Geopolitics

Highlights Social unrest in the US is driven by structural and cyclical factors as well as election-year opportunism. It can still cause volatility. Unrest will weigh on consumer and business confidence – adding to already ugly fundamentals. The market has come around to our view that Trump is an underdog in the election. This is a risk to equities since a Democratic victory will bring full control of government. President Trump has low legal or political constraints to deploying the military if violence gets worse in the streets. This increases tail risks of a civilian death that amplifies the unrest. A “silent majority” of voters could give Trump a polling boost as a “law and order” candidate later this year. This could require us to upgrade his odds of reelection. The US dollar faces long-term headwinds but we are unlikely to reinitiate our long EUR-USD trade until the US election cycle is complete. Feature Chart 1Markets Skyrocket On Stimulus & Reopening Markets Skyrocket On Stimulus & Reopening Markets Skyrocket On Stimulus & Reopening Economic reopening and stimulus are winning the day as investors continue to look forward to a time when growth and corporate earnings recover yet inflation and risk-free rates remain suppressed. Judging by the breakout of cyclical versus defensive stocks and risk-on versus risk-off currencies, the rally could continue and the gap between stock markets and macro fundamentals could widen further for some time (Chart 1). The market is looking through the most widespread social unrest since 1968 in the United States, which emerged due to the death in police custody of a black man, George Floyd, in Minneapolis. History suggests that over a one-year horizon, social unrest can be ignored – but in the near term it could yet provoke volatility. This risk is underrated because the market already believes that the unrest is a known quantity without material impact, yet this report shows otherwise. We see four new risks, the first three negative for the market. Chart 2US Consumer Sentiment Is Vulnerable US Consumer Sentiment Is Vulnerable US Consumer Sentiment Is Vulnerable Consumer confidence and activity could worsen in the face of historic national unrest. The slight uptick in improving consumer expectations could reverse (Chart 2). President Trump’s odds of reelection could fall permanently, triggering a downgrading of long-run earnings expectations. A mistake could cause unrest to reach an unknown critical threshold that strikes fear into investors about US stability. The US debate has moved on from racism to “fascism” as Trump’s opponents criticize him for his authoritarian rhetoric and deployment of military forces to secure parts of Washington, DC. Structural factors are driving the riots which means they may smolder and additional incidents could cause them to flare up throughout summer and fall. The deployment of troops to quell civil unrest – as in any country at any time – could easily lead to bloody mistakes. The upside risk is that Republican senators will capitulate even sooner on fiscal spending measures, seeing that their corporate power base is likely to feel more concerned about the collapse of society. The House Democrats and President Trump already share an interest in larding up the spending, so it was only a matter of time till the senate caved in anyway. If the next $2 trillion arrives without the June-July hiccup that we expect, then the market could power higher (Chart 3). Chart 3Global Fiscal Stimulus Continues To Grow Social Unrest Can Still Cause Volatility Social Unrest Can Still Cause Volatility In this report we show why US social unrest is structural and how it can still bring equity volatility. Also, the online betting market has caught up to our view that Trump is the underdog in the election. The prospect of full Democratic Party control could start to weigh on US equities. The upside risk to this view would be markets cheer Biden – which is unlikely for long – or if the violent protests create a “silent majority” that helps Trump win the swing states. If his polling improves in the wake of the riots – and the stock rally continues unabated – then we may upgrade his reelection odds from 35% to 50% or higher. Bottom Line: A pullback would be a buying opportunity, but a 10% correction could easily transpire given that a falling market reduces Trump’s odds greatly and could kill the market’s faith in Trump reflation policy from 2021-24. How Social Unrest Came To The United States The US was ripe for a major bout of unrest, as we have highlighted in past reports such as “Populism Blues” (2017), “Civil War Lite” (2019), and “Peak Polarization” (2020), as well as in our top five “Black Swans” report for this year. Our updated “Great Gatsby Curve” shows countries with high levels of income inequality and social immobility. The US is right in the danger zone, joined by other countries that have had unrest or political disruptions (Argentina, Chile, UK, Italy) or will soon (China) (Chart 4). African Americans suffer the worst of these ills and also have long-running grievances with the criminal justice system. Chart 4The US Is In The Danger Zone For Populism, Unrest Social Unrest Can Still Cause Volatility Social Unrest Can Still Cause Volatility Unrest was an easy prediction even before the pandemic and recession, which made matters worse. The US ranks last, among developed markets, just below Greece, in our COVID-19 Unrest Index (Table 1). This index combines four factors – economic fundamentals, vulnerability to COVID-19, household grievances, and governance indicators – to rank countries according to their susceptibility to social unrest. US unemployment has soared higher than that of other countries as it has less generous automatic stabilizers. Table 1US Ranks Worst In Our COVID-19 Social Unrest Rankings Social Unrest Can Still Cause Volatility Social Unrest Can Still Cause Volatility When it comes to the virus, the US is not any harder hit than most of its European peers (Chart 5). And the black community is not much harder hit than whites, although both have suffered more than their population share would imply, and more than the Hispanic community (Chart 6). Chart 5US No Different Than Western Europe On COVID-19 Deaths Social Unrest Can Still Cause Volatility Social Unrest Can Still Cause Volatility   Chart 6COVID-19 Least Deadly For Hispanics Social Unrest Can Still Cause Volatility Social Unrest Can Still Cause Volatility However, the lockdowns have caused the unemployment rate to soar and exacted a greater toll on the least educated and lowest paid members of society. The election is enflaming the situation. President Trump’s economy has now performed little better for households than President Obama’s economy, assuming they suffer an income and wealth shock at least equal to that of 2008-09 (Chart 7). Chart 7Households Suffer Massive Income Shock Households Suffer Massive Income Shock Households Suffer Massive Income Shock Given the collapsing economy, Trump is doubling down on “law and order,” taking an aggressive stance against rioting and looting and thus provoking a backlash. The media is also in a feeding frenzy as the pandemic and economic reopening narratives lose traction and yet Trump perseveres. Polarization is intensifying as a result. Trump’s rhetoric has been egregious as always. His threat to invoke the Insurrection Act of 1807 is not. President George Bush Sr invoked the act to suppress the LA riots in 1992. The act’s provisions, as well as the specific exceptions to the posse comitatus laws and norms, give the president broad discretion in matters precisely like these. The real constraint is not legal but political: any popular backlash from Trump and his advisers in trying to “dominate the battlespace” when it comes to civilians at home. Rioting and looting are also unpopular, so a larger crackdown could easily happen if more unrest takes place. Since the riots are driven by structural factors, they could still escalate, especially if another incident of police brutality occurs. Bottom Line: US unrest is driven by structural and cyclical factors and thus we are in for another “long, hot summer” like 1967. Negative surprises should be expected. The larger risks have to do with the impact on the election and sentiment. Trump’s Polling Was Dropping Even Before The Riots Trump’s approval rating has fallen to the lowest level this year and diverged from the historic average (Chart 8). This increases the risk that the market experiences volatility either in expectation of “regime change” in November or in reaction to Trump’s attempts to regain the initiative. Trump’s deviation from President Obama’s approval at this stage in 2012 is a warning sign (Chart 9). Chart 8Trump’s Polling Drops Below Average Social Unrest Can Still Cause Volatility Social Unrest Can Still Cause Volatility Chart 9Trump Falls Off Obama’s Pathway To Reelection Social Unrest Can Still Cause Volatility Social Unrest Can Still Cause Volatility Chart 10Trump’s Pandemic Bounce Turns Negative, Unlike Others Social Unrest Can Still Cause Volatility Social Unrest Can Still Cause Volatility Trump and the Republican Party received a smaller polling bounce from the pandemic – and year-to-date the bounce is not only gone but has turned negative, comparable only to Vladimir Putin and United Russia (Chart 10). At its peak it was smaller than that of previous US presidents in crisis situations (Table 2, see Appendix). These data come from before the George Floyd incident which will make matters worse for Trump, given that initial polls suggest 35% approve and 52% disapprove of his response to it. The presumptive Democratic nominee Joe Biden is narrowly leading in all major swing states (Chart 11A). Trump has dropped off in critical swing states of Florida, Wisconsin, and Arizona (Chart 11B). Biden is closer to Trump than he should be in states like Ohio and even Texas. Chart 11ATrump Trailing Biden In Swing States Social Unrest Can Still Cause Volatility Social Unrest Can Still Cause Volatility Chart 11BTrump Loses Critical Support In FL, WI, AZ Social Unrest Can Still Cause Volatility Social Unrest Can Still Cause Volatility Chart 12Biden Polling Better Than Clinton Did Against Trump Social Unrest Can Still Cause Volatility Social Unrest Can Still Cause Volatility Biden is tentatively outperforming Hillary Clinton’s showing in 2016 in head-to-head polls against Trump, including in swing states (Chart 12). He has not been on voters’ minds much during the crises. But he has strong support among African American voters, who primarily handed him the party’s nomination, so he may be able to exploit the unrest. Voters indicate they favor him on race relations as well as the coronavirus, though they still favor Trump on the economy. Bottom Line: Trump’s polling was deteriorating before the social unrest. It will suffer more in the near term. But there are still five months until the election. The Market Now Recognizes That Trump Is An Underdog Now, with the country’s biggest cities ablaze, the market is waking up to the fact that Trump and the Republicans have a much greater chance of entirely losing control of the government in just five months. Online gamblers have recently upgraded Biden and the Democrats substantially (Chart 13). Opinion polling has shown weakness but now it is likely to seep into the financial industry’s consciousness that US domestic political risks could still go higher. Policy uncertainty will not fall as sharply as otherwise expected during the economic reopening. Unrest typically reflects negatively on the ruling party, suggesting the status quo is unacceptable and driving voters to vote for change. This is one of the 13 keys to the presidency under the scheme of Professor Allan J. Lichtman, at American University, who has predicted every popular vote outcome since 1984. If one accepts this thesis, then at least five of the keys have now turned against Trump and the GOP. If the economy somehow continues to shrink in the third quarter, or if GDP per capita falls harder than estimated in Chart 7 above, Lichtman’s model will turn against Trump (Table 3, see Appendix). Our own argument has been that a health crisis and surge in unemployment alone are enough to undercut him given his thin margins of victory four years ago and low approval rating. The George Floyd incident reinforces this logic. Not only is voter turnout correlated with the change in unemployment over the president’s term in office, but the correlation holds in swing states and among African Americans. Here is where the devastating impact of COVID-19 among blacks may be relevant (Chart 14). Chart 13Online Bookies Now See Trump Is Underdog Social Unrest Can Still Cause Volatility Social Unrest Can Still Cause Volatility Chart 14Hardship For Blacks In Swing States Social Unrest Can Still Cause Volatility Social Unrest Can Still Cause Volatility Chart 15Unemployment Pushes Up Voter Turnout (For Blacks And All) Social Unrest Can Still Cause Volatility Social Unrest Can Still Cause Volatility If the pandemic and unemployment did not already provide sufficient motivation, then the George Floyd incident might rally this core Democratic Party constituency to turn up at the ballot box (Chart 15). That is a threat to President Trump given that Barack Obama is not on the ballot, so black turnout is unlikely to reach 2008 or 2012 levels. Bottom Line: An increase in African American voter turnout due to unemployment and poor race relations would broaden the electoral pathway to a Democratic victory in November. A Risk To The View: The Silent Majority Could the unrest help Trump? Possibly. Once the peaceful protests turned violent, the possibility emerged that Trump could benefit. The Democrats are not in a strong position whenever they link themselves to economic lockdowns and rioting and looting. It is clear from the police killings and unrest of 2014-15 that more and more people have lost confidence in police treating blacks and whites equally (Chart 16), but they do not make up a majority. Chart 16Over Time, Voters Losing Confidence In Police Fairness Social Unrest Can Still Cause Volatility Social Unrest Can Still Cause Volatility Chart 17Majority Sees Racism As Individual, Not Institutional Social Unrest Can Still Cause Volatility Social Unrest Can Still Cause Volatility Moreover, two-thirds of citizens, two-thirds of Hispanics, and almost half of blacks believed at that time that racism and discrimination stem from individual actions rather than institutional factors (Chart 17). Confidence and institutional trust will fall during today’s crisis moments but the above polls suggest limits to the protest movement. Generally Americans are satisfied with the work of their local police departments (Chart 18). This includes 72% of blacks. Only about a quarter of Americans report being harassed by the police at any time, according to a Monmouth University poll. Chart 18Silent Majority? Most Americans Satisfied With Local Police Social Unrest Can Still Cause Volatility Social Unrest Can Still Cause Volatility Almost 80% of people believe police funds should be increased or kept the same, versus 21% who agree with defunding the police. Only 39% of blacks support such a proposal (Chart 19). If House Democrats pass legislation characterized as taking funds away from police it will hurt them. Chart 19Silent Majority? Americans Don’t Want To Cut Police Funding Social Unrest Can Still Cause Volatility Social Unrest Can Still Cause Volatility Finally, regarding the use of the military, 58% of Americans approve of the US military supplementing city police forces, while 30% oppose (Chart 20). George Bush Sr deployed troops in a similar predicament, the LA riots of 1992, albeit with an invitation from the California governor. Chart 20Silent Majority? Americans Mostly Support Military Aid To Police Amid Unrest Social Unrest Can Still Cause Volatility Social Unrest Can Still Cause Volatility Legal constraints on Trump’s use of the military are low. Given that the political constraint is also low, a resurgence in violence will likely lead to a crackdown. Trump could benefit if it is managed successfully, but the risk of a bloody mistake that harms or kills civilians would also go up. Bottom Line: Trump could benefit from his pitch as the candidate of law and order if unrest continues, violence worsens, and his actions are deemed to restore order. We will upgrade Trump’s reelection odds if his polling improves and the stock market and economy continue to rebound. Investment Takeaways Historic bouts of unrest show that market volatility occurred in the wake of the 1965-69 