Financial Markets

An analysis on Turkey is available below.   Highlights Due to the sizable stimulus announced by the NPC, we are upgrading our outlook for Chinese growth for this year. Nevertheless, in terms of investment strategy, we are reluctant to chase China-related plays higher at the moment. Rising geopolitical tensions between the US and China will likely produce a pullback in China-related risk assets, providing a better entry point in the months ahead. The RMB is set to depreciate dragging down emerging Asian currencies. There is evidence that the equity rally from late-March lows has been driven or supercharged by retail investors worldwide. Such retail-driven manias never end well, though they can last for a while. Feature Emerging market equities are facing a critical technical resistance. Chart I-1 shows that over the past decade, EM share prices often found support at the horizontal line during selloffs. The latter could now become a resistance point. In turn, the Australian dollar and the S&P 500 have climbed to their 200-day moving averages (Chart I-2). Chart I-1EM Stocks Are Facing A Technical Resistance Chart I-2S&P 500 And AUD Are At Critical Technical Juncture   Having rallied strongly in the past two months, it is reasonable to expect that global risk assets will take a breather as investors assess the economic and geopolitical outlooks. China: Aggressive Stimulus… China has embarked on another round of aggressive stimulus. The government program approved by the National People’s Congress (NPC) last week laid out the following macro policy objectives: Stabilize employment. The NPC has pledged to create more than 9 million new jobs in urban areas. Although this is lower than last year’s target of more than 11 million new jobs, it is very ambitious given the number of layoffs that have occurred year-to-date. Chart I-3China: Money/Credit Is Set To Re-Accelerate Significantly accelerate the growth rate of broad money supply and total social financing relative to last year. Indeed, broad money growth accelerated in April and will continue to move higher (Chart I-3). Lending to enterprises and households as well as overall bank asset growth have all accelerated (Chart I-3, bottom two panels). Boost aggregate government spending (budgetary and quasi-fiscal) growth to 13.2% in 2020 versus 9.5% last year.   Local government’s special bond quotas have been set at RMB 3.75 trillion yuan, compared with RMB 2.15 trillion last year. The central government will issue special bonds in the order of 1 trillion yuan. The proceeds will be transferred to local governments to support tax and fee reductions, as well as to boost consumption and investment.  Support SMEs. The government will extend its beneficial loan-repayment policy for SMEs until March 2021. It will extend exemptions for SMEs on social security contributions, VAT and other fees and taxes through to the end of this year. The government estimates a total of RMB 2.5 trillion in tax and fee reductions for companies in 2020. Table I-1 details potential scenarios for the credit and fiscal spending impulse (CFI). In our baseline scenario, the CFI will rise to 15.5% of GDP by year-end (Chart I-4). In short, in 2020 the CFI will likely be larger than it was in 2015-’16 and closer to its 2012 level. However, it will still fall short of the 2009-2010 surge. Table I-1Simulation On Credit And Fiscal Spending Impulse For 2020 Chart I-4Our Projections For The Credit And Fiscal Spending Impulse In summary, it is fair to say that for now, the authorities have abandoned their deleveraging objective and are encouraging a substantial acceleration of both debt and credit. However, it will take time before the stimulus filters through the economy and boosts growth. This will be the case because of the following persistent headwinds: First, the reduced willingness of households and enterprises to spend. The top panel of Chart I-5 reveals that consumers’ marginal propensity to spend is falling. Enterprises’ willingness to invest continues to trend lower. Historically, companies’ willingness to invest has been a good indicator for industrial metals prices. So far it has not validated the advance in base metals (Chart I-5, bottom panel). The rationale for this correlation is that Chinese companies account for 50-55% of global industrial metals demand. Second, the COVID-19 economic downturn in China was much worse than previous downturns, and the financial health of companies and households is considerably poorer than before. This is why it will take very large amounts of stimulus to produce even a moderate recovery. In particular, a portion of the credit expansion will go toward plugging operating cash flow deficits at companies rather than to augment investment. For example, in the US, commercial and industrial loan growth surged in 2007/08 and this year (Chart I-6). In all of those cases, the underlying cause for credit acceleration was companies drawing on their credit lines to close their negative operating cashflow gaps. Chart I-5China: Households And Enterprises Are Less Willing To Spend Chart I-6US Loan Growth Spikes In Recessions The same phenomenon is presently occurring in China. This entails more credit origination will be required in China in this cycle before we witness a revival in capital spending. Third, geopolitical tensions between the US and China will escalate further in the months ahead. We elaborate on this in more detail below. As far as China’s growth outlook is concerned, rising geopolitical tensions with the US will weigh on both consumer and business confidence. On the whole, due to the sizable stimulus announced by the NPC, we are upgrading our outlook for Chinese growth for this year. Nevertheless, in terms of investment strategy, we are reluctant to chase China-related plays higher at the moment. Rising geopolitical tensions will likely produce a pullback in China-related risk assets, providing a better entry point in the months ahead. Chart I-7Chinese Economy: Still Very Weak In addition, the mainland economy is still undergoing post-lockdown normalization – not recovery. Both capital spending and household consumption are still in recession (Chart I-7).    Bottom Line: China is yet again resorting to aggressive fiscal and credit stimulus. Mainland growth is bound to improve over the remainder of the year. However, financial markets have run a bit ahead of themselves, and we will wait for a pullback before recommending China-related plays.  …But Geopolitics Is A Major Risk Despite an improving growth outlook, Asian and China-related risk assets could struggle in the months ahead due to escalating geopolitical tensions between the US and China. On the surface, the COVID-19 crisis seems to be the culprit behind rising tensions between the two nations. However, the pandemic has only accelerated an otherwise unavoidable confrontation between the existing superpower and the rising one. BCA’s Geopolitical Strategy team has been writing about cumulating tensions and the potential for them to boil over in the months before the US election. The contours of the rise in geopolitical tensions will be as follows: President Trump’s chances of re-election have declined, with the recession gripping the US economy and unemployment surging. There is little doubt that he will use external foes to rally the nation behind the flag. Blaming China for the pandemic and acting tough is probably the only way for Trump to switch his campaign’s nucleus from the economy to foreign policy, which will raise the odds of his election victory. The US administration will not resort to import tariffs this time around. Going forward, the administration’s goal will be cutting China’s access to foreign technology. Technology in general and semiconductors in particular will be the key battleground in this new cold war. The US will also step up its pressure on multinationals to move production out of China. The broader idea is to impede China’s technological advance. Even though the US rhetoric on China’s policies toward Hong Kong will be tough, there is little the US can do or will do regarding Hong Kong. Rather, the more important battleground will be Taiwan and its semiconductor industry. Finally, China’s political leadership cannot tolerate being perceived as weak domestically in the face of US pressures. They will retaliate against the US. One form of retaliation against Trump could be pushing North Korea to test its strategic military weapons that could undermine Trump’s foreign policy credibility in the US. Another form of retaliation could be tolerating moderate currency depreciation. The latter will challenge Trump’s claims that he has been victorious in dealing with China. The latest decision to ban US and foreign companies from accepting orders from Huawei and the slide in the value of the RMB are consistent with these narratives. To our surprise, however, financial markets in general and Asian markets in particular have not sold off meaningfully in response to the US ban on Huawei and renewed RMB depreciation. Critically, China is the world’s largest consumer of semiconductors, accounting for 35% of global semiconductor demand. Restricting Chinese purchases would be negative for global semiconductor producers. China has been aware of the risk of US restrictions on its imports of semiconductors and has been ramping up its semi imports since 2018. Semi imports have been booming even though smartphone sales had been shrinking (Chart I-8). This is a sign of large semiconductor restocking in China which has helped global semi sales in general and TSMC sales in particular in the past 18 months. In brief, major semi restocking by China in the past 18 months along with the ban on sales to Huawei all but ensure that global semiconductor sales will be weak this year. It does not seem that global semi stocks in general and Asian ones in particular are pricing in this outcome. Global semiconductor stocks are a hair below their all-time highs, and their trailing P/E ratio is at 21. Specifically, given Huawei is the second-largest customer of TSMC, the latter’s sales will be negatively affected (Chart I-9). Chart I-8Has China Been Stockpiling Semiconductors? Chart I-9TSMC Has Benefited From China Stockpiling Semiconductors Finally, both DRAM and NAND prices are falling anew (Chart I-10). Further, DRAM revenue proxy correlates with Korean tech stocks and points to lower share prices (Chart I-11). Chart I-10Semiconductor Prices Have Begun Falling Chart I-11Semiconductor Prices Are Still Deflating DRAM Revenue Proxy And Korean Tech Stocks Crucially, Chinese, Korean and Taiwanese stocks account for 60% of the MSCI EM equity market cap. Hence, a selloff in these bourses will weigh on the EM equity index. Chart I-12 shows that the latest drawdown in these North Asian equity markets was relatively small compared to the drop in the rest of the EM equity universe. Hence, Chinese, Korean and Taiwanese share prices are not discounting a lot of bad news making them vulnerable to the geopolitical risks that lie ahead. Financial markets in Asia are very complacent to mounting geopolitical risks stemming from the US-China confrontation. The RMB is set to depreciate dragging down emerging Asian currencies. Chart I-12North Asian Stocks Versus The Rest Of EM Bottom Line: Financial markets in Asia are very complacent to mounting geopolitical risks stemming from the US-China confrontation. The RMB is set to depreciate dragging down emerging Asian currencies. The large share of Chinese, Korean and Taiwanese stocks in the MSCI EM equity index implies significant downside risks to the EM equity benchmark. The Global Economic Outlook As economies around the world open, the level of economic activity will certainly begin to rise. The opening of shops, offices and various other facilities will result in a partial normalization and an increase in economic activities.  However, we cannot call this a recovery. Rather it is just a snapback from the lockdowns which both equity and credit markets have already fully priced in. The outlook for global share prices and credit markets depends on what happens to the global economy following this post-lockdown snapback. Will the snapback be followed by an actual recovery or will the level of activity stagnate at low levels? For now, our sense is that following the initial snapback a U-shaped recovery is the most likely global scenario. This does not exclude the possibility that activity in some sectors/countries will follow a square root trajectory.  From a global macro perspective, we have the following observations to share: Certain industries will likely experience stagflation. Due to social distancing measures, they will be forced to limit their output/capacity and compensate for their increased costs by charging higher prices. In this group, we would include airlines, restaurants, and other service sector businesses. The short-term outlook for consumer spending is contingent on fiscal stimulus. A material reduction in fiscal support for households will weigh on their spending capacity. Capital spending will remain subdued outside China’s stimulus-driven local government and SOE investment outlays, and outside the technology sector, generally. Critically, economic activity in many countries and industries will remain below pre-pandemic levels until late this year. This implies that despite the snapback, some businesses will still be operating below or close to their breakeven points. This will have ramifications on their ability to service debt and on their willingness to invest and hire. Any rise in government bond yields worldwide will be limited as central banks in both DM and EM will cap yields by augmenting their purchase of government and in some cases corporate bonds. We discussed EM QE programs in detail in last week’s report. Bottom Line: It is tempting to interpret the post-lockdown snapback in economic activity as a recovery. However, the nature and depth of this recession is unique. Investors should consider both the direction of economic indicators and the level of economic activity in relation to a company’s breakeven point. This is an extremely difficult task. And that is in addition to gauging the odds of a second wave of COVID-19 infections later this year. In the context of such complexities facing investors, there is astonishing evidence that the recent equity rally has been driven by unsophisticated retail investors. A Retail-Driven Equity Rally There is growing evidence that the equity rally from late-March lows has been driven or supercharged by retail investors, worldwide. There is growing evidence that the equity rally from late-March lows has been driven or supercharged by retail investors, worldwide. Such retail-driven manias never end well, though they can last for a while. The following articles corroborate the worldwide phenomenon that retail investors have been opening broker accounts en masse and investing in stocks: Bored Day Traders Locked at Home Are Now Obsessed With Options Frustrated sports punters turn to US stock market Coronavirus spawns new generation of Japanese stock pickers Stuck at Home, More Filipinos Try Luck at Stock Investing It is fair to assume that retail investors do very little fundamental analysis. Not surprisingly, since March global share prices have decoupled from profit expectations. Although some professional investors have no doubt also played the rally, surveys of asset managers and traders suggest that generally they have stayed lukewarm on stocks. Specifically, the net long position of asset managers and leveraged funds in various US equity index futures remains very low (Chart I-13). Chart I-14 shows that US traders’ and professional individual investors’ sentiment on US stocks are at multi-year lows. Only US investment advisors have become fairly bullish again (Chart I-14, bottom panel). Chart I-13Fund Managers Have Stayed Lukewarm On Stocks Chart I-14Professional Investors’ Sentiment On Stocks Have Been Subdued Who will capitulate first: retail or professional investors? It is hard to predict the behavior of investors but, if we had to guess, our take could be summed up as follows:  If geopolitical tensions escalate much more or the number of COVID-19 inflections in some large countries rises anew, retail investors will likely sell before professional investors step in. In this scenario, share prices will drop considerably. In the case of an absence of geopolitical tensions or a new wave of infections, it is hard to see how economic data that is improving could lead to a substantial drawdown in equities even if the level of activity remains very depressed. In this case, corrections will be small and short-lived. Investment Strategy Chart I-15Beware Of Breakdowns For global equity portfolios, we continue recommending underweighting EM stocks. Regardless of the direction of global share prices, EM will continue underperforming DM (Chart I-15, top panel). The basis for this is rising geopolitical tensions in China and weakness in the RMB will spill over into other emerging Asian currencies (Chart I-15, bottom panel). We continue recommending short positions in the RMB and KRW versus the US dollar. In terms of the absolute performance of EM equities and credit markets, as well as EM currencies versus the greenback, we recommend being patient. Global and EM financial markets are presently at a critical juncture, as illustrated in Charts 1 and 2 on pages 1 and 2. If these and some other markets meaningfully break above current levels of resistance, we will upgrade our stance on EM stocks and credit markets and close our short positions in EM currencies versus the US dollar. If they fail to do so, a considerable selloff is likely to follow. As to EM local currency bonds, we are long duration but cautious on EM currencies. For the full list of our recommendations for EM equity, credit, local fixed-income and currency markets, please refer to pages 18 and 19.   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Lin Xiang, CFA Research Analyst linx@bcaresearch.com     Turkish Lira: Facing A Litmus Test The Turkish lira has rolled over at its resistance level on a total return (including carry) basis (Chart II-1). The spot rate versus the US dollar is at its 2018 low. In short, the exchange rate is facing a litmus test. The culprit of a potential downleg in the lira is an enormous monetary deluge. Chart II-2 reveals that broad money supply growth has accelerated to 35% from a year ago. Local currency money supply is skyrocketing because the central bank and commercial banks are engaged in rampant money creation and public debt monetization. Chart II-1Turkish Lira (Including Carry): A Good Point To Short Chart II-2Turkey’s Broad Money: The Sky Is The Limit While such macro policies could benefit economic growth in the short term, they also herald growing inflationary pressures and currency devaluation. First, Turkish commercial banks have been on a government bonds buying binge since 2018 (Chart II-3, top panel). They presently own 62% of total local currency government bonds, up from 45% in early 2018. In addition, the central bank is de-facto engaging in government debt monetization. The Central Bank of Turkey (CBT) has bought TRY 40 billion of government bonds in the secondary market since March (Chart II-3, bottom panel). When a central bank or commercial bank buys a local currency asset from a non-bank, a new local currency deposit is created in the banking system and the money supply expands.  Chart II-3Turkey: Public Debt Monetization In Full Force Chart II-4Turkey: Loan Growth Exceeds 30% Second, the commercial banks’ local currency loan growth has surged to 32% (Chart II-4). Government lending schemes and newly introduced regulations are incentivizing commercial banks to continue lending in order to boost domestic demand. In particular, state owned banks are providing loans at interest rates well below both the policy and inflation rates. The most likely outcome from such policies is rampant capital misallocation and an increase in non-performing loans. The former will weigh on productivity in the long turn. Third, the central bank has been providing enormous amounts of liquidity to commercial banks (Chart II-5, top panel). The latter’s local currency excess reserves – which are exclusively created out of thin air by the central bank - have surged (Chart II-5, bottom panel). In fact, the effective policy rate has been hovering below the actual policy rate, suggesting that there is an excess liquidity overflow in the banking system. In a nutshell, the central bank has been providing fuel to commercial banks to expand money supply via the purchases of local currency government bonds and loan origination. Fourth, an overly loose monetary stance will lead to higher inflation and currency devaluation. Moreover, wages continue to expand at an annual rate of 15-20%, confirming the fact that inflationary pressures are genuine and broad within this economy (Chart II-6). Higher inflation, and the consequent loss of purchasing power, is leading residents to switch their holdings of liras to foreign currencies. Chart II-5Central Banks' Liquidity Provision To Banks Chart II-6Turkey: A Sign Of Genuine Inflation Higher inflation, and the consequent loss of purchasing power, is leading residents to switch their holdings of liras to foreign currencies. Finally, Turkey’s current account deficit is set to widen, and the central bank’s net foreign currency reserves are non-existent at best. Booming credit growth will keep domestic demand and imports stronger than they otherwise would be. In the meantime, the complete collapse in tourism revenues and Turkey’s large foreign debt obligations, estimated at $160 billion over the next six months, entail negative balance of payment dynamics. Barring capital controls, Turkey will not be able to preclude further currency depreciation. Investment Implications Short the Turkish lira versus the US dollar. We recommend dedicated equity investors underweight Turkish equities and credit relative to their respective EM benchmarks. Also, we are reiterating our short Turkish banks / long Russian banks position. Local currency yields will offer little protection against currency depreciation. As such, investors should underweight domestic bonds.   