Fixed Income

Highlights Social distancing must persist to prevent dangerous super-spreading of COVID-19. The jobs recovery will be much weaker than the output recovery, because the sectors most hurt by social distancing have a very high labour intensity. This will force a prolonged period of ultra-accommodative monetary policy… …structurally favour T-bonds and Bonos over Bunds and OATs… …growth defensives such as tech and healthcare… …and the S&P 500 over the Euro Stoxx 50. Stay overweight Animal Care (PAWZ). Working from home has generated a puppy boom. Fractal trade: short gold, long lead. Feature As economies reopen, economists and strategists are quibbling about the shape of the output recovery: U, V, W, square root, or even ‘swoosh’. But for the furloughed or displaced worker, the more urgent question is, what will be the shape of the jobs recovery? Unfortunately, the jobs recovery will be much weaker than the output recovery – because the sectors most hurt by social distancing have a very high labour intensity (Chart Of The Week). Chart Of The Week 1ALeisure And Hospitality Makes A Large Contribution To Jobs Relative To Output Chart Of The Week 1BFinance Makes A Small Contribution To Jobs Relative To Output Output Might Snap Back, But Jobs Will Not The sectors most hurt by social distancing make a huge contribution to employment but a much smaller contribution to economic output. This is true for Europe and all advanced economies, though the following uses US data given its superior granularity and timeliness. The leisure and hospitality sector generates 11 percent of jobs, but just 4 percent of output. Retail trade generates 10 percent of jobs, but just 5 percent of output. It follows that if both sectors are operating at half their pre-coronavirus capacity, output will be down by 4.5 percent, but employment will collapse by 10.5 percent. Conversely, sectors which are relatively unaffected by social distancing make a small contribution to employment but a much bigger contribution to economic output. Financial activities generate just 6 percent of jobs, but 19 percent of economic output. Information technology generates just 2 percent of jobs, but 5 percent of output (Table I-1). Table I-1Sectors Hurt By Social Distancing Have A Very High Labour Intensity If economies are reopened but social distancing persists – either via government policy or personal choice – then output can rebound in a V-shape, but employment cannot (Chart I-2). Forcing a prolonged period of ultra-accommodative monetary policy, with all its ramifications for financial markets. Chart I-2UK Unemployment Is Set To Surge If The US Is Any Guide This raises a key question. Must social distancing persist? To answer, we need to pull together our latest understanding of COVID-19. COVID-19: What We Know So Far Many people argue that coronavirus fears are disproportionate. The mortality rate seems comfortingly low, at well below 0.5 percent (Chart 3). Yet this argument misses the point. Chart I-3The COVID-19 Mortality Rate Is Not High COVID-19 is dangerous not because it kills, but because it makes a lot of people seriously ill. It has a low mortality rate, but a high morbidity rate. According to the World Health Organisation, around one in six that gets infected “develops difficulty in breathing”. Moreover, The Lancet points out that many recovered COVID-19 patients suffer pulmonary fibrosis, a permanent scarring of the lungs that impairs their breathing for the rest of their lives. Hence, while COVID-19 is highly unlikely to kill you, it could damage your health forever1 (Figure I-1). Figure 1COVID-19 Is Unlikely To Kill You, But It Could Permanently Damage Your Lungs The most famous COVID-19 victim to date is British Prime Minister Boris Johnson who spent several days recovering in intensive care. By his own admission, Johnson’s only pre-existing conditions are that he is overweight and “drinks an awful lot”. But those pre-existing conditions could apply to a large swathe of the population. COVID-19 is virulent. But we now know that most infections are the result of so-called ‘super-spreaders’ – a small minority of virus carriers who infect tens or hundreds of other people. We also know that talking loudly, singing, or chanting tends to eject higher doses of the virus, and in an aerosol form that can linger in enclosed spaces. This creates the perfect conditions for one infected person to infect scores of others very quickly.  Based on this latest knowledge, the good news is that economies can reopen. The bad news is that, until an effective vaccine is developed, social distancing must persist. Specifically, people must avoid forming the crowds, congregations, and loud gatherings that can generate very dangerous super-spreading events. Hence, the sectors that are most hurt by social distancing – leisure and hospitality and retail trade – will continue to operate well below capacity for many months, at a minimum. And as these sectors have a very high labour intensity, there will be no V-shape recovery in jobs. Without Higher Bond Yields, European Equities Struggle To Outperform Social distancing is set to persist, which will create heaps of slack in advanced economy labour markets. This will force central banks to push the monetary easing ‘pedal to the metal’ – though in many cases, the pedal is already at the metal. In turn, this will force bond yields to stay ultra-low and, where they can, go even lower. One immediate takeaway is to stay overweight positively yielding US T-bonds and Spanish Bonos versus negatively yielding German Bunds and French OATs. Depressed bond yields must also compress the discount rate on competing long-duration investments that generate safely growing cashflows. Meaning, growth defensive equities such as technology and healthcare. Now comes the part that is conceptually difficult to grasp because it is novel to this unprecedented era of ultra-low bond yields. Take some time to absorb the following few paragraphs. For growth defensives, both components of the discount rate – the bond yield and the equity risk premium (ERP) – compress together. This is because the ERP is a tight function of the difference in equity and bond price ‘negative asymmetries’, defined as the potential price downside versus upside. When bond yields converge to their lower limit, bond prices converge to their upper limit, which increases the potential price downside versus upside. The result is that the difference in equity and bond negative asymmetries converges to zero, forcing the ERP to converge to zero. As the discount rate on growth defensives such as tech and healthcare collapses towards zero, the net present value must increase exponentially. This exponentially higher valuation of tech and healthcare is a mathematical consequence of the novel risk relationship between growth defensive equities and bonds at ultra-low bond yields. The unprecedented phenomenon has a major implication for European equity relative performance. The Euro Stoxx 50 is heavily underweight technology and healthcare, and this defining sector fingerprint is the key structural driver of European equity market relative performance (Chart I-4). Meanwhile, the relative performance of technology and healthcare is just an inverse exponential function of the bond yield (Chart I-5). The upshot is that European equities tend to outperform other regions only when bond yields are heading higher and the growth defensives are underperforming (Chart I-6). Chart I-4The Euro Stoxx 50's Underweight In Tech Drives Its Relative Performance Chart I-5Tech Outperforms When The Bond Yield Declines... Chart I-6...Hence, Without Higher Bond Yields The Euro Stoxx 50 Struggles To Outperform Some commentators are calling the higher valuations in tech and healthcare a new bubble. But it is a bubble only to the extent that bond yields are in a ‘negative bubble’, meaning that ultra-low yields are unsustainable. However, with social distancing set to leave heaps of slack in the advanced economy labour markets, ultra-low bond yields are here to stay and could go even lower. Moreover, as shown earlier, tech and healthcare demand and output are immune to social distancing. They may even benefit from social distancing. Hence, on a one-year horizon and beyond, stay overweight the growth defensive tech and healthcare sectors. And stay overweight the tech and healthcare heavy S&P 500 versus Euro Stoxx 50. A Puppy Boom We finish on a very positive note for animal lovers. The shift to working from home has generated a puppy boom. The Association of German Dogs claims that “the demand for puppies is endless” and the UK Kennel Club says that “there is unprecedented demand.” In the era of social distancing, the waiting list for puppies has quadrupled, and prices of easy to look after crossbreeds such as cockapoos have more than doubled. The demand for pet food and equipment is also very strong. Dogs make excellent companions for the socially isolated, which describes how many people are now feeling. Furthermore, with millions of people now working from home or on extended furlough, a growing number of households can fulfil the dream of owning a dog. We have recommended a structural overweight to the Animal Care sector based on the ‘humanisation’ of pets and the structural uptrend in spend per pet, especially on veterinary costs (Chart I-7). Animal Care has outperformed by 50 percent in the past two and a half years, but the shift to working from home will add impetus to the structural uptrend (Chart I-8). Chart I-7Animal Care Prices Are Rising... Chart I-8...And The Animal Care Sector Is Strongly Outperforming Stay overweight Animal Care. The ETF ticker, appropriately enough, is called PAWZ.  Fractal Trading System This week’s recommended trade is to short gold versus lead, given that the relative performance recently reached a fractal resistance point that has successfully identified four previous turning points. Set the profit target and symmetrical stop-loss at 13 percent. In our other open trades, five are in profit and one is in loss. The rolling 1-year win ratio now stands at 64 percent. When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated  December 11, 2014, available at eis.bcaresearch.com.   Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1    https://www.thelancet.com/journals/lanres/article/PIIS2213-2600(20)30222-8/fulltext 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 The Chinese economy continues to recover, albeit less quickly than the first two months following a re-opening of the economy. The demand side of the Chinese economic recovery in May marginally outpaced the supply side, with a notable improvement concentrated in the construction sector. We are initiating two new trades: long material sector stocks versus the broad indices, in both onshore and offshore equity markets. Feature The recovery in China’s economy and asset prices has entered a “tapering phase”, in which the speed of the recovery is normalizing from a rapid rebound two months after the economy re-opened. The direction of the ultra-accommodative monetary and fiscal stance has not changed, but the aggressiveness in the stimulus impulse is abating as the recovery continues. As we highlighted in last week’s report, the announced stimulus at this year's NPC was less than meets the eye of investors.1 Chart 1A Quick Reversal In The Outperformance Of Chinese Stocks Near-term downside risks in Chinese stocks were highlighted by last week’s quick reversal in the outperformance of Chinese equities relative to global benchmarks (Chart 1). As the US and European economies re-open and the stimulus impulse in major developed markets (DMs) is at peak intensity, Chinese stocks will underperform those in DMs, particularly US stocks. The re-escalation in Sino-US tensions will also add to the near-term volatility in Chinese equities. Therefore, we maintain our tactical (0-3 months) neutral view on aggregate Chinese equity indexes, in both domestic and offshore markets. Beyond Q2, however, our baseline view still supports an outperformance in Chinese stocks. The stepped-up stimulus measures since March should start to trickle down into the broader economy. Global business activities and demand will slowly normalize in the summer, helping to revive China’s exports. Moreover, an intensified pressure on employment, indicated in this month’s employment subcomponents in manufacturing and non-manufacturing PMIs, should prompt policymakers to roll out more growth-supporting measures in Q3. Tables 1 and 2 below highlight key developments in China’s economic and financial market performance in the past month. Table 1China Macro Data Summary Table 2China Financial Market Performance Summary Chart 2ASpeed Of Manufacturing Activity Recovery Has Moderated China’s official manufacturing PMI slipped to 50.6 in May from 50.8 a month earlier (Chart 2A). While the reading suggests that manufacturing activities are still in an expansionary mode, the speed of the expansion has moderated compared with April and March. The supply side of manufacturing activities and employment were the biggest drags on May’s official PMI. The production subcomponent in the PMI decelerated whereas new orders increased from April (Chart 2A, bottom panel). The net result is an improved supply-demand balance in the manufacturing sector, however, the improvement is marginal. It also differs from the V-shaped recovery in 2008/09, when both new orders and production subcomponents grew simultaneously (Chart 2B). The demand side of the economy is still concentrated in the policy-driven construction sector. The rebound in construction PMI continues to significantly outpace that in manufacturing and non-manufacturing PMIs (Chart 2C, top panel). The construction employment sub-index ticked up by 1.7 percentage points in May, compared with a slowdown of 0.8 percentage points in manufacturing and 0.1 percentage points in non-manufacturing employment PMIs (Chart 2C, bottom panel). Chart 2BDemand Struggles To Outpace Supply Chart 2CDemand Recovery Is Concentrated In Construction While a buoyant construction sector should provide a strong tailwind to raw material prices and related machinery sales, a laggard recovery from other sectors means the upside potential in aggregate producer prices (PPI) will be limited in the current quarter. In May, there was a rebound in the PMI sub-indices measuring raw material purchase prices and ex-factory prices, which heralds easing in the contraction of PPI in Q2 (Chart 3). However, neither of the PMI price sub-indices has returned to levels reached in January, when PPI growth was last positive. Moreover, weaker readings in the purchases and raw material inventory subcomponents suggest that manufacturers may be reluctant to restock due to sluggish global trade and a lagging rebound in domestic demand (Chart 3, bottom panel).  This month’s PMI shows that the employment subcomponents in both the manufacturing and non-manufacturing PMIs are contracting (Chart 4). Because demand for Chinese export goods remains sluggish, we expect unemployment in China’s labor-intensive export manufacturing sector to rise in Q2 and even into Q3. The intensified pressure on employment will likely prompt Chinese policymakers to roll out more demand-supporting measures. Chart 3PPI Contraction Will Ease But Upside Limited In Q2/Q3 Chart 4Employment In Trouble, A Catalyst For More Easing The BCA Li Keqiang Leading Indicator rose moderately in April. A plunge in the Monetary Conditions Index (MCI) limited the magnitude of the indicator's increase, offsetting an uptick in money supply and credit growth (Chart 5). A rapid disinflation in headline consumer prices (CPI) since the beginning of this year has pushed up the real savings deposit rate, which contributed to the MCI’s nose-dive. In our view, the MCI’s sharp drop is idiosyncratic and does not signify a tightening in the PBoC’s monetary stance or overall monetary conditions. Huge fluctuations in food prices have been driving the headline CPI since March 2019, while the core CPI remains stable. While food prices historically have very little correlation with the PBoC's monetary policy actions, a disinflationary environment will provide the central bank more room for easing. Odds are high that the PBoC will cut the savings deposit rate for the first time since 2015.  Chart 5Monetary Conditions Are Not As Tight As The Indicator Suggests The yield curve in Chinese government bonds quickly flattened around the time of the National People’s Congress (NPC), with the short end of the curve rising faster than the long end (Chart 6). This is in keeping with our assessment that while the market is expecting the recovery to continue in China, it is unimpressed with the intensity of upcoming stimulus and monetary easing. Monetary easing seems to be taking a pause, but we do not think this indicates a change in the PBoC’s policy stance (Chart 7). Instead, weak global demand, slow recovery in the domestic economy and intensified pressure on domestic employment, all will incentivize policymakers to up their game by mid-year. As such, we expect the yield curve to steepen again in H2, with the short-end of the curve fluctuating at a low level and the 10-year government bond yield picking up when the economy gains traction. Chart 6The Bond Market May Be Incorrectly Pricing In A Monetary Tightening Chart 7A Pause Before More Easing In June The spread in Chinese corporate bond yields has dropped by more than 30bps from its peak in April. This is in line with that of major DM countries and a reflection of the easier liquidity conditions globally (Chart 8). We anticipate that the yield spreads in Chinese corporate bonds will continue to normalize. However, a flare in US-China tensions will put upward pressure on the financing costs of lower-rated corporations (Chart 8, bottom panel). The default rate among Chinese corporate bonds is unlikely to rise meaningfully this year, in light of ultra-accommodative monetary conditions and the Chinese government’s bailout programs to backstop corporate defaults. Chinese corporate bond defaults and non-performing loans historically have correlated with periods of financial sector de-leveraging and de-risking, other than during economic downturns. We continue to recommend investors hold China’s corporate bonds in the coming 6-12 months in a USD-CNH hedged term. Chart 8Financing Costs May Rise For Lower-Rated Corporations Chart 9Cyclicals Are Struggling To Break Out Among Chinese equities, cyclical sectors have struggled to outperform defensives in both onshore and offshore markets (Chart 9). This reflects investors’ concerns over the slow recovery in domestic demand and heightened geopolitical risk between the US and China. As such, we continue to favor domestic, demand-driven sectors among the cyclical stocks, such as consumer discretionary and construction-related materials. We upgraded consumer discretionary stocks from neutral to overweight on May 20, and we are now initiating two trades to long material sector stocks versus the broad markets in both the domestic and investable markets. The constituents of both China’s investable and domestic material sectors are highly concentrated in the metal and mining subsectors, which roughly account for half of the material sectors’ weight in the MSCI and MSCI A Onshore Indexes, respectively. Chart 10 highlights that the material sectors’ relative performance is highly correlated with CRB raw materials in both domestic and investable markets. Given that China’s credit cycles historically lead the CRB material index by about six months, China’s massive credit stimulus will boost CRB raw materials by end-Q2 and thus, the outperformance of the material sectors.  The RMB has depreciated by almost 3% in the wake of a re-escalation in US-China frictions. The CNY/USD spot rate is approaching its weakest point reached in September 2019 (Chart 11). Furthermore, on May 29, the PBoC set the CNY/USD reference rate at its lowest level since 2008, a move that suggests defending the RMB is no longer in China’s interest. Downward pressure on the RMB will persist in the months leading up to the November US presidential election. The US economy is in a much more fragile state than in 2018/19, which may hinder President Trump’s willingness to resort to tariffs between now and November. However, we cannot completely roll out the probability that Trump will impose further tariffs on Chinese exports, if he is losing the election through weak public support and is removed from his financial and economic constraints.  In any case, in the coming months CNY/USD exchange rate will likely continue to decouple from the economic fundamentals such as interest rate differentials (Chart 11, bottom panel). Instead, the exchange rate will be largely driven by market sentiment surrounding the US-China frictions.  Volatility in CNY/USD will increase, but the overall trend in the CNY/USD will continue downwards as long as the escalation in US-China tensions persists. On a 6- to 12-month horizon, however, we expect that the depreciation trend in the RMB to moderately reverse as the Chinese economy continues to strengthen. Chart 10Material Sectors Should Benefit From The Stimulus And Construction Boom Chart 11The CNY/USD Will Continue To Decouple From Interest Rate Differentials Qingyun Xu, CFA Senior Analyst qingyunx@bcaresearch.com   Jing Sima China Strategist jings@bcaresearch.com   Footnotes 1    Please see China Investment Strategy Weekly Report "Taking The Pulse Of The People’s Congress," dated May 28, 2020, available at cis.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations

Highlights Chart 1More Stimulus Forthcoming? Last week we posited that bond yields could move modestly higher during the next couple of months as the US economy re-opens and economic growth recovers. However, any economic recovery is contingent on the US consumer maintaining an adequate amount of income, whether that income comes from employment or government assistance. So far, real personal income is holding up nicely. It is actually up 9% since February as the CARES act’s one-time stimulus checks and enlarged unemployment insurance benefits have more than offset the 9% drop in income from non-government sources (Chart 1). Contrast this with 2008, when government assistance only tempered the peak-to-trough decline in income from 8% to 4%. However, the stimulus checks are not recurring and the extra unemployment benefits lapse at the end of July. Before then, either employment income will have to rise or the government will have to pass additional stimulus measures. Otherwise, real personal income will fall and any nascent economic recovery will be stopped in its tracks. Stay tuned. Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 181 basis points in May, bringing year-to-date excess returns up to -705 bps. The average index spread tightened 28 bps on the month and has tightened 199 bps since the Fed unveiled its corporate bond purchase programs on March 23. However, the index’s 12-month breakeven spread remains above its historical median (Chart 2). Spreads are high relative to history and the investment grade corporate bond market benefits strongly from Fed support.1 The sector therefore meets both our criteria for an overweight allocation. One caveat to our overweight stance is that while Fed lending can forestall bankruptcy, it can’t clean up highly-levered corporate balance sheets. With firms taking on more debt, either from the Fed or the public market, ratings downgrades remain a risk. Indeed, Moody’s already downgraded 18 investment grade issuers in March and another 7 in April, while recording no upgrades in either month (panel 4). With downgrade risk still in play, sector and firm selection is particularly important. Investors should seek out pockets of the market that are unlikely to be downgraded, subordinate bank bonds being one example (bottom panel).2  Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Table 3BCorporate Sector Risk Vs. Reward* High-Yield: Neutral Chart 3AHigh-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 427 basis points in May, bringing year-to-date excess returns up to -937 bps. The average index spread tightened 107 bps on the month and has tightened 463 bps since the Fed unveiled its corporate bond purchase programs on March 23. Encouragingly, lower-rated (B & below) credits performed well in May, but they still lag the Ba credit tier since the March 23 peak in spreads (Chart 3A). Appendix A on page 14 shows returns for all fixed income sectors since March 23. Chart 3BB-Rated Excess Return Scenarios Better performance from the lower credit tiers that don’t benefit from the Fed’s emergency facilities signals that investors are becoming more optimistic about an economic turnaround. But for our part, we remain skeptical about valuations in the B-rated and lower space. Chart 3B shows that “moderate” and “severe” default scenarios for the next 12 months – defined as a 9% and 12% default rate, respectively, with a 25% recovery rate – would lead to a negative excess spread for B-rated bonds.3 The same holds true for lower-rated credits. We appear to be on track for that sort of outcome. Moody’s recorded 15 defaults in April, the highest monthly figure since the 2015/16 commodity bust, bringing the trailing 12-month default rate up to 5.4%. Meanwhile, the trailing 12-month recovery rate is a meagre 21%. MBS: Underweight Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 3 basis points in May, bringing year-to-date excess returns up to -31 bps. Chart 4MBS Market Overview The average yield of the conventional 30-year MBS index rose from 1.18% to 1.74% on the month, and the index duration extended from 1.5 to 2.9. The result is that value – as measured by the index option-adjusted spread (OAS) – has improved considerably, especially relative to other spread products. The 30-year conventional MBS index OAS is now 100 bps. This is greater than the 91 bps and 93 bps offered by Aaa-rated consumer ABS and Agency CMBS, respectively. It’s also greater than the 91 bps offered by Aa-rated corporate bonds (Chart 4). There’s no doubt that MBS are starting to look more attractive, and if current trends continue, we will likely upgrade our recommendation in the coming months. However, we are reluctant to do so just yet because we worry that the prepayment assumptions embedded in the current index OAS will turn out to be too low. Our concern stems from the extremely high primary/secondary mortgage spread (bottom 2 panels). That wide spread shows that capacity constraints have so far prevented mortgage originators from competing on price and dropping rates, even as Treasury and MBS yields plummeted. The risk remains that bond yields will stay low and that primary mortgage rates will eventually play catch-up. That could lead to a surge of refinancing activity and wider MBS spreads. Government-Related: Underweight Chart 5Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 162 basis points in May, bringing year-to-date excess returns up to -474 bps. Sovereign debt outperformed duration-equivalent Treasuries by 589 bps on the month, bringing year-to-date excess returns up to -930 bps. Foreign Agencies outperformed the Treasury benchmark by 99 bps in May, bringing year-to-date excess returns up to -798 bps. Local Authority debt outperformed Treasuries by 187 bps in May, bringing year-to-date excess returns up to -688 bps. Domestic Agency bonds outperformed by 15 bps, bringing year-to-date excess returns up to -72 bps. Supranationals outperformed by 8 bps, bringing year-to-date excess returns up to -31 bps. We updated our outlook for USD-denominated Emerging Market (EM) Sovereign bonds in a recent report.4 In that report we posited that valuation and the performance of EM currencies are the primary drivers of sovereign debt performance (Chart 5). On valuation, we noted that the USD sovereign bonds of: Mexico, Saudi Arabia, UAE, Colombia, Qatar, South Africa and Malaysia all offer a spread pick-up relative to US corporate bonds of the same credit rating and duration. However, of those countries that offer attractive spreads, most have currencies that look vulnerable based on the ratio of exports to foreign debt obligations. In general, we don’t see a compelling case for USD-denominated sovereigns based on value and currency outlook, although Mexican debt stands out as looking attractive on a risk/reward basis.    Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 290 basis points in May, bringing year-to-date excess returns up to -646 bps (before adjusting for the tax advantage). Municipal bond spreads versus Treasuries tightened considerably in May, but valuations remain very attractive. The 2-year Aaa Muni / Treasury spread stands at -2 bps, implying a breakeven effective tax rate of 12%.5 Meanwhile, the 10-year Aaa Muni / Treasury spread is above zero (Chart 6). As we showed in last week’s report, municipal bonds are also attractively priced relative to corporates across the entire investment grade credit spectrum.6 In last week’s report we also flagged our concern about the less-than-generous pricing offered by the Fed’s Municipal Liquidity Facility (MLF). At present, MLF funds are only available at a cost that is well above current market prices (panel 3). This means that the MLF won’t help push muni yields lower from current levels. Despite the MLF’s shortcomings, we aren’t yet ready to downgrade our muni allocation. For one thing, federal assistance to state & local governments is likely on its way, and the Fed could feel pressure to lower MLF pricing if that stimulus is delayed. Further, while the budget pressure facing municipal governments is immense, states are also holding very high rainy day fund balances (bottom panel). This will help cushion the blow and lessen the risk of ratings downgrades. Treasury Curve: Buy 5-Year Bullet Versus 2/10 Barbell Chart 7Treasury Yield Curve Overview The Treasury curve steepened in May, as long-maturity yields rose and short-dated yields declined slightly. The 2-year/10-year Treasury slope steepened 5 bps to end the month at 49 bps. The 5-year/30-year Treasury slope steepened 19 bps to end the month at 111 bps. One good thing about the fed funds rate being pinned at zero is that it greatly simplifies yield curve strategy. As we showed in a recent report, when the funds rate is at its lower bound the Treasury slope will trade directionally with yields.7 That is, the yield curve will steepen when yields rise and flatten when they fall. Therefore, if you want to put on a position that will profit from lower yields but that doesn’t increase the average duration of your portfolio, you can enter a duration-neutral flattener: long a 2/10 or 2/30 barbell and short the 5-year or 7-year bullet, in duration-matched terms. Or if, like us, you do not want to make a large duration bet but suspect that Treasury yields will move modestly higher as the US economy re-opens during the next couple of months, you can enter a duration-neutral steepener: long the 5-year bullet and short a duration-matched 2/10 barbell.8 In terms of value, the 5-year yield no longer trades deeply negative relative to the 2/10 and 2/30 barbells (Chart 7), though it remains somewhat expensive according to our models (see Appendix B). TIPS: Overweight Chart 8TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 62 basis points in May, bringing year-to-date excess returns up to -494 bps. The 10-year TIPS breakeven inflation rate rose 8 bps to 1.16%. The 5-year/5-year forward TIPS breakeven inflation rate rose 5 bps to 1.48%. March’s market crash created an extraordinary amount of long-run value in TIPS. For example, headline CPI has to average below 1.16% for the next decade for a buy & hold investor to lose money long the 10-year TIPS and short the equivalent-maturity nominal Treasury. In last week’s report we argued that such a position should also work on a 12-month horizon.9 We calculate that headline CPI will have to be below -0.6% for the next 12 months for a long TIPS/short nominals position to lose money. With the recent drop in core inflation not mimicked by the trimmed mean and oil prices already on the mend (Chart 8), we’d bet against headline CPI getting that low. We also advise investors to enter real yield curve steepeners.10 In a repeat of the 2008/09 zero-lower-bound episode, front-end real yields jumped this year when oil prices collapsed (bottom 2 panels). In 2008/09, the real yield curve steepened sharply once oil prices troughed. We think now is a good time to position for a similar outcome. ABS: Overweight Chart 9ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 101 basis points in May, bringing year-to-date excess returns up to -104 bps. The index option-adjusted spread for Aaa-rated ABS tightened 49 bps on the month to 91 bps. It remains 51 bps above where it was at the beginning of the year. Aaa-rated ABS meet both our criteria to own. Index spreads are elevated and the securities benefit from Fed support through the TALF program. Specifically, TALF allows eligible counterparties to borrow against Aaa ABS collateral at a rate of OIS + 125 bps (Chart 9). TALF benefits don’t extend to non-Aaa ABS and we recommend avoiding those securities even though valuation is more attractive. Since the March 23 peak in spreads, non-Aaa ABS have outperformed Aaa-rated ABS by 197 bps, but have only re-traced a fraction of their prior losses (panel 2). As with municipal bonds, Aaa ABS yields are now below the cost of TALF loans. This certainly makes the bullish case for ABS spreads less robust. However, unlike munis, yields are only slightly below the cost of Fed support (bottom panel). Also, as shown on page 1, government spending has so far prevented a collapse in personal income. As long as this continues, it should prevent a wave of consumer bankruptcies and ABS defaults. Non-Agency CMBS: Overweight Chart 10CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 99 basis points in May, bringing year-to-date excess returns up to -697 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS tightened 22 bps on the month to 169 bps. As was the case in April, non-Aaa CMBS underperformed Aaa securities (Chart 10). This is not surprising given that only Aaa-rated CMBS benefit from the Fed’s TALF program and the underlying credit outlook for commercial real estate is very poor with most people now working from home. We continue to recommend avoiding non-Aaa CMBS, but think that Aaa spreads can tighten further. The cost of borrowing against Aaa CMBS through TALF remains well below the current Aaa non-agency CMBS yield (panel 3). Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 62 basis points in May, bringing year-to-date excess returns up to -161 bps. The average index spread tightened 9 bps on the month to 93 bps, still well above typical historical levels (bottom panel). The Fed is supporting the Agency CMBS market by directly purchasing securities as part of its Agency MBS purchase program. The combination of strong Fed support and elevated spreads makes the sector a high conviction overweight. Appendix A: Buy What The Fed Is Buying The Fed rolled out a number of aggressive lending facilities on March 23. These facilities focused on different specific sectors of the US bond market. The fact that the Fed has decided to support some parts of the market and not others has caused some traditional bond market correlations to break down. It has also led us to adopt of a strategy of “Buy What The Fed Is Buying”. That is, we favor those sectors that offer attractive spreads and that benefit from Fed support. The below Table tracks the performance of different bond sectors since the March 23 announcement. We will use this to monitor bond market correlations and evaluate our strategy’s success. Performance Since March 23 Announcement Of Emergency Fed Facilities Appendix B: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of May 29, 2020) Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 5Butterfly Strategy Valuation: Standardized Residuals (As Of May 29, 2020) Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of 51 bps in the 5 over 2/10 cell means that we would only expect the 5-year to outperform the 2/10 if the 2/10 slope steepens by more than 51 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) Appendix C: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Chart 11Excess Return Bond Map (As Of May 29, 2020) Footnotes 1 For a detailed description of the Fed’s different emergency facilities please see US Investment Strategy/US Bond Strategy Special Report, “Alphabet Soup: A Summary Of The Fed’s Anti-Virus Measures”, dated April 14, 2020, available at usbs.bcaresearch.com 2 For more details on our recommendation to favor subordinate bank bonds please see US Bond Strategy Weekly Report, “Negative Oil, The Zero Lower Bound And The Fisher Equation”, dated April 28, 2020, available at usbs.bcaresearch.com 3 For an explanation of how we calculate default-adjusted spreads by credit tier please see US Bond Strategy Weekly Report, “Is The Bottom Already In?”, dated April 21, 2020, available at usbs.bcaresearch.com 4 Please see US Bond Strategy Weekly Report, “The Treasury Market Amid Surging Supply”, dated May 12, 2020, available at usbs.bcaresearch.com 5 Investors will see a greater after-tax yield in the municipal bond compared to the Treasury bond if their effective tax rate is above the breakeven effective tax rate. 6 Please see US Bond Strategy Weekly Report, “Bonds Are Vulnerable As North America Re-Opens”, dated May 26, 2020, available at usbs.bcaresearch.com 7 Please see US Bond Strategy Weekly Report, “Life At The Zero Bound”, dated March 24, 2020, available at usbs.bcaresearch.com 8 The rationale for why barbell positions profit from curve flattening and bullet positions profit from curve steepening is found in US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com 9 Please see US Bond Strategy Weekly Report, “Bonds Vulnerable As North America Re-Opens”, dated May 26, 2020, available at usbs.bcaresearch.com 10 For more details on this recommendation please see US Bond Strategy Weekly Report, “Negative Oil, The Zero Lower Bound And The Fisher Equation”, dated April 28, 2020, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation

Highlights In this Weekly Report, we present our semi-annual chartbook of the BCA Central Bank Monitors. All of the Monitors are now below the zero line, indicating the need for continued easy global monetary policy to help mitigate the COVID-19 recession (Chart of the Week). Central bankers have already responded in an intense and rapid fashion to the crisis, delivering a series of rate cuts, increased asset purchase programs and measures to support bank lending to businesses suffering under quarantines. All of these vehicles have helped trigger a powerful rally in global bond markets that helped revitalize risk assets as well. After the coordinated global easing response of the past few months, the optimal policy choices now differ from country to country. This creates opportunities to benefit from country allocation decisions even in a world of puny government bond yields. The overall signal from our Central Bank Monitors is still bond bullish, however – at least over the next few months until there is evidence of how fast global growth is rebounding from the COVID-19 lockdowns. An Overview Of The BCA Central Bank Monitors Chart of the WeekUltra-Accommodative Monetary Policies Are Still Required Chart 2A Bond-Bullish Message From Our CB Monitors The BCA Central Bank Monitors are composite indicators designed to measure the cyclical growth and inflation pressures that can influence future monetary policy decisions. The economic data series used to construct the Monitors are not the same for every country, but the list of indicators generally measure the same things (i.e. manufacturing cycles, domestic demand strength, commodity prices, labor market conditions, exchange rates, etc). The data series are standardized and combined to form the Monitors. Readings above the zero line for each Monitor indicate pressures for central banks to raise interest rates, and vice versa. Through the nexus between growth, inflation, and market expectations of future interest rate changes, the Monitors do exhibit broad correlations to government bond yields in the Developed Markets (Chart 2). All of the Monitors are indicating intense pressure to maintain very easy monetary policies in response to the global COVID-19 recession. While the bad economic and inflation news is largely discounted in the depressed level of bond yields worldwide, there are still opportunities to position country allocations within a government bond portfolio based on the message from our Monitors (overweighting the US, the UK and Canada, underweighting Germany and Japan). All of the Monitors are indicating intense pressure to maintain very easy monetary policies in response to the global COVID-19 recession.  