disturbances, the 1992 LA riots, the breakdown of order in New Orleans after Hurricane Katrina in 2005, and the protests and riots against police brutality in 2014-15. Unrest did not prevent the market from rallying in all of these cases, but it did in some, and pullbacks also followed unrest periods. In every case presidential approval suffered – and in 1968, 1992, 2006, and 2014 the ruling party suffered losses in the election (Charts 21 A-D). Chart 21AThe ‘Long, Hot Summer’ Saw Inflation, Volatility The 'Long, Hot Summer' Saw Inflation, Volatility The 'Long, Hot Summer' Saw Inflation, Volatility Chart 21BLA Riots Saw Unemployment, Volatility LA Riots Saw Unemployment, Volatility LA Riots Saw Unemployment, Volatility Chart 21CKatrina Saw Volatility, Presidential Approval Drop Katrina Saw Volatility, Presidential Approval Drop Katrina Saw Volatility, Presidential Approval Drop Chart 21DFerguson Saw Volatility Amid Falling Unemployment Ferguson Saw Volatility Amid Falling Unemployment Ferguson Saw Volatility Amid Falling Unemployment Chart 22Confidence Suffers Amid Social Unrest Social Unrest Can Still Cause Volatility Social Unrest Can Still Cause Volatility Furthermore, consumer and business confidence generally suffered in these periods (Chart 22). Trump’s reelection bid could fail to recover, which would make him a lame duck and heighten political risks dramatically. Our longstanding view that the party that wins the White House will also win the senate is reinforced by this year’s polls. The market is reacting to stimulus now but policies look to turn a lot tougher on business. The election puts a self-limiting factor into the equity rally. Either the market sells off in the short run to register the currently likely victory of Joe Biden, who will hike taxes, wages, and regulation, or the market rallies all the way till the election, increasing the chances of President Trump’s reelection, which would revolutionize the global system, especially on trade, and would require a selloff around December. The US dollar faces near-term headwinds as global growth recovers and uncertainty related to COVID-19 abates, but the near term is murky, whereas the major headwinds are over a cyclical time horizon. Our theme of “peak polarization” in the US contrasts starkly with our theme of “European integration” and implies that the euro can continue to advance. However, we are unlikely to reinitiate our long EUR-USD trade until the US election cycle is complete. The risk of a Trump victory is still substantial and we view Europe as a marginal loser in that scenario. We still expect investors to flee to the dollar in the event of any global crisis, even if it originates in the United States.   Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com Appendix Table 2Trump’s Crisis Polling Bounce Compared To Previous Presidential Bounces Social Unrest Can Still Cause Volatility Social Unrest Can Still Cause Volatility Table 3Lichtman’s 13 Keys To The Presidency Likely Turning Against Trump … Economy Critical Social Unrest Can Still Cause Volatility Social Unrest Can Still Cause Volatility

Highlights Our base case reflects our view that China’s strong fiscal and monetary stimulus, combined with a weaker US dollar, will provide a favorable backdrop for copper markets in 2H20. Supply factors are for the most part reflected in current copper prices. In 2H20, the speed of the demand recovery will be the determining factor for prices. Global policy uncertainty remains high.  Assessing the joint effects of global monetary and fiscal stimulus, along with consumers’ willingness to spend once lockdowns are lifted will keep uncertainty at relatively high levels.  A possible second wave of COVID-19 returning large economies to lockdown status looms large for copper markets, and for commodity markets generally. The combination of safe-haven demand and a continued dollar shortage for borrowers without access to US swap lines could keep the dollar well bid, suppressing foreign flows to EM economies and commodity demand at the margin. Tactically, we remain on the sidelines until the fog clears around these known and unknown unknowns.  A $3/lb COMEX refined copper price is likely in 2H20, but the risks to this outlook remain high. Feature Copper prices will end the year higher vs. current levels in our base case. But uncertainty remains elevated. Copper prices will end the year higher vs. current levels in our base case. But uncertainty remains elevated. Assessing the synchronicity of EM recoveries and the joint effects of global monetary and fiscal stimulus, along with consumers’ willingness to spend once lockdowns are lifted is extremely difficult. Looming over all of these considerations: A possible second wave of COVID-19 returning large economies to lockdown status loom large. Tactically, we remain on the sidelines as the fog clears around some of these known and unknown unknowns. Importantly, our positive view rests on our expectation of a robust recovery in China’s economic activity and, to a lesser extent, in its main export destinations, which were hit later by the pandemic. A weak recovery in China would slow the rate at which the current copper supply surplus subsides. At ~ $2.50/lb, copper prices have recovered significantly since bottoming in March at $2.11/lb on the COMEX. Still, clearing the $3.30/lb double top reached in June 2018 will require either a significant increase in global demand or a sharp contraction in supply, which we do not expect. Copper markets were severely hit by the global pandemic: Prices fell 10% in January, as the case count grew in China – the largest copper-consuming market – followed by another 19% decline as the virus spread globally (Chart of the Week). The intensification of lockdowns globally pushed copper markets to a 60k MT surplus as of March – the latest data reported by the World Bureau of Metal Statistics (WBMS) – from a 20k MT deficit in 2019. Bearish sentiment moved our Tactical Composite Indicator – which captures sentiment, positioning, and momentum dynamics – to oversold territories on in March (Chart 2). Chart of the WeekCopper Prices Were Severely Hit By The Pandemic Speed Of Demand Recovery Remains Key To Copper Prices Speed Of Demand Recovery Remains Key To Copper Prices Chart 2Bearish Sentiment Crushes Copper Prices Bearish Sentiment Crushes Copper Prices Bearish Sentiment Crushes Copper Prices After reaching a low of $2.11/lb on March 23, COMEX copper prices surged 18% with few interruptions as the Chinese economy reopened, and global monetary and fiscal authorities supplied unprecedented economic support (Chart 3). This prompted a wave of short-covering by money managers, releasing some of the downward pressure on prices (Chart 4). Chart 3Unprecedented Fiscal Response Speed Of Demand Recovery Remains Key To Copper Prices Speed Of Demand Recovery Remains Key To Copper Prices Chart 4Money Managers Neutral For Now Money Managers Neutral For Now Money Managers Neutral For Now Still, hedge funds have not yet entered bullish positions on the metal. And, importantly, inventory levels are not drawing sharply. China’s Economy Bottomed, World ex-China Still Contracting Our outlook hinges primarily on our assessment of China’s policy-driven copper demand – both from domestic usage perspective, and, to a lesser extent, from copper-intensive exported goods. Since the end of the Global Financial Crisis (GFC), copper prices have mostly shadowed China’s economic cycles (Chart 5). China’s importance for copper markets now dominates that of major DM countries (Chart 5, panel 3). The influence of global supply-demand fundamentals on copper prices has declined. Prices are increasingly policy-driven with supply adjusting to demand as dictated by Chinese policymakers’ decisions on the allocation of total social financing funds in that economy. Thus, our outlook hinges primarily on our assessment of China’s policy-driven copper demand – both from domestic usage perspective, and, to a lesser extent, from copper-intensive exported goods. According to the International Copper Study Group (ICSG), around 17% of Chinese copper demand comes from exports of products containing copper.1 In “normal” times, we rely heavily on our monthly indicators to gauge economic and commodity cycles. However, the speed with which the COVID-19 pandemic evolves – and the associated fiscal and monetary responses to it – makes short-term forecasting of cyclical commodities a perilous task. Chart 5DM Consumption Pales Vs. China DM Consumption Pales Vs. China DM Consumption Pales Vs. China High-frequency data suggest Chinese economic growth bottomed in March and is rapidly recovering (Chart 6). Chart 6Chinese Economy Returning To Normal Speed Of Demand Recovery Remains Key To Copper Prices Speed Of Demand Recovery Remains Key To Copper Prices Meanwhile in China’s major export destinations, the number of confirmed COVID-19 cases appear to be flattening, containment measures are gradually easing, and mobility is improving (Chart 7, panel 1 and 2). Globally, the copper- and oil-to-gold ratios have stabilized, and stock prices for nine of the largest copper producers have trended up since March 23 (Chart 7, panel 3 and 4). That said, we believe it is still too early to adopt a high-conviction view about a price recovery trajectory. For one, China recently reintroduced containment measures in certain regions, as clusters of coronavirus cases were detected, highlighting the fragility of the current recovery.2 Chart 7China's Major Export Partners Could Rebound Soon China's Major Export Partners Could Rebound Soon China's Major Export Partners Could Rebound Soon Chart 8Strong Domestic Demand, Weak Export Growth Strong Domestic Demand, Weak Export Growth Strong Domestic Demand, Weak Export Growth Moreover, the rebound in overall Chinese demand hasn’t fully offset the collapse in its exports. As a result, the reopening of the supply side of the economy outpaced demand growth (Chart 8). Extrapolating this to its copper market: Chinese refined copper production (40% share of world output) is facing robust domestic demand but weak export demand for copper (44% and 9% of world demand), leaving its market with a supply surplus. Nonetheless, absent a severe second wave of COVID-19 cases, the infrastructure-focused stimulus and market-friendly real estate policies in the country will allow internal demand to overtake production in 2H20, despite limited external demand (more on this below). China’s Credit Growth To Drive Copper Demand Higher The key message emerging from the NPC is that policymakers are willing to do whatever it takes – including abandoning their deleveraging objectives – to reflate the economy.  Markets were unimpressed by the fiscal package announced during China’s National People’s Congress (NPC) last month, which, for the first time in decades, did not contain an annual economic growth target in the Government Work Report (Table 1). Even so, the key message emerging from the NPC is that policymakers are willing to do whatever it takes – including abandoning their deleveraging objectives – to reflate the economy. Broad money and total social financing growth will accelerate relative to last year and notably exceed nominal GDP growth. Our Emerging Markets strategists expect China’s fiscal and credit impulse will reach 15.5% this year (Chart 9).3 Table 1No Economic Growth Target In The Government Work Report Speed Of Demand Recovery Remains Key To Copper Prices Speed Of Demand Recovery Remains Key To Copper Prices Additionally, China pledged to stabilize employment and targeted the creation of 9 million new jobs in urban areas. This is an ambitious target amidst the massive layoffs induced by the COVID-19 pandemic this year. Chart 9Chinese Credit Growth Will Surge Chinese Credit Growth Will Surge Chinese Credit Growth Will Surge Policymakers also reserved policy space to be used – without the approval of the NPC at the Politburo’s mid-year review – in the event the shock from the pandemic proves persistent.4 Past episodes of Chinese stimulus resulted in strong rallies in base metals prices. Given China now represents more than half of global copper consumption (vs. 43% in 2009 following the GFC, and 32% in 2012 following the euro area debt crisis), we expect this new round of stimulus will lead to a sharp increase in copper prices.5 By and large, refined copper prices are highly sensitive to growth in EM imports – particularly China’s – which are closely tied to income growth. The latest CPB World Trade Monitor data for March shows EM ex-China imports have been resilient suggesting the rebound in China’s economic activity might be spilling over to other EMs highly leveraged to China (Chart 10). Still, our main cyclical commodity demand indicators were declining as of April. We expect stimulus-driven EM income and investment growth will show up in our indicators in 2H20 (Chart 10). Chart 10Awaiting A Rebound In Our Cyclical Indicators Speed Of Demand Recovery Remains Key To Copper Prices Speed Of Demand Recovery Remains Key To Copper Prices Stalling Primary And Secondary Supply Growth In addition to the demand implications, lockdowns also resulted in restrictions – and few complete shutdowns – in mining activities in copper-producing countries. The ICSG revised down its global mine and refined copper output by 950k MT and 1.1mm MT, respectively, for this year on the back of the COVID-19 pandemic.6 The group now expects 2020 mine supply to decline by 3% this year and refined production to remain flat y/y, for a second consecutive year. While important, these adjustments were insufficient to completely offset the large negative demand shock in 1Q and 2Q20.7 In 2H20, the supply-side outlook rests on the evolution of COVID-19 cases and associated governments’ responses in major ore and refined copper-producing countries (i.e. Chile, Peru, US, DRC, China, Russia, and Japan). So far, mining activities were mostly treated as essential and allowed to operate at reduced capacity under additional sanitary and social distancing guidelines. Confirmed cases in these countries appears to be slowing, this could allow activity to slowly return to normal (Chart 11). Chart 11Further Supply Disruptions Are Unlikely Speed Of Demand Recovery Remains Key To Copper Prices Speed Of Demand Recovery Remains Key To Copper Prices Supply factors are for the most part reflected in current prices. Going forward the speed of the demand recovery will be the determining factor for copper prices.  While mining and refining of copper concentrates were often classified as essential, scrap activities were not. According to the ICSG, copper scrap supplied decreased significantly as trade flows and generation, collection, and disassembling activities were disrupted by the pandemic. China’s import of scrap copper – a key input for Chinese refiners – declined 37% in 1Q20. This prompted the government to allow more scrap imports to fill the gap, but it might struggle to find suppliers. Globally, scrap makes up ~ 25% of total refined copper supply, thus, it usually plays a non-negligible role in the rebalancing of global markets. Supply factors are for the most part reflected in current prices. Going forward the speed of the demand recovery will be the determining factor for copper prices. In addition, the crisis began at an abnormally low inventory level. Thus, despite the temporary build in 1Q20, inventories are still below their 2010 to 2019 average. The rebound in demand, combined with flat supply and limited scrap availability, will move Chinese inventory down in 2H20 and offset any builds at the LMEX and COMEX warehouses, supporting copper prices this year (Chart 12). Chart 12Inventories Still Low Despite Builds In 1Q20 Inventories Still Low Despite Builds In 1Q20 Inventories Still Low Despite Builds In 1Q20 USD Depreciation Leads To EM Economic Growth Uncertainty over the duration of lockdowns globally continues to fuel safe-haven demand for USD. As the COVID-19 shock abates we expect a weaker US dollar to be more supportive to copper demand. Uncertainty over the duration of lockdowns globally continues to fuel safe-haven demand for USD (Chart 13). The shortage of USD experienced by EM debtors servicing dollar-denominated debt continues to hamper their recovery. The combination of safe-haven demand and a continued dollar shortage for borrowers without access to US swap lines is keeping the dollar well bid, suppressing foreign flows to EM economies and commodity demand at the margin (Chart 14, panel 1). Chart 13Global Financial Cycles Hurting EM Economies Speed Of Demand Recovery Remains Key To Copper Prices Speed Of Demand Recovery Remains Key To Copper Prices Chart 14Uncertainty Keeps USD Well Bid Uncertainty Keeps USD Well Bid Uncertainty Keeps USD Well Bid The Fed will continue to accommodate USD demand, in an ongoing attempt to reverse a tightening of global financial conditions. EM economies – the bulk of base metals demand growth – are facing dual domestic demand and global financial shocks.8 These economies have become more dependent on foreign portfolio inflows, both in debt and equity markets (Chart 14, panel 2). Thus, global financial cycles now have a significant impact on their growth. The main factors influencing these flows are risk appetite, EM exchange rates, and DM interest rates.9 We expect all factors to support inflows to emerging markets as the COVID-19 shock abates. The Fed will continue to accommodate USD demand, in an ongoing attempt to reverse a tightening of global financial conditions. A lower USD will decrease the local-currency cost of consuming commodities ex-US. Metals producers' ex-US will face higher local-currency operating costs, reducing supply growth at the margin. A depreciating USD is a necessary factor for our bullish cyclical commodities view (Chart 15). The risk to this view is a severe second wave of COVID-19 infection which would cause safe assets to spike anew. Chart 15Metals Inversely Correlated With The US Dollar Metals Inversely Correlated With The US Dollar Metals Inversely Correlated With The US Dollar $3.00/lb Copper Price Likely; Geopolitical Risks Mounting Over the short term, geopolitical risks – chiefly mounting Sino-US tensions – could derail the rally in copper prices and other risk assets.  