Andrija Vesic Associate Editor andrijav@bcaresearch.com   Footnotes Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights The good stock market = ‘growth defensives’ like technology that benefit from lower bond yields. The bad stock market = ‘value cyclicals’ like banks that suffer from lower bond yields. Structurally favour growth defensives given that ultra-low bond yields are here to stay. Adjust the sovereign bond portfolio to: Long 30-year US T-bonds and Spanish Bonos. Short 30-year German Bunds and French OATs. Fractal trade: Long 10-year Spanish Bonos, short 10-year New Zealand bonds. Feature It has become increasingly meaningless to talk about ‘the stock market’ as one entity. The stock market has split into two distinct markets: a ‘good stock market’ and a ‘bad stock market’. To be clear, the split started before the coronavirus crisis, but the crisis has hastened the break-up (Chart of the Week). Chart of the WeekThe Good Stock Market, And The Bad Stock Market What distinguishes the good stock market from the bad stock market? The answer is the relationship with the bond yield. For the good market, the dominant message from lower bond yields is a valuation boom and higher prices (Chart I-2); but for the bad market, the dominant message from lower bond yields is a profits recession and lower prices. Chart I-2Tech Stocks Rally On Lower Bond Yields The Good Stock Market, And The Bad Stock Market For the good stock market, the valuation uplift that comes from lower bond yields far outweighs the coronavirus induced slump to sales and profits. Conversely, for the bad stock market, the coronavirus induced slump to sales and profits far outweighs any valuation uplift from lower bond yields. For the ‘good stock market’, the valuation uplift from lower bond yields outweighs the coronavirus induced slump to sales and profits.  The valuation uplift from lower bond yields is greatest for growth stocks. This is because the further into the future that cashflows are, the greater the increase in their ‘net present values’ Moreover, this valuation uplift becomes exponential at ultra-low bond yields. As bond prices start to have less upside than downside, they become riskier. Hence, both components of the required return on growth stocks – the bond yield and the equity risk premium – shrink together, justifying the exponentially higher net present value (Chart I-3).   Chart I-3Tech Valuations Rise Exponentially On Lower Bond Yields Meanwhile, the coronavirus induced slump to sales and profits is greatest for cyclical stocks. For many cyclicals – such as airlines, hotels, and restaurants – the hit to sales, profits, and employment will be long-lasting, as consumer and business behaviour adapts to the post Covid-19 world. Hence: The good stock market = ‘growth defensives’ whose epitome is technology. The bad stock market = ‘value cyclicals’ whose epitome is banks (Chart I-4). Chart I-4Banks Sell Off On Lower Bond Yields Banks suffer a double whammy. Not only does the lower bond yield signify a structurally poor outlook for credit creation which constitutes bank ‘sales’, but the flattening yield curve also signifies a shrinking net interest (profit) margin. Euro area banks suffer an additional complication. They are exposed to the sovereign yield spread on ‘periphery’ bonds such as Italian BTPs over German bunds. A widening of such spreads signals heightening tensions within the euro area, which hurts the solvencies of periphery banks with large holdings of periphery bonds (Chart I-5). Chart I-5Euro Area Banks Also Sell Off On Wider Sovereign Yield Spreads It follows that euro area banks need two conditions to rally. High quality bond yields must rise, and peripheral euro area yield spreads must fall. Given that such a star alignment is likely to be the exception rather than the norm, euro area banks should be bought for the occasional countertrend rally when technical signals justify it. Right now, the required signal is for high-quality bonds to become technically overbought, presaging a tactical bout of bond underperformance and bank outperformance. However, our most-trusted technical indicator is not yet giving the required signal. Stay tuned (Chart I-6). Chart I-6Bonds Are Not Yet Technically Overbought In the meantime, we prefer to play the euro area’s increasing solidarity – specifically, to underwrite a €500bn coronavirus recovery plan – through relative value positions in sovereign bonds. In our recent webcast Why Leaving The Euro Would be MAD, But Mad Things Happen we pointed out that in the euro era, labour market competitiveness in Spain has improved by more than in France. Making it hard to justify the near 100bps yield premium on 30-year Spanish Bonos versus French OATs (Chart I-7). Chart I-7The Yield Premium On Spanish Bonos Is Hard To Justify Since inception a year ago, our long 30-year US T-bonds and Italian BTPs versus 30-year German Bunds and Spanish Bonos is up by 15 percent. It is time to adjust this bond portfolio. Go long 30-year US T-bonds and Spanish Bonos versus 30-year German Bunds and French OATs. And take profit on long 10-year Italian BTPs versus 10-year Spanish Bonos. Are Ultra-Low Bond Yields Sustainable? At first glance, the divergence of the stock market into a booming good part and a languishing bad part might tempt investors to play long-term ‘mean reversion’: specifically, to sell growth defensives like technology and buy value cyclicals like banks. But be careful. The concept of mean reversion is only meaningful if the underlying trend is sideways – or in technical terms ‘stationary’. Statistics 101 warns us that if the underlying trend is not stationary, the concept of mean reversion – and indeed the much-abused concept of ‘standard deviation’ – is meaningless. If inflation persists below 2%, bond yields will remain ultra-low. Given that all investment is now just one big correlated trade to the bond yield, this raises a crucial question: is the bond yield stationary? Put another way, are bonds in an almighty bubble? Are bond yields unsustainably low, and at risk of a violent spike upwards? The answer depends on a further question: is sub-2 percent inflation unsustainably low? (Chart I-8) If inflation persists below central banks’ totemic 2 percent inflation target, then central banks will have no choice but to push and hold the monetary easing ‘pedal to the metal’. Therefore, bond yields will keep trending lower until, one by one, they reach the lower bound at around -1 percent. Chart I-8Is Sub-2 Percent Inflation Unsustainably Low? To us, the answer to this question is crystal clear. Not only is sub-2 percent inflation sustainable, it is the norm. Genuine price stability is not an arbitrary 2 percent inflation target that central banks can pluck out of the air. Rather, it is a steady state of broadly flat-lining prices that economies can remain in for centuries, so long as governments do not debase the broad money supply. Between 1675 and 1914 – when Great Britain was mostly on the gold standard – the price level barely budged, meaning inflation averaged near-zero for hundreds of years (Chart I-9). Chart I-9Inflation Averaged Near-Zero For Hundreds Of Years Today we have fiat money rather than the gold standard. However, the rapidly growing cryptocurrency asset-class is an embryonic 21st century gold standard ‘waiting in the wings.’ The mere fact that an alternative, and potentially superior, monetary system is waiting in the wings is a strong incentive for competent governments to preserve the value of fiat money. Which is to say, an incentive not to destroy the genuine price stability that advanced economies have now re-entered after a brief lapse in the 20th century. Ultra-Low Bond Yields Are Here To Stay, Structurally Favouring Growth Defensives It is in the gift of governments to destroy price stability should they desire. Witness Argentina, Venezuela or Zimbabwe. Yet these examples and the example of the 1970s teach us that when price stability is destroyed, inflation appears non-linearly, which is to say unpredictably and uncontrollably. This is because it suddenly becomes rational for governments to create money as fast as possible, and for consumers and firms to spend it as fast as possible. As the product of money supply and its velocity equals nominal demand, inflation skyrockets (Chart I-10). Chart I-10When Price Stability Is Destroyed, Inflation Appears Non-Linearly An early warning sign that governments are on the road to Venezuela is that central banks lose their independence. Or, at the very least, their inflation-targeting remits become diluted. Neither of these seem conceivable right now. Sub-2 percent inflation was the norm for hundreds of years. Never say never – but in the advanced economies the destruction of price stability is a tail-risk rather than a central threat. The upshot is that ultra-low bond yields are here to stay. Long-term investors should structurally own the good stock market – growth defensives – and structurally avoid the bad stock market – value cyclicals. That said, from time to time, there will be tactical countertrend opportunities to go long value cyclicals like banks. Stay tuned for those tactical opportunities. This leaves one final question: when all investment has just become one big correlated trade to the bond yield, how can investors take on uncorrelated positions to diversify? The answer is to take long-short positions within growth defensives, and within value cyclicals. For example, within growth defensives right now, stay tactically long personal products versus healthcare. Fractal Trading System* As discussed, Spanish Bonos offer good relative value. They are also technically oversold relative to other developed market sovereign bonds. Accordingly, this week’s recommended trade is long Spanish 10-year Bonos, short New Zealand 10-year bonds. Set the profit target and symmetrical stop-loss at 3.5 percent. In other trades, long PLN/EUR quickly achieved its 2 percent profit target at which it was closed. The rolling 1-year win ratio now stands at 62 percent. Chart I-11 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 Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields   Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations  

Highlights Investment Grade Sector Valuation: Our investment grade corporate bond sector valuation models for the US, euro area, UK, Canada and Australia show some common messages, as markets have adjusted to a virus-stricken world. The most attractive valuations can be found within Energy and Financials, with defensive sectors like Utilities and Consumer Non-Cyclicals looking expensive everywhere. Global Corporate Bond Strategy: Investors should focus global investment grade corporate bond allocations along country lines, while keeping overall spread risk close to benchmark levels, over the next 6-12 months. Specifically, we favor overweighting the US (especially at maturities of five years or less where the Fed is buying) and the UK, while keeping a neutral allocation to euro area corporates. We also like Australian and Canadian corporate debt versus sovereigns in both countries. Feature Chart 1A Swift Policy Response Has Brought Spreads Under Control Global policymakers have responded swiftly and aggressively to the COVID-19 outbreak and associated deep worldwide recession. This includes not only fiscal stimulus and monetary easing, but central banks buying corporate debt outright and providing other liquidity backstops. Coming at a time of collapsing economic growth and deteriorating corporate credit quality, these combined policy initiatives have reduced the negative tail risk for growth-sensitive assets like corporate debt. The result: a sharp tightening of corporate bond spreads across the developed markets (Chart 1). After such a large and broad-based rally, the easiest gains from the “beta” of owning corporate credit have been exhausted. Additional spread tightening is still expected in the coming months as governments begin to restart their economies after the COVID-19 quarantines start to loosen and global growth slowly begins to improve. Spreads are unlikely to return all the way to the pre-virus tights, however, as the recovery will be uneven and there is still the threat of a second wave of coronavirus infections later this year. To that end, it makes sense for investors to begin seeking out the “alpha” in corporate debt markets by looking at relative valuations across sectors to find opportunities. It makes sense for investors to begin seeking out the “alpha” in corporate debt markets by looking at relative valuations across sectors to find opportunities.  In this report, we will conduct a review of our entire suite of global investment grade corporate sector relative value models. We will cover the US, provide fresh updates of our recently published look at the euro area1 and the UK,2 while also revisiting our relative value framework for Canada first introduced last year.3 We will also apply the same corporate bond sector value methodology to a new country: Australia. In addition, we will examine value across credit tiers using breakeven spread analysis for each of these regions. A Brief Note On Our Corporate Bond Relative Value Tools Before delving into the results from our models, we take this opportunity to refresh readers on the methodology underpinning these analyses. Our sector relative value framework determines “fair value” spreads for each of the major and minor industry level sub-indices of the overall investment grade universe of individual developed market economies (using Bloomberg Barclays bond indices). The methodology takes each sector’s individual option-adjusted spread (OAS) and regresses it with all other sectors in a cross-sectional model. The models vary slightly across countries/regions, as the independent variables in the regression are selected based on parameter significance and predictive power for local sector spreads. Using the common coefficients from that regression, a risk-adjusted "fair value" spread is calculated. The difference between the actual OAS and fair value OAS – a.k.a. the residual from the regression - is our valuation metric used to inform our sector allocation ranking. We then look at the relationship between these residuals and duration-times-spread (DTS), our primary measure of sector riskiness, to give a reading on the risk/reward trade-off for each sector. We then apply individual sector weights based on the model output and our desired level of overall spread risk to come up with a recommended credit portfolio. The weights are determined at our discretion and are not the output from any quantitative portfolio optimization process. The only constraints are that all sector weights must add to 100% (i.e. the portfolio is fully invested with no use of leverage) and the overall level of spread risk (DTS) must equal our desired target. To examine value across credit tiers, we use a different metric - 12-month breakeven spread percentile rankings. Specifically, we calculate how much spread widening is required over a one-year horizon to eliminate the yield advantage of owning corporate bonds versus duration-matched government debt. We then show those breakeven spreads as a percentile ranking versus its own history, to allow comparisons over periods with differing underlying spread volatility. With the key details of our models squared away, we will now present the results of our models for each country/region, along with our recommended allocation across sectors. We also discuss our recommended level of overall spread risk for each country/region, which helps inform our specific sector weightings. A Country-By-Country Assessment Of Investment Grade Corporates US In Table 1, we present the latest output from our US investment grade sector valuation model. In keeping with the framework used by BCA Research US Bond Strategy, we use the average credit rating, duration, and duration-squared (convexity) of each sector as the model inputs. To determine our US sector recommendations, we not only need to look at the spread valuations from the relative value model, but we must also consider what level of overall US spread risk (DTS) to target. Table 1US Investment Grade Corporate Sector Valuation & Recommended Allocation With the Fed now purchasing investment grade corporates with maturities of up to five years in the primary and secondary markets, it makes sense to take advantage of that explicit support by focusing exposures on shorter-maturity bonds. Thus, we recommend targeting a relatively moderate level of spread risk (within an overweight allocation to US investment grade corporates) by favoring sectors with a DTS less than or equal to that of the overall US investment grade index. The sweet spot, therefore, is the upper-left quadrant in Chart 2 - sectors with positive risk-adjusted spread residuals from the relative value model and a relatively lower DTS. Chart 2US Investment Grade Corporate Sectors: Risk Vs. Reward Chart 3US IG: More Value In The Lower Tiers On that basis, some of the most attractive overweight candidates are Cable Satellite, Media Entertainment, Integrated Energy, Diversified Manufacturing, Brokerage/Asset Managers, and Other Financials. Meanwhile, the least attractive sectors within this framework are Railroads, Communications, Wirelines, Wireless, Other Industrials and Utilities (including Electric, Natural Gas, and Other Utilities). While we have chosen to underweight much of the Energy space (with the exception of Integrated Energy) because of generally high DTS numbers, investors who are comfortable with taking on a higher level of spread risk can find some of the most attractive risk-adjusted valuations within oil related sectors. Our colleagues at BCA Research Commodity & Energy Strategy expect oil prices to continue to steadily rise in the months ahead, with Brent oil trading, on average, at $40/bbl this year and $68/bbl in 2021.4 We recommend targeting a relatively moderate level of spread risk (within an overweight allocation to US investment grade corporates). Across credit tiers, the higher-quality portion of the US investment grade corporate bond market appears unattractive, with spreads ranking below the historical median for Aaa- and Aa-rated debt (Chart 3). Conversely, Baa-rated debt appears most attractive, with spreads almost in the historical upper quartile. Euro Area In Table 2, we present the results of our euro area investment grade sector valuation model. The independent variables in this model are each sector’s duration, trailing 12-month spread volatility, and credit rating. Note that we will be using the same independent variables in our UK model. Table 2Euro Area Investment Grade Corporate Sector Valuation & Recommended Allocation Spreads have already tightened significantly since our last discussion of euro area corporates in mid-April, with credit markets more fully pricing in greater monetary stimulus from the European Central Bank (ECB) – including increased government and corporate bond purchases. Thus, we believe it is reasonable to target a neutral level of overall portfolio DTS close to that of the benchmark index (within a neutral allocation to euro area investment grade). This means that, visually, we can think about our overweight candidates as sectors that are in the top half of Chart 4 - with positive residuals from our relative value model - but close to the dashed vertical line denoting the euro area benchmark index DTS. Target a neutral level of overall portfolio DTS close to that of the benchmark index (within a neutral allocation to euro area investment grade). Chart 4Euro Area Investment Grade Corporate Sectors: Risk Vs. Reward Chart 5Euro Area IG: All Credit Buckets Are Attractive Within this framework, the most attractive sectors are Diversified Manufacturing, Packaging, Media Entertainment, Wireless, Wirelines, Automotive, Retailers, Services, Integrated Energy, Refining, Other Industrials, Bank Subordinated Debt and Brokerage/Asset Managers. The most unattractive sectors are Chemicals, Metals & Mining, Lodging, Restaurants, Consumer Products, Pharmaceuticals, Independent Energy, Midstream Energy, Airlines, Electric Utilities, and Senior Bank Debt. On a breakeven spread basis, all euro area investment grade credit tiers look attractive and rank well above their historical medians (Chart 5). The greatest value is in the upper rungs, with Aa-rated spreads ranking in the historical upper quartile; Aaa-rated and A-rated spreads almost meet that qualification as well, with Baa-rated spreads lagging a bit further behind (but still well above median). UK In Table 3, we present the latest output from our UK relative value spread model. With the Bank of England’s record expansion of corporate bond holdings still underway, we see good reason to maintain our overweight allocation to UK investment grade corporates on a tactical (0-6 months) and strategic basis (6-12 months). We are also targeting an overall portfolio DTS higher than that of the benchmark index—which we accomplish by overweighting sectors in the upper right quadrant of Chart 6. Table 3UK Investment Grade Corporate Sector Valuation & Recommended Allocation Chart 6UK Investment Grade Corporate Sectors: Risk Vs. Reward Chart 7UK IG: Value In All Tiers Except Aaa Based on this framework, some of the most attractive overweight candidates are Diversified Manufacturing, Cable Satellite, Media Entertainment, Railroads, Financial Institutions, Life Insurance, Healthcare and Other Financials. Meanwhile, the most unattractive sectors are Basic Industry, Chemicals, Metals and Mining, Building Materials, Lodging, Consumer Products, Food & Beverage, Pharmaceuticals, Energy, and Technology. On a breakeven spread basis, Aa-rated spreads appear most attractive while A-rated and Baa-rated spreads also rank above their historical medians (Chart 7). Canada Table 4 shows the output from our Canadian relative value spread model. The independent variables in this model are: sector duration, one-year ahead default probability (as calculated by Bloomberg) and credit rating. Table 4Canada Investment Grade Corporate Sector Valuation & Recommended Allocation This week, the Bank of Canada (BoC) will join peer central banks in purchasing investment grade debt via its Corporate Bond Purchase Program (CBPP). First announced in April, the program has a maximum size of C$10 billion, equal to only 2% of the Bloomberg Barclays Canadian investment grade index. Nonetheless, the BoC’s actions have already helped rein in corporate spreads. Yet given this unprecedented support