In each BCA Central Bank Monitor Chartbook, we include a new chart for each country that we have not shown previously. In this edition, we show the components of the Monitors, grouped into those focusing on economic growth and inflation, plotted alongside our estimate of the appropriate level of central bank policy interest rates derived using a Taylor Rule. Fed Monitor: Policy Must Stay Accommodative Our Fed Monitor has collapsed below the zero line to recessionary levels (Chart 3A) in response to the coronavirus crisis. The Fed has already delivered a series of aggressive policy responses since March to help support an economy ravaged by the virus, including: interest rate cuts; quantitative easing (QE), including buying corporate and municipal debt; and setting up lending schemes for small businesses. The lockdown of almost the entire country has helped “flatten the curve” of the spread of COVID-19, but at a painful economic cost. The unemployment rate rose to 14.7% in April, the highest level since the Great Depression, and is expected to peak at levels above 20%. The result is unsurprising: a massive increase in spare economic capacity with a threat of deflation as headline CPI inflation plummeted to 0.3% in April (Chart 3B). Chart 3AUS: Fed Monitor Chart 3BUS Realized Inflation Flirting With 0% Within the components of our Fed Monitor, weakening growth has been the main driver of the decline (Chart 3C). Our Taylor Rule estimate suggests a deeply negative fed funds rate is “appropriate”, although the Fed is likely to pursue other avenues of easing like yield curve control before ever attempting a sub-0% policy rate. Chart 3CNegative Rates Are 'Required' In The US, But The Fed Has Other Options The fall in US Treasury yields over the past few months has been in line with the decline in our Fed Monitor (Chart 3D). While the US economy is slowly awakening from lockdowns, consumer and business confidence are likely to remain fragile given the numerous risks from a second wave of COVID-19, worsening US-China relations and, more recently, social unrest. Thus, we continue to recommend an overweight strategic allocation to the US within global government bond portfolios. The fall in US Treasury yields over the past few months has been in line with the decline in our Fed Monitor Chart 3DTreasury Yields Fully Reflect Pressure For More Fed Easing BoE Monitor: Negative Rates On The Horizon? Our Bank of England (BoE) Monitor has collapsed to the lowest level in its history on the back of the severe COVID-19 recession (Chart 4A). The BoE already cut the Bank Rate to 0.1% in March, ramped up asset purchases, and introduced a Term Funding scheme to support business lending. Any additional easing from here might entail negative policy rates, which markets are already discounting. The UK unemployment rate is expected to peak around 8%, with the BoE projecting the economy to shrink by -14% this year, which would be the worst recession in modern history. Inflation has dropped sharply on the back of the dual collapse of energy prices and economic growth, ending a period of currency-fueled inflation increases (Chart 4B). Chart 4AUK: BoE Monitor Chart 4BUK Realized Inflation Is Slowing Rapidly The components of our BoE Monitor fully reflect the dire economic situation (Chart 4C), with weak growth – led by sharp falls in business confidence – driving the collapse of the Monitor more than falling inflation pressures. Our Taylor Rule estimate of the policy rate is not yet calling for negative rates, but that is because we are using the New York Fed’s estimate of r* as the neutral real rate, which is a relatively high 1.4% (by comparison, r* in the US is estimated to be 0.5%). Chart 4CNegative Rates Are Not Yet Required In The UK The sharp fall in the BoE Monitor suggests that Gilt yields will remain under downward pressure in the coming months (Chart 4D). New BoE Governor Andrew Bailey has stated that a move to negative rates is not imminent, but markets will continue to flirt with the notion of sub-0% interest rates until the economy and inflation stabilize. We maintain an overweight stance on UK Gilts. Chart 4DBoE Monitor Suggests Continued Downward Pressure On Gilt Yields ECB Monitor: Continued Monetary Support Is Needed Our European Central Bank (ECB) Monitor is now well below the zero line, signaling a strong need for easier monetary policy to fight the COVID-19 downturn (Chart 5A). The ECB has delivered multiple measures to ease monetary conditions, including a new €750bn bond-buying vehicle and liquidity operations to help banks maintain lending to European businesses.​​​​​​​​​​​​​​ The recession has hit the region hard, with real GDP declining by -3.8% in Q1, the sharpest fall since records began in 1995. Unemployment rates have climbed higher, although to much lower levels than seen in the US thanks to more generous government labor support programs that have helped to limit layoffs. The sharp downturn has resulted in both a surge in spare economic capacity and plunge in headline inflation to 0.3% in April (Chart 5B). Chart 5AEuro Area: ECB Monitor Chart 5BEurope Is On The Edge Of Deflation Within the individual components of our ECB Monitor, both weaker growth and near-0% inflation have both contributed to the Monitor’s decline (Chart 5C). Our Taylor Rule measure shows that the ECB’s current stance of having policy rates modestly below 0% is appropriate. Chart 5CThe ECB Needs To Keep Its Foot On The Monetary Accelerator Despite the ECB’s easing measures, and in contrast to the message from our ECB Monitor, the downward momentum in core European bond yields has been fading (Chart 5D). With the ECB reluctant to push policy rates deeper into negative territory, and with reliable cyclical indicators like the German ZEW and IFO surveys showing signs that euro area growth is starting to recover from the lockdowns, the case for even lower core European yields in the coming months is not strong. We maintain our recommended underweight stance on German and French government bonds. We maintain our recommended underweight stance on German and French government bonds. Chart 5DNo Pressure For Higher German Bund Yields BoJ Monitor: What More Can Be Done? Our Bank of Japan (BoJ) Monitor has fallen further below zero, indicating easier policy is required (Chart 6A). The BoJ has already introduced additional easing measures in the past couple of months: extending forward guidance (inflation is projected to remain below the BoJ’s 2% target for the next three years), increasing asset purchases and enhancing loan programs to small and medium sized companies. New cases of COVID-19 have slowed sharply in Japan, prompting an end to the national state of emergency last week. Importantly, the virus did not hit Japan's labor market as severely as in other developed countries. The unemployment rate did reach a two-year high in April, but is still only 2.6% (Chart 6B). Fiscal stimulus and measures to protect job losses have played a major role in preventing a bigger spike in joblessness. Even with those measures, growth remains weak and realized inflation is heading back towards deflation. Chart 6AJapan: BoJ Monitor Chart 6BJapan Nearing Deflation Once Again Looking at the components of our BoJ Monitor, contracting growth, more than weakening inflation pressures, is the bigger driver of the fall in the Monitor below zero (Chart 6C). However, our Taylor Rule estimate does not suggest that the current level of the policy rate is out of line. Chart 6CBoJ Needs More Easing (Somehow) Until The Economy Revives The BoJ’s current combined policies of negative rates, QE and yield curve control are keeping JGB yields at near-0% levels. Those policies are also suppressing yield volatility and preventing an even bigger fall in JGB yields (with larger capital gains) as suggested by our BoJ Monitor (Chart 6D). We continue to recommend a maximum underweight in Japanese government bonds in a yield-starved world. Chart 6DJGB Yields Will Be Anchored For Some Time BoC Monitor: Deflationary Pressures Intensifying Our Bank of Canada (BoC) Monitor has collapsed into “easier policy required” territory, reaching levels last seen during the 2009 recession (Chart 7A). The central bank has already introduced several easing measures to help boost the virus-stricken economy, including cutting the Bank Rate to a mere 0.25% and starting a QE program to buy government bonds for the first time ever. Before the COVID-19 outbreak, some softening of the economy was already underway. Now, after the imposition of nationwide lockdowns to limit the spread of the virus, the unemployment rate has spiked to 13% - a level last seen in the early 1980s. The result is a massive deflationary output gap has opened up (Chart 7B), with realized headline CPI inflation printing at -0.2% in April. Chart 7ACanada: BoC Monitor Chart 7BOutright Headline CPI Deflation In Canada The fall in our BoC Monitor has been driven by both collapsing economic growth and weakening inflation pressures (Chart 7C). Our Taylor Rule estimate suggests that one of new BoC Governor Tiff Macklem’s first policy decisions may need to be a move to negative interest rates. Macklem and other BoC officials have not played up the possibility of cutting rates below 0%. However, the fact that the BoC provided no economic growth forecasts in the most recent Monetary Policy Report highlights the extreme uncertainties surrounding the economic impact from COVID-19 – even with the Canadian government providing a large fiscal response to the pandemic. Chart 7CBoC Monitor Plunging Due To High Unemployment & Low Inflation We upgraded our recommended stance on Canadian government debt to overweight back in March, and the collapse of the BoC Monitor suggests continued downward pressure on Canadian yields (Chart 7D). Stay overweight. The collapse of the BoC Monitor suggests continued downward pressure on Canadian yields.  