For April, our copper demand model suggested prices were at equilibrium relative to underlying demand trends (Chart 16). Chart 16Copper Prices Will Rise As The USD Depreciates Copper Prices Will Rise As The USD Depreciates Copper Prices Will Rise As The USD Depreciates When simulating a 10% decline in the USD and a rebound in EM import growth in 2H20, our model suggests COMEX copper prices could move 25% higher, holding everything else constant. In reality, the USD’s path and the extent of the EM import rebound are among the key known unknowns we confront in estimating a model for copper prices. We do not have a precise view on these variables, which is why we run simulations. Theory would suggest the stimulus we are seeing globally points to a lower USD and a pick-up in EM imports, however, and these factors will create a more supportive environment for metals prices. Over the short term, geopolitical risks – chiefly mounting Sino-US tensions – could derail the rally in copper prices and other risk assets. With the US election now only 5 months away, President Trump’s odds of being reelected on the back of a strong economy are fading amidst the COVID-19 pandemic. According to our Geopolitical strategists, Trump is the underdog and will need to double down on foreign and trade policies to prop-up his chances of winning. Meanwhile, China is seeking to solidify its sphere of influence.10 This is causing US-China tensions to intensify. Depending on the nature of the actions taken by the Trump administration (i.e. increasing tariffs on US imports of Chinese goods vs. cutting China’s access to foreign technology), metals prices could suffer, as was the case in 2018. With these geopolitical risks in mind, we maintain that China’s strong fiscal and monetary stimulus, combined with a falling US dollar will provide a favorable backdrop for copper markets in 2H20.   Hugo Bélanger Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com     Commodities Round-Up Energy: Overweight Doubts about OPEC 2.0’s commitment to extending their deepest-ever production cuts expiring this month to July, perhaps August, took some of the steam out of crude-oil rally earlier in the week. In our modeling, we do not see the need to extend the massive voluntary cuts announced by the Kingdom of Saudi Arabia (KSA) and its Gulf allies: KSA’s cuts of ~ 4.5mm b/d vs. its April output level of 12mm b/d starting this month will take the Kingdom’s output to ~ 7.5mm b/d. The UAE and Kuwait also voluntarily added cuts of 100k and 80k b/d, respectively, to their agreed quotas. We continue to believe the current schedule of production cuts will result in a physical supply deficit in 3Q20, which will require OPEC 2.0 to begin raising production to keep prices from getting too high going into a US presidential election. We expect Brent prices to average $40/bbl this year and $68/bbl next year, with WTI trading $2 - $4/bbl below that (Chart 17).11 Base Metals: Neutral Iron ore prices breached $100/MT this week, as COVID-19-induced supply disruptions in Brazil – the largest exporter of high-grade ore – and South Africa leave the seaborne market open to Australian suppliers to meet higher Chinese demand as port inventories are rebuilt. FastMarkets MB, a sister company of BCA Research, reported May exports to China from Brazil were down 28% y/y to 21.5mm MT from just under 30mm MT the year prior. Iron ore exports from Australia are expected to exceed A$100 billion this year, according to government estimates reported by the Financial Times.12 Precious Metals: Neutral As we go to press, gold prices retreated to $1,700/oz from ~ $1,740/oz last week, exhibiting a positive correlation with the dollar. This is a result of rising risk appetite globally as economies exit lockdowns. In the US, interest rates are continuing to support gold. Going forward, the probability of negative rates is remains low, but the Fed will continue to buy more debt from the public and private sectors to push the shadow rate further down. This supports gold prices (Chart 18). Chart 17Crude Prices Will Rebound Crude Prices Will Rebound Crude Prices Will Rebound Chart 18Fed Buying Supports Gold Prices Fed Buying Supports Gold Prices Fed Buying Supports Gold Prices     Footnotes 1     Please see “The Impact of the COVID-19 Pandemic on World Copper Supply,” published by the International Copper Study Group on May 21, 2020. 2     A resurgence of infection triggered renewed lockdowns over a region of 100 million people in May. Please see More than 100 million people in China's northeast back under lockdown to thwart potential second wave published by the National Post on May 19, 2020. 3    Please see BCA's Emerging Markets Strategy Weekly Report "EM Stocks Are At A Critical Resistance Level," published May 28, 2020. It is available at ems.bcaresearch.com. 4    Please see BCA's China Investment Strategy Weekly Report "Taking The Pulse Of The People’s Congress," published May 28, 2020. It is available at cis.bcaresearch.com. 5    There remains a risk global monetary stimulus fails to ignite strong consumer and business consumption. The unprecedented shock could raise precautionary savings and keep risk aversion elevated for an extended period. Based on the Quantity Theory of Money, money supply times velocity (the rate at which money changes hands) equals nominal GDP. Low confidence translates to a low velocity of money limiting the reach of monetary policy. This value is extremely difficult to forecast. 6    Please see “The Impact of the COVID-19 Pandemic on World Copper Supply,” published by the International Copper Study Group on May 21, 2020. 7     According to BGRIMM Lilan Consulting, China’s real demand for refined copper declined by ~22% in 1Q20. This implies a ~11% decline in global copper consumption. Please see footnote 6 for more details. 8    Global financial cycles capture how global financial conditions affect individual economies. The analysis of these cycles stressed the importance of common factors in global risk asset prices which are driven by risk appetite and US monetary policy. These factors are mainly explained by developments in advanced economies but have a drastic effect on emerging markets. Please see Iñaki Aldasoro, Stefan Avdjiev, Claudio Borio and Piti Disyatat (2020). “Global and domestic financial cycles: variations on a theme,” BIS Working Papers, No 864. 9    Please see Chapter 3 of the Global Financial Stability Report titled “Managing Volatile Portfolio Flows,” published by IMF. 10   Please see BCA's Geopolitical Strategy Weekly Report "Spheres Of Influence (GeoRisk Update)," published May 29, 2020. It is available at gps.bcaresearch.com. 11    Please see our May 21, 2020 report entitled US Politics Will Drive 2H20 Oil Prices for our latest view on oil fundamentals and prices, available at ces.bcaresearch.com. 12    Please see Australia’s iron ore miners exploit supply gap as Covid-19 hobbles rivals published by the Financial Times June 3, 2020.   Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Trade Recommendation Performance In 2020 Q1 Speed Of Demand Recovery Remains Key To Copper Prices Speed Of Demand Recovery Remains Key To Copper Prices Commodity Prices and Plays Reference Table Trades Closed in 2020 Summary of Closed Trades Speed Of Demand Recovery Remains Key To Copper Prices Speed Of Demand Recovery Remains Key To Copper Prices

The SPX has broken out to fresh recovery highs defying recent rising political and geopolitical risks. The reopening of the economy is the primary driver of renewed market euphoria, along with the ongoing easy fiscal and monetary policies. Sentiment is not as extended as at the February SPX peak or previous SPX peaks in the past few years. However, greed is slowly showing up on our radar screens as investors that have missed out on the rally are chasing performance and also there is an added element of a short squeeze. One potential negative catalyst that could cause a healthy reset is the rise in the polls of Democratic presidential candidate Joe Biden ahead of the November elections. The chart shows that over the past year the S&P 500 has moved in lockstep with the relative odds of a Republican versus a Democrat getting elected President. In truth, the online gambling community has been slow to react to the erosion of President Trump’s platform due to pandemic and recession – so his odds could fall further in the near term. At the margin, a Biden win should be negative for the stock market as he is perceived as more hostile to businesses and the specter of higher taxes could trip up the SPX. Our Geopolitical Strategy has highlighted this risk in recent reports, including on May 15.1 Bottom Line: While we remain constructive on the SPX over the coming 9-12 month time horizon, a flare in geopolitical risks and uncertainty around the upcoming election could serve as catalysts for a much needed breather in equities. Housekeeping Housekeeping   Footnotes 1Please see BCA Geopolitical Strategy Weekly Report, “Michelle, Amash, Trump, Biden” dated May 15, 2020, available at gps.bcaresearch.com

Highlights There are no atheists in foxholes, and no Austrians ahead of this election: Republican senators and White House staffers may grumble about giveaways, but they cannot risk being painted as the Grinch who Stole Essential Services in the homestretch of the campaign. A Biden victory will mean a leftward swing: Our geopolitical strategists believe markets are underestimating the extent to which a Biden victory would lead to a less friendly backdrop for investment capital. Tensions with China are likely to escalate: China-bashing is popular with the electorate, and a desperate White House may turn up the heat to recover its standing in the polls. The battle for great-power supremacy remains unresolved. The pandemic is causing the retreat from globalization to accelerate before our eyes: Curtailing offshoring and building new redundancies into supply chains will weigh on corporate profit margins and undermine earnings growth. Feature We had the pleasure of sitting down with Matt Gertken, the leader of BCA’s Geopolitical Strategy service, for a webcast last week. The timing could not have been better, as the pandemic has thrust Washington into the spotlight and the campaign will keep it there until Election Day. This report blends the US Investment Strategy and Geopolitical Strategy teams’ takes on the broad themes we discussed and is a starting point for thinking about the 2020 election and its financial market implications. We will return to the topic throughout the summer and early fall as developments unfold. Republicans in the Senate can talk tough now, but they will have to knuckle under if they want to keep their majority (and the White House). Future Fiscal Largesse Though the scale of the CARES Act was huge, powering the United States to the head of the global class in terms of fiscal stimulus (Chart 1), both parties were discussing the next phase of COVID-19 relief before the ink on the bill was dry. Two months later, that momentum has stalled as Republicans have begun to push back against a fifth wave of spending (the CARES Act was the third). Senator Lindsey Graham (R-SC) has taken direct aim at the $600 weekly federal unemployment benefit supplement, scheduled to expire at the end of July, calling unemployment benefits in excess of pay an “aberration,” and pledging that the program will be extended “over [his] dead body.” Chart 1A Massive Amount Of Fiscal Stimulus Elections Have Consequences Elections Have Consequences That benefit may be generous on a Scandinavian scale,1 but along with the direct $1,200 payments sent to nearly two-thirds of households, it is helping the economy withstand deleterious social distancing measures. Shoring up the finances of vulnerable households will help them stay current on their auto loans and rent or mortgage payments, staving off a wave of repossessions, evictions and foreclosures, and preventing a cascading chain of defaults that would intensify the economic pressure. Table 1The Battleground States Need Help Elections Have Consequences Elections Have Consequences Graham’s rhetorical flourishes aside, Republicans cannot hand the Democrats an opening to cast them as Scrooge when the campaign intensifies in late summer. Trump’s 2016 victory turned on flipping Florida and Rust Belt stalwarts Pennsylvania, Ohio, Michigan and Wisconsin from the Democrats, and all those states are in play again except Ohio (Chart 2). Unemployment is elevated in the battleground Rust Belt states, and we think it must be higher than the official measure in a state as dependent on tourism as Florida (Table 1).2 Channeling the Grinch by taking unemployment benefits and essential workers away from put-upon voters in pivotal states3 is not a winning electoral strategy. Caught between an aid proposal that both Democrats and the White House want, Republican senators will ultimately have to concede. Chart 2The Midwest And Florida Are Crucial Elections Have Consequences Elections Have Consequences Rounding Out The Democratic Ticket Chart 3A New Obama-Biden Ticket? Elections Have Consequences Elections Have Consequences Presumptive Democratic nominee Biden is considering the pool of candidates to fill the number two spot on the ticket. Vice-presidential picks generate a lot of discussion when they’re made, but they typically have little influence on election outcomes. Among this year’s crop of contenders for the presidential nomination, only Senator Amy Klobuchar (D-MN) could fulfill the typical VP function of helping to land a swing state. Klobuchar would likely appeal to soccer moms and suburban independents capable of being swayed back to the Democrats, but her moderate sensibilities wouldn’t expand Biden’s appeal to the party’s progressive wing or inspire younger voters. Senator Elizabeth Warren (D-MA) could help attract progressives and younger voters who see Biden as the status quo, but her antipathy toward big business could turn off swing voters and she would come at the cost of a senate seat.4 Voters have an unfavorable view of Kamala Harris (D-CA) and her contentious exchanges with Biden in the early debates could make for an awkward pairing. Stacey Abrams has recently entered the picture and would be an asset if she were able to increase African-American voter turnout, but she has a thin government resume. Michelle Obama is the only choice who would make a splash and significantly boost Biden’s prospects. She is viewed way more favorably than the rest of the field (Chart 3), would solidify Biden’s connection with Barack Obama, and increase turnout among the progressive, female, and minority voters the ticket needs to tip the scales in its favor. Unfortunately for the Democrats, she has unequivocally indicated that she does not wish to run. Biden has said he’d welcome her onto the ticket in a second, and he will likely put off his choice until efforts to draft her definitively fail. Michelle Obama could shake up the race if the Democrats can