from the central bank, with room to add more if necessary to stabilize Canadian financial conditions, we feel comfortable recommending an overweight allocation to Canadian investment grade corporates vs. Canadian sovereign debt, but with spread risk close to the overall index. Consequently, we are targeting sectors in the upper half of Chart 8 with a DTS close to the corporate average denoted by the dashed line. Chart 8Canada Investment Grade Corporate Sectors: Risk Vs. Reward Chart 9Canada IG: Great Value Across Tiers Our top overweight candidates are concentrated within the Financials category: Life Insurance, Healthcare REITs and Other Financials. Meanwhile, we recommend underweighting Construction Machinery, Environmental, Retailers, Supermarkets, Wirelines, Transportation Services, Cable Satellite, and Media Entertainment. On a breakeven spread basis, there is value in all credit tiers in the Canadian investment grade space, with Aaa-rated, Aa-rated, and Baa-rated spreads all in the uppermost historical quartile (Chart 9). Australia Table 5 shows the output from our new Australia relative value spread model. The independent variables in this model are sector credit rating, one-year ahead default probability (as calculated by Bloomberg), and yield-to-maturity. Due to the relatively small size of the Australian corporate bond market, we are focusing our analysis on Level 3 sectors within the Bloomberg Barclays Classification System (BCLASS) rather than the more granular Level 4 analysis we have employed for other markets. Table 5Australia Investment Grade Corporate Sector Valuation & Recommended Allocation We recently recommended going overweight Australian investment grade corporate debt vs. government bonds.5 We feel comfortable reiterating that overweight stance while maintaining a neutral level of overall spread risk. As with Canada, we are looking for sectors in Chart 10 that show positive risk-adjusted valuations and have a DTS close to the Australian corporate benchmark. Chart 10Australia Investment Grade Corporate Sectors: Risk Vs. Reward Chart 11Australia IG: Favor A-Rated and Baa-Rated Credit Based on that, our top overweight candidates are Capital Goods, Consumer Cyclicals, Energy, Other Utility, Insurance, Finance Companies, and Other Financials. Meanwhile, we are avoiding sectors such as Technology, Transportation, Electric and Natural Gas. On a breakeven spread basis, Baa-rated spreads look incredibly attractive, ranking at the 99.9th percentile; A-rated spreads are also above their historical median (Chart 11). Meanwhile, the higher quality Aaa and Aa tiers are relatively unattractive. As the relevant data by credit tier are not available in the Bloomberg Barclays Indices, we have instead used the Bloomberg AusBond Indices for this particular case, which unfortunately limits the history of our analysis to mid-2014. Bottom Line: Investors should focus global investment grade corporate bond allocations along country lines, while keeping overall spread risk close to benchmark levels, over the next 6-12 months. Specifically, we favor overweighting the US (especially at maturities of five years or less where the Fed is buying) and the UK, while keeping a neutral allocation to euro area corporates. We also like Australian and Canadian corporate debt versus sovereigns in both countries. Comparing Sector Valuations Across Markets The above analyses have allowed us to paint a picture of sector valuation within regions. However, there is added benefit in looking at risk-adjusted valuations across the three major corporate bond markets—the US, euro area and UK—with the intent of spotting broader sector level trends in the global investment grade universe that are not limited to just one market. Looking at Table 6, we can see some clear patterns: Table 6Valuations Across Major Corporate Bond Markets Chart 12Canada, Euro Area, and UK Win Out On A Breakeven Spread Basis The most attractive sectors across the board are concentrated in the Financials space. Brokerage/Asset Managers, Insurance—especially Life Insurance - REITs and Other Financials all look well positioned. Valuations for Oil Field Services and Refining within the Energy space are also creating an attractive entry point ahead of the steady rebound in oil prices. Conversely, the most expensive sectors are the traditionally “defensive” ones, such as Utilities, Consumer Non-Cyclicals, and even Technology, which is now debatably a defensive sector. Most interesting are the idiosyncratic stories. These are sectors which have benefited or lost in outsized ways due to the unique impacts of COVID-19 on the economy, but which also have relatively wide or tight risk-adjusted spreads across all three countries. For example, Packaging and Paper, which should benefit from the increased demand for online shopping, and Media Entertainment, which benefits from a captive audience boosting streams and ratings, both have attractive spreads. On the other hand, we have Restaurants, with unattractive spread valuations at a time where more people will choose to stay home rather than take the health and safety risks associated with eating out. The most expensive sectors are the traditionally “defensive” ones, such as Utilities, Consumer Non-Cyclicals, and even Technology, which is now debatably a defensive sector. Finally, we can also employ our breakeven spread analysis to assess value across investment grade corporate bond markets and the country level (Chart 12). Within this framework, all the regions we have covered in this report appear attractive – especially Canada, the euro area and the UK – with Australia only appearing fairly valued. Bottom Line: Our investment grade corporate bond sector valuation models for the US, euro area, UK, Canada and Australia show some common messages, as markets have adjusted to a virus-stricken world. The most attractive valuations can be found within Energy and Financials, with defensive sectors like Utilities and Consumer Non-Cyclicals looking expensive everywhere.   Shakti Sharma Research Associate ShaktiS@bcaresearch.com Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Please see BCA Research Global Fixed Income Strategy Weekly Report, "Buy What The Central Banks Are Buying", dated April 14, 2020, available at gfis.bcaresearch.com. 2 Please see BCA Research Global Fixed Income Strategy Weekly Report, "Global Inflation Expectations Are Now Too Low", dated April 28, 2020, available at gfis.bcaresearch.com. 3 Please see BCA Research Global Fixed Income Strategy Weekly Report, "The Great White North: A Framework For Analyzing Canadian Corporate Bonds", dated August 28, 2019, available at gfis.bcaresearch.com. 4 Please see BCA Research Commodity & Energy Strategy Weekly Report, "US Politics Will Drive 2H20 Oil Prices", dated May 21, 2020, available at ces.bcaresearch.com. 5 Please see BCA Research Global Fixed Income Strategy Special Report, "Australia: All Good Streaks Must Come To An End", dated May 13, 2020, available at gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Portfolio Strategy The Fed’s extremely easy monetary backdrop along with easy fiscal policy remain the dominant macro themes, and they will continue to underpin the equity market. We remain constructive on the equity market’s prospects on a cyclical 9-12 month time horizon. While the path of least resistance remains higher for the S&P biotech index, we do not want to overstate our welcome and are putting it on downgrade alert and instituting a 5% rolling stop in order to protect profits. Relative supply/demand dynamics, social distancing, the pendulum swinging from renting to owing and enticing relative technicals and valuations, all signal that a long S&P homebuilders/short S&P REITs pair trade is primed to generate alpha.   Recent Changes Initiate a long S&P homebuilders/short S&P real estate trade, today. Table 1 Feature The SPX had a bumper week last week, but failed to pierce through the 200-day moving average. A flare up in the US/China trade war, a barrage of positive coronavirus vaccine news and Jay Powell’s 60 minutes interview brought back some volatility in trading, however, the VIX remains in a steady downturn. Importantly, investors are nowhere near as complacent as during the 2018/19 or early 2020 SPX peaks, judging by VIX futures positioning (net speculative positions shown inverted, Chart 1). Chart 1Positioning Is Far... In other words, there is still room for equities to rise before sentiment reaches greedy levels. A number of other indicators we track confirm that recent SPX trading is associated more with panic than with euphoria. Namely, Chart 2 shows that our Complacency-Anxiety, Capitulation and Equity Sentiment Indicators, all corroborate that investor confidence is far from previous exuberant peaks, and signal that there is scope for additional equity gains on a cyclical 9-12 month time horizon.  Delving deeper into investor psyche, our sense is that there are three distinct camps of investors at the current juncture, two of which are fiercely battling it out in the stock market. Chart 2…From Complacent First there are the pessimists that we call “second wavers” that are more often than not also “Fed non-believers” or “Fed fighters”. They argue that stocks are extremely expensive and if a second wave of the corona virus hits, then stocks are going to plunge anew given the lack of a valuation cushion, as all the money in the world (Fed QE5) cannot cure the virus (top panel, Chart 3). Second, there are the optimists that are hopeful that a vaccine/drug cocktail discovery is looming to effectively eradicate the coronavirus. These investors also believe in the smooth reopening of the economy. But, even if there were a second wave, their thinking goes that our societies/governments/health care systems are all going to be more prepared and effective to deal with a second viral outbreak in the fall. In addition, they are in the “do not fight the Fed” camp. Finally, there are the more moderate investors that lie somewhere in between these two camps. They sat tight and held on to their stock positions during the 36% peak-to-trough SPX drawdown and have likely been on the sidelines lately (bottom panel, Chart 3) awaiting a catalyst to either deploy fresh capital or raise some cash. We are in the more optimistic camp and while a vaccine may be months away, we will have to figure out a way as a society to more effectively protect the elderly that are most at risk from the virus and continue to live on, as we first posited in the March 23rd Weekly Report when we outlined 20 reasons to buy stocks and reprint here: "20. Social-distancing measures in the West will ultimately break the Epidemic Curve first derivative and arrest the panic. Even if COVID-19 comes back in force, the fact is that most of the patients who succumb to it are elderly. In Italy, the average age of death is 80 years old. As such, the final circuit-breaker ahead of a GFC would be desensitization by the population, as selective quarantines – targeting the elderly cohorts – get implemented in order to allow other people to return to work. Furthermore, two “silver bullet” solutions remain as tail risks to the bearish narrative. First, a biotech or pharmaceutical company may make a breakthrough in the fight against COVID-19. Not necessarily a vaccine, but a treatment. Finally, upcoming warm weather in the northern hemisphere may also help the fight against the virus."1 Chart 3Cash Hoarding Is Associated With Market Troughs Chart 4Loose Monetary Policy… Moreover, we definitely refrain from fighting the Fed as we outlined in our recent “Fight Central Banks At Your Own Peril” Weekly Report2 and reiterate that view today (Chart 4). While some investors were surprised by Jay Powell’s 60 Minutes interview remarks on the way the Fed digitally creates money, Ben Bernanke in another 60 Minutes interview in March 20093 made a similar comment that we cited in our March 23 Weekly Report (please refer to reason number 6 to buy equities).4 Importantly, we felt that Jay Powell’s demeanor was more like “please test our resolve Mr. Market if you reckon the FOMC is out of ammunition”. As a reminder, the Fed is in a position of strength: devaluing a currency is easy, revaluing/defending a currency is difficult and at times impossible as FX (and gold) reserves eventually run dry. In sum, the Fed’s extremely easy monetary backdrop along with easy fiscal policy (Chart 5) remain the dominant macro themes, and they will continue to underpin the equity market. Eventually, a liquidity handoff to growth will take root, and the SPX will no longer require the immense fiscal and monetary supports. As a result we continue to believe that stocks will be higher in the coming 9-12 months. Chart 5…And Easy Fiscal Policy Are Underpinning Stocks Biotech Delivers We have been overweight the S&P biotech index and adding alpha to our portfolio in the double digits, however we do not want to overstate our welcome and are putting it on downgrade alert and instituting a 5% rolling stop in order to protect profits. While a few technology sectors and subsectors have come close to vaulting to fresh all-time highs, none other than the S&P biotech index has managed such an impressive feat. The stealthy advance in biotech stocks has been earnings driven and is not only confined to the narrow based Big-Pharma lookalike S&P biotech index (Chart 6). The broader-based NASDAQ biotech index comprising 209 stocks has also quietly sprang to uncharted territory. True, relative share prices have yet to make the all-time high leap, but have bested the market roughly by 30% year-to-date irrespective of the biotech index or ETF tracked (Chart 6). Importantly, growth stocks in general and biotech stocks in particular perform exceptionally well in a disinflationary growth environment. Therefore biotech stocks are the primary beneficiaries of the Fed’s QE5 and NIRP policies at a time when inflation is missing in action (top panel, Chart 7). Chart 6Earnings-Led Advance This goldilocks backdrop is also evident in the US bank credit impulse that has gone parabolic. When there is flushing liquidity and growth is scarce and declining, investors flock to any growth they can get their hands on (bottom panel, Chart 7). Chart 7Goldilocks Backdrop US dollar based liquidity, also underpins biotech stocks. In recent research, we have been highlighting that the Fed is indirectly targeting the debasing of the greenback. All this excess US dollar liquidity will eventually boost global growth, and reflate corporate earnings via the export relief valve. Biotech stocks will also get a fillip from a depreciating US dollar (Chart 8). Our overweight thesis in biotech was predicated – among other things – upon Big Pharma taking out biotech players and acquiring their coveted drug pipelines. We continue to side with the potential M&A targets, rather than the acquirers. The number of industry M&A deals has reached fever pitch and deal premia are still averaging over 60% (Chart 9). Chart 8Dollar Flooding Is A Boon For Biotech Equities Currently, the global race to find a coronavirus vaccine has further propelled biotech stocks. Indeed, investors are voting with their feet and are betting on a vaccine breakthrough. Thus, the allure of biotech stocks has also increased a notch as the possibility of a vaccine makes their earnings streams even more valuable and desirable to Big Pharma. A mega M&A deal in the space would not take us by surprise. Chart 9M&A Activity Will Remain Robust A few words are in order on the earnings, valuation and technical fronts. While relative share price momentum is galloping higher, it is moving in lockstep with rising earnings estimates (second panel, Chart 10). We would be extremely concerned if this were a multiple expansion driven relative share price advance. In fact, the biotech forward P/E trades both below the historical mean and at a 39% discount to the broad market hovering near an all-time low (Chart 10). Even on a dividend yield basis, biotech stocks are cheap sporting a higher (and safer) dividend yield than the SPX (bottom panel, Chart 10). Chart 10Biotech Stocks Are As Cheap As They Have Ever Been Chart 11Earnings Hurdle Remains Low Finally, relative long-term profit growth euphoria reaching astronomical levels, preceded previous S&P biotech index peaks: three times in the past two decades biotech stocks were projected to surpass SPX profit growth by roughly 10%. The current reading has plunged to negative 1.2% (Chart 11). Netting it all out, the global race for a coronavirus vaccine, robust earnings growth, ample US dollar liquidity and generationally low interest rates suggest that the path of least resistance remains higher for the S&P biotech index.   Bottom Line: Stay overweight the S&P biotech index, but put it on downgrade alert and set a 5% rolling stop in order to protect profits. The ticker symbols for the stocks in this index are: BLBG: S5BIOT – ABBV, ALXN, AMGN, BIIB, GILD, INCY, REGN, VRTX. Intra-Real Estate Trade Idea There is an exploitable trade opportunity in the real estate market, preferring residential real estate to commercial real estate (CRE). The cleanest way to play this is via a long S&P homebuilders/short S&P REITs pair trade, and we recommend initiating such a market-neutral trade today. Relative performance remains below the upward sloping time trend and at least a mini overshoot phase is in the cards in the coming quarters (Chart 12). One of the key drivers for this pair trade is the ebb and flow of owning versus renting and the current message is positive for homebuilders at the expense of REITs (Chart 13). Chart 12Looming Overshoot Phase Chart 13Own Versus Rent Upswing Is Bullish For The Pair Trade Home ownership has suffered a setback and never reclaimed its pre GFC highs. However, there is pent up demand for single family homes, especially given the recent drubbing of interest rates which should bring first time home buyers back into the market. Millennials up to now have been more of a renter generation, but as household formation increases for the largest cohort in the US, homeownership will make a comeback. One can argue that both real estate segments are interest rate sensitive and that they should benefit from lower rates. However, banks are more willing to lend to consumers in order to buy a home rather than to investors for CRE properties/projects by a factor of 2:1 according to the latest Federal Reserve Senior Loan Officer survey.5 Similarly, whereas demand for CRE loans has collapsed according to the same survey in April, demand for residential real estate loans spiked (top panel, Chart 14). In times of coronavirus-induced social distancing there is a lot more risk associated with CRE versus residential properties. Apartment REITs for example have an element of density-related risk versus the allure of a single family home in the suburbs. Likely social distancing will place a premium on single family homes in coming quarters at the expense of living in high rises in the city. This backdrop bodes well for home prices, but ill for CRE prices which according to Green Street Advisors contracted by 9% in April.6 Keep in mind that residential real estate price only very recently surpassed their 2006 zenith whereas CRE price are still hovering at one standard deviation above the previous peak (Chart 14). Debt deflation is a real threat for CRE prices and given that REITs are at the bottom of this levered asset’s capital structure it is last to collect.  Also the long-term ramifications to demand on CRE are grave compared with residential real estate. On the office REIT segment as an example, we deem that corporations will rethink their often expensive downtown office space requirements and likely downsize, as working from home has become mainstream. The unintended consequence of this realization is that demand for (larger) single family homes will also increase as workers opt to set up more comfortable working spaces at suburban homes. Chart 14Homebuilders Have The Upper Hand Shopping mall REITs are under relentless attack from the Amazonification of the economy and now have to contend with social distancing. The retail shopping experience will never be the same again sustaining the threat of extinction for shopping centers. On the construction front, single family housing starts are breaking ground at the historical mean and way below the 2006 peak run-rate, however, multi-family supply has gone parabolic (Chart 15). These diverging supply conditions are a harbinger of rising relative share prices. Finally, with regard to technicals and valuations homebuilders have the upper hand. Our Technical Indicator is in the neutral zone and relative valuations have collapsed near all-time lows offering a compelling entry point to the pair trade (Chart 16). Chart 15Supply Dynamics Favor Homebuilders Chart 16Relative Pessimism Is Contrarily Positive Netting it all out, relative supply and demand dynamics, social distancing, the pendulum swinging from renting to owing and enticing relative technicals and valuations, all signal that a long S&P homebuilders/short S&P REITs pair trade is primed to generate alpha.  Bottom Line: Initiate a long S&P homebuilders/short S&P REITs pair trade today. The ticker symbols for the stocks in the S&P homebuilding and S&P REITs indexes are: BLBG: S5HOME – LEN, PHM, NVR, DHI, and BLBG: S5REITS – AMT, PLD, CCI, EQIX, DLR, SBAC, PSA, AVB, EQR, WELL, ARE, O, SPG, ESS, WY, MAA, VTR, DRE, PEAK, BXP, EXR, UDR, HST, REG, IRM, VNO, FRT, AIV, KIM, SLG, respectively.   Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com     Footnotes 1     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 2     Please see BCA US Equity Strategy Weekly Report, “Fight Central Banks At Your Own Peril” dated April 14, 2020, available at uses.bcaresearch.com. 3    https://www.cbsnews.com/news/ben-bernankes-greatest-challenge/2/ 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    https://www.federalreserve.gov/data/sloos/sloos-202004.htm 6    https://www.greenstreetadvisors.com/insights/CPPI             Current Recommendations Current Trades Strategic (10-Year) Trade Recommendations Size And Style Views June 3, 2019 Stay neutral cyclicals over defensives (downgrade alert)  January 22, 2018 Favor value over growth May 10, 2018 Favor large over small caps (Stop 10%) June 11, 2018 Long the BCA  Millennial basket  The ticker symbols are: (AAPL, AMZN, UBER, HD, LEN, MSFT, NFLX, SPOT, TSLA, V).