Chart 7DCanadian Yield Momentum In Line With The BoC Monitor RBA Monitor: Rate Cutting Cycle Is Done Due to a slump in export demand and a weakening housing market, our Reserve Bank of Australia (RBA) monitor has been consistently calling for rate cuts since April 2018 (Chart 8A). Australia began its easing cycle early, having delivered a total of 125bps of stimulus since June 2019, with the two most recent cuts coming directly in response to the COVID-19 crisis. As in other developed markets, the unemployment gap in Australia has widened dramatically, owing to job losses concentrated in tourism, entertainment, and dining out (Chart 8B). Although inflation briefly breached the low end of the RBA’s 2-3% target band in Q1, this will not be a lasting development. The RBA sees headline CPI deflating by -1% year-on-year in Q2/2020 and, even as far as 2022, only sees it growing at 1.5%. Chart 8AAustralia: RBA Monitor Chart 8BInflation Will Remain Stuck Below RBA 2-3% Target Although both the growth and inflation components of our RBA Monitor are below zero, the former drove the most recent decline (Chart 8C) led by consumer confidence almost touching the 2008 lows. The RBA has already responded by cutting rates to near 0%, well below the Taylor Rule implied estimate, and initiating yield curve control with a cap on 3-year government bond yields at 0.25%. Chart 8CNo Pressure For The RBA To Go To Negative Rates Overall, Australian bond yields have accurately priced in the dovish signal from our RBA Monitor (Chart 8D). With COVID-19 relatively well contained in Australia, there is less pressure on the RBA to ease further. Governor Lowe has also ruled out negative rates, which will put a floor under yields. Owing to these factors, we confidently reiterate our neutral stance on Australian government debt within global fixed income portfolios. Australian bond yields have accurately priced in the dovish signal from our RBA Monitor. Chart 8DAustralian Bond Yields Are Unlikely To Move Much Lower RBNZ Monitor: Cause For Concern After a resurgence late last year, our Reserve Bank of New Zealand (RBNZ) Monitor has declined to a level slightly below zero (Chart 9A). The RBNZ responded to the pandemic by delivering a massive -75bps cut in March, but has since left the policy rate untouched, preferring to deliver further stimulus by doubling the size of its QE program. Forward guidance is signaling that the policy rate will remain at 0.25% until 2021, but the central bank has not ruled out negative rates in the future. ​​​​​​​Although the actual unemployment numbers do not yet capture the impact of the pandemic, both consensus and RBNZ forecasts call for a blowout in the unemployment gap (Chart 9B). The RBNZ expects the steady improvement in inflation seen up to Q1/2020 to be wiped out, with headline CPI projected to remain below the 1-3% target range until mid-2022. Chart 9ANew Zealand: RBNZ Monitor Chart 9BRealized NZ Inflation Was Drifting Higher, Pre-Virus Surprisingly, the inflation component of our RBNZ Monitor is actually calling for tighter monetary policy, owing to significant strength in the housing market (Chart 9C). However, this trend is likely to reverse - the RBNZ foresees a -9% decline in house prices over the remainder of 2020. Meanwhile, growth components such as consumer confidence and employment will remain depressed, holding down our RBNZ monitor. Chart 9CGrowth, Now Inflation, Has Driven The RBNZ Monitor Lower Overall, the momentum in New Zealand bond yields seems to have overshot the message from our RBNZ Monitor (Chart 9D). However, with so much uncertainty about business investment and cash flows from key sectors such as tourism and education, it is too early to bet on an improvement in yields. We therefore maintain a neutral recommendation on NZ sovereign debt. Chart 9DNZ Bond Yields Are Unlikely To Move Lower Riksbank Monitor: Worries For The Coronavirus Mavericks Amid the global pandemic, our Riksbank Monitor has collapsed to all-time lows (Chart 10A). In its April monetary policy decision, the Riksbank opted for continued asset purchases and liquidity measures to support bank lending to companies over a move to negative rates. One of the primary concerns for the Riksbank is headline CPI inflation, which fell into mild deflation (-0.4% year-over-year) in April on the back of lower energy prices and weaker domestic demand (Chart 10B). This could spill over into a lasting decline in long-term inflation expectations if the economy does not quickly improve. Chart 10ASweden: Riksbank Monitor Chart 10BSwedish Realized Inflation Back To 0% Both the growth and inflation components of our Riksbank Monitor are calling for further easing, with the growth component now at post-crisis lows (Chart 10C). The collapse on the growth side can be attributed to historic falls in retail confidence, the manufacturing PMI and employment while the inflation component remains depressed due to low headline numbers and inflation expectations. Chart 10CThe Riksbank Hates Negative Rates, But Could Still Need Them If The Economy Worsens The sharp downward move in our Riksbank Monitor suggests Swedish bond yields should remain under downward pressure in the coming months (Chart 10D). The key factor for yields will be the effect of the relatively lax measures implemented by Sweden to combat the pandemic. Sweden saw positive GDP growth in Q1/2020 due to fewer restrictions on the economy. However, infection and mortality rates are much higher in Sweden than in neighboring countries and, as a result, Denmark and Norway excluded Sweden from their open border agreement. Continued restrictions of the sort are bearish for growth – and bullish for bonds – in this trade-dependent economy. Chart 10DSwedish Bond Yields Will Remain Under Downward Pressure   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Ray Park, CFA Research Analyst ray@bcaresearch.com ​​​​​​​Shakti Sharma Research Associate ShaktiS@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

Feature The key to how markets will move over the coming 12 months is whether the coronavirus pandemic turns out to be a short-term (albeit severe) disruption to the world economy, or something more fundamentally damaging. Markets currently – with global equities up by 34% since March 23 – are clearly pricing in the former. They seem to be saying that the sudden stop to the economy – with US employment, for example, rising to a post-war high in just two months (Chart 1) – is not a problem, since most of the unemployed are furloughed and will quickly return to work once businesses reopen. Enormous stimulus (direct fiscal spending in G20 countries of 4.6% of GDP, even if loans and guarantees are excluded – Chart 2) and aggressive monetary policy (major central banks’ balance sheets have ballooned by $4.7trn since March – Chart 3) will tide us over until normality returns, and then provide a big boost to risk assets. Unprecedented efforts by drugs companies will soon produce a vaccine against COVID-19. Recommended Allocation   Chart 1Can Unemployment Come Down As Quickly? Chart 2Unprecedented Fiscal… Chart 3...And Monetary Stimulus All this is possible. Certainly, the amount of excess liquidity being pumped into the economy by central banks (Chart 4) could dramatically boost economic activity and asset prices once the world returns to normal. The newsflow over coming months may largely be positive, with a gradual easing of lockdowns, a rebound in economic data (it cannot mathematically get any worse), and an abatement of the pandemic during the northern hemisphere summer. Many investors remain pessimistic (Chart 5) and so may be pulled into markets if stocks continue to rise. In this environment – and with the alternatives so unattractive (10-year US Treasurys at 0.6% anyone?) – we wouldn’t want to take a bet against equities. Chart 4Liquidity Will Boost Assets - Eventually But is the market ignoring the risks? Easing of lockdown could lead to a flare-up of new COVID-19 cases: China has already had to reintroduce some containment measures when this happened (Chart 6). Chart 5Retail Investors Remain Bearish   Chart 6What Happens When Lockdowns Are Eased? While COVID-19 cases have peaked in Asia, Europe, and North America, there is a new wave in Emerging Markets, particularly those such as Brazil which were lax in implementing containment measures (Chart 7). Even where the pandemic has waned, consumers seem highly reluctant to go to restaurants (Chart 8) or fly on airplanes (Chart 9). Chart 7The Pandemic Is Shifting To Emerging Economies Consumer-facing companies may no longer see revenues down by 70% or 80% over the next few months, but they could still be 10% or 20% below normal levels. How many business models are robust enough to survive that? As for a vaccine, it is worth remembering that no vaccine has ever been developed for a coronavirus in humans. We may have to learn to live with the disease. Chart 8Consumers Are Not Yet Going To Restaurants... Chart 9…Or On Planes The longer the pandemic lasts, the more damaging will be its second-round effects. Already banks are turning more cautious about lending (Chart 10), and rating agencies are rapidly downgrading companies (Chart 11). We are likely to see a wave of corporate defaults, Emerging Market borrowers struggling to service their foreign-currency debts, and banks getting into trouble as a result – though monetary and fiscal bridging programs may defer these problems for a while. Chart 10Banks Are Turning More Cautious... Chart 11...And Companies Are Being Downgraded The US/China relationship is also a concern in the run-up to November’s US presidential election. It will be tempting for President Trump to turn tough on China, a policy that could be popular with the US electorate, which has become more anti-China in recent months (Chart 12). Problems over Hong Kong, China failing to hit the import targets it promised in January’s trade agreement, and action against Huawei (whose license expires in mid-August) mean that the conflict could escalate quickly. China would also much prefer Joe Biden as US president, and will do nothing to help President Trump get reelected. Chart 12Being Tough On China Is Popular In The US Chart 13The Dollar Has Not Reacted To The Risk-On Rally In this environment of unusual uncertainty, we continue to leaven our benchmark-weight position in global equities with relatively cautious tilts: overweight the lower-beta US market and structural-growth sectors such as Healthcare and Tech. We maintain our large position in cash, and would continue to hold gold as a hedge against tail risks. The risk to this view is that over coming months – if the environment continues to stabilize – there is a vicious rotation into pure cyclical plays, perhaps driven by a fall in the US dollar (which has until recently been surprisingly stable during the past two months’ risk-on rally – Chart 13), a rise in commodity prices, and higher long-term interest rates. This scenario would trigger outperformance by Emerging Markets and eurozone stocks, and value-oriented sectors such as Materials and Financials. This might be possible for a short period but, given the risks highlighted above, we would not recommend long-term investors to shift their portfolios in this direction.   