convince her to join the ticket. Investors should keep an eye on the Democratic ticket. Joe Biden will turn 78 in November. He will be a one-term president if he wins, and his public appearances suggest that he’s slower on the draw than he used to be. He may rely on his second-in-command much more than the average president and she will immediately become the odds-on favorite for the 2024 nomination. If the Democrats gain control of the Senate alongside a Biden victory, as our Geopolitical Strategy service projects, financial markets may have to begin discounting a future with materially less friendly regulatory and tax policy. China Tensions Will Not Go Away Chart 4The Middle Kingdom Is Out Of Favor Elections Have Consequences Elections Have Consequences Our geopolitical strategists have long flagged US-China tensions as the paramount geopolitical flashpoint. The only standalone nations with superpower potential are engaged in a long-term struggle for hegemony. The trade tensions that waxed and waned across all of 2019 were only one act of a longer-running play. Investors should not have been lulled into thinking the Phase 1 trade agreement would end the friction between the two countries. Politicians can be counted upon to give their constituents what they want, especially during election campaigns. China’s unpopularity with US voters has reached a new high in the wake of the pandemic (Chart 4), and candidates are likely to compete with one another to appear tougher on China. Between now and the election, there is a possibility that tensions could ramp up considerably. If the president finds his re-election prospects suffering from the COVID-19 outbreak and soaring unemployment, he may look to transform himself into a wartime president, boldly asserting American interests globally, and serially baiting an unpopular foe like China. Profit Margin Pressures Are Coming Except when interrupted by recessions, S&P 500 profit margins have climbed steadily higher since the early ‘90s (Chart 5). Several factors contributed to the increase in corporate profitability: the PC revolution, outsourcing, China’s entry into the WTO, the declining power of labor unions and, punctuating the rise in 2018, the 40% cut in the top marginal corporate tax rate (from 35% to 21%). If the Democrats take the White House and the Senate, we expect that corporate tax rates will swiftly rise. The top marginal rate may not go all the way back to 35%, but it has room to rise from its lowest level since before the US entered World War II (Chart 6), and any increase will represent a profit headwind. Re-configuring supply chains will reduce margins. Higher taxes will, too, if Democrats can take the White House and the Senate. Chart 5Corporate Profit Margins Are Vulnerable Corporate Profit Margins Are Vulnerable Corporate Profit Margins Are Vulnerable Chart 6A Democratic Sweep Will Lead To Higher Taxes A Democratic Sweep Will Lead To Higher Taxes A Democratic Sweep Will Lead To Higher Taxes Our Geopolitical Strategy service identified peak globalization as an important theme not long after it began publishing in 2012. The outbreak of the pandemic seems as if it will accelerate the retreat from globalization (Chart 7), and any reduction in outsourcing is likely to weigh on profit margins until automated inputs can supplant more expensive domestic labor. Onshoring is not the only factor likely to increase corporate costs after the pandemic, however. Companies are likely to seek to diversify their supply chains so that they are not so reliant on a single country or supplier. Building up redundancies within supply chains will make those chains more stable, but it will also increase costs. Chart 7The Pandemic Is Accelerating The Trend Away From Globalization The Pandemic Is Accelerating The Trend Away From Globalization The Pandemic Is Accelerating The Trend Away From Globalization A Biden victory is not the only source of election downside. If the president wins re-election, the odds of tariff conflicts with Europe will rise significantly. Unconstrained by having to contest another election, the administration could ratchet up the pressure on Europe, prompting certain retaliation from Brussels. Our strategists see a greater chance for trade peace, ex-China, if Biden captures the White House. Investment Implications The overriding questions on investors’ minds are why the stock market and the economy have parted company so decisively and how long they can continue to diverge. Our explanation turns on policy: the Fed has intervened mightily to hold down Treasury yields and keep financial markets functioning, while Congress has thrown open the federal coffers to keep laid-off workers and suddenly teetering businesses afloat. The social distancing measures imposed to slow the spread of COVID-19 caused economic activity to crater. Monetary and fiscal policy have been deployed to build a bridge over that crater, lest capital, people and businesses disappear into it like the Union troops at Petersburg. Ever since they began to rally in late March, financial markets have focused exclusively on the bridge. The Fed has the capacity and the will to install more monetary planks should the crater prove to be wider than initially estimated. Congress’ commitment is shakier, but the election will compel Republicans to provide more funding should it become necessary to prevent a dire outcome. The virus alone will dictate how long the bridge will have to be in place and investors can only guess at the virus' future course. Given the stock market’s pattern of surging on positive preliminary data for potential treatments or vaccines and barely easing when those data are shown to hold far less promise, it appears that its expectations are skewed to the right-hand side of the distribution. There appears to be considerable room for disappointment on the public health front. The possibility that markets are giving short shrift to a robust second wave of infections, or overestimating the speed with which a vaccine can be developed and distributed, is not a reason to short equities or be underweight them in balanced portfolios, though. The rally has been too strong, and there is a subset of right-tail outcomes that could well come to pass. We continue to expect a correction, and are carrying excess cash to prepare for it, but we are maintaining a neutral tactical outlook in the event of a positive surprise. We are optimistic about equities’ prospects over a twelve-month timeframe. Our rationale is that easy monetary policy and generous fiscal spending will outlive the social distancing measures they were prescribed to treat. Low interest rates, ample liquidity and pumped-up aggregate demand form a highly supportive backdrop for equities and should help them handily outperform bonds. The difference between our outlook and the equity market’s may simply be a matter of timing; the resurgent S&P 500 seems to be skipping ahead to the twelve-month conclusion and looking through the uncertainties that will arise along the way. The bears face daunting odds if Congress approves a meaningful fifth phase of fiscal stimulus: every trillion dollars extends the dark US bar in Chart 1 by another five percentage points. TIPS will eventually be the asset of choice when the debt has to be repaid but, in the meantime, equities have undeniable appeal.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 According to a new working paper, the median unemployed worker is eligible for benefit payments equivalent to 134% of his/her pre-layoff compensation. https://www.nber.org/papers/w27216 Accessed May 26, 2020. 2 Nevada, home to the Magic Kingdom for adults, has the nation’s highest unemployment rate (28.2%). 3 Most state constitutions mandate balanced budgets. In the absence of federal aid, local school, fire, police and public hospital payrolls will have to be pared in response to declining sales and income tax revenues. 4 Massachusetts’ Republican governor would get to appoint her replacement until a special election could be held.

Highlights China is taking advantage of global chaos to solidify its sphere of influence – beginning with Hong Kong. The crisis is also motivating the European Union to link arms more tightly through a symbolic step toward fiscal solidarity and transfers. US, Chinese, and European stimulus measures are cyclically positive but near-term risks abound. Hiccups in stimulus rollout are to be expected – and China’s disappointing stimulus thus far may cause market turmoil before policymakers do what we expect and add greater oomph. US-China relations are breaking down as we outlined, as renminbi depreciation coincides with Trump approval depreciation. The risks of the UK failing to agree to a trade deal with the EU are higher than prior to COVID-19. Stay defensive tactically – the risk-on rally is not yet confirmed by major reflation indicators yet geopolitical risks are spiking. Feature Chart 1Will Geopolitics Stunt The Early Bull's Growth? Will Geopolitics Stunt The Early Bull's Growth? Will Geopolitics Stunt The Early Bull's Growth? After wavering at the 2,900 level, the S&P 500 broke above 3,000. As we go to press, it is holding the line, despite a surge in geopolitical risk emanating from the efforts of the Great Powers to consolidate their spheres of influence at the expense of globalization. Key cyclical indicators are on the verge of breaking out. Our “China Play Index,” which consists of the Australian dollar, Swedish equities, Brazilian equities, and iron ore prices, is reviving smartly. The copper-to-gold ratio, however, is not really confirming the rally (Chart 1). Nor are Asian currencies. We recommend a tactically defensive stance. We are not dogmatic, but are not convinced that the rally will overcome near-term risks. We expect explosive political and geopolitical events throughout the summer. Near-Term Geopolitical Risks To The Rally Our reasons for near-term caution are as follows: Global stimulus hiccups: China’s National People’s Congress over the weekend disappointed expectations on the size of economic stimulus. This is a short-term risk, we argue below, but nevertheless a risk. The US Congress may not pass stimulus until July 2 and the final law will fall short of the House bill of $3 trillion. The European “Next Generation EU” recovery fund is only 750 billion euros in size and may not be agreed until July, or even September if the financial market does not impose urgency. We elaborate below. Ultimately policymakers will keep doing “whatever it takes” but there will be hiccups first and they will trouble the market in the near term (Chart 2). Chart 2Stimulus Tsunami Will Peak This Summer Spheres Of Influence (GeoRisk Update) Spheres Of Influence (GeoRisk Update) Sino-American conflict: The “phase one” trade deal was never going to bring durable comfort to markets about US-China cooperation, and the outbreak of COVID-19 prompted our March 13 argument that US-China tensions would erupt sooner than we thought. So far the market is grinding higher despite the materialization of this risk. Mega-stimulus and the equity rally enable the US and China to clash. At some point escalation will upset the market. Domestic stimulus is substituting for a collapse in globalization and risk markets are cheering. But increased domestic support will enable political leaders to clash with each other and keep upping the ante. The higher the market goes the more willing President Trump will be to expend some ammunition on China and other political targets. But if you play with sticks, somebody always gets hurt. The market is betting that Trump is a typical US president, typically bashing China in an election year. We are arguing that he is atypical, that this is an atypical election year, and that China’s own ambition cannot be left out of the equation. Wild cards: Jokers, one-eyed jacks, suicidal kings, and aces are all wild in this deck. Emerging markets like Russia (Chart 3) – and rogue regimes like Iran – pose non-negligible risks of upsetting the global rebound this year. Chart 3ARussian Risk To Rise Further On Libya, US Tensions Russian Risk To Rise Further On Libya, US Tensions Russian Risk To Rise Further On Libya, US Tensions Chart 3BRussian Risk To Rise Further On Libya, US Tensions Russian Risk To Rise Further On Libya, US Tensions Russian Risk To Rise Further On Libya, US Tensions   Chart 4Equity Investors Wise To Erdogan's Mischief Equity Investors Wise To Erdogan's Mischief Equity Investors Wise To Erdogan's Mischief Investors cannot focus on tail risks all the time, but not all geopolitical risks are tail risks. This is particularly the case because of the US election, which heightens Washington’s willingness to retaliate to any provocations. Geopolitics in the Mediterranean are verifiably unstable, particularly in Libya where Russia looks to make a major intervention yet Turkey is also involved (Chart 4). This affects North African and European security. Iran is under historic stress and will attempt to undermine the Trump administration as it has no downside to Democratic victory in November. In a recent event we hosted with the CFA Institute in India and Asia Pacific, only 4% of participants highlighted Russia and 2% Iran as a significant source of political risk this year, while 93% highlighted the US and China. Clearly the US-China competition is the great game. But other risks are underrated, especially Russia. Stimulus hiccups this summer are likely to be overcome in the US, EU, and China, so perhaps the market will look through this risk while economies reopen and leading indicators inevitably improve. US-China tensions could remain bound within Trump’s desire to keep the stock market up during his election campaign and China’s desire not to incur Trump’s unmitigated wrath if he happens to be reelected. Russian, Iranian, and emerging market risks, if they materialize, may have merely localized and ephemeral market effects. However, Trump’s falling approval rating and executive decree to open the social media companies to litigation supports our thesis that he is not enslaved by the stock market. The market is expecting “the Art of the Deal” to lead to positive outcomes but that assumption is not as reliable in a recessionary context as it is in an economic boom. The Atlanta Fed’s second quarter real GDP growth estimate stands at -40.4%. Any state that provokes the US over the next five months risks a massive or unpredictable retaliation. China will ultimately bring stimulus to 15.5% of GDP. Deflation and unemployment are a massive constraint. We do not mention the well-known risks of weak consumer activity and business investment amid the pandemic, which itself is expected to revive in the fall with no guarantee of a vaccine by then. Bottom Line: In the near term, maintain safe haven trades such as long Japanese yen, US Treasuries, and defensive equity sectors. China Stimulus Hiccups Won’t Last, But Will Sow Doubt The most important question in China is the implication of the National People’s Congress with regard to the size of stimulus. After the stimulus blowout of 2015-16, Xi Jinping consolidated power and launched a deleveraging campaign. His administration is determined to keep a lid on systemic risks, especially the money and credit bubble. Chart 5China's Stimulus Faces Doubts But Will Prove Huge In The End China's Stimulus Faces Doubts But Will Prove Huge In The End China's Stimulus Faces Doubts But Will Prove Huge In The End Beijing’s targets for central and local government spending disappointed market observers. In Chart 2 above, we revised Beijing’s fiscal stimulus from 11% of GDP to 4.3% of GDP as a result of lower-than-expected targets for local government special bonds and central government special treasury bonds, as well as a corrected calculation of the fiscal relief for small and-medium-sized enterprises. This 4.3% understates the real size of China’s stimulus because it includes only fiscal elements. Since the Communist Party and state bureaucracy control the banks and many large enterprises, one must also include credit growth – it is a quasi-fiscal factor. Total social financing (total private credit) is usually the biggest element of China’s periodic bouts of stimulus. While Chinese authorities showed restraint in their fiscal measures, they announced that credit growth would “significantly” exceed nominal GDP growth, which has collapsed due to the virus lockdowns. Our Emerging Markets Strategy estimates that credit growth will accelerate to 14% this year, making for an 11.2% of GDP increase in total credit, and a combined fiscal and credit impulse that will reach 15.5% of GDP (Chart 5). The