Highlights Economic conditions are quite bad, … : Stay-at-home orders have decimated economic activity, giving rise to massive layoffs. … but policy makers embarked on a mighty initial effort to limit the longer-run effects: Mixing emergency GFC programs with bold new initiatives, the Fed has kept markets functioning and restrained defaults. Congress did its part with the CARES Act, opening the fiscal taps full blast to ease the burden on struggling households and businesses. Now the key question is if they’ll have the stomach to do more: Several businesses will not reopen, and it will be some time before nonfarm payrolls regain their peak. Successive waves of monetary and fiscal accommodation may be required to prevent longer-term scarring. Feature If we could have just one data series to assess the health of the economy, we would choose the monthly employment situation report. Though employment is only a coincident indicator, it is a powerfully self-reinforcing series, influencing consumption (Chart 1), fixed investment and future hiring. The unemployment rate also drives most household credit performance models, thereby influencing banks’ willingness to make auto, credit card and mortgage loans. The ripple effects of job losses can lead to a broader tightening of financial conditions, exacerbating downturns. Chart 1As Goes Employment, So Goes Consumption The April release was grim. The headline unemployment rate leaped by ten percentage points to 14.7%, its highest level since the Depression, but it failed to convey the full picture. With greater than 2% of the labor force having been laid off in each of the two weeks following the survey cut-off date, we estimate that the unemployment rate at the end of April was another four percentage points higher. There is a sizable gap between the 38.6 million workers who have filed for unemployment since mid-March and the 17.3 million newly unemployed captured in the March and April household surveys. The labor market data will get worse before it gets better, and we assume that the unemployment rate will peak above 20%. Astonishing numbers of jobs have been lost in the blink of an eye.  To avoid getting caught up in the unemployment rate’s technicalities, we are focusing on the change in employment. The establishment survey’s nonfarm payrolls series1 shrank by 21 million in March and April, or 14% from its February peak. To put the current episode into context, the 6.3% peak-to-trough decline in payrolls that played out over 25 months from February 2008 through February 2010 was previously the worst of the postwar era, dwarfing the typical recessionary payroll contraction of 1.5-3% (Chart 2). Chart 2Payrolls Have Never Shrunk Anything Like This Before Readers who’ve had their fill of the word “unprecedented” can call the employment contraction breathtaking. One mitigating factor, cited by economists inside and outside of the Fed, is that four-fifths of the layoffs have been characterized as temporary (Chart 3). That is certainly a positive, and we don’t doubt that nearly all bars, restaurants, gyms, hotels and concert venues would like to reopen. They surely planned to when stay-at-home orders were initially implemented, but things have changed over the ensuing ten weeks, and a new research paper suggests that only about three-fifths of laid-off workers will be recalled.2 Chart 3Nearly Every Laid-Off Worker Expects To Be Recalled For most of the postwar era, it took about 18 to 24 months for employment to recover its pre-recession peak. With the onset of the twenty-first century’s “jobless recoveries,” however, employment has rebounded much more slowly across cycles. After the dot-com bust and the global financial crisis, it took four and six years, respectively, to make new highs (Chart 4). The combination of manufacturing outsourcing and the ongoing automation of white-collar tasks is likely to make the slower pace of employment recovery the rule. Investors should anticipate that unemployment will linger at elevated levels through 2021 even in the event of an optimistic scenario. Chart 4Employment Doesn't Rebound Like It Used To Congress Versus The Data When employment falls, the virtuous circle in which changes in employment feed into further changes in employment becomes a vicious circle. Falling employment doesn’t just directly weigh on activity via less consumption and fixed investment; it also leads to reduced credit availability via tighter lending standards. With COVID-19 looming as a massive shock to consumer credit performance, Congress rushed to prop up the income streams of households in harm’s way. It began by sending $1,200 checks to more than 60% of taxpayers (single filers with less than $75,000 of adjusted gross income, and married couples with less than $150,000). One-off $1,200 payments could help strapped households, but the CARES Act’s more significant measure provided for a weekly $600 supplement to state unemployment benefits through the end of July. Weekly state-level benefits average about $400. When coupled with the federal supplement, unemployed workers will receive around $1,000 per week, slightly above the average weekly wage. After applying the stimulus check, the average worker will earn 10% more over his/her first three months of joblessness than s/he did when working full time. Why leave the couch when sitting in front of the TV is more lucrative than venturing outside? The Fed is deliberately aiming to keep households and businesses from defaulting. The direct payments3 and the supplemental unemployment benefits could prevent spending from falling, and consumer loan performance from weakening, as much as they otherwise would given the scale of layoffs. The Department of Labor has tracked the share of the average worker’s income that is replaced by unemployment benefits (the replacement rate) since the late nineties. During the two recessions covered by that sample period, laid-off workers received benefits amounting to just 40% of their previous income (Chart 5). Not surprisingly, consumer loan defaults surged (Chart 6). We are hopeful that credit performance through July, the expiration date of the supplemental benefit program, will be much better than simple regression analyses based on the unemployment rate would project, leaving ample room for a positive surprise. Chart 5Unemployment Benefits Typically Replace Just 40% Of Average Income ... Chart 6... But Consumer Borrowers Might Be Able To Stay Current When They Exceed It Powell Versus The Data In his 60 Minutes interview broadcast on May 17th, Fed Chair Jay Powell repeatedly indicated that the Fed is also pursuing a finger-in-the-dike strategy. Early in the interview, after lamenting the seriousness of the COVID-19 shock, he noted, “the good news is that we have policies that can go some way toward minimizing those [hysteresis-like] effects. And that’s by keeping people and businesses out of insolvency just for maybe three or six more months while the health authorities do what they can do. We can buy time with that.” He came back to the short-term-stimulus-to-prevent-long-term-impairment theme toward the end, explicitly referencing credit performance. “[W]e have tools to try to minimize the longer-run damage to the supply side of the economy. And these tools just involve keeping people solvent, keeping them in their homes, keeping them paying their bills just for maybe a few more months. And the same thing with businesses. Keeping them away from Chapter 11 if it’s available.” It seems reasonable to assume that the worst of the public health news will have passed by the fall. If employment were to rebound in line with re-opening measures, six months of active fiscal and monetary support, from March to September, ought to be enough to stave off long-run damage. As the massive scale of the job losses is revealed, however, we are beginning to rethink our own assumptions about when the economy will truly be able to stand on its own. As Chart 4 suggests, it may be unrealistic to think that the US can return to full employment by 2022, especially as the lockdowns may have given businesses lots of ideas about where they can permanently reduce headcount. The Fed is prepared for such a contingency, to hear the Chair tell it: It may well be that the Fed has to do more. It may be that Congress has to do more. And the reason we’ve got to do more is to avoid longer-run damage to the economy. [W]e’re not out of ammunition by a long shot. No, there’s really no limit to what we can do with these lending programs that we have. So there’s a lot more we can do to support the economy, and we’re committed to doing everything we can as long as we need to. Powell’s take did not come as news to markets, even if it helped stocks romp higher the day after the interview was broadcast. The Fed moved with dizzying speed in March, and its measures have been effective. Taking the corporate bond market as an example, spreads narrowed sharply after the primary- and secondary-market corporate credit facilities were announced on March 23rd (Chart 7) and have fallen to a level consistent with a run-of-the-mill recession (Chart 8). Corporate bond issuance set an all-time monthly record in March, then broke it in April, all without the Fed buying a single bond until mid-May. Chart 7The Fed Tamed The Corporate Bond Market Without Firing A Shot ... Chart 8... And Spreads Are Now At Levels Consistent With A Ho-Hum Recession Investment Implications Investors can count on the Fed’s whatever-it-takes pledge, but they shouldn’t expect the Fed to defend the economy from monumental job losses all by itself. States, cities and towns need cash grants to avoid laying off wide swaths of their workforces, and only Congress and the administration can issue them. Despite their public wavering, we do not think that Republicans will want to spurn masses of unemployed voters and their teachers, police and firefighters ahead of the election. Bailout fatigue and deficit worries will make succeeding iterations of aid packages less generous, though. A wave of defaults and business failures would complicate the near-term recovery playbook. Independent of longer-run effects, financial markets will fare better over the next year if fiscal and monetary policy continue to focus on limiting avoidable busts. We think they will, however begrudgingly, but financial markets already discount this benign outcome. Jay Powell is singing the SIFI banks' song. The combination of Fed support and low valuations makes them especially attractive. Relentlessly accentuating the positive leaves risk assets vulnerable in the near term. We continue to expect some sort of an equity correction and have no appetite for anything but the BB-rated top tier of high yield corporates. Over the tactical 0-to-3-month timeframe, we continue to recommend that multi-asset investors maintain a benchmark equity weighting, while underweighting bonds and overweighting cash. We recommend overweighting equities, underweighting bonds and equal-weighting cash over the cyclical 3-to-12-month timeframe. Within bonds, we are underweight Treasuries and high yield, and overweight investment grade, over both timeframes. The SIFI banks will benefit most directly if policymakers are able to limit consumer and business defaults. Chair Powell’s 60 Minutes refrain should have been music to their management teams’ and stockholders’ ears. They are the rare prominent segment of the market that is viewing the glass as half-empty. Investors have a considerable margin of safety buying them at or near their book value and they continue to be our favorite long idea.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 The employment situation report is compiled from a survey of households (used to calculate the size of the labor force and the unemployment rate) and a survey of business establishments (used to calculate net employment gains, hours worked and earnings). The foregoing unemployment discussion referenced the household survey; the subsequent discussion and charts reference the establishment survey. 2 Barrero, Jose Maria, Nicholas Bloom and Steven J. Davis, 2020. "COVID-19 Is Also a Reallocation Shock," NBER Working Paper No. 27137. Accessed May 21, 2020. Using historical data samples analyzed by other researchers, and the responses to the Survey of Business Uncertainty, the authors estimate that only 58% of pandemic-induced layoffs will prove to be temporary. 3 Another round of direct payments is being debated on Capitol Hill as we go to press.