Equities: Our “minimum volatility” approach has worked well: US equities and structural growth sectors such as Healthcare and Tech continued to outperform both during the sell-off in February and March and in the subsequent rebound (Chart 14). For now, we prefer to stick to this cautious stance on a 12-month investment horizon. It is possible, though, that there could be some short-term rotation into value and small cap stocks if the environment improves further over the next couple of months (Chart 15). We are partially hedged against this sort of upside surprise through our overweight in Industrials (which would benefit from a ramp-up in Chinese infrastructure spending, in particular) and neutral on Emerging Markets and Australia. Chart 14"Min Vol" Equities Have Outperformed Chart 15Could There Be A Shift To Value And Small Caps? Fixed Income: Government bond yields have not risen despite the risk-on rally, and we expect this to remain the case. Continuing uncertainty, central bank insistence that easy monetary policies will stay in place for a long time, and deflationary pressures over coming months warrant a neutral stance on duration – though returns from high-quality government bonds will be around zero. In the longer-run, however, the pandemic is likely to prove inflationary: like in a post-war environment, excess liquidity, supply constraints, and pent-up demand could push up consumer prices in 12 months’ time. Consumers are already noticing that the goods they are actually buying now (as opposed to the weightings in the consumption basket used to measure inflation) are rising in price (Chart 16). We recommend TIPS as a hedge, particularly given how cheap they are (with the 10-year breakeven at only 1.2%). Corporate credits that are supported by central bank buying remain attractive, although with spreads having already contracted the easy money has been made (Chart 17). BCA Research’s fixed-income strategists prefer US and UK investment-grade and BB-rated corporate bonds in the Media, Financials and Energy sectors.1 Chart 16Consumers Are Sniffing Out Inflation Chart 17The Easy Money Has Been Made In Credit Currencies: It will pay to watch the US dollar. It is overvalued and no longer supported by interest rate differentials, but as a safe haven currency has seen inflows given global economic uncertainty. For now, we remain neutral. Emerging Market currencies are likely to remain under pressure, particularly since EM central banks have followed the example of their Developed Market counterparts and for the first time embarked on QE to boost their economies (Chart 18). This could lead to rising inflation in some EMs, as central banks essentially monetize government debt. Chart 18EM Central Banks Are Starting QE Too Commodities: China has quietly been ramping up its credit growth, and this will eventually have a positive impact on industrial metals prices, which have showed tentative signs of bottoming (Chart 19). The rebound in oil prices has further to run. OPEC oil production is likely to fall by around 4 million barrels/day from its Q4 2019 level, with further output drops from capital-constrained North American shale producers (Chart 20).   Chart 19Industrial Commodities Bottoming? Harder to predict is how quickly demand – currently down around 15% year-on-year – will recover. BCA Research’s oil strategists, based on an assumption of a strong demand revival in H2, forecast Brent crude to rise above $50 a barrel by end-2020. Chart 20Oil Supply Has Fallen Significantly Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com Footnotes 1  Please see Global Fixed Income Strategy, "Hunting For Alpha In The Global Corporate Bond Jungle," dated May 27, 2020, available at gfis.bcaresearch.com. Recommended Asset Allocation

Dear Client, In lieu of our regular report next week, we will be sending you a Special Report from my colleague Jonathan LaBerge. Jonathan will be examining the global effectiveness of recent pandemic containment measures to judge both the odds of a second infection wave and what policy responses are likely to be effective in countering one were it to occur. I hope you find the report insightful. Best regards, Peter Berezin, Chief Global Strategist Highlights Fiscal deficits have soared in the wake of the pandemic, putting government debt-to-GDP ratios on a trajectory to reach post-WWII highs in many countries. Contrary to popular belief, there is little reason to think that fiscal relief will make it more difficult for governments to repay their obligations down the road. Larger budget deficits tend to increase overall national savings when the economy is depressed because private savings rise more than enough to compensate for the decline in government savings. The end result is a higher level of national wealth that governments can tax in the future. That said, there is more than one way to tax national wealth. For political reasons, higher inflation coupled with financial repression may prove to be more feasible than other forms of taxation. While inflation is not an imminent risk, it could become a formidable problem in two-to-three years. Investors should maintain below-benchmark levels of duration in fixed-income portfolios and favor inflation-linked securities over nominal bonds. Gold prices will rise over the long haul. The yellow metal should perform well even in the near term if the dollar weakens during the remainder of this year, as we anticipate. Real estate investors should reallocate capital away from densely populated urban areas towards suburbs and farmland. Stay Cyclically Overweight Equities Global equities continued to climb higher this week, as more countries reopened their economies. As we discussed three weeks ago in our report entitled “Risks To The U,” the main downside risk facing stocks is a second wave of the disease.1 While the number of new COVID-19 cases has declined in many countries, it continues to rise in others. As a result, the global tally of new cases remains broadly flat. The daily number of deaths seems to be trending lower, but that could easily reverse if social distancing measures are abandoned too quickly (Chart 1). Chart 1COVID-19: Global New Cases Remain Broadly Flat, While Deaths Seem To Be Trending Slightly Lower Chart 2Joined At The Hip Given this risk, we do not have a strong near-term (3-month) view on the direction of equities. Google searches for the “coronavirus” have closely correlated with equity prices and credit spreads (Chart 2). If fears of a new outbreak were to escalate, risk assets would suffer. Looking at a cyclical (12-month) horizon, we still recommend a modest overweight to stocks. Even if a vaccine does not become available later this year, increased testing should allow for a more economically palatable approach to containment strategies. Ample fiscal support will also help. As we provocatively asked in a report entitled “Could The Pandemic Lead To Higher Stock Prices?”,2 one can easily imagine a scenario where central banks keep rates near zero for the foreseeable future, while ongoing fiscal stimulus enables the labor market to reach full employment. Such an outcome could allow corporate profits to return to pre-pandemic levels, but leave the discount rate lower than before. The end result would be a higher fair value for the stock market. Although we would not counsel investors to bank on such a fortuitous outcome, the probability of it occurring is reasonably high – probably in the range of 30%-to-40%. This makes us inclined to favor stocks over a cyclical horizon. Will Indebted Governments Spoil The Party? One potential flaw in this bullish thesis is that massive government deficits could push up interest rates, crowding out private-sector investment in the process. As we argue below, such worries are misplaced for now. For the time being, bigger budget deficits will likely lead to an increase in overall savings, thus raising investment relative to what would have happened in the absence of any stimulus. That said, as we conclude towards the end of this report, there will come a time – probably in two-to-three years – when most economies are back to full employment. If budget deficits are still high at that point, inflation and long-term bond yields could end up rising substantially. Keynes To The Rescue The IMF expects budget deficits in advanced economies to exceed 10% of GDP in 2020, significantly higher than during the financial crisis. The sea of red ink is projected to push government debt-to-GDP ratios to fresh highs in many economies (Chart 3). Chart 3AGovernment Debt Levels Have Surged In The Wake Of The Pandemic Chart 3BGovernment Debt Levels Have Surged In The Wake Of The Pandemic Chart 4The Paradox Of Thrift: Not Just A Theory Should bond investors be worried? Not for now. One of John Maynard Keynes’ great insights was that an individual’s attempt to increase savings could lead to a collective decline in savings, a phenomenon he called the paradox of thrift. Keynes argued that if everyone tried to save more, the resulting contraction in spending would cause total employment to fall by so much that overall income would decline by more than spending. As a result, aggregate savings would fall. This is precisely what happened during the Great Depression and in the aftermath of the Global Financial Crisis (Chart 4). The paradox of thrift implies that bigger budget deficits in a depressed economy will lead to an increase in overall savings, as private savings rise more than one dollar for every dollar decline in government savings. S-I=CA One can see this point using the familiar macroeconomic accounting identity which says that the difference between what a country saves and invests should equal its current account balance.3 In the absence of a change in the current account balance, any increase in investment will translate into an increase in savings. If the government stimulates aggregate demand by increasing spending, cutting taxes, or boosting transfer payments, companies are likely to respond by investing more (or at least not cutting capital expenditures as much as they would otherwise). Thus, if fiscal stimulus raises investment, it will also raise aggregate savings. Chart 5Huge Spike In The US Personal Savings Rate This conclusion has important implications for bond yields. If bigger budget deficits lead to an increase in overall savings, there is no reason to expect real bond yields to rise very much, at least in the short term. The failure of bond yields to rise since March, when governments began to trot out one fiscal stimulus package after another, is a testament to this fact. So too is the stimulus-induced surge in the US personal saving rate, which reached a record high of 33% in April (Chart 5). All That Money Printing If bigger government budget deficits are, in some sense, self-financing, why are so many people convinced that the Fed and other central banks are effectively “monetizing” deficits by buying up bonds? Part of the answer has to do with how