dramatic global economic shock and the hit to China’s labor market ensure that additional stimulus will be applied as needed to plug the output gap. Soaring unemployment is a fundamental risk to social stability and hence to single-party rule. This means that the fiscal impulse will in the end likely exceed 4.3% as new measures are rolled out later this year. It also means that credit growth will surprise to the upside, as the regime loosens the reins on shadow banks as well as state-controlled lenders. Nevertheless, accepting our Emerging Market Strategy’s base case of 15.5% of GDP fiscal and credit impulse, we would note that China’s economy is much larger as a share of the global economy today than it was in previous rounds of stimulus. Thus while the stimulus may be smaller than that in 2008 as a proportion of China’s economy, it is larger as a proportion of the world’s (Table 1). China-linked asset prices, such as industrial metals, will see rising demand over time. Table 1China Fiscal+Credit Impulse Will Be Big Relative To World Spheres Of Influence (GeoRisk Update) Spheres Of Influence (GeoRisk Update) The Xi administration’s preference is not to overstimulate and exacerbate its problems of imbalanced growth, falling productivity, and excessive indebtedness. But its constraint is deflation, unemployment, and social instability. Insufficiently loose policy in the midst of a very deep global recession could prove to be the biggest policy mistake of all time. To refuse to loosen as needed, or to re-tighten policy too soon, would be to make a cruel joke out of the new policy slogan, “the Six Stabilities and Six Guarantees” and jeopardize Xi Jinping’s ability to reconsolidate power ahead of the twentieth National Party Congress in 2022. Rather the constraint will force policymakers to alter any hawkish preferences if growth looks to relapse. Bottom Line: Doubts about the sufficiency of China’s fiscal and monetary stimulus pose a near-term risk to global risk assets since investors face disappointing stimulus promises on the surface, combined with lack of certainty about Beijing’s willingness to increase stimulus going forward. We are confident that Beijing will ultimately do whatever it takes to stabilize employment and try to ensure social stability. But this implies near-term challenges and possibly a market riot prior to resolution. Before then, many market participants, including in China, will believe that the Xi Jinping administration will be hawkish and resistant to re-leveraging. China’s Sphere Of Influence Global geopolitical risk stems from the Xi Jinping regime at least as much as from the Donald Trump regime, as we have long pointed out. The scenario unfolding as we go to press is precisely the one we outlined back in March in which Beijing depreciates its currency to ease its economic woes while President Trump’s approval rating falls due to his own woes, prompting him to retaliate. The CNY-USD exchange rate is largely pricing out the phase one trade deal, which is marked by the peak in renminbi strength in Chart 6. Chart 6Phase One Trade Deal Priced Out Of Renminbi Already Phase One Trade Deal Priced Out Of Renminbi Already Phase One Trade Deal Priced Out Of Renminbi Already Chart 7China's Warning To Trump Could Scrap Trade Deal China's Warning To Trump Could Scrap Trade Deal China's Warning To Trump Could Scrap Trade Deal This depreciation is not merely the effect of market moves – though weakness in global and Asian trade and manufacturing certainly reinforce it. The People’s Bank of China’s fixing rate has been guiding the currency to its lowest point since 2008 amid the spike in US-China tensions over the past month (Chart 7). China says it will adhere to the phase one deal as long as it is mutual. It is buying more soybeans, cotton, pork, and beef from the United States relative to last year. Demand has collapsed. Unless China decides to dictate purchases as a subsidy to keep the agreement alive, its purchases will fall short of the huge expansion envisioned in the deal. US actions could nullify the deal anyway. President Trump and his Economic Director Larry Kudlow have both suggested that the administration no longer cares about maintaining the deal. China was fast becoming unpopular in the US and this trend has skyrocketed as a result of COVID-19. China’s other notable decision at the National People’s Congress was to state that it would impose a new national security law on Hong Kong SAR, after the autonomous financial center’s long reluctance to do so. Beijing has sought greater direct control of the city since early in Xi’s term, in contravention of the promise of 50 years of substantial autonomy enshrined in the Sino-British Joint Declaration of 1984. Beijing’s action comes after Hong Kong’s widespread civil unrest last year and ahead of the city’s Legislative Council elections in September, which will likely become a major geopolitical flashpoint. The United States is retaliating by removing Hong Kong’s designation as an autonomous region. This entails higher tariffs, tougher export controls, stricter visa requirements, and likely sanctions directed at mainland entities that will enforce the national security law in various ways, including eventually some Chinese banks. The US also accelerated sanctions against China for its civil rights abuses in Xinjiang – sanctions that target tech and security companies – and is moving forward with a bill to threaten Chinese companies that hold American Depository Receipts (ADRs) with delisting from American stock exchanges if they do not meet the same auditing requirements as other foreign companies. This potentially affects $1.8 trillion in market capitalization over a 3-4 year period. China’s power grab in Hong Kong initiates a market-negative Sino-American dynamic that will last all year. It cannot be assumed that Trump will accept Beijing’s implicit offer of swapping phase one trade deal implementation for China’s historic encroachment on Hong Kong’s autonomy. The imposition of legislative dependency on Hong Kong should not have been a surprise to investors given recent trends, but it was, as Hong Kong equities fell by 6% at first blush. There is more downside, judging by our China GeoRisk Indicator, which is in a clear uptrend for all of these reasons and correlates reasonably well with the Hang Seng index (Chart 8). Chart 8Hong Kong Equities Face More Downside From Geopolitics Hong Kong Equities Face More Downside From Geopolitics Hong Kong Equities Face More Downside From Geopolitics While the US will retaliate over Hong Kong, the question for global investors is whether the conflict spills over into the rest of China’s periphery. This would highlight the systemic nature of the geopolitical risk and make it harder for the market to swallow the new cold war. Our Taiwan Strait GeoRisk Indicator (Chart 9) is pricing zero political risk despite the clear risk that Beijing will eventually resort to economic sanctions to penalize the mainland-skeptic government there; that the US will seek to shore up the diplomatic and defense relationship in significant ways in what may be the final five months of the Trump administration; and that Taiwan may seek to draw the US into granting greater economic and security assurances. Chart 9Taiwan Equities Pricing ZERO Geopolitical Risk ... Huge Mispricing Taiwan Equities Pricing ZERO Geopolitical Risk ... Huge Mispricing Taiwan Equities Pricing ZERO Geopolitical Risk ... Huge Mispricing Our Korea GeoRisk Indicator (Chart 10) has also fallen drastically. This risk indicator deviates from Korean equities frequently due to North Korean risks, which equity investors tend (usually correctly) to ignore. This year is different, however, because Kim Jong Un’s decision whether to give Trump a diplomatic win, or frustrate him with the test of a nuclear device or intercontinental ballistic missile, actually has a bearing on Trump’s election odds and the pace of US-China escalation. If Kim humiliates Trump then we expect Trump to make a major show of force in the region that would draw China into a strategic standoff. Chart 10North Korea Is Relevant In 2020 Due To Trump North Korea Is Relevant In 2020 Due To Trump North Korea Is Relevant In 2020 Due To Trump China is attempting to solidify its sphere of influence, first in Hong Kong but later in Taiwan and the Korean peninsula. The United States is pushing back and the US election cycle combined with massive stimulus means that push will come to shove. Bottom Line: Investors should steer clear of Chinese, Taiwanese, and Korean currencies and risk assets in the near term. We recommend playing the cyclical China recovery via Korean equities over the long run. The European Sphere Of Influence The European Union is also attempting to strengthen and expand its sphere of influence – namely with steps in the direction of a fiscal union. Our GeoRisk Indicators are generally flagging a huge drop in political risk for Germany, France, Italy, and Spain (Charts 11A & 11B). The reason is that the economies have collapsed yet the equity market has bounded back on ECB quantitative easing and huge promises of fiscal support. In the coming months these risk indicators will rise even as economies reopen because the debate over fiscal and monetary policies is heating up. Our base case is that both the debate over EU recovery funds and the German constitutional court’s objections to QE will resolve in dovish compromises. Chart 11AEurope’s Not-Quite Hamiltonian Moment Europe's Not-Quite Hamiltonian Moment Europe's Not-Quite Hamiltonian Moment Chart 11BEurope’s Not-Quite Hamiltonian Moment Europe's Not-Quite Hamiltonian Moment Europe's Not-Quite Hamiltonian Moment At issue on the fiscal front is the EU Commission’s “Next Generation EU” recovery fund. Commission President Ursula von der Leyen is offering to create a 750 billion euro relief fund (500 billion in grants, 250 billion in loans). The decision is contentious because it would entail the EU Commission issuing bonds – essentially joint bonds among the EU states – to raise funds that would then be distributed through the EU Commission seven-year budget (2021-7). Joint issuance would be a symbolic step toward greater solidarity. This proposal began with an agreement between French President Emmanuel Macron and German Chancellor Angela Merkel to launch the 500 billion in grants. Merkel signaled earlier this year that she was prepared to accept joint bond issuance focused on the immediate crisis. When more fiscally hawkish or euroskeptic states objected that loans should be used instead of grants, von der Leyen simply added their proposal to the total, despite the fact that the ECB and European Stability Mechanism (ESM) already offer emergency loans to help states through the global crisis. The proposal marks a victory of the fiscally dovish Mediterranean states (once called “Club Med”) over the frugal Germans, with Macron prevailing on Merkel to foist yet another major compromise onto her conservative German power base in the name of European integration and solidarity before she exits the chancellorship in 2021. But it is not as if German elites like Merkel and von der Leyen are running amok: German public opinion is Europhile and supportive of bolder actions to share burdens, save the union, and shore up the continental economy. The market is not pricing any political risk in Taiwan despite clear dangers. Stay short Taiwanese equities. The recovery fund itself is limited in size, relative to overall stimulus actions thus far. But it would plug an important gap for states like Italy and Spain, which are constrained by large public debt loads and have not provided enough stimulus as yet. The “Frugal Four,” the Netherlands, Austria, Sweden, and Denmark, are leading the opposition to the use of grants rather than loans and any effort to establish a track leading to European fiscal union. But they are also willing to negotiate. Estonia and other nations are also objecting, with the eastern Europeans seeking to ensure that southern Europe does not take the lion’s share of the funds, while the core European states will use the funds to pressure populist and euroskeptic eastern states that have defied the European Court of Justice and other institutions (Chart 12). Chart 12Europe: Distribution Of ‘NextGen EU’ Fund Spheres Of Influence (GeoRisk Update) Spheres Of Influence (GeoRisk Update) A final decision may not be settled by the time of a special summit in July but some compromise should be expected by the fall or (latest) end of year. The proposal would do the very thing that its opponents resist: pave the way toward jointly issued bonds in future that do not have a time limit or a single purpose (today’s sole purpose being pandemic relief). Hence the negotiations will be intense and it will likely require a return of financial instability to bring them to a conclusion. The global financial crisis and its aftermath provoked a higher degree of integration among the EU member states despite the tendency of the mainstream media to assume that the dissonance between monetary and fiscal policy would create an unbridgeable rupture. COVID-19 is now supporting this pattern of Brussels not letting a good crisis go to waste. Chart 13Europe Fends Off Latest Doubts About Solidarity Europe Fends Off Latest Doubts About Solidarity Europe Fends Off Latest Doubts About Solidarity The reason is that the EU is a geopolitical project. As Russia revived, the US began to act unilaterally and unpredictably, and China emerged as a global heavyweight, European powers were forced to huddle together ever more tightly to create economies of scale and improve their security against various external and unconventional threats. Influential German Finance Minister Olaf Scholz has compared the new recovery fund to the work of American founding father Alexander Hamilton in mutualizing the early American states’ war debt so as to create a tighter fiscal union among the states. For that very reason the more Euroskeptic member states oppose the proposal – long rejecting the idea of a “United States of Europe.” Today’s proposals are more symbolic, less substantial, than Hamilton’s famous Compromise of 1790. Nevertheless we would not underrate them as they highlight the way the European states continually turn crisis moments that worry the markets about European break-up into new opportunities to combine more closely. As such it is fitting that the European break-up risk premium has fallen, signifying a drop in peripheral bond spreads (Chart 13). The battle over debt mutualization is not over yet so spreads could widen again, but the trend will be down as the bloc develops new tools to combat the latest crisis. The United Kingdom obviously marks a major exception to this reinforcement of the European sphere of influence. The Brits are historically and geopolitically opposed to a unified continental political power. Having decided to leave, they lack the ability to obstruct from within. But they are also not necessarily more likely to yield in their trade negotiations. British political risks are understandably low because Prime Minister Boris Johnson and his Conservative Party won a strong mandate in December and technically do not have to face voters again until 2024. The major limitation on a “no trade deal” outcome in talks with Brussels was a recession – yet that has already occurred. London could ultimately bite the bullet and accept that outcome if the trade talks turn acrimonious. The GBP/EUR is not pricing a full “no deal” exit. Stimulus and economic recovery suggest that it is a good time to go long sterling but we will pass on this trade in the short run due to resilient dollar strength and the reduced barrier to exiting without a trade deal (Charts 14A & 14B). Chart 14ABrexit Trade Talks Not Globally Relevant Brexit Trade Talks Not Globally Relevant Brexit Trade Talks Not Globally Relevant Chart 14BBrexit Trade Talks Not Globally Relevant Brexit Trade Talks Not Globally Relevant Brexit Trade Talks Not Globally Relevant Bottom Line: We do not yet recommend reinstituting our long EUR/USD trade, which we initiated late last year as part of our annual forecast. The COVID-19 crisis has created such a spike in geopolitical and political risk that we expect the US dollar to remain surprisingly strong throughout the coming months and for US equities to outperform global equities beyond expectation. Nevertheless we will look to reinitiate this long-term trade at an appropriate time, as it fits squarely with our “European Integration” theme since 2012. Investment Takeaways Our contention that “geopolitics is the next shoe to drop” has materialized. This has negative near-term implications for global risk assets. However, thus far, market positives have outweighed negatives for global investors faced with the reopening of economies and wartime-magnitude fiscal and monetary stimulus. Buying risky assets makes sense for investors with a long-term investment horizon – and we recommend cyclical plays like commodities, corporate bonds, infrastructure stocks, and defense stocks in our strategic portfolio. We also recognize that if key cyclical and reflation indicators break out from here, then a cyclical bull market could take shape. Yet our analytical framework reveals that recession and mega-stimulus have diminished the financial and economic constraints that would normally deter geopolitical actors from ambitious actions on the international stage. Most notably, the US election dynamic has turned upside-down. President Trump is the underdog and will need to develop a reelection bid that does not hinge on the economy. Doubling down on “America First” foreign policy and trade policy makes the most sense and the ramifications are negative for the markets over the next five months. This is the key dynamic that makes US-China, US-North Korea, US-Russia, and US-Iran tensions more market-relevant than they would otherwise be. It also will dampen an otherwise positive story for the euro, in the short run.   Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com Section II: Appendix : GeoRisk Indicator China: China: GeoRisk Indicator China: GeoRisk Indicator Russia: Russia: GeoRisk Indicator Russia: GeoRisk Indicator UK: UK: GeoRisk Indicator UK: GeoRisk Indicator Germany: Germany: GeoRisk Indicator Germany: GeoRisk Indicator France: France: GeoRisk Indicator France: GeoRisk Indicator Italy: Italy: GeoRisk Indicator Italy: GeoRisk Indicator Canada: Canada: GeoRisk Indicator Canada: GeoRisk Indicator Spain: Spain: GeoRisk Indicator Spain: GeoRisk Indicator Taiwan: Taiwan: GeoRisk Indicator Taiwan: GeoRisk Indicator Korea: Korea: GeoRisk Indicator Korea: GeoRisk Indicator Turkey: Turkey: GeoRisk Indicator Turkey: GeoRisk Indicator Brazil: Brazil: GeoRisk Indicator Brazil: GeoRisk Indicator Section III: Geopolitical Calendar