Feature The crisis surrounding COVID-19 eventually will pass and hopefully life gradually will return to some degree of normality. Even if it is not possible to completely eradicate the virus, we will have to learn to live with it, assuming effective treatments and vaccines become available. The alternative, that no treatments or vaccines will be developed, seems excessively gloomy. But that does not mean economic conditions will quickly return to pre-crisis levels. The severity of the current contraction guarantees that economies initially will see one or two quarters of very strong growth when businesses resume operations. However, it is hard to be positive about the pace of recovery beyond that initial spurt. The job losses have been horrendous, and they will not all be temporary. A University of Chicago study estimated that 42% of recent job layoffs will end up being permanent.1 Many businesses – especially small ones - may decide against reopening given the uncertainty about future revenue growth and/or the restrictions imposed by new physical distancing procedures. Many small businesses are financially fragile with the median company holding less than one month’s cash on hand.2 According to OpenTable, 25% of US restaurants will close permanently. Against this background, considerable fiscal stimulus will not deliver a strong recovery – it merely limits the severity of the downturn. Any short-term forecasts are highly speculative because so much depends on the path of infections. At the bullish end of the spectrum, perhaps the rate of infection will continue to ease in most major countries and a vaccine will become widely available before the end of the year. At the other extreme, the rate of infection could spike back up as economies reopen, leading to a more virulent second wave later this year. And if you want to be really bearish, the virus may mutate, preventing the development of an effective vaccine. After all, there is no vaccine against the common cold and the vaccine for the regular flu has not eradicated that virus. Opinions about the outlook are all over the map and the sad truth is that nobody really knows what will happen. It all underscores the huge challenges facing governments as they try to judge the appropriate pace of restarting economies, opening schools and relaxing social interactions. In this report, I want to look beyond the fog-shrouded near-term outlook and consider the extent to which there may be a lasting impact on economic trends. Specifically, I will focus on the implications of Covid-19 on long-run economic growth, inflation and monetary/fiscal policy. Will Potential Growth Be Infected? Over the long run, an economy expands at its potential rate which is dictated by the growth in the labor force and productivity. How will the Covid-19 crisis affect these trends in the years ahead? As is well known, declining birth rates have led to sharply slowing labor force growth in all the major economies and this trend will continue for at least the next 20 years (Chart 1). The loss of life due to the virus is tragic but is not large enough to have a major impact on population growth. Moreover, the most seriously affected age cohort – those 70 and above – generally are not in the labor force. But two other trends could affect labor force growth: a shift in participation rates and policies toward immigration. The participation rate measures the percentage of the population aged 16 and over that are employed or actively seeking work. In other words, it is the labor force as a percent of the working-age population, typically broken down into different age cohorts. The US participation rate has plunged as a result of recent unprecedented job losses (Chart 2). While it will spike up as the economy reopens, it is far from clear that it will quickly return to pre-crisis levels. Many job losses will be permanent leading to a rise in the number of discouraged workers who give up on seeking new employment. This would depress future labor force growth relative to its pre-crisis expected trend. Chart 1A Poor Demogrpahic Backdrop For Growth Chart 2The US Labor Participation Rate   For many developed countries, immigration provides an important offset to the slow growth or even decline in domestic populations. For the US, projections from the UN imply that net migration will account for more than half of total population growth in the next decade, rising to almost two-thirds in the 2030s, assuming the net migration rate holds at its past rate of around three people per 1000 of population. Even before Covid-19, there was a growing backlash against high levels of immigration in the US and several European countries and this could now be reinforced. Thus, in a post-virus world, labor force growth could be slightly lower than previously projected in some areas. What about productivity, the more important driver of economic growth? Forced shutdowns have required businesses to adapt their operations to survive when revenues have evaporated. This undoubtedly has led to the discovery of several ways to boost efficiency and that should be a permanent change for the better. Moreover, there is now an added incentive to accelerate the adoption of labor-saving and productivity-enhancing artificial intelligence technologies. On the other hand, some changes will be negative for productivity. Factory closures in China clearly highlighted the downside of supply chains being dependent on a small number of distant providers. Companies in the west had increased sourcing from China and other emerging countries for a good reason: it saved a lot money and was thus good for productivity and profits. After all, productivity is all about delivering goods and services of the same or better quality at a lower unit cost. Chart 3Profit Margins Are Headed Lower It seems inevitable that many companies will seek to establish more reliable supply chains and in some cases that will involve onshoring – i.e. bringing back production to home countries. This will bring advantages, but costs will be higher and profit margins correspondingly lower. Profit margins had already peaked from their unsustainably high level and further sharp declines are in prospect. (Chart 3). Globalization has been a very positive force for productivity and a reversal has the opposite effect. A second problem for future productivity is that the outlook for business investment has taken a turn for the worse. The severe damage to corporate balance sheets means that many companies will be less willing and able to embark on new capital spending initiatives. A reduced pace of capital spending will have a negative impact on future productivity growth. A third issue is that new safety protocols will introduce friction into the economic system, much in the way that the response to 9/11 made air travel a much more tedious business. If businesses must take measures to ensure greater physical distancing for both employees and customers, that implies an increased cost with little obvious benefit to efficiency. Finally, another legacy of the virus will be greater government involvement in the economy, something that is not conducive to increased productivity. And in many countries, there is likely to be a shift of resources into healthcare. That may be highly desirable from the perspective of social welfare but it implies fewer resources for other areas. Overall, the above discussion suggests that potential GDP growth in the developed economies will be negatively impacted by the Covid-19 crisis. It is hard to quantify the impact but even a modest reduction in annual growth can have large cumulative effects over time. Economies can grow above potential rates for a while if they are force-fed with rapid credit growth, but that era has passed. The shock of the economic and financial meltdown of 2007-09 was enough to end the love-affair with debt on the part of consumers in the US and many other countries. This is highlighted by the weakness in US mortgage demand in the past decade, despite record-low mortgage rates (Chart 4). At the end of 2019, mortgage applications were no higher than 20 years previously, despite a record-low unemployment rate and the 30-year mortgage rate falling from 8.5% to 3.5% over the period. While mortgage demand and thus household sector credit growth remained strong in the past decade in economies such as Canada, Australia and some European countries, the current crisis likely means that the Debt Supercycle finally has died in those places as well (Chart 5). Financial caution on the part of consumers and many businesses will push up private sector saving rates in the years ahead. Rising private sector saving rates will make it easier to finance large budget deficits but argue against a return to strong economic growth. Chart 4Weak US Mortgage Demand Despite Record Low Yields Chart 5Household Debt: Peaked or Peaking   Inflation Or Deflation? Chart 6A Deflationary Shock This is a controversial question. Clearly, the short-term picture is deflationary – one merely needs to look at the trend in oil and commodity prices (Chart 6). Large negative shocks to demand are by their nature deflationary. And when economies start to open again, many businesses – especially in discretionary areas such as travel and tourism – will be under pressure to offer large discounts to attract customers. And with double-digit unemployment rates, labor will not be in a strong bargaining position when it comes to wages. The bigger uncertainty relates to the longer-term outlook. On the one hand, a world of moderate rather than strong growth does not lend itself to serious inflationary pressures. On the other hand, there will be supply constraints in some areas that have the opposite effect. For example, a lasting decline in airline capacity could lead to upward pressure on airfares: the era of super-cheap air travel may well be over. And, as noted above, a retreat from globalization reverses one of the big drivers of low inflation during the past couple of decades. Even more importantly, there is the issue of monetary and fiscal policy. The policy response to Covid-19 dwarfs even the radical actions during the 2007-9 financial meltdown. Public sector debt levels have soared in response to stimulus spending and collapsing tax receipts and central banks have flooded the system with liquidity. These policy actions typically raise the alarm about a future inflation threat. Chart 7The US Monetary Transmission Process is Impaired Current central bank actions are not inflationary. Previous rounds of quantitative easing (QE) did not lead to higher inflation because the “printed money” largely ended up in bank reserves, not the broader economy. In a post-Debt Supercycle world, easy money is no longer able to trigger a renewed credit boom, and in that sense, the money-credit transmission process is impaired. This is illustrated in Chart 7 by the collapse in the money multiplier (the ratio of broad to narrow money) and the downward trend in money velocity (the ratio of nominal GDP to broad money). QE was great for asset prices but it did not lead to a vibrant economy and rising inflationary pressures. And the same will be true this time around – at least in the next year or so. Central bank actions are keeping the economic shutdown from translating into a financial system shutdown and this is incredibly important. The inflation risks will come later. The current generation of central bankers have been in office during a period of recurring economic shocks and a persistent undershoot of inflation relative to target. When this goes on for long enough, it is sure to affect the perceived balance of risks. In other words, if the bigger threat is believed to be weak growth rather than inflation, then that will encourage policymakers to err on the side of ease, raising the odds that inflation will at some point surprise on the upside. Chart 8Markets Are Not Priced For Higher Long-Run Inflaton It is easy to see why the authorities may not be overly concerned with a period of higher inflation. It could be justified as an offset to the many years where inflation ran below desired levels. And it would help lower the burden of bloated government debt. And central banks could thwart a revolt by bond vigilantes against inflation by buying up any bonds the private sector was not willing to purchase. A return to a 1970s world of rampant inflation is not in prospect. Back then, policy complacency was accompanied by a formidable combination of strong labor unions, buoyant commodity prices, poor corporate productivity and embedded inflation expectations on the part of both business managers and workers. Those conditions no longer exist and are unlikely to re-emerge to any significant degree. Thus, we are not headed for double-digit inflation. But inflation could well get back into the 4% to 5% range in a few years’ time. And the markets are not priced for this with 5-year CPI swap rates at 0.8%, and 10-year swap rates at 1.3% (Chart 8). Policy At The Extremes We are in the midst of an extraordinary surge in government deficits and debt. The age-old concern that large fiscal deficits lead to higher interest rates and thus crowd out private investment is not applicable in the current environment. Central bank policies of QE and anchoring short rates at zero, along with investor demand for safe assets, are keeping bond yields at historically low levels. And none of that will change any time soon. Nevertheless, fiscal trends do matter. Economies eventually will recover and it will not be appropriate for central banks to keep interest rates at zero indefinitely. As interest rates rise, public sector debt arithmetic will turn uglier. This will leave the authorities with tough choices as the growing cost of debt servicing will eat into the revenues available for other spending programs. And this will occur when deficits will already be under persistent upward pressure from rising pension and health-care costs of an aging population. The direct impact of fiscal policy on economic growth reflects the changes in budget deficits, not their levels. Thus, for policy to remain stimulative, underlying deficits would have to keep rising as a share of GDP. That does not seem likely once economies stabilize and governments scale back current relief programs. For example, the latest IMF projections show general government deficits as a share of GDP for the G7 economies rising from 3.8% in 2019 to 12% in 2020, then falling back to 6.2% in 2021. Those swings partly reflect the cyclical impact of recession and recovery on revenues and spending, rather than discretionary changes in policy. In other words, the move in the cyclically-adjusted deficit would be less extreme. Nonetheless, it highlights that in the absence of continued new stimulus measures, fiscal policy will become more restrictive. Given the prospect of a moderate recovery, fiscal imbalances will not diminish quickly. Meanwhile, there will be pressure for increased spending on health care and transfers to financially-strapped regional/local governments. And there is talk in some countries of the need to create a basic income program for all households. That would be a hugely expensive project, even allowing for offsetting changes to tax systems. On the subject of taxes, it is inevitable that rates will have to increase given budget constraints and the need to fund high levels of spending. The bottom line is that the current environment of fiscal profligacy cannot persist. In the heat of the pandemic and economic shutdown there is no limit on what governments are prepared to do. And the markets are not providing any constraints on policymakers. After things calm down, the harsh reality of unprecedented public debt burdens eventually will prove a huge challenge to the authorities. Advocates of Modern Monetary Theory (MMT) are not overly concerned about this because they believe central banks can finance any amount of public deficits with no adverse impact on the economy. But there is a caveat: this is sustainable only for as long as inflation stays under control. If inflation rises, then even MMT argues for fiscal discipline. How will it all play out? There is no chance that developed economies will be able to grow out of their public debt problems and we should rule out explicit default. And there will not be any stomach for the degree of austerity that would be required to bring deficits back to reasonable levels. That leaves monetization as the likely end point. And that implies monetary policy being kept easier than economic conditions warrant, leading eventually to higher inflation. The Short Run Trumps The Long Run, But… This report has speculated about some of the long-run implications of the current environment. Those hardly seem to matter during a crisis and the associated massive uncertainty about what will happen economically, politically, financially and socially over the coming year. Never has Keynes’ dictum “In the long run we are all dead” seemed more apposite. Worries about long-term trends in inflation and/or public debt seem misplaced relative to more immediate concerns. In terms of a well-used analogy, if a building is on fire, the imperative is to put out the flames. The problems caused by water damage can be dealt with later because otherwise, there may not be any building left to repair. Nevertheless, investment decisions should not focus exclusively on the short run – especially when the range of possible outcomes is so vast. The 37 years from end-1982 to end-2019 were an extraordinary period for investors with total returns from global equities compounding at 10.3% a year and long-term bonds not far behind. And this was despite two vicious equity bear markets with the world index dropping by more than 50% between March 2000 and October 2002 and again between October 2007 and March 2009. There is no other comparable 37-year period in history where both bonds and stocks have delivered such strong returns. The key was a very favorable starting point: both equities and bonds were very cheap in late 1982 with the world index trading at around 10 times earnings and 10-year Treasurys offering a real yield of around 7%. We currently have very different valuations. The price-earnings ratio for world equities currently is more than 17 and real bond yields are negative. These are not good starting points for potential long-run returns. With nominal yields below 1%, bond returns will be minimal over the next decade. Stocks should do better given that the dividend yield is above bond yields, but returns will be very modest by historical standards (see Table 1). Table 110-Year Asset Return Projections Concluding Thoughts Much is being written about how Covid-19 will affect the way economies operate in future and how we will all be forced to conduct our lives. Many believe that the virus is a major game changer with some of the changes that have resulted from the crisis becoming a permanent feature. Of course, it is all highly speculative. I am skeptical that there will be lasting major changes in social behavior. People tend to have short memories and, with the critical assumption that vaccines and treatments become available, I expect that we will return to our old habits. People will go back on cruises, pack into bars and restaurants and attend large sporting and cultural events. In other words, life will go on much as before. But the virus will lead to some economic and political effects, both good and bad. On the bad side, the path to economic recovery will be rocky and long-run growth is likely to be negatively affected. And current extreme actions will leave future monetary and fiscal policy massively constrained in dealing with a world of sluggish growth. Meanwhile, inflation could eventually become a problem and the drift toward economic and political nationalism will be reinforced. On a more positive note, businesses are finding new ways to boost efficiency and maybe there will be progress in reducing extreme levels of inequality. We are all in the unfortunate position of being bystanders to an ongoing crisis. There are no compelling historical precedents to light the way forward and every government is struggling to find the right balance between reviving economic activity and preserving lives. In the face of such massive uncertainty, it makes sense to adopt a cautious near-term investment strategy. Hopes that risk assets can be supported solely by hyper-easy monetary policies seem very complacent in my view. The strong bounce in equity prices from their March lows suggests that this is not a bad time to de-risk portfolios.   Martin H. Barnes, Senior Vice President Chief Economist mbarnes@bcaresearch.com Footnotes 1  Jose Maria Barrero, Nick Bloom, and Steven J. Davis, "COVID-19 Is Also a Reallocation Shock," Beker Friedman Institute, May 5, 2020. 2 Alexander W. Bartik, Marianne Bertrand, Zoë B. Cullen, Edward L. Glaeser, Michael Luca, Christopher T. Stanton, "How are Small Businesses Adjusting to Covid-19? Early Evidence From A Survey," NBER Working Paper 26989, April 2020.

