplete whatever little net FX reserves it currently has to fund BoP deficits. This would simultaneously shrink local banking system liquidity, pushing domestic interbank rates higher.  All in all, the Egyptian authorities are facing a tight tradeoff: (1) either they continue to defend the currency at the expense of depressing the economy and worsening public debt dynamic, or (2) they tolerate a one-off currency devaluation which would allow the monetary authorities reduce interest rates aggressively. Worryingly, not only would high interest rates devastate the already shaky Egyptian economy, but higher domestic interest rates carry major ramifications for Egypt’s public debt sustainability as discussed earlier. A one-off currency devaluation is painful and carries some political risks yet, it is still the least worst choice for Egypt from a longer-term perspective. Although inflation will spike due to pass-through from currency devaluation, it will be a transitory one-off increase (Chart I-15). Besides, the pertinent risk to the Egyptian economy currently is low inflation and high real interest rates (Chart I-16). Chart I-15Egypt: Currency-Induced Inflation Is A One-Off Egypt: Currency-Induced Inflation Is A One-Off Egypt: Currency-Induced Inflation Is A One-Off Chart I-16Egypt: Real Interest Rates Are High Egypt: Real Interest Rates Are High Egypt: Real Interest Rates Are High     In turn, currency depreciation will ultimately provide the CBE with scope to reduce its policy rate which will help stimulate the ailing economy as well as make public debt trajectory more sustainable. Finally, odds are high that Egyptian authorities might choose to devalue the currency sooner rather than later. The basis for this is that the government’s foreign public debt is still relatively small at 18% of the GDP and 19% of the total government debt (Chart I-11, on page 8). Further, the majority (70%) of Egypt’s foreign public debt remains linked to international and bilateral government loans making it easier to renegotiate their terms than in the case of publicly traded sovereign US dollar bonds (Chart I-11, bottom panel). This means that currency depreciation will not materially deteriorate the government’s debt servicing ability. Furthermore, Egypt has experience managing and tolerating currency depreciation. The currency depreciated against the US dollar by 50% in 2016 and before that by 12% in 2013. Bottom Line: The Central Bank of Egypt will not hike interest rates or sell its foreign currency reserves for too long to defend the pound. Odds are high that it will allow the currency to depreciate and will cut interest rates materially. Investment Recommendations Chart I-17Egyptian Pound In The Forward Market Egyptian Pound In The Forward Market Egyptian Pound In The Forward Market Investors should buy Egyptian 3-year local currency bonds while hedging their currency exposure. The basis is that low inflation and a depressed economy in Egypt will lead the CBE to cut rates by several hundred basis points over the next 12 months while allowing currency to depreciate. Forward markets are pricing 5% depreciation in the EGP in the next 6 months and 10% in the next 12 months (Chart I-17). We would assign a higher probability of depreciation.   For now, EM credit portfolios should have a neutral allocation on Egyptian sovereign credit. While another potential drop in oil prices and the currency devaluation could push sovereign spreads wider (Chart I-18), eventually large rate cuts by the CBE will make public debt dynamics more sustainable. Absolute return investors should wait for devaluation to go long on Egypt’s US dollar sovereign bonds. Chart I-18Remain Neutral On Egypt's Sovereign Credit Remain Neutral On Egypt's Sovereign Credit Remain Neutral On Egypt's Sovereign Credit Chart I-19Remain Neutral On Egyptian Equities Remain Neutral On Egyptian Equities Remain Neutral On Egyptian Equities   Equity investors should keep a neutral allocation on Egyptian stocks with an EM equity portfolio (Chart I-19). Lower interest rates ahead will eventually boost this stock market. Ayman Kawtharani Editor/Strategist ayman@bcaresearch.com      1 This is the view of BCA’s Emerging Markets Strategy service and it differs from the view of BCA’s Commodities and Energy Strategy service. 2 We exclude the Central Bank’s foreign liabilities due in 2020 as they are mostly deposits at the Central Bank of Egypt owed to Gulf countries. It is highly likely that Gulf lenders will agree to extend these deposits given the difficulties Egypt is experiencing. 3 Excluding the Central Bank’s foreign liabilities due in the next 12 months. Please refer to above footnote. 4 The amount of net foreign exchange reserves currently at the Central Bank – i.e. excluding the Bank’s foreign liabilities– are now low at $8 billion. 5 Gulf Co-operation Countries (GCC) are in no position to provide much financial assistance due to the pandemic and oil crash as they are under severe financial strain themselves. Also, GCC countries run strict currency pegs and need to preserve their dwindling foreign exchange reserves to defend their currency pegs to the US dollar.