one defines monetization. Governments create money whenever they purchase goods or services or make transfers to the public by running down their deposits at the central bank. In theory, the public could use that money to buy government bonds, which would allow the government to replenish its account at the central bank. In practice, it is usually a bit more circuitous than that. Chart 6Commercial Banks Deposits, Bank Reserve Held At The Fed, And Fed Holdings Of Treasuries Have All Expanded This Year What normally happens is that the public places the money in a commercial bank deposit and the commercial bank then transfers the money to its account at the central bank. Next, the central bank buys the bonds from the government, crediting the government’s deposit account at the central bank in the process. Chart 6 shows that this is precisely what has happened this year: Commercial bank deposits, bank reserves held at the Fed, and the Fed’s holdings of Treasuries have all risen by roughly the same amount. Granted, there is a bit more to the story. If the central bank buys bonds, it will push down bond yields at the margin, allowing the government to finance itself more cheaply than it could otherwise. However, this is a far cry from the sort of “money printing” that many people have in mind. True debt monetization occurs when governments lose all access to outside financing, forcing the central bank to pick up the tab. Such situations invariably involve accelerating inflation and a collapsing currency, which often culminates in hyperinflation. This is clearly not the case today. Back To Full Employment The idea that bigger budget deficits can generate enough private savings to more than fully compensate for any loss in government savings is applicable only for economies with spare capacity. Once the economy reaches full employment, fiscal stimulus will not lead to more income or production since everyone who wants a job already has one. At that point, bigger budget deficits will cause the economy to overheat and inflation to rise, potentially forcing the central bank to raise rates. Higher interest rates will reduce investment. Higher rates will also put upward pressure on the currency, leading to a reduction in net exports and a corresponding deterioration in the current account balance. If investment and the current account balance both decline, then savings, which is just the sum of the two, must also fall. Strategies For Alleviating A Debt Burden Once the free lunch from fiscal stimulus disappears, the question of how to address the government debt accumulated during the downturn becomes paramount. There are four ways to reduce the ratio of government debt-to-GDP: 1) outgrow the debt burden; 2) tighten fiscal policy; 3) default; and 4) inflate away the debt. Outgrowing It At the end of the Second World War, many governments found themselves saddled with high levels of debt. In the US, the government debt-to-GDP ratio stood at 121% in 1945. In the UK, it hit 270%. In Canada, it reached 155%. For the most part, these governments did not repay the debt they incurred during the war. As Chart 7 shows, the nominal value of debt outstanding either rose or remained broadly constant following the war. What happened was that rapid GDP growth led to a shrinkage in debt-to-GDP ratios. Compared with the post-war period, the two drivers of an economy’s growth potential, labor force and productivity growth, are both weaker now. Thus, outgrowing the debt by raising the denominator of the debt-to-GDP ratio will be more difficult than in the past. It’s About g-r That said, the trajectory of the debt-to-GDP ratio does not depend solely on GDP growth; it also depends on the interest rate that the government pays to service its debt. Conceptually, it is the difference between the two that determines whether the level of any given budget deficit is sustainable or not. While trend GDP growth in advanced economies has declined since the 1950s, equilibrium interest rates have also fallen. As a consequence, the spread between growth rates and interest rates is only somewhat smaller in advanced economies today than it was in the 1950s and 60s and notably higher than it was in the 1980s and 90s (Chart 8). Indeed, as Chart 9 shows, g-r has been trending higher for hundreds of years! Chart 7The Case Of Outgrowing The Debt Burden Post-WWII Chart 8The Rate Of Economic Growth Has Been Higher Than Interest Rates   Chart 9A Multi-Century Trend In The Spread Between Growth And Interest Rates Today, government borrowing rates in most economies are well below trend growth rates. No matter the size of the budget deficit, the ratio of debt-to-GDP will converge to a stable level as long as the interest rate the government pays on the debt is below the growth rate of the economy.4  A Gordian Fiscal Knot Of course, there is no guarantee that real rates will remain below the rate of trend growth. As we have discussed before, the exodus of baby boomers from the labor force, a peak in globalization, and rising political populism could all curtail aggregate supply, leading to a depletion of national savings.5 What would happen if governments allowed debt levels to reach very high levels only to find that the neutral rate of interest — the interest rate consistent with full employment and stable inflation — has risen above the growth rate of the economy? Raising the policy rate would be very painful in a high-debt environment because even a small increase in interest rates would lead to a large rise in interest payments. Faced with this reality, some governments might elect to tighten fiscal policy. An increase in taxes or a decline in government spending would not only create some resources to pay back debt, but it would also reduce aggregate demand, pushing down the neutral rate of interest in the process. Don’t Blame The Stimulus Ironically, all the fiscal relief efforts that governments have carried out over the past few months have probably left them better placed to pay back debt than if no stimulus had been undertaken in the first place. Box 1 illustrates this point with a numerical example, but the intuition for this claim can be seen easily enough. As noted earlier, fiscal stimulus in a depressed economy will raise overall savings. This means that after the pandemic is over, governments will have a larger tax base available to them than they would have had in the absence of any stimulus (although, obviously, the tax base would be even larger if the pandemic had never occurred). The Inflation Solution Chart 10Long-Term Inflation Expectations Remain Very Depressed Still, any decision to tighten fiscal policy down the road is going to be an inherently political one. What if governments do not have the political will to tighten fiscal policy even if the economy begins to overheat? Defaulting on the debt is always an option in that case, but not one that any sensible government would choose given the devastating impact this would have on the financial system and broader economy. Rather, it is conceivable that governments will lean on central banks to keep rates low and let inflation accelerate. While higher inflation will not boost real GDP, it will raise nominal GDP, allowing the ratio of government debt-to-GDP to decline. Investors currently assign very low odds to such an outcome. Long-term market-based inflation expectations remain very depressed (Chart 10). Yet, we think such an eventuality is more plausible than widely believed. As long as inflation does not spiral out of control, central banks are likely to welcome rising prices. A higher inflation rate would make monetary policy more effective by allowing central banks to bring real rates deeper into negative territory whenever the economy falls into recession. Higher inflation would also result in steeper yield curves, reoxygenating commercial banks’ profitability. Profiting From Higher Inflation The path to higher interest rates is paved with lower rates. In order to generate inflation, central banks will need to keep rates at very low levels even once the economy has returned to full employment. Given that unemployment is quite high today, inflation is not an imminent risk. However, it could become a formidable problem in two-to-three years. Investors should maintain below-benchmark levels of duration in fixed-income portfolios and favor inflation-linked securities over nominal bonds. While gold is no longer super cheap, it remains a good hedge against inflation. The yellow metal should also do well if the dollar weakens during the remainder of this year, as we anticipate. As a countercyclical currency, the dollar tends to fall whenever global growth picks up (Chart 11). Chart 11Gold Will Do Well When The Dollar Weakens As Global Growth Picks Up Chart 12Farmland Would Benefit From High Inflation Lastly, land will gain from low interest rates in the near term and higher inflation in the long term. Farmland and suburban land are particularly appealing. The pandemic has made remote working more commonplace. It has also highlighted the potential dangers of living in densely populated cities. Since most suburbs are built on top of land that was previously zoned for agriculture, farmland should benefit from the retreat from urban living, much like it did during the inflationary period of the 1970s (Chart 12). Box 1Saving More By Spending More   Peter Berezin Chief Global Strategist peterb@bcaresearch.com   Footnotes 1  Please see Global Investment Strategy Weekly Report, “Risks To The U,” dated May 7, 2020. 2  Please see Global Investment Strategy Weekly Report, “Could The Pandemic Lead To Higher Stock Prices?” dated April 23, 2020. 3  Gross Domestic Product (GDP) can be computed as the sum of consumption (C), investment (I), government spending (G), and net exports (X-M). Gross National Product (GNP) is equal to GDP except that the former includes net income from abroad (which is included in the current account balance). Thus, GNP=C+I+G+CA, or GNP-C-G=I+CA. Savings (S) is equal to GNP-C-G. Taken together, the two expressions imply S-I=CA, or S=I+CA. 4  Please see Global Investment Strategy Weekly Report, ”Is There Really Too Much Government Debt In The World?” dated February 22, 2019. 5  Please see Global Investment Strategy Weekly Report, “A Structural Bear Market In Bonds,” dated February 16, 2018. Global Investment Strategy View Matrix Current MacroQuant Model Scores

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