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

    Highlights Risk assets continue to ignore the dire state of the economy. “Don’t fight the Fed” will dictate investment policy for the coming months. Populism and supply-chain diversification will shape the world after COVID-19. Global stimulus will result in higher long-term inflation when the labor market returns to full employment. Asset prices are not ready for higher inflation rates. Precious metals, especially silver, will offer inflation protection. Stocks should structurally outperform bonds, even if they generate lower returns than in the past. Tech will continue to rise for now, but this sector will suffer when inflation turns higher. Feature Despite the continued collapse in economic activity, the S&P 500 remains resilient, bolstered by the largesse of the Federal Reserve and US government, and generous stimulus packages in other major economies. Stocks will likely climb even higher with this backdrop, but a violent second wave of COVID-19 infections may derail the scenario in the near term. The biggest risk, which is long-term in nature, is rising inflation. Public debt ratios will skyrocket in the G-10 and many emerging markets. Private debt loads, which are elevated in most countries, will also increase. Add rising populism and ageing populations into this mix and the incentive to push prices higher and reduce real debt loads becomes too enticing. Long-term investors must be wary. For the time being, overweight equities relative to bonds, but the specter of rising inflation suggests that growth stocks (e.g. tech) will not offer attractive long-term returns. Investors with an eye on multi-year returns should use the ongoing surge in growth stocks to strategically switch their portfolios toward small-cap equities, traditional cyclicals and precious metals. Economic Freefall Continues Most economic indicators paint a dismal picture for the US. Industrial activity is suffering tremendously. In April, industrial production collapsed by 15%, a pace matching the depth of the Great Financial Crisis (GFC). The ISM New Orders-to-Inventories ratio remains extremely weak with no glimmer of a rebound in IP in May. The numbers for trucking activity and railway freight are equally poor. Chart I-1A Worried Consumer Saves A Worried Consumer Saves A Worried Consumer Saves The US labor market has not been this ill since the 1930s. 20.5 million jobs vanished in April and the unemployment rate soared to 14.7%, despite a 2.5 percentage point decline in the participation rate. The number of employees involuntarily working in part-time positions has surged by 5.9 million, which has hiked up the broader U-6 unemployment rate to 22.8%. Wage growth has rebounded smartly to 7.7%, but this is an illusion. Average hourly earnings rose only because low-wage workers in the leisure and hospitality fields bore the brunt of the pain, accounting for 37% of layoffs. The worst news is that the Bureau of Labor Statistics (BLS) classifies any worker explicitly fired due to COVID-19 as temporarily laid off, but without a vaccine it is highly unlikely that employment in the leisure, hospitality or airline sectors will normalize anytime soon. Unsurprisingly, lockdowns have limited the ability of households to spend. Americans have boosted their savings rate to 13.1%, the highest level in 39 years, as they worry about catching a potentially deadly illness, losing their jobs, watching their incomes fall, or all of the above (Chart I-1). This double hit to both employment and consumer confidence sparked a 22% collapse in retail sales on an annual basis in April, the worst reading on record. Putting it all together, real GDP contracted at a 4.8% quarterly annualized rate in Q1 2020 and the Congressional Budget Office expects second-quarter annual growth to plummet to -37.7%. The New York Fed’s Weekly Economic Index suggests a more muted contraction of 11.1% (Chart I-2), which would still represent a post-war record. Investors must look beyond the gloom. The economic weakness is not limited to the US. In Europe and in emerging markets, retail sales and auto sales are disappearing at an unparalleled pace. Industrial production readings in those economies have been catastrophic and manufacturing PMIs are still in deeply contractionary territory. As a result, our Global Economic A/D line and our Global Synchronicity indicator continues to flash intense weakness (Chart I-3). Chart I-2The Worst Is Still To Come The Worst Is Still To Come The Worst Is Still To Come Chart I-3Dismal Growth, Everywhere Dismal Growth, Everywhere Dismal Growth, Everywhere   Chart I-4China Leads The Way China Leads The Way China Leads The Way Investors must look beyond the gloom. China’s experience with COVID-19 is instructive despite questions regarding the number of cases reported. China was the first country to witness the painful impact of COVID-19 and the quarantines needed to fight the disease. It was also the first country to control the virus’s spread and, most importantly, to escape the lockdown, along with being the first to enact economic stimulatory measures. The results are clear: industrial production, domestic new orders, and to a lesser extent, retail sales, are all experiencing V-shaped recoveries (Chart I-4). Even Chinese yields are rising, despite interest rate cuts by the People’s Bank of China. Accommodative Policy Matters Most The global policy “put option” is still in full force, which is boosting asset prices. A 41% rally in the median US stock reflects both a massive amount of funds inundating the financial system and a recovery that will take hold in the coming 12 months in response to this stimulus and the end of lockdowns. Global monetary policies have been even more aggressive than after the GFC. Interest rates have fallen as quickly and as broadly as they did around the Lehman bankruptcy. Moreover, unorthodox policy measures have become the norm (Chart I-5). Chart I-5Easy Policy, Everywhere Easy Policy, Everywhere Easy Policy, Everywhere In China, credit generation is quickly accelerating and has reached 28% of GDP, the highest in 2 years. Moreover, policymakers are emphasizing the need to create 9 million jobs in cities and keep the unemployment rate at 6%. Consequently, the recent rebound in construction activity will continue because it is a perfect medium to absorb excess workers. The ever-expanding quotas for local government special bonds to CNY3.75 trillion will also ensure that infrastructure spending energizes any recovery. Therefore, we expect Chinese imports of raw materials and machinery to accelerate into the second half of the year. The country’s orders of machine tools from Japan have already bottomed, which bodes well for overall Japanese orders (Chart I-6). Europe has also moved in the right direction. Government support continues to expand and combined public deficits will reach EUR 0.9 trillion, or 8.5% of GDP. Governmental guarantees have reached at least EUR1.4 trillion. Meanwhile, the European Central Bank’s balance sheet is swelling more quickly than during either the GFC or the euro area crisis (Chart I-7). Unsurprisingly, European shadow rates have collapsed to -7.6% and European financial conditions are the easiest they have been in 8 years. Chart I-6Will China's Rebound Matter? Will China's Rebound Matter? Will China's Rebound Matter? Chart I-7The ECB Is Aggressive The ECB Is Aggressive The ECB Is Aggressive   More importantly, COVID-19 has broken the taboo of common bond issuance in Europe. Last week, Chancellor Merkel, President Macron and EC President von der Leyen hatched a plan to issue common bonds that will finance a EUR 750 billion recovery fund as part of the European Commission Multiannual Financial Framework. The EC will then allocate EUR 500 billion of grants (not loans) to EU nations as long as they adhere to European principles. The unified front by the three most senior European politicians reflects elevated support for the EU among all European nations and an understanding that economic ruin in the smaller nations could capsize the core nations (Chart I-8). Hence, fiscal risk-sharing will increasingly become the norm in Europe. Unsurprisingly, Italian, Spanish, Portuguese and Greek bond spreads all narrowed significantly following the announcement. Chart I-8The Forces That Bind The Forces That Bind The Forces That Bind Chart I-9Negative Rates Are Here, Sort Of Negative Rates Are Here, Sort Of Negative Rates Are Here, Sort Of US policymakers have abandoned any semblance of orthodoxy. The Fed’s programs announced so far have lifted its balance sheet by $2.9 trillion and could generate an expansion to $11 trillion by year-end. Moreover, Fed Chair Jerome Powell has highlighted that there is “no limit” to what the Fed can do with its unconventional policy apparatus. The nature of the US funding market makes negative rates very dangerous and, therefore, highly doubtful in that country. Nonetheless, the Fed is willing to buy more paper from the public and private sectors to push the shadow rate and real interest rates further into negative territory (Chart I-9). Moreover, the Federal government has already bumped up the deficit by $3 trillion and the House has passed another $3 trillion in spending. Senate Republicans will pass some of this program to protect themselves in November. According to BCA Research’s Geopolitical Strategy service, a total escalation in the federal deficit of $5 trillion (or 23% of 2020 GDP) is extremely likely this year. Chart I-10The Fed Is Monetizing The Deficit The Fed Is Monetizing The Deficit The Fed Is Monetizing The Deficit Combined fiscal and monetary policy in the US will have a more invigorating impact on the recovery than the measures passed in 2008-09. They represent a larger share of output than during the GFC (10.5% versus 6% of GDP for the government spending and 15.2% versus 8.3% for the Fed’s balance sheet expansion). Moreover, the Fed is buying a much greater percentage of the Treasury’s issuance than during the GFC (Chart I-10). Therefore, the Fed is much closer to monetizing government debt than it was 11 years ago. The combined monetary and fiscal easing should result in a larger fiscal multiplier because the private sector is not financing as much of the government’s largesse. Thus, the increase in the private sector’s savings rate should be short-lived and the current account deficit will widen to reflect the greater fiscal outlays. Low real rates and a larger balance-of-payments disequilibrium should weaken the dollar which will ease US financial conditions further. A Trough In Inflation Maintaining incredibly easy monetary and fiscal conditions as the economy reopens will lead to higher inflation when the labor market reaches full employment. Core CPI has collapsed to 1.4% on an annual basis and to -2.4% on a three-month annualized basis, the lowest reading on record. The breakdown of the CPI report is equally dreadful (Chart I-11). However, CPI understates inflation because the basket measured by the BLS includes many areas of commerce currently not frequented by consumers. Items actually purchased by households, such as food, have experienced accelerating inflation in recent months. Fiscal risk-sharing will increasingly become the norm in Europe. Beyond this technicality, the most important factor behind the anticipated structural uptick in inflation is a large debt load burdening the global economy. Total nonfinancial debt in the US stands at 254% of GDP, 262% in the euro area, 380% in Japan, 301% in Canada, 233% in Australia, 293% in Sweden and 194% in emerging markets (Chart I-12). Historically, the easiest method for policymakers to decrease the burden of liabilities is inflation; the current political climate increases the odds of that outcome. Chart I-11Weak Core Weak Core Weak Core Chart I-12Record Debt, Everywhere Record Debt, Everywhere Record Debt, Everywhere   Households in the G-10 and emerging markets are angry. Growing inequalities, coupled with income immobility, have created dissatisfaction with the economic system (Chart I-13). Before the GFC, US households could gorge on debt to support their spending patterns, and inequalities went unnoticed. After the crisis revealed weakness in the household sector, banks tightened their credit standards and consumption slowed, constrained by a paltry expansion of the median household income. As a consequence, the American public increasingly supports left-wing economic policies (Chart I-14). Chart I-13Inequalities + Immobility = Anger June 2020 June 2020 Chart I-14The US Population's Shift To The Left June 2020 June 2020 COVID-19 is exacerbating the population’s discontent and highlighting economic disparities. The recession is hitting poor households in the US harder than the general population or highly skilled white-collar employees who can easily telecommute. Millennials, the largest demographic group in the US, are also irate. Their lifetime earnings were already lagging that of their parents because most millennials entered the job market in the aftermath of the GFC.1 Their income and balance sheet prospects were beginning to improve just as the pandemic shock struck. Finally, in response to the lockdowns and school closures caused by COVID-19, young families with children have to juggle permanent childcare and daily work demands from employers, resulting in a lack of separation between home and office.2  Economic populism will generate a negative supply shock, which will push up prices (Diagram I-1). BCA has espoused the theme of de-globalization since 20143 and COVID-19 will accelerate this trend. Firms do not want fragile supply chains that fall victim to random shocks; instead, they are looking to diversify their sources (Chart I-15). Additionally, workers and households want protection from foreign competition and perceived unfair trade practices. This sentiment is evident in a lack of trust toward China (Chart I-16). China-bashing will become a mainstay of American politics and rising tariffs will continue to increase the cost of doing business (Chart I-17). Last year’s Sino-US trade war was a precursor of events to come. Diagram I-1The Inflationary Impact Of A Stifled Supply Side June 2020 June 2020 Chart I-15COVID-19 Accelerates The Desire To Repatriate Production June 2020 June 2020 Chart I-16China As A Political Piñata June 2020 June 2020 Chart I-17The Cost Of Doing International Business Will Rise The