Dear client, In lieu of our regular weekly report next week, we will hold a webcast on Thursday at 10:00 am ET discussing both tactical and strategic currency considerations. The format will be a short presentation, followed by a Q&A session. We look forward to engaging with you. Kind regards, Chester Ntonifor Vice President, Foreign Exchange Strategy Highlights Go short the Gold/Silver ratio (GSR). Hold a basket of NOK and SEK against a basket of the dollar and euro. Go long sterling. Feature Chart I-1The Dollar And Business Cycles When constructing a basket of high-conviction positions, the starting point is usually the framework used to build the portfolio. Ours is through a three-factor lens. The first lens determines what macroeconomic environment we are operating in. Think of a four-quadrant matrix, with growth on one axis and inflation on the other. Intuitively, the dollar should do best when global growth is decelerating and inflation is falling. The climatic expression of this is a deflationary bust, when all bets are off and the dollar is king. On the other side of the spectrum, the dollar should weaken as global growth rebounds (Chart I-1). The second lens is valuation. Specifically, as the drop in cyclical currencies in a deflationary bust approach a capitulation phase, value begins to put a cushion under deteriorating fundamentals. In our previous work, we showed that foreign exchange value-trading strategies based on PPP are profitable over the long term.1  Finally, technical indicators are our third lens for two reasons. First, they are the most powerful indicators for short-term trades. Second, they act as a bridge between bombed-out valuations and a subsequent improvement in macro fundamentals. For example, a saucer-shaped bottom in a cyclical currency can usually be a prelude to a U-shaped economic recovery. A high-conviction trade is one that ticks all three boxes or is agnostic to the first but has a powerful signal from both the second and third. Using this framework, we suggest two trades this week. Go Short The Gold/Silver Ratio When looking at our four-quadrant matrix, it is clear that the dollar tends to rise during a downturn, and fall early in the cycle. Intra-cycle performance is more nuanced. With both first- and second-quarter GDP likely to contract severely around the world, growth is likely to bounce back later this year if economies stay open. This should, ceteris paribus, lead to a weaker dollar. A bearish view on the dollar can be expressed by being short the GSR. The Gold/Silver ratio (GSR) tends to track the US dollar (Chart I-2), so a bearish view on the dollar can be expressed by being short the GSR. It is well known that most of the time, bullion is inversely correlated to the US dollar, not only due to the numeraire effect but also as competing monetary standards. Given that silver tends to rise and fall more explosively than the price of gold (Chart I-3), it makes sense that the GSR should inversely track the greenback. Part of the reason for silver’s explosive – albeit lagged – response is that the silver market is thinner and more volatile, with open interest in futures about one-third of gold. Chart I-2GSR And The Dollar Chart I-3Silver Has Explosive Rallies The potency of the GSR is in its leading properties, as it provides important information on the battleground between easing financial conditions and a pickup in economic (or manufacturing) activity. The GSR tends to rally ahead of an economic slowdown, then peaks when growth is still weak but financial conditions are easy enough to short-circuit any liquidity trap. Silver fabrication demand benefits from new industries such as solar and a flourishing “cloud” orbit – both of which are capturing the new manufacturing landscape. Not surprisingly, the GSR has led the rise and fall of many ASEAN and Latin American currencies that are at the forefront of manufacturing (Chart I-4). Chart I-4GSR, Latam And Asean Currencies A key assumption in a lower GSR is that the global economy fends off a deeper recession, which would otherwise sustain a high and rising ratio. But even if we are wrong and the dollar remains stronger over the next 12-18 months, the valuation cushion from being short the GSR is outstanding. The ratio broke above major overhead resistance at 100 just as the dollar liquidity crunch was intensifying, and is now staging a V-shaped reversal. Historically, these reversals tend to be quick, powerful, and extremely volatile. Unless gold is entering a new paradigm versus silver, the forces of mean reversion should pull the ratio towards 50 (Chart I-5). Chart I-5Big Downside Potential For GSR The next important technical level for silver is the $18-$20-per-ounce zone. This has acted as a strong overhead resistance since 2015, and has provided strong downside support for silver prior to that. If silver is able to punch through this zone, this will help bridge the gap between silver and gold fundamentals. Globally, the world produces 24,201 tons of silver a year and 3,421 tons of gold. That is a supply ratio of 7:1. Meanwhile, the price ratio between gold and silver is 100:1. This seems like a very wide gap, given that the physical supply of silver is in deficit. Bottom Line: We have been flagging the GSR as a key indicator to watch since last year.2 Our sell-stop on the ratio was finally triggered at 100. Place stops at 110, with an initial target of 75. Go Long Sterling, In Addition To NOK And SEK If the dollar is indeed in a renewed downtrend, the most potent beneficiaries of this move will be NOK and SEK. Our basket of long Scandinavian currencies against both the dollar and the euro has a significant margin of safety, even if we are offside on the dollar trend (Chart I-6). The euro will naturally pop on dollar weakness, but a very liquid beneficiary could also be sterling. Trade negotiations between the UK and EU are clearly breaking down. The worst-case scenario is a no-deal Brexit, in which case the pound could significantly decline. The key question would be by how much? Every time there has been maximum pessimism on the pound driven by Brexit fears, the line in the sand has been 1.20.  The first observation is that each time the odds of a “hard” Brexit have risen significantly, the threshold for cable downside has been 1.20. The first occurrence was the aftermath of the UK referendum in 2016. The second episode was when Prime Minister Boris Johnson was elected with a mandate to take the UK out of the EU (Chart I-7). Intuitively, this suggests that every time there has been maximum pessimism on the pound driven by Brexit fears, the line in the sand has been 1.20. Of course, a pandemic can change this dynamic, as we saw with the drop in cable to 1.15 in March, but this move was not isolated to sterling. Chart I-6SEK And NOK Are Attractive Chart I-7GBP Has Historically Bottomed At 1.2 While a no-deal Brexit is not our base case, it is still instructive to simulate cable downside in the case of  such an event. Given that the last time Britain majorly defected from a union was during the Exchange Rate Mechanism (ERM) crisis in the 1990s, revisiting this episode could be instructive. The episode leading to the collapse of the pound in 1992 has important lessons for today.3 Britain entered the ERM in October of 1990 in an attempt to find a stable nominal anchor. In other words, with high inflation and an overvalued currency, adopting German interest rates was expected to temper inflation and realign the real exchange rate. Fundamental models show the pound as being very cheap. Problems began to surface in June 1992, when the Danes voted no in a referendum on the Maastricht Treaty that included a chapter on the EMU. As doubts towards the progress of a union began to rise, investors started to question where the shadow exchange rate for ERM currencies lay, especially the Italian lira and the Spanish peseta. Britain also massively stepped up its interventions in the foreign exchange market in August of that year, having to borrow excessively to increase reserves. Britain was eventually forced to suspend its membership in the ERM. Herein lies the key differences with today. Support for the euro within member countries is extremely strong. So, while EUR/GBP may have near-term upside, a destabilizing fall in the pound relative to the euro is unlikely. A substantial rise in the EUR/GBP, assuming little euro breakup risk, is a bet on the fact that not only is the pound misaligned versus the German “Deutschemark,” but it is also expensive versus the Italian “Lira” and Spanish “Peseta.” This seems unrealistic. The pound was overvalued as the UK entered the ERM, judging from its real effective exchange rate adjusted for consumer prices. A persistent inflation differential between the UK and Germany had led to significant appreciation in the real rate. That gap is much narrower today (Chart I-8). Moreover, fundamental models show the pound as being very cheap, especially versus the US dollar on both a PPP and productivity basis. During the ERM crisis, most of the adjustment in the pound happened quickly, but a key difference is that it was unanticipated. Foreign exchange markets today are extremely fluid and adjust to expectations quite fast. From its peak, GBP/USD depreciated by 24% by end of October 1992. Peak to trough, cable has fallen by almost 30% today. Given this drop, it is hard to imagine that the probability of a no-deal Brexit is not priced into cable. The real effective exchange rate of the pound is now lower than where it was after the UK exited the ERM in 1992, with a drawdown that has been similar in magnitude (24% in both episodes). In the event a deal is forged, the pound should converge toward the mid-point of its historical real effective exchange rate range, which will pin it at least 15%-20% higher (Chart I-9). Chart I-8Not Much Misalignment In U.K. Prices Today Chart I-9Cable Valuation Reflects Brexit Risk Bottom Line: Go long the pound as a trade but maintain tight stops at 1.20. Our limit sell on EUR/GBP was a whisker from being triggered this week at 0.9. While we will respect this level, long-term investors can start slowly shorting the cross.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Please see Foreign Exchange Strategy Special Report, “Introducing An FX Trading Model,” dated April 24, 2020 avaiable at fes.bcaresearch.com. 2 Please see Foreign Exchange Strategy Weekly Report,  “On Money Velocity, EUR/USD And Silver,” dated October 11, 2019, available at fes.bcaresearch.com. 3 Mathias Zurlinden, “The Vulnerability of Pegged Exchange Rates: The British Pound in the ERM,” Economic Research, Vol. 75, No. 5 (September/October 1993). Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the US have been mostly negative: Retail sales fell by 16.4% month-on-month in April, following an 8.3% decrease the previous month. The preliminary Markit manufacturing PMI increased from 36.1 to 39.8 in May. The services PMI also improved from 26.7 to 36.9. The NAHB housing market index increased from 30 to 37 in May. This follows a contraction in building permits by 21% month-on-month in April and a 30% month-on-month drop in housing starts. Initial jobless claims kept rising by 2438K for the week ended May 15th. The DXY index fell by 1% this week. The DXY index has been stuck in a narrow trading range between 98.50 and 101, ever since the Fed’s swap liquidity programs were unveiled. This suggests a stalemate between weak global growth and improving financial conditions. Report Links: Cycles And The US Dollar - May 15, 2020 Capitulation? - April 3, 2020 The Dollar Funding Crisis - March 19, 2020 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area have been negative: GDP contracted by 3.2% year-on-year in Q1. Employment fell by 0.2% quarter-on-quarter in Q1. The seasonally-adjusted trade surplus narrowed to €23.5 billion from €25.6 billion in March. The current account surplus fell from €37.8 billion to €27.4 billion. The ZEW sentiment index improved from 25.2 to 46 in May. The preliminary Markit manufacturing PMI increased from 33.4 to 39.5 in May. The services PMI also ticked up from 12 to 28.7. The euro increased by 1.7% against the US dollar this week. During a recent speech at the Institute for Monetary and Financial Stability Policy Webinar, the ECB member Philip R. Lane reinforced that the ECB will continue to constantly assess the monetary measures and is fully prepared to further adjust its instruments, which might include increasing the size of the PEPP. Report Links: On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 On Money Velocity, EUR/USD And Silver - October 11, 2019 Japanese Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan have been negative: GDP plunged by 3.4% year-on-year in Q1. Industrial production fell by 5.2% year-on-year in March. Machinery orders fell by 0.7% year-on-year in March, following a 2.4% contraction in February. Exports and imports both fell by 21.9% and 7.2% year-on-year respectively in April. The total trade balance fell from a ¥5.4 billion surplus to a ¥930.4 billion deficit. The preliminary manufacturing PMI fell from 41.9 to 38.4 in May. The Japanese yen fell by 0.9% against the US dollar this week. The Bank of Japan announced on Tuesday that it will hold an emergency policy meeting on Friday, May 22nd, following the bleak GDP data on Monday. Report Links: The Near-Term Bull Case For The Dollar - February 28, 2020 Building A Protector Currency Portfolio - February 7, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the UK have been negative: The unemployment rate slightly decreased from 4% to 3.9% in March. Average earnings including bonuses grew by 2.4% year-on-year. Headline retail price inflation fell from 2.6% year-on-year to 1.5% year-on-year in April. The Markit manufacturing PMI increased from 32.6 to 40.6 in May. The services PMI also improved from 13.4 to 27.8. The British pound increased by 0.9% against the US dollar this week. This week saw the UK selling its long-term government bonds with negative yield for the first time in history. Moreover, the BoE has also not ruled out the possibility of negative interest rates. Please refer to our front section this week for a more detailed analysis on the pound. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 A Few Trade Ideas - Sept. 27, 2019 United Kingdom: Cyclical Slowdown Or Structural Malaise? - Sept. 20, 2019 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia have been negative: The Westpac leading index fell by 1.5% month-on-month in April. Retail sales plunged by 17.9% month-on-month in April. The preliminary Commonwealth manufacturing PMI slipped from 44.1 to 42.8 in May, while the services PMI increased from 19.5 to 25.5. The Australian dollar appreciated by 2.6% against the US dollar this week. The RBA minutes released this week noted that the Australian economy had been severely affected by the COVID-19, and most of the contraction was expected to occur in the second quarter of 2020. The current economic contraction is unprecedented in the 60-year history of the Australian economy. Report Links: On AUD And CNY - January 17, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 A Contrarian View On The Australian Dollar - May 24, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand have been negative: The Manufacturing PMI fell from 53.2 to 26.1 in April. The services PMI also plunged from 52 to 25.9. PPI output prices increased by 0.1% quarter-on-quarter in Q1, while input prices depreciated by 0.3% quarter-on-quarter. House sales plunged by 78.5% year-on-year in April. The New Zealand dollar appreciated by 3.4% against the US dollar this week, making it the best performing G10 currency. The RBNZ indicated that the recent rate cuts have not been transferred via lower mortgage rates or lower retail rates. They have also expressed concerns about a higher mortgage default rate once the 6-month mortgage repayment deferrals expire. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Place A Limit Sell On DXY At 100 - November 15, 2019 USD/CNY And Market Turbulence - August 9, 2019 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada have been negative: Headline consumer prices contracted by 0.2% year-on-year in April, falling into deflationary territory for the first time since 2009. Core inflation fell from 1.6% to 1.2% year-on-year in April. Trade sales contracted by 2.2% month-on-month in March.  Existing home sales plunged by 56.8% month-on-month in April, following a 14.3% decrease in March. The Canadian dollar rose by 1.3% against the US dollar this week. Statistics Canada shows that in April, consumer prices deflation is led by transportation, clothing and footwear, which saw yearly declines of 4.1% and 4.4% respectively. However, consumers paid more for food due to higher demand. Rice, eggs and pork prices rose by 9.2%, 8.8%, and 9% year-on-year respectively in April. In addition, household cleaning products and toilet paper prices also surged in April. 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 Chart II-16CHF Technicals 2 Recent data in Switzerland have been negative: Producer and import prices contracted by 4% year-on-year in April, following a 2.7% yearly decrease in March. Total sight deposits continued to rise from CHF 669.1 billion to CHF 673.5 billion last week. The Swiss franc appreciated by 0.5% against the US dollar this week. Due to the COVID-19 pandemic, KOF published a new forecast for Switzerland in May, which now forecasts the economy to rebound gradually once the current lockdown restrictions are eased. However, tax revenues in Switzerland are expected to fall by over CHF 5.5 billion this year and CHF 25 billion over the next years. Report Links: On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 Portfolio Tweaks Before The Chinese New Year - January 24, 2020 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway have been negative: Exports plunged by 24% year-on-year to NOK 58.8 billion in April. Imports fell by 10.8% year-on-year to NOK 55.5 billion. The trade surplus fell by 78.5% year-on-year to NOK 3.2 billion. The Norwegian krone appreciated by 3.2% against the US dollar this week, fuelled by the recent oil prices recovery. Statistics Norway showed that the recent plunge in exports was mostly led by crude oil, natural gas, and fish exports. Natural gas condensates exports, on the other hand, rose by 44.7% year-on-year in April. That being said, we remain long the Norwegian krone from the valuation perspective. 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 Chart II-20SEK Technicals 2 Recent data in Sweden have been negative: Industry capacity fell slightly from 89.4% to 89.2% in Q1. Total number of employees grew by 0.3% year-on-year in Q1, compared with a 0.4% growth the previous quarter. The Swedish krona appreciated by 2.8% against the US dollar this week. In the latest Financial Stability Report released this Wednesday, the Riksbank highlighted that “if the crisis becomes prolonged, the risks to financial stability will increase”. Moreover, the Bank stated that they are ready to contribute by providing the necessary liquidity to help banks maintaining sufficient credit supply. 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 German bunds and Swiss bonds are no longer haven assets. The haven assets are the Swiss franc, Japanese yen, and US T-bonds. Gold is less effective as a haven asset. During this year’s coronavirus crash, the gold price fell by -7 percent. As such, our haven asset of choice for a further demand shock would be the 30-year T-bond, whose price rose by 10 percent during the crash. Technology and healthcare are the two sectors most likely to contain haven equities. Fractal trade: long Polish zloty versus euro. German Bunds And Swiss Bonds Are No Longer Haven Assets Chart of the WeekGold Is Tracking The US 30-Year T-Bond Price... But The T-Bond Is The Better Haven Asset European investors have been left defenceless. German bunds and Swiss bonds used to be the safest of haven assets. You used to be able to bet your bottom dollar – or euro or Swiss franc for that matter – that the bond prices would rally during a demand shock. Not in 2020. When the global economy and stock markets collapsed from mid-February through mid-March, the DAX slumped by -39 percent. Yet the German 10-year bund price, rather than rallying, fell by -2 percent, while the Swiss 10-year bond price fell by -4 percent.1  The lower limit to bond yields is around -1 percent. The reason is that German and Swiss bond yields are close to the practical lower limit to yields, which we believe is around -1 percent (Chart I-2). This means that German and Swiss bond prices cannot rise much, though they can theoretically fall a lot. Chart I-2German And Swiss Bond Yields Are Near Their Practical Lower Bound The behaviour of German bunds and Swiss bonds during the current crisis contrasts with previous episodes of market stress when their yields were unconstrained by the -1 percent lower limit. During the heat of the euro debt crisis in 2011, the 10-year bund price rallied by 12 percent. Likewise, during the frenzy of the global financial crisis in 2008, the 10-year bund price rallied by 7 percent (Chart I-3 - Chart I-5). Chart I-3German And Swiss Bonds Protected Investors During The 2008 Crash Chart I-4German And Swiss Bonds Protected Investors During The 2011 Crash Chart I-5German And Swiss Bonds Did Not Protect Investors During The 2020 Crash The defencelessness of European investors can also be illustrated via a ‘balanced’ 25:75 portfolio containing the DAX and 10-year German bund. The balanced portfolio theory is that a large weighting to bonds should counterbalance a sharp sell-off in equities, thereby protecting the overall portfolio. The theory worked well… until now. In this year’s coronavirus crisis, the 25:75 DAX/bund portfolio suffered a loss of -13 percent. This is substantially worse than the loss of -2 percent during the euro debt crisis in 2011, and the loss of -7 percent during the global financial crisis in 2008 (Chart I-6 - Chart I-8). Chart I-6A 25:75 DAX:Bund Portfolio Lost 7 Percent During The 2008 Crash Chart I-7A 25:75 DAX:Bund Portfolio Lost 2 Percent During The 2011 Crash Chart I-8A 25:75 DAX:Bund Portfolio Lost 13 Percent During The 2020 Crash What Are The Haven Assets? The lower limit to the policy interest rate – and therefore bond yields – is around -1 percent, because -1 percent counterbalances the storage costs of holding physical cash or other stores of value. If banks passed a deeply negative policy rate to their depositors, the depositors would flee into other stores of value. But if banks did not pass a deeply negative policy rate to their depositors, it would wipe out the banks’ net interest (profit) margin. Either way, a deeply negative policy rate would destroy the banking system. German and Swiss bond prices cannot rise much. German and Swiss bond yields are close to the -1 percent lower limit, meaning that the bond prices are close to their upper limit. Begging the question: what are the haven assets whose prices will rise and protect long-only investors when economic demand slumps? We can think of three. The Swiss franc. The Japanese yen (Chart I-9). US T-bonds. Chart I-9The Swiss Franc And Japanese Yen Are Haven Assets During the coronavirus crash, the 10-year T-bond price rallied by 4 percent while the 30-year T-bond price rallied by 10 percent (Chart I-10). Compared with German bund and Swiss bond yields, US T-bond yields were – and still are – further from the -1 percent lower limit. The good news is that long-dated T-bonds can still protect investors during a demand shock, although be warned that the extent of protection diminishes as yields get closer to the lower limit. Chart I-10Long-Dated US T-Bonds Are Haven Assets What about gold? As gold has a zero yield, it becomes relatively more attractive to own as the yield on other haven assets declines and turns negative. In fact, through the last three years, the gold price has been nothing more than a proxy for the US 30-year T-bond price (Chart of the Week). But gold is an inferior haven asset. During the coronavirus crash, the gold price fell by -7 percent, meaning it did not offer the protection that T-bonds offered. As such, our haven asset of choice for a further demand shock would not be gold. It would be the 30-year T-bond. What Are The Haven Equities? Many investors still use (root mean squared) volatility as a metric of investment risk. There’s a big problem with this. Volatility treats price upside the same as price downside. This is unrealistic. Nobody minds the price upside, they only care about the downside! Hence, a truer metric of risk is the potential for short-term losses versus gains. This truer measure of risk is known as negative asymmetry, or negative skew. In the twilight zone of ultra-low bond yields, bond prices take on this unattractive negative skew. As German bunds and Swiss bonds have taught us this year, bond prices can suffer losses, but they cannot offer gains. This means that bonds become riskier investments relative to other long-duration investments such as equities whose own negative skew remains relatively stable. The upshot is that the prospective return offered by equities must collapse. This is because both components of the equity return – the bond yield plus the equity risk premium – shrink simultaneously.  Equity valuations rise as an exponential function of inverted bond yields. Given that valuation is just the inverse of prospective return, the effect is that equity valuations rise as an exponential function of inverted bond yields. Chart I-11 illustrates this exponentiality by showing that technology equity multiples have tightly tracked the inverted bond yield plotted on a logarithmic scale. Chart I-11Technology Valuations Are Exponentially Sensitive To The (Inverted) Bond Yield Unfortunately, not all equities will benefit from this powerful dynamic. Equities must meet two crucial conditions to justify this exponential re-rating. One condition is that their sales and profits must be relatively resilient in the face of the current coronavirus induced demand shock. And they should not be at risk of a structural discontinuity, as is likely for say airlines, leisure and many other old-fashioned cyclicals. A second condition is that their cashflows must be weighted further into the future, so that their ‘net present values’ are much more geared to the decline in bond yields. Equities that meet these two conditions are likely to benefit the most from the ongoing era of ultra-low bond yields. And the two equity sectors that appear the biggest beneficiaries are technology and healthcare. In the coronavirus world, these two sectors will likely contain the haven equities. Stay structurally overweight technology and healthcare. Fractal Trading System* This week’s recommended trade is to go long the Polish zloty versus the euro. The profit-target and symmetrical stop-loss are set at 2 percent. Most of the other open trades are flat, though long Australian 30-year bonds versus US 30-year T-bonds and Euro area personal products versus healthcare are comfortably in profit.  The rolling 1-year win ratio now stands at 61 percent. Chart I-12PLN/EUR When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated  December 11, 2014, available at eis.bcaresearch.com. Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1 From February 19 through March 18, 2020. 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 Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields   Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations  

Feature The SPX suffered its third 5.3-7.3% pullback since early April last week, which we deem a healthy development as markets cannot go up in a straight line. While there is a chance this latest pullback may morph into a correction, our sense is that equities will remain range bound in the near-term consolidating the vast gains made since the March 23 lows. Now that earnings season is practically over and macro data will remain backward looking, a large void signals that technicals will dominate trading. On that front, this looming lateral move will likely confine the SPX between the critical 50-day and 200-day moving averages – a roughly 10% range between 2,712 and 3,000 – until a catalyst breaks the stalemate (top panel, Chart 1A). With regard to the cyclical outlook, ultra-accommodative fiscal and monetary policies remain the dominant macro themes, and underpin our sanguine equity market view for the next year. Chart 1AConsolidating Gains Dollar The Reflator Importantly, King Dollar is a key macro variable that we are closely monitoring and as we highlighted last week, the Fed is indirectly aiming at jawboning the greenback.1 US dollar based liquidity is one of the most important determinants/drivers of global growth. The longer US dollar liquidity gets replenished, the more upward pressure it will put on SPX momentum and SPX EPS (Chart 1B). Sloshing US dollar based liquidity will serve as a much needed catalyst for a global growth recovery. Chart 1BHeed The Message From US Dollar Liquidity: Chart Of The Year Candidate The Yield Curve, Interests Rates And Profits Meanwhile, the yield curve, in fact a number of different yield curve slopes, troughed prior to the SPX in March, preserving its leading properties both near equity market tops and bottoms (middle & bottom panels, Chart 1A). The Fed orchestrated the steepening of the yield curve – which is typical during recessions – with the two preemptive cuts in March. Crucially, the yield curve is signaling that in the back half of the year SPX profits will also trough. True, a profit shortfall is upon us in Q2, and the steeper the fall, the higher the chance of a V-shaped recovery, owing to base effects (yield curve shown advanced, Chart 2). Chart 2Steep Yield Curve Slope Will Reflate Profits Encouragingly, the Fed reiterated last week that it will remain ultra-accommodative. While it will refrain from delving into NIRP, QE5 can expand anew and sustain the perching of the 2-year and even the 5-year and 7-year Treasury yields near zero. In fact, the shadow fed funds rate is already below zero as we highlighted last week.2 This monetary backdrop coupled with rising fiscal deficits as far as the eye can see – which will put upward pressure on long-term Treasury yields – will ensure a steep yield curve, and thus engineer a profit recovery (Chart 2). With regard to the interplay of interest rates and profit growth, the two are tightly inversely correlated (Chart 3). Empirical evidence suggests that since the mid-1980s profit growth is the mirror image of the year-over-year change in 7-year Treasury yields, albeit with a significant lag. Chart 3Interest Rate Pummeling Is A Boon For EPS What EPS Growth Is Discounted? Currently, if the relationship between profits and yields were to hold, then SPX EPS growth would stage a sizable come back in 2021. Chart 4 depicts the sell side’s quarterly EPS forecasts all the way to end 2021. Indeed, following a steep contraction, a brisk V-shaped profit recovery is looming in 2021 as we first argued three weeks ago that “historical precedents show an explosive year-over-year growth increase in EPS from recessionary troughs”.3 In more detail, Chart 5 breaks down 12-month forward EPS growth per sector. Tech comes out on top and by a wide margin with a near double-digit profit growth rate in absolute terms. This gulf is even more pronounced relative to the contracting SPX EPS growth rate. In fact, tech relative profit growth just reached the highest level since 2004 and explains the broad market’s tech dependence. As a reminder, tech market cap is back to the 2018 peak despite the fact the GOOGL and FB have now moved to the newly formed S&P communication services index. If one were to add the pair and AMZN back to the tech sector’s weight, it would comprise over 36% of the SPX, higher even than the dotcom bubble era (Chart 6)! Chart 4V-Shaped Profit Recovery Chart 5Tech… Chart 6…Reigns Supreme Tech Titans Digression A brief digression is in order as it pertains to the tech titans. We have been inundated with requests recently on the subject of valuations and the concentration of returns in the top five SPX stocks. We first commented on this in January, and reiterate today that the current tech sector’s supposed overvaluation is nowhere near the dotcom excesses .4 Back then, the top five SPX stocks commanded a forward P/E over 60, but today’s valuation pales in comparison with the late-1990s, as the equivalent P/E is roughly half that multiple (please refer to Chart 2 of the January 27, 2020 Weekly Report). Why? Because at the turn of the millennium, tech stocks had very little earnings to show for, but now the tech sector has the largest profit weight among its GICS1 peers. Thus, tech stocks trade at a modest 9% premium to the broad market whereas in 1999 they were changing hands at more than twice the SPX multiple (Chart 7). Chart 8 attempts to shed more light on the subject. The top panel shows the overall SPX market cap and also excluding the top five stocks. Then we subtract the top five stocks’ forward P/E from the broad market and show where the S&P 500 ex-top five stocks P/E trades (second panel, Chart 8). Since the FB IPO, these stocks have indeed increased their influence on the broad market’s valuation (third panel, Chart 8). Chart 7What Relative Overvaluation? Chart 8Top Five Are Pricey, But For Good Reason Sectorial Profit Growth Breakdown Circling back to the breakdown of 12-month forward EPS growth per sector, traditional defensive sectors (utilities, staples and health care) all enjoy positive 12-month forward profit growth in absolute terms, and so do communication services that just kissed off the zero line. All other sectors are contracting at differing degrees (Chart 5). On a longer-term basis, as expected no GICS1 sector is slated to contract, but their five-year growth rates are widely dispersed. Consumer discretionary, real estate, materials and tech occupy the top ranks with double digit growth rates, while utilities, consumer staples, energy, industrials and financials are in mid-single digits and at the bottom of the pit. Communication services and health care hover in the middle, on a par with the broad market (Chart 9). Chart 9Long-Term Growth Has Reset Lower Higher Profits Are Synonymous With Higher Returns Intuitively, the higher the forward profit growth rate, the higher each sector’s trailing return. Chart 10 depicts this positive correlation on the GICS1 sectors and corroborates that the laggard energy sector has the lowest year-to-date return, whereas tech stocks lead the pack. Importantly, SPX sector profit weights are extremely important. Chart 11 ranks the GICS1 sectors 12-month forward profit weights. Tech, health care and financials comprise roughly 60% of total S&P 500 earnings for the coming year. Whereas the drubbing in the energy sector (83% projected EPS contraction) has drifted into oblivion within the SPX context and has a mere 0.5% profit weight (Chart 11). Chart 10Higher Growth = Higher Returns Chart 11Top three Comprise 60% Of Profit Weight Bottom Line: While the top three sectors inherently carry the bulk of the risk on the SPX earnings front courtesy of the high concentration, our sense is that both tech (neutral) and health care (overweight) will deliver according to the messages from our macro EPS growth models (Chart 12). Financials (overweight) profits are a question mark, and therefore pose the greatest risk to our still constructive 9-12 month broad equity market view.     Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com Chart 12EPS Growth Models Emit Positive Signals   Footnotes 1     Please see BCA US Equity Strategy Weekly Report, “The Bottomless Punchbowl” dated May 11, 2020, available at uses.bcaresearch.com. 2     Ibid. 3    Please see BCA US Equity Strategy Weekly Report, “Gauging Fair Value” dated April 27, 2020, available at uses.bcaresearch.com.          4    Please see BCA US Equity Strategy Weekly Reports, “Three EPS Scenarios” dated January 13, 2020 and “When The Music Stops...” dated January 27, 2020, available at uses.bcaresearch.com.  

Highlights At 50% Trump’s reelection odds are too high, flagging a risk to equity markets of policy discontinuity. The virus, unemployment, and wages will weigh on him over the year. Trump’s polling is firm because the crisis is still acute. If it remains firm when the dust settles then we will reassess. Trump is competitive in swing states, but not clearly leading. The stock market, as a single variable, is an excellent gauge of reelection odds for ruling parties in US elections going back to 1896. It gives Trump a 16% chance as of today. This is too low, but unemployment and wages also suggest he is an underdog. Michelle Obama and Justin Amash are potential spoilers flying under the radar. The Senate will follow the White House, signaling an understated risk of a total policy reversal and hard left turn in US policy. Massive stimulus motivates our long run risk-on trades: cyber security, infrastructure, Fed-backed corporate bonds, and China reflation plays. Europe and European industrials stand to benefit on a relative basis if Biden wins. Feature Chart 1Recent Poll Shows Trump Leads In Swing States President Donald Trump’s reelection bid is holding up better than we expected so far this year. Trump leads former Vice President Joe Biden in swing states by 52% to 45%, according to a poll taken by CNN from May 7-10 (Chart 1). Our poll of polls below are not as supportive, but this is a strong sign of competitiveness for a sitting president in the midst of a pandemic, recession, social unrest, and controversy over reopening the economy. Naturally several clients have pushed back against our decision to downgrade Trump’s chances of victory from 55% to 35% back in March. We don’t mind the heat – we took the heat for two years while we favored Trump for reelection. Moreover we are not dogmatic. If the facts change, we will change our minds. So far, we are sticking to our view. It is a view that implies risk to corporate earnings and hence supports a tactically bearish or short positioning on the S&P 500. If Trump maintains and builds on his popular support, particularly by August when the Republican and Democratic parties hold their conventions, then we will upgrade his odds, assuming that the economy is improving and the pandemic is abating. At present the market is underrating the challenges facing the president, as we outline in this report. Reopening Poses Downside Risks To Trump Chart 2US Follows The Swedes So far reopening is helping Trump, but it poses a major risk to him down the line this year. The election is five months away – a world away. The new “whistleblower’s complaint” against the Trump administration argues that America faces its “darkest winter in modern history” due to the impending second wave of the virus. However, we rely on the testimony of Anthony Fauci to the Senate this week. Fauci said that states can continue to reopen as long as they adhere to federal guidelines that require 14 days of declining cases in the first phase. June 1 is an acceptable time for most states to open. The trajectory of US deaths per million is deviating from the path of the European Union and moving toward the path charted by Sweden. Swedes have adhered strictly to looser guidelines; Americans have adhered loosely to stricter guidelines. The US death count per million people, a lagging indicator, will rise or at least remain flat in the coming months if states and individuals are not vigilant and compliant (Chart 2). One should assume, however, that governments and individuals will alter their behavior for the sake of self-preservation and in light of new information. Interior American states – those not included in the “COVID confederacy” of western and eastern Democratic states – have seen a tentative drop in deaths (Charts 3A & 3B). While looser restrictions will lead to higher deaths than otherwise, it is not a foregone conclusion that it will be unmanageable for the health system. Chart 3AInterior US Sees Rising COVID Cases … Chart 3B… And Deaths Could Rise From Here From an Electoral College perspective – an absurd way to look at a pandemic, but such are the times – the red states will see an accelerating case count and death toll if they do not actively manage the reopening process (Charts 4A & 4B). This is a political liability. Chart 4ARed States Stable In Case Count … Chart 4B… Yet Deaths Could Tick Up Expectations that Trump is a slam dunk for reelection neglect the obvious fact that interior states shut down before they suffered the full brunt of the pandemic. If new outbreaks spiral out of control, it will have a negative political ramification for those pushing for a quick reopening. That will eventually accrue to the president, with whom the buck stops. A resurgence of infections, whether this summer or this fall, will be met with better preparedness, in terms of non-pharmaceutical intervention (social distancing) and likely pharmaceutical intervention as well (anti-virals, probably not yet a vaccine). But the virus is now underrated as a political risk since President Trump is fully identified with the decision to “liberate” the states yet his polls are firm and online gamblers on sites like PredictIt are giving him a roughly 50% chance of winning reelection. Bottom Line: If outbreaks spiral out of control in swing states then the incumbent president and ruling party will be punished. The evolution of cases and deaths is critical in the near term. Uncertainty over reopening, and understated risks of political change, call for a higher equity risk premium and hence more downside for share prices. Trump’s Approval Gains Are Slight Americans are hitting “peak polarization” this year and the coming years. It is well known that partisanship is affecting voters’ views on objective reality. But notice that all consumers are getting more optimistic about the future, not just Republicans (Chart 5). Chart 5Sentiment Is Polarized But Everyone Sees Improvements On Horizon Uncertainty over reopening and understated risks of political change, call for more downside for share prices. There is a clear bifurcation in voter’s opinions of Trump’s handling of the economy as against the pandemic. Voters approve less and less of his pandemic response; they disapprove less and less of his handling of the economy (Charts 6A & 6B). Chart 6ATrump’s Approval Falling On COVID-19 … Chart 6BYet Supported On Economy Chart 7Voters Wary Of Reopening Too Fast The implication is that if the economy is the single biggest issue in November, then Trump made the right electoral call to reopen fast and focus on presiding over the biggest stimulus in history. Yet a clear majority feels the country is lifting restrictions too quickly. Only a slight majority of Republicans agree with him (Chart 7). Recent Emerson and Marist polls reinforce the point that the economy is the most important issue. Biden is leading Trump on the coronavirus – and notably leading older voters on both issues (Charts 8A & 8B). Chart 8AVoters Still Most Concerned About The Economy Chart 8BYet One Poll Says Biden Gaining Lead On Both Economy And Pandemic Trump’s national approval rating remains underwater, but it has gradually converged with the average of American presidents (Chart 9). A major incident of social unrest – which is possible given active protest movements amid high polarization – would hurt him. The lowest point in his approval rating occurred in August 2017 during the Charlottesville, Virginia protests against taking down a statue of Confederate General Robert E. Lee that turned bloody. Incidents of social unrest will be exploited by both political extremes, but a rise in unrest in general would cause anxiety among middle-of-the-road voters and tend to hurt the ruling party. Chart 9Trump Rising – But Social Unrest A Risk Chart 10Trump Not Yet Clearly On Obama Trajectory Chart 11Trump Gaining Among Hispanics, But Slight Dip Among Elderly Comparing Trump’s approval rating to his immediate predecessors is more realistic because general presidential approval has declined over time due to polarization. On this front, Trump is falling short of President Obama at this stage in 2012. Of course, he could still rally in the lead-up to the campaign, as is typical of sitting presidents (Chart 10). An important caveat is that Trump is making headway in unexpected voting groups. His support is surging among Hispanics, who are disproportionately hurt by economic lockdowns due to the sectoral concentration of their labor, yet less likely to die of COVID-19 (most likely because they are a younger cohort relative to blacks and whites). Moreover this trend began before the coronavirus and coincides with a rise in approval among electorally vital Midwesterners, as well as young people (Chart 11). The implication is that Democrats’ decision to impeach Trump has helped him, just as we argued it would last year, and yet COVID-19 has not reversed his gains. Older people, as mentioned, are a very important exception. They are the critical voting bloc and most susceptible to the virus. They are tentatively becoming less approving of the president. This is according to this Gallup poll, to the CNN poll highlighted at the top of this report, and the aforementioned poll in Chart 8 above. The right-leaning pollster Rasmussen – a proxy for those trying to avoid anti-Trump skews in polling due to any self-censorship or methodological biases – shows that Trump’s approval rating bottomed at a slightly lower level than it did when the Zelensky call appeared last fall, but not as low as during the market plunge and political controversies of late 2018 (Chart 12). This is good news for Trump. Chart 12Trump Reviving From Virus Hit, Shows Rasmussen Polling Chart 13Trump’s Polling Bounce Small Relative To Peers Yet Trump’s polling “bounce,” as the nation rallies around his leadership amid crisis, is small at two percentage points. Other leaders have gotten bigger boosts (Chart 13). More importantly, Trump’s polling bounce is miniscule compared to the average bounce for American presidents during crises that assail the US from the outside (Table 1). Table 1Trump’s Crisis Polling Bounce Compared To Previous Presidential Bounces Bottom Line: Trump is holding up surprisingly well with voters amid the crisis given his past polling. This is an important signal. But it is important to see if it is sustained after the acute phase passes. His polling gains are small relative to US history and contemporary peers. His consistent strong marks on the economy only matter if the economy is the chief issue of the election, but the pandemic creates a major risk that this election could be one of the unusual elections in which a non-economic issue is the most salient. Trump Isn’t Winning In Head-To-Head Polls Earlier we highlighted Trump’s lead in swing states, according to the latest CNN poll. But in our aggregate of polls, Biden is leading in all swing states except Ohio (Chart 14A). Chart 14ABiden Leads Swing State Poll-Of-Polls Except Ohio The lead is within the margin of error in Wisconsin, Florida, and Arizona, meaning the candidates are effectively tied. But that reflects negatively on the sitting president, since incumbents have an advantage over challengers, and Biden is widely known to be a deeply flawed challenger. Trump has taken a big hit in head-to-head polls in critical states. Moreover the year-to-date change in these head-to-head polls suggests that Trump has taken a big hit in critical states: Florida, Arizona, and even Ohio, which should be rock solid for him (Chart 14B). Chart 14BTrump Suffered Blow From Virus In Swing State Poll-Of-Polls The consolation for Trump is that Biden, “Sleepy Joe in the basement,” who is fending off mounting accusations of sexual misconduct against Tara Reade, has either lost ground or made negligible gains. Clients often tell us they do not trust the polls. But post-WWII history shows that polls are fairly accurate and more accurate for sitting presidents than their challengers. Incumbents have averaged 55% of the popular vote, versus 49% for challengers, a clear indication of the incumbent advantage (Chart 15A). Chart 15ASitting Presidents Usually Win The Popular Vote Voter intentions in October and November ahead of the election are usually only 0.8% lower than the sitting president’s actual vote share. However, the same polls tend to underrate challengers by 2.2% (Chart 15B). Chart 15BPolling Is Accurate – Yet Underrates Challengers More Than Incumbent Presidents Chart 16Trump’s Favorability Less Negative, Biden’s Turns Negative Favorability polling is of limited relevance, given that the candidates for president in 2016 and 2020 are the least favorable of all politicians. Polarization makes it so that being hated by the other party is an asset. But it is notable that Trump’s net favorability is not half as negative as it was in 2016, and that he is tied with Biden, whereas Biden has fallen a great distance since the last economic crisis, when he had greater favorability than Barack Obama (Chart 16). Bottom Line: The candidates are virtually tied in the swing states and Biden’s slight lead in our poll-of-polls has not benefited from the crisis. Incumbents tend to outperform their polling by one point, but challengers tend to outperform by two. Biden is manifestly a weak challenger but taking all the evidence together he has a slight lead at present in the swing states. Stock Market And Recession Are Worrisome For Trump Table 2Trump’s Odds 50% At Most Based On Historic Recession/Election Probabilities US elections are a referendum on the incumbent party. Recessions tend to destroy sitting presidents. This is true, but there are important exceptions. A close look at the odds of sitting presidents, as well as sitting parties, and the timing of when the economy resumes expansion, suggests that Trump’s odds of winning are at best 50/50 (Table 2). Our own quantitative election model shows the same thing, and has hovered at 51% all along, although it will flip key states against him once state-level data are updated for the collapse in the economy. Fernando Crupi, of BCA Research Commodity & Energy Strategy, shows what a simple and straightforward look at the S&P 500 implies about Trump’s odds. Together we looked at two variables in elections since 1896: the market performance year to date on October 31 of the election year, and the result of the election for the incumbent party, i.e. victory if the incumbent party is reelected or loss if the new president hails from the opposing party. To estimate the probability of victory we use a logistic model, a widely used statistical tool designed to predict probabilities which can only range between zero and one, never hitting them.1 It is virtually impossible for an election outcome to be certain. The results are as follows: The year-to-date performance of the S&P 500 is a statistically significant variable (at the 5% level) in determining the fate of an incumbent party and has a positive correlation with it. Out of 31 elections, the model correctly predicted the outcome of 77% of the elections in-sample. While this is far from perfect it is remarkable given that we are using the market performance as the only explanatory variable. The effect of an additional percentage point of stock market performance is not linear on the incumbent party’s re-election odds, so two numbers are worthwhile expressing. At the mean S&P 500 YTD performance of the 31 elections, an additional percentage point increase in the market would increase the incumbent party’s odds of winning by 2.8 percentage points, and a decrease would decrease it by the same. By comparison, for all possible values of market performance, the average effect of an additional percentage point increase (or decrease) of the market would increase (or decrease) the probability of an incumbent party re-election by 2.1 percentage points. Chart 17 helps to visualize the model – for any percentage of market performance YTD as of October 31, it shows Trump’s odds of reelection this fall. With the S&P down by 13% this year, Trump’s odds would be 16%. A 10ppt recuperation in the S&P 500 from here would increase his chances to 40% and a 15ppt recuperation would bring him to 55%. Chart 17The Stock Market Says Trump’s Reelection Odds Are 16% Obviously the stock market is likely to rally or sell off for various reasons, for instance, if it thinks that the economy will get worse and the incumbent will lose. A change of government introduces policy uncertainty. Our own electoral model, explained in previous reports, is more robust than this back-of-the-envelope experiment and produces a more favorable outcome for Trump. So while the S&P may be low-balling Trump at 16%, we have no basis either in history or in formal modeling to give him more than a 50% chance as things stand today. And subjectively we think 50% is too high. Presidential approval follows the unemployment rate in the final innings of the campaign. Trump is doomed by this measure. Lastly, to reiterate and update key points we have made in the past: Presidential approval tends to follow the unemployment rate in the final innings of the campaign. Trump is obviously doomed by this measure, as it is the net change over time that matters most (Charts 18A & 18B). Chart 18AUnemployment Rate A Huge Chart 18B… And Tends To Predict Voter turnout is one of the hardest variables to predict, but it follows pretty closely with the change in unemployment over the preceding four years in the swing states. High turnout amid a deep recession is negative for the incumbent president (Chart 19). Chart 19Surge In Unemployment Positive For Turnout, Yet Hurts Incumbent Our subjective probability of reelection, at 35% as of March 24, holds up pretty well in this light. We will adjust this as new evidence comes to light. Bottom Line: To claim that Trump’s odds of reelection are substantially higher than 50% is to argue that “this time is different.” The market should keep falling from its April 29 peak around 2950 not only because of uncertainty about the pandemic and economy but also because of the risk that Trump’s troubles lead to market-negative outcomes. Michelle And Justin As Spoilers With multiple overlapping crises and high polarization, we have highlighted the high potential for extreme events, black swans, and spoilers. These do not include any move of the election date – that would make Trump look weak and would require House Democrats to agree to change a key 1845 statute.2 But they include almost everything else: violent incidents, disputes over voting methods amid the virus, vote recounts, judicial interventions, Electoral College irregularities, congressional intercession, refusals to concede, you name it. We would not be surprised if the Supreme Court took an opportunity currently before it to rule in favor of punishments against “faithless electors” or even to prohibit electors from voting contrary to the popular will in general. On a much less important note, we would also not be surprised if the high court enables President Trump’s personal accounts and tax records to be subpoenaed. Another possible spoiler: Michelle Obama. Chart 20Michelle Obama Objective Best Pick For Vice President Biden is currently mulling his pick for the vice presidential candidate. None of the candidates are magical: Senator Amy Klobuchar makes the most sense of the conventional options as she could improve his standing among women, Midwesterners, white voters, and suburbanites. She hails from Minnesota, he from Pennsylvania, creating a potential pincer movement in the Electoral College. Klobuchar’s favorability is stronger than that of Senators Elizabeth Warren and Kamala Harris, neither of whom can help bring a swing state (Chart 20).3 Yet Warren is well known and could help mend the gap with the progressive wing of the party. Picking her highlights the understated risk to the market of a progressive turn in Biden’s platform. Stacey Abrams could help bring over the black vote but she is sorely lacking in credentials and is reminiscent of the GOP’s desperate and failed bid to reconnect with its base by nominating Sarah Palin in 2008. The obvious choice is Michelle Obama. She has the highest favorability by far, including when her detractors are netted out. She solidifies Biden’s connection with Barack Obama, helps energize progressives, women, and minorities who are needed to turn out. And her power base is in the Midwest. One little problem … Michelle has repeatedly said she does not wish to run. Others have confirmed she has no interest. And a Machiavellian political adviser could advise her to wait until later when there is no incumbent president and then run directly for the top job, free of Biden’s baggage. We held the latter view, until the corona crisis. Trump was heavily favored prior to recession. Now the tables have turned. And a vice presidential role would improve her chances of being the first woman president later. The fact that she apparently does not want to run is obviously a huge problem. But her party needs her and this fact may become increasingly evident as Biden’s weaknesses are exposed. Vice presidential picks seldom make a difference in the campaign. At best they can help bring a swing state. But this election is different. Biden would turn 78 immediately after being elected; he is more likely than the average president to depend upon his VP while ruling, and to pass the baton to the VP early. COVID-19 underscores this risk. In other words, this year is the rare case where the Veep pick is important enough to matter and a charismatic candidate exists who could materially improve the odds of the opposition party’s victory. Would Michelle really help? An argument could be made that the Obama legacy is tarnished and that Trump would relish the chance to run against the Obama brand. However, our reasoning is based on Electoral College scenarios drawn from the best demographic data available, which suggest that the strongest challenge the Democrats can mount in 2020 is to reproduce the 2012 Obama/Biden ticket (Chart 21). Chart 21Electoral College Scenarios Say Biden/Obama 2012 Redux Best Shot For Dems To Beat Trump Chart 22Amash Is Small, But Significant Another important potential spoiler is Justin Amash. Amash is a former Republican who defected from the party due to his opposition to Trump and has since become the nation’s first congressman of the Libertarian Party. Amash could be important because he hails from Michigan, a key swing state, and is a splinter from the right-wing rather than the left-wing, thus potentially threatening President Trump’s thin margins in the battleground states. Currently Amash is winning 3%-5% of the popular vote, according to polls (Chart 22). Historically an extremely elevated third party vote is a threat to the incumbent president and ruling party, regardless of ideological affiliation. This is because it bespeaks general popular discontent, which in turn reflects negatively on the status quo and ruling party. However, so far Amash is not popular enough to hit the extremely elevated threshold. Looking at third party candidacies that have drawn more than 2% of the vote over history, the incumbent party wins 50% of the time. So the historical results are indecisive, but they do show potential for Amash to play the spoiler (Table 3). Table 3How Do Sitting US Presidents And Their Parties Fare When Voters Turn To Third Parties? Furthermore a larger group of Democrats and Democratic-leaning voters are determined not to vote for Biden than Republican and Republican-leaning voters are determined not to vote for Trump (Chart 23). The Republican Party rank and file support Trump enthusiastically, more so than Democrats support Biden, especially in the swing states (Chart 24). This suggests that Amash will fail to get traction among Republicans. Chart 23Left-Leaners Reject Biden More Than Right-Leaners Reject Trump Chart 24GOP More Zealous For Trump Than Dems For Biden We would not rule him out, however. The context of pandemic, deep recession, and extreme polarization is fertile for a third party candidate, as was the case in 2016. If support for Trump wanes due to the mounting death toll and unemployment rate, the weakness of Biden might point to defections from Trump’s camp to Amash. Again, this could be particularly relevant in swing states. Amash may not garner more votes than Gary Johnson, his Libertarian predecessor in 2016, since that year saw an “open election” favorable to third parties, whereas this year there is an incumbent running. But Amash has flown entirely under the radar. He is therefore underrated by markets. And his impact, in the final analysis, will likely prove more negative for the ruling party than Biden, who is very far from a libertarian. Bottom Line: Peak polarization and a historic national crisis will produce black swans. But some spoilers are identifiable. Biden picking Michelle Obama, and a small but significant margin of Republicans defecting to Amash in swing states, are non-negligible risks to Trump’s reelection odds. What About The Senate? Democrats are likely to retain the House of Representatives, unless the positive trends for Trump that we have highlighted start to snowball into massive momentum. Hence the Senate will be decisive to the legislative success of the next administration. It is especially relevant if a Democrat wins, since the implication would be single party control of both legislative and executive branches. By contrast, Trump’s reelection would imply a continuation of today’s balance of power. Online gamblers have finally come around to our long-held view that the Senate will go the way of the White House: currently PredictIt gives the Democrats a 52% chance, up substantially from last year. Republican Senate leaders have openly aired their fears as the election cycle picks up. The risk to Republican control is not merely because the crisis has erased the uptick in Republican Party affiliation (Chart 25), nor is it due to the break in Republican momentum in generic voter party support (Chart 26), though these developments are unwelcome to Republicans. Chart 25Republican Affiliation Of Voters Rolls Over Chart 26Democrats Tick Up Slightly In Generic Congressional Ballot Rather, politics have increasingly become nationalized and more Republican senators are at risk than Democrats due to the windfall Republican senate victory in 2014. Current polling reinforces that the Senate stands on a knife’s edge, as all races are virtually tied, except Colorado, which is a likely shoo-in for Democrats. Arizona is almost as good for them (Chart 27). Democrats need to take four seats plus the White House to win the chamber. Chart 27Close Races In Senate Will Follow The White House Bottom Line: The Senate will go the way of the White House, which means the market is not only underrating a Biden victory but also underrating the probability that he is unconstrained. With peak polarization, and full Democratic control, Biden would not prove a center-left president in office. He would end up governing to the left of the Obama administration. Investment Takeaways Why does the election matter? If Trump loses, the United States will most likely see another total reversal of national policy, as in 2016 and 2008. Yet this time the macroeconomic, political, and demographic backdrop will make it harder for Republicans to stage as effective of resistance as in 2010-16. This is positive for aggregate demand, due to fiscal policy, but negative for corporate earnings. Biden will be pushed to the left by the progressive wing of his party and will face relatively few legislative or judicial constraints. The Democrats will also surprise the market with a tough stance toward China to steal back the mantle of fighting for American workers. Big business will face higher taxes, sweeping re-regulation, and trade restrictions, all at the same time. The S&P 500 has fallen 4% since we recommended investors step back from the rally. We see more downside due to sluggish recoveries, viral outbreaks, hiccups in providing stimulus, and political and geopolitical risks. The S&P’s next support levels are at 2670 and 2250. Chart 28China Faces Protectionism Either Way, But Europe Only With Trump In the short term, Trump’s odds are overrated. We will upgrade him if the stock market, economy, and political indicators improve substantially from what we are seeing today by August when the two parties hold their conventions. What about our view that Trump will crack down on China? A crackdown will cause the S&P to sell. Yet a dramatic selloff that destroys his reelection hopes, or a rally based on massive stimulus, both encourage him to escalate the crisis. Politically, confronting China is positive for him and he cannot let Biden outmaneuver him on workers, trade, and China. This entire dynamic leaves us inclined to be risk-averse. For investors with a long time horizon we recommend selective risk-on investments such as cyber-security, infrastructure, China reflation plays, and investment grade corporate bonds, the latter now backed by the Federal Reserve. A parting thought on industrials. Gargantuan stimulus is positive for cyclical stocks over the long run. But Trump’s reelection raises the prospect of trade war not only with China but also with Europe. It also increases the substantial risk of an expanding conflict with Iran that sows unrest in the Middle East over the next five years. Whereas Biden would seek a united front with Europe against China and would reduce Middle Eastern risks to Europe. Hence over the long run European industrials can benefit disproportionately from a Biden win, on a policy-oriented basis, compared to a Trump win (Chart 28).     Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com Fernando Crupi Research Associate fernandoc@bcaresearch.com Footnotes 1 Compared to a simple regression line, the effect of the explanatory variable on the predicted probabilities varies along the curve. An increase (or decrease) in our explanatory variable by one unit has a smaller and smaller effect on the probability of victory as we approach our upper and lower probability bounds of 0 and 1. Obviously this model cannot fully explain the outcome of an election nor establish causality, but it gives us a good indication of how important the market performance is for an incumbent party to be re-elected. 2 Please see Acts of the Twenty-Eight Congress of the United States, Statute II, Library of Congress. www.loc.gov. 3 The only superior scenario mathematically, in which Biden aims solely at winning back the Democrats’ old blue collar white voter base, is much less likely to succeed given that these voters have drifted to the GOP in recent decades and have been galvanized by Trump.