Cost Of Doing International Business Will Rise The Cost Of Doing International Business Will Rise Chart I-18A Problem For Productivity A Problem For Productivity A Problem For Productivity The rate of capital stock accumulation does not bode well for the supply side of the economy. Productivity trails the path of capex, with a long time lag. The 10-year moving average of non-residential investment in the US bottomed three years ago. Its subsequent uptick should enhance average productivity. However, the growth of the real net capital stock per employee remains weak and will not strengthen because companies are curtailing spending in the recession. Moreover, the efficiency of the capital stock is well below its long-term average and probably will not mend if supply chains are made less efficient. These factors are negative for productivity and thus, the capacity to expand the supply side of the economy (Chart I-18). Finally, a significant share of capital stock is stranded and uneconomical. The airline industry is a good example. Going forward, regulations will keep the middle row seats empty. Fewer filled seats imply that the capital stock has lost significant value, which creates a negative supply shock for the industry. To break even, airlines will have to raise the price of fares. IATA estimates that fares will increase by 43%, 49% and 54% on North American, European and Asian routes, respectively (Table I-1). The same analysis can be applied to restaurants, hotels, cinemas, etc. – industries that will have to curtail their supplies and change their practices in response to COVID-19. Table I-1The Inflationary Impact Of Supply Cuts June 2020 June 2020 Chat I-19Pandemics Boost Wages June 2020 June 2020 While rising populism will hurt the supply side of the economy, it will also hike demand. Redistribution is an outcome of populism. Corporate tax hikes hurt rich households that receive more than 50% of their income from profits. High marginal tax rates on high earners will also curtail their disposable income. Shifting a bigger share of national income to the middle class will depress the savings rate and boost demand. It is estimated that the middle class’s marginal propensity to spend is 90% compared with 60% for richer households. In fact, in the past 40 years, the shift in income distribution has curtailed demand by 3% of GDP. Pandemics also increase real wages. Òscar Jordà, Sanjay Singh, and Alan Taylor demonstrated that European real wages accelerated following pandemics (Chart I-19). Fewer willing workers contributed to the climb in real wages by decreasing the supply of labor. Higher real wages are positive for consumption. China-bashing will become a mainstay of American politics and rising tariffs will continue to increase the cost of doing business. Populism will also put upward pressure on public spending. Governments globally and in the US are bailing out the private sector to an even larger extent than they did after the GFC. Discontent with expanding inequalities and the perceived lack of accountability of the corporate sector4 will push the government to be more involved in economic management than it was after 2008. Moreover, the post-2008 environment showed that austerity was negative for private sector income growth and the economic welfare of the middle class (Chart I-20). Thus, government spending and deficits as a share of GDP will be structurally higher for the coming decade. Higher deficits mechanically boost aggregate demand which is inflationary if the advance of aggregate supply is sluggish. Chat I-20Austerity Hurts June 2020 June 2020 Central banks will likely enable these inflationary dynamics. The Fed knows that it has missed its objective by a cumulative 4% since former Chairman Ben Bernanke set an official inflation target of 2% in 2012. Thus, it has lost credibility in its ability to generate 2% inflation, which is why the 10-year breakeven rate stands at 1.1% and not within the 2.3%-2.5% range that is consistent with its mandate. Moreover, the Fed is worried that the immediate deflationary impact of COVID-19 will further depress inflation expectations and reinforce low realized inflation. This logic partly explains why the Fed currently recommends more stimulus and the Federal Open Market Committee will be reluctant to remove accommodation anytime soon. Inflation will likely move toward 4-5% after the US economy regains full employment. Central banks may fall victim to growing populism. Both the Democrats and Republicans want control over the US Fed. If Congress changes the Fed’s mandate, there would be great consequences for inflation. Prior to the Federal Reserve Reform Act of 1977, the Fed’s mandate was to foster full employment conditions without any explicit mention of inflation. Therefore, the Fed kept the unemployment rate well below NAIRU for most of the post-war period. This tight labor market was a key ingredient behind the inflationary outbreak of the 1970s. After the reform act explicitly imposed a price stability directive on top of the Fed’s employment mandate, the unemployment rate spent a much larger share of time above NAIRU, which contributed to the structural decline in inflation after 1982 (Chart I-21). Chat I-21The Fed's Mandate Matters The Fed's Mandate Matters The Fed's Mandate Matters Finally, demographics will also feed inflationary pressures. The global support ratio peaked in 2014 as the number of workers per dependent decreased due to ageing of the population in the West and China (Chart I-22). A declining support ratio depresses the growth of the supply side of the economy because the dependents continue to consume. In today’s world, dependents are retirees, who have higher healthcare spending needs. This healthcare spending will accrue additional government spending. Moreover, it will continue to push up healthcare inflation, which will contribute to higher overall inflation (Chart I-23). Chat I-22Demographics: From Deflation To Inflation Demographics: From Deflation To Inflation Demographics: From Deflation To Inflation Chat I-23Aging Will Feed Healthcare Inflation Aging Will Feed Healthcare Inflation Aging Will Feed Healthcare Inflation   Bottom Line: COVID-19 has highlighted inequalities in the population and will accelerate a move toward populism that started four years ago. Consequently, the supply side of the economy will grow more slowly than it did in prior decades, while greater government interventions and redistributionist policies will boost aggregate demand. Additionally, monetary policy will probably stay easy for too long and demographic factors will compound the supply/demand mismatch. Inflation will likely move toward 4-5% after the US economy regains full employment, but will not surge to 1970s levels. Investment Implications Chat I-24Breakevens Will Listen To Commodities Breakevens Will Listen To Commodities Breakevens Will Listen To Commodities Extremely accommodative economic policy and a shift to higher inflation will dominate asset markets for the next five years or more. Breakevens in the G-10 are pricing in permanently subdued inflation for the coming decade, which creates a large re-pricing opportunity if inflation troughs when the labor market reaches full employment. Investors cannot wait for inflation to turn the corner to bet on higher breakevens. After the GFC, core CPI bottomed in October 2010, but US breakevens hit their floor at 0.15% in December 2008. Instead, a rebound in commodity prices and a turnaround in the global economic outlook may signal when investors should buy breakevens (Chart I-24). Chat I-25Deleterious US Balance Of Payments Dynamics Deleterious US Balance Of Payments Dynamics Deleterious US Balance Of Payments Dynamics A repricing of inflation expectations will depress real rates. Central banks want to see inflation expectations normalize towards 2.3%-2.5% before signaling an end to accommodation. Moreover, political pressures and high debt loads will likely loosen their reaction functions to higher breakeven. As a result, real interest rates will decline because nominal ones will not rise by as much as inflation expectations. This is exactly what central banks want to achieve because it will foster a stronger recovery. Our US fixed-income strategists favor TIPS over nominal Treasurys. The dollar will probably depreciate in the post-COVID-19 environment. As we wrote last month, the US is the most aggressive reflator among major economies. The twin deficit will expand while US real rates will remain depressed. This is very negative for the USD, especially in an environment where the US money supply is outpacing global money supply (Chart I-25).5 Additionally, Chinese reflation will stimulate global industrial production, which normally hurts the dollar. EM currencies are cheap enough that long-term investors should begin to bet on them (Chart I-26), especially if global inflation structurally shifts higher. Precious metals win from the combination of higher inflation, lower real rates and a weaker dollar. However, silver is more attractive than gold. Unlike the yellow metal, it trades at a discount to the long-term inflation trend (Chart I-27). Moreover, silver has more industrial uses, especially in the solar panel and computing areas. Thus, the post-COVID-19 recovery and the need to double up supply chains will boost industrial demand for silver and lift its price relative to gold. Our FX strategists recommend selling the gold-to-silver ratio.6 Chat I-26Cheap EM FX Cheap EM FX Cheap EM FX Chat I-27Silver Is The Superior Inflation Hedge Silver Is The Superior Inflation Hedge Silver Is The Superior Inflation Hedge   Chat I-28Still Time To Favor Stocks Over Bonds Still Time To Favor Stocks Over Bonds Still Time To Favor Stocks Over Bonds Investors should favor stocks over bonds. This statement is more an indictment of the poor value of bonds and their lack of defense against rising inflation than a structural endorsement of stocks. The equity risk premium is elevated. To make this call, we need to account for the lack of stationarity of this variable and adjust for the expected growth rate of earnings. Nonetheless, once those factors are accounted for, our ERP indicator continues to flash a buy signal in favor of equities at the expense of bonds (Chart I-28). Moreover, bonds tend to underperform stocks when inflation trends up for a long time (Table I-2).   Table I-2Rising Inflation Flatters Stocks Over Bonds June 2020 June 2020 Chart I-29Bonds Are Prohibitively Expensive Bonds Are Prohibitively Expensive Bonds Are Prohibitively Expensive In absolute terms, G-7 government bonds are also vulnerable, both tactically and structurally. They are overbought and currently trade at their greatest premium to fair value since Q4 2009 and Q1 1986, two periods followed by sharp rebounds in yields (Chart I-29). Moreover, the previous experience with QE programs shows that even if real rates diminish, the reflationary impact of aggressive monetary policy on breakeven rates is enough to increase nominal interest rates (Chart I-30). Additionally, as our European Investment Strategy team indicates, bond yields are close to their practical lower bound, which creates a negative skew to their return profile.7 This asymmetric return distribution destroys their ability to hedge equity risk going forward, making this asset class less appealing to investors. This problem is particularly salient in Europe and Japan. A lower dollar, which is highly reflationary for global growth, will likely catalyze the rise in yields.   Chart I-30QE Will Lift Breakevens And Yields QE Will Lift Breakevens And Yields QE Will Lift Breakevens And Yields As long as real rates remain under downward pressure, the window to own stocks remains open, even if stocks continue to churn. Equities are expensive, but when yields are taken into consideration, their adjusted P/E is in line with the historical average (Chart I-31). Moreover, periods of weak growth associated with lower real interest rates can foster a large expansion in multiples (Chart I-32). Chart I-31Low Bond Yields Allow High Stock Multiples Low Bond Yields Allow High Stock Multiples Low Bond Yields Allow High Stock Multiples Chart I-32Multiples Will Rise Further As The Fed Floods The World With Low Rates Multiples Will Rise Further As The Fed Floods The World With Low Rates Multiples Will Rise Further As The Fed Floods The World With Low Rates Whether to have faith in stocks in absolute terms on a long-term basis is complicated by our view on inflation and populism. Strong inflation will increase nominal rates. Moreover, low productivity coupled with higher real wages, less-efficient supply chains and higher taxes will accentuate the margin compression that higher inflation typically creates. Thus, equities are expected to generate poor real returns over the long term, even if they beat bonds. Chart I-33Tech EPS Leadership Tech EPS Leadership Tech EPS Leadership Tech stocks are another structural problem for equities. Including Amazon, Google and Facebook, tech stocks account for 41% of the S&P 500’s market cap. As our US Equity Strategy service explains, wherever tech goes, so does the US market.8 Tech stocks are the current market darling. Today, the tech sector is the closest thing to a safe-haven in the mind of market participants, because a post-COVID-19 environment will favor tech spending (telecommuting, e-commerce, cloud computing, etc.). The problem for long-term investors is that this view is the most consensus view. Already, investors expect the tech sector to generate the highest EPS outperformance relative to the rest of the S&P 500 in more than 15 years (Chart I-33). Moreover, in a low-yield environment, investors are particularly willing to bid up the multiples of growth stocks such as tech equities because low interest rates result in muted discount factors for long-term cash flows. When should investors begin betting against the tech sector? Backed by a powerful narrative, tech stocks are evolving into a mania. Yet, contrarian investors understand, being too early to sell a mania can be deadly. Bond yields should not be relied on to signal an end to the bubble. During most of the 1990s, tech would outperform the market when Treasury yields declined. However, when the tech outperformance became manic, yields became irrelevant. From the fall of 1998 to the beginning of 2000, 10-year yields rose from 4.2% to 6.8%, yet the tech sector outperformed the S&P 500 by 127%. More recently, yields rose from 1.33% in the summer of 2016 to 3.25% in November 2018, but tech outperformed the broader market by 39%.   Investors should favor stocks over bonds. Instead, higher inflation will be the key factor to end the tech sector’s infallibility. Since the 1990s, higher core inflation has led periods of tech underperformance by roughly six months. This relationship also held at the apex of the tech bubble in the second half of the 1990s (Chart I-34). Relative tech forward EPS suffers when core inflation rises, as the rest of the S&P 500 is more geared to higher nominal GDP growth. In essence, if nominal growth is less scarce, then the need to bid up growth stocks diminishes. Moreover, the dollar will likely be the first early signal because it leads nominal GDP. As a result, a weak dollar leads to a contraction in tech relative multiples by approximately 9 months (Chart I-35). Chart I-34Tech Hates Inflation... Tech Hates Inflation... Tech Hates Inflation... Chart I-35...And A Soft Dollar ...And A Soft Dollar ...And A Soft Dollar   We recommend long-term investors shift their portfolios toward industrial equities when inflation turns the corner. As a corollary, the low exposure of European and Japanese stocks to the tech sector suggests these cheap bourses will finally reverse their more-than-a-decade-long underperformance at the same time. This strategy means that even if the S&P 500 generates negative real returns during the coming decade, investors could still eke out positive returns from their stock holdings. Higher inflation will be the key factor to end the tech sector’s infallibility. Chart I-36The Time For Commodities Is Coming Back The Time For Commodities Is Coming Back The Time For Commodities Is Coming Back Finally, commodities plays are also set to shine in the coming decade. Commodities are very cheap and oversold relative to stocks (Chart I-36). Commodities outperform equities in an environment where inflation rises, real rates decline and the dollar depreciates. Consequently, materials and energy stocks may be winners. As a corollary, Latin American and Australian equities should also reverse their decade-long underperformance when inflation and the dollar turn the corner. This month's Section II Special Report is an in depth study of the Spanish Flu pandemic, written by our colleague Amr Hanafy and also published in BCA Research’s Global Asset Allocation service. Amr thoroughly analyses the evolution of the 100-year old pandemic and which measures mattered most to contain the virus and allow a return to economic normality. Mathieu Savary Vice President The Bank Credit Analyst May 28, 2020 Next Report: June 25, 2020 II. Lessons From The Spanish Flu What Can 1918/1919 Teach Us About COVID-19?   “Those who cannot remember the past are condemned to repeat it” George Santayana – 1905 Chart II-1Coronavirus: As Contagious But Not As Deadly As Spanish Flu June 2020 June 2020 Today’s economy is very different to that of 100 years ago. Many countries then were in the middle of World War I (which ended in November 1918). The characteristics of the Spanish Flu which struck the world in 1918 and 1919 were also different to this year’s pandemic. COVID-19 is almost as contagious as the Spanish Flu, but it is much less deadly (Chart II-1). Healthcare systems and treatments today are far more advanced than those of a century ago: many people who caught Spanish flu died of complications caused by bacterial pneumonia, given the absence of antibiotics. Influenza viruses tend to mutate rapidly: the influenza virus in 1918 first mutated to become far more virulent in its second wave, and then to become much milder. Coronaviruses have a “proofreading” capacity and mutate less easily.9  Nevertheless, an analysis of the pandemic of 100 years ago provides a number of insights into the current crisis, particularly now that policymakers are easing social-distancing rules to help the economy, even at the risk of more cases and deaths. Among the lessons of 1918-1919: Non-pharmaceutical interventions (NPIs) do lower mortality rates. The speed at which NPIs are implemented and the period of implementation are as important as the number of measures taken. Removing or relaxing measures too early can lead to a renewed rise in mortality rates. It is hard to compare current fiscal and monetary policies to those taken during the 1918 pandemic, since policy in both areas was already easy before the pandemic as a result of the world war. However, a severe pandemic would certainly call for a wartime-like fiscal and monetary response. The economy was negatively impacted by the pandemic in 1918-19 but, despite the shock to industrial activity and employment, the economy subsequently rebounded quickly, in a V-shaped recovery. Introduction Predicting how the economy will react to the COVID-19 pandemic is hard. Governments and policymakers face multiple uncertainties: How effective are different containment measures? Will cases and deaths rebound quickly if lockdown measures are eased? When will the coronavirus disappear? When will a vaccine be ready? With an event unprecedented in the experience of anyone alive today, perhaps there are some lessons to be learned from history. For this Special Report, we attempt to draw some parallels between the current situation and the 1918-19 Spanish flu. We focus on the different containment efforts implemented, the role that fiscal and monetary policies played, the impact on markets and the economy, and whether history can throw any light on how the COVID-19 crisis might pan out. The 1918 Spanish Flu Chart II-2The Spanish Flu Hit The World In Three Waves The Spanish Flu Hit The World In Three Waves The Spanish Flu Hit The World In Three Waves The 1918 influenza pandemic was the most lethal in modern history. Soldiers returning from World War I helped spread the pandemic across the globe. The first recorded case is believed to have been in an army camp in Kansas. While there is no official count, researchers estimate that about 500 million people contracted the virus globally, with a mortality rate of between 5% and 10%. The pandemic occurred over three waves in 1918 and 1919 – the first in the spring of 1918, the second (and most deadly) in the fall of 1918, and the third in spring 1919 (Chart II-2). In the US alone, official data estimate that around 500,000 deaths (or over 25% of all deaths) in 1918 and 1919 were caused by pneumonia and influenza.10 The pandemic moved swiftly to Europe and reached Asia by mid-1918, but became more lethal only towards the end of the year (Map II-1).11 Map II-1The Spread Of Influenza Through Europe June 2020 June 2020 Initially, scientists were puzzled by the origin of the influenza and its biology. It was not until a decade later, in the early 1930s, that Richard Shope isolated the particular influenza virus from infected pigs, confirming that a virus caused the Spanish Flu, not a bacterium as most had thought. Many of those who caught this strain of influenza died as a result of their lungs filling with fluid in a severe form of pneumonia. In reporting death rates, then, it is considered best practice to include deaths from both influenza and pneumonia. The first wave had almost all the hallmarks of a seasonal flu, albeit of a highly contagious strain. Symptoms were similar and mortality rates were only slightly higher than a normal influenza. The first wave went largely unnoticed given that deaths from pneumonia were common then. US public health reports show that the disease received little attention until it reappeared in a more severe form in Boston in September 1918.12 Most countries did not begin investigating and reporting cases until the second wave was underway (Chart II-3). Chart II-3Most Countries Began Reporting Only When The Second Wave Hit June 2020 June 2020 This second wave – which was more lethal because the virus had mutated – had a unique characteristic. Unlike the typical influenza mortality curve – which is usually “U” shaped, affecting mainly the very young and elderly – the 1918 influenza strain had a “W”-shaped mortality curve – impacting young adults as well as old people (Chart II-4). This pattern was evident in all three waves, but most pronounced during the second wave. The reason for this was that the infection caused by the influenza became hyperactive, producing a “cytokine storm” – when mediators secreted from the immune system result in severe inflammation.13 Simply put, as the virus became virulent, the body’s immune system overworked to fight it. Younger people, with strong immune systems, suffered most from this phenomenon. Chart II-4A Unique Characteristic: Impacting Younger Adults June 2020 June 2020 By the summer of 1919, the pandemic was over, since those who had been infected had either died or recovered, therefore developing immunity. The lack of records makes it difficult to assess if “herd immunity” was achieved. However, some historical accounts and research – particularly for army groups in the US and the UK – suggest that those exposed to the disease in the first mild wave were not affected during the second more severe wave.14 The failure to define the causative pathogen at the time made development of a vaccine impossible. Nevertheless, some treatments and remedies showed modest success. These varied from using a serum – obtained from people who had recovered, who therefore had antibodies against the disease – to simple symptomatic drugs and various oils and herbs. The Effectiveness Of Non-Pharmaceutical Interventions (NPIs) Chart II-5Travel Slowed...Just Not Enough Travel Slowed...Just Not Enough Travel Slowed...Just Not Enough What we today call “social distancing” showed positive effects during the 1918-19 pandemic. These included measures very similar to those applied today: school closures, isolation and quarantines, bans on some sorts of public gatherings, and more. However, there were few travel bans. The number of passengers carried during the months of the pandemic did noticeably decline though (Chart II-5). Table II-1, based on research by Hatchett, Mecher and Lipsitch, breaks down NPIs by type for 17 major US cities. Most cities implemented a wide range of interventions. But it was not only the type of NPIs implemented that made a difference, but also the speed and length of implementation. Further research by Markel, Lipman and Navarro based on 43 US cities shows that the median number of days between the first reported influenza case and the first NPI implementation was over two weeks. The median period during which various NPIs were implemented was about six weeks (Table II-2). Table II-1Measures Applied Then Are Very Similar To Those Applied Today June 2020 June 2020 Table II-2NPIs Were Implemented Only For Short Periods June 2020 June 2020 Markel, Lipman and Navarro's findings show that a rapid public-health response was an important factor in reducing the mortality rate by slowing the rate of infection, what we now refer to as “flattening the curve.” There were major differences in cities’ policies: both the speed at which they implement NPIs, and the length of the implementation period. Chart II-6 shows that: Cities that acted quickly to implement NPIs slowed the rate of infections and deaths (Chart II-6, panel 1) Cities that acted quickly had lower mortality rates from influenza and pneumonia (Chart II-6, panel 2) Cities that implemented NPIs for longer periods had fewer deaths (Chart II-6, panel 3) Chart II-7 quantifies the number of NPIs taken, the time it took to implement the measures, and the length of NPIs to gauge policy strictness. Cities with stricter enforcement had lower death rates than those with laxer measures. Chart II-6Fast Response And Longer Implementation Led To Fewer Deaths... June 2020 June 2020 Chart II-7...So Did Policy Strictness June 2020 June 2020     For example, Kansas City, less than a week after its first reported case, had implemented quarantine and isolation measures. By the second week, schools, churches, and other entertainment facilities closed. Schools reopened a month later (in early November) but quickly shut again until early January 1919. While we do not have definitive dates on when each NPI was lifted, some sort of protective measures in Kansas City were in place for almost 170 days. By contrast, Philadelphia, one of the cities hardest hit by Spanish Flu, took more than a month to implement any measures. Its tardiness meant that it reached a peak mortality rate much more quickly: in 13 days compared to 31 days for Kansas City. Even after the first reported case, the Liberty Loans Parade was still held on September 28, 1918 – with the knowledge that hundreds of thousands of spectators might be vulnerable to infection.15,16 It was not until a few days later that institutions were closed and a ban on public gatherings was imposed. Many other cities also held a Liberty Loans Parade, including Pittsburgh and Washington DC, but Philadelphia’s was the deadliest. Studies also show that relaxing interventions too early could be as damaging as implementing them too late. St. Louis, for example, was quick to lift restrictions and suffered particularly badly in the second wave as a result. It later reinstated NPIs up until end of February 1919. Other cities that eased restrictions too early (San Francisco and Minneapolis, for example) also suffered from a second swift, albeit milder, increase in weekly excess death rates from pneumonia and influenza (Chart II-8). Chart II-8Relaxing Lockdown Measures Too Early Can Lead To A Second Rise In Deaths... June 2020 June 2020 Chart II-9...And So Can Highly Effective Measures June 2020 June 2020 Of course, NPIs cannot be implemented indefinitely. A recent research paper by Bootsma and Ferguson raises the point that suppressing a pandemic may not be the best strategy because it just leaves some people susceptible to infection later. They argue that highly effective social distancing measures, which allow a susceptible pool of people to reintegrate into society when the measures are lifted, are likely to lead to a resurgence in infections and fatalities in a second peak (Chart II-9).17 They suggest an optimal level of control measures to reduce R (the infection rate) to a value that makes a significant portion of the population immune once measures are lifted.  The Impact Of The Spanish Flu On The Economy And Markets How did the Spanish Flu pandemic affect the economy? Many pandemic researchers ignore the official recession identified by the NBER during the months of the pandemic (between August 1918 and March 1919).18 The reason is that most of the evidence indicates that the economic effects of the 1918-19 pandemic were short-term and relatively mild.19 Disentangling drivers of the economy is, indeed, tricky given that WW1 ended in November 1918. However, it is easy to underestimate the negative impact of the pandemic since the war had such a big impact on the economy, as well as investor and public sentiment. Various research papers support the fact that, while the pandemic did indeed have an adverse effect on the economy, NPIs did not just depress mortality rates, but also sped the post-pandemic economic recovery.20 Research by Correia, Sergio, and Luck showed that the areas most severely affected by the pandemic saw a sharp and persistent decline in real economic activity, whereas cities that intervened earlier and more aggressively, experienced a relative increase in economic activity post the pandemic.21 Their findings are based on the increase in manufacturing employment after the pandemic compared to before it (1919 versus 1914). However, note that the rise of manufacturing payrolls in 1919 was high everywhere given the return of soldiers post-WWI. The researchers also note that those cities hardest hit by the pandemic also saw a negative impact on manufacturing activity, the stock of durable goods, and bank assets. Chart II-10Short-Term Price Impact Was Disinflationary Short-Term Price Impact Was Disinflationary Short-Term Price Impact Was Disinflationary Because Spanish flu disproportionately killed younger adults, many families lost their breadwinner. In economic terms, this implies both a negative supply shock and negative demand shock. If fewer employees are available to produce a certain good, supply will fall. The same reduction in employment also implies reduced income and therefore lower purchasing power. Both cases will result in a decrease in output. However, the change in prices depends on the decline of supply relative to demand. In 1918-19, the impact was disinflationary: demand declined by more than supply, and both spending and consumer prices fell during the pandemic (Chart II-10). US factory employment fell by over 8% between March 1918 and March 1919 – the period from the beginning of the first wave until the end of the second wave. It is important to note, however, that few businesses went bankrupt during the pandemic years (Chart II-11). Additionally, the November 1918 Federal Reserve Bulletin highlighted that many cities, including New York, Kansas City, and Richmond, experienced a shortage of labor due to the influenza.22 Factory employment in New York fell by over 10% during this period. The link between the labor shortages and the decline in industrial production is unclear. Industrial activity in the US peaked just before the second wave, contracting by over 20% during the second wave (Chart II-12). Various industries reported disruptions: automobile production fell by 67%, anthracite coal production and shipments fell by around 45%, and railroad freight revenues declined by over seven billion ton-miles (Chart II-12, panels 2, 3 & 4). However, some of this decline is attributed to falling defense production after the war. Chart II-11Loss Of Middle-Aged Adults = Loss Of Breadwinners Loss Of Middle-Aged Adults = Loss Of Breadwinners Loss Of Middle-Aged Adults = Loss Of Breadwinners Chart II-12Activity Slowed, But Rebounded Quickly Activity Slowed, But Rebounded Quickly Activity Slowed, But Rebounded Quickly   Chart II-13The War Had A Bigger Impact On The Stock Market Than The Pandemic The War Had A Bigger Impact On The Stock Market Than The Pandemic The War Had A Bigger Impact On The Stock Market Than The Pandemic Chart II-14Monetary Policy Was Easy...Even Before The Pandemic Started Monetary Policy Was Easy...Even Before The Pandemic Started Monetary Policy Was Easy...Even Before The Pandemic Started The equity market moved in a broad range in 1915-1919 and fell sharply only ahead of the 1920 recession (Chart II-13). Seemingly, stock market participants were more focused on the war than the pandemic. The lack of reporting of the pandemic could have contributed to this: newspapers were encouraged to avoid carrying bad news for reasons of patriotism and did not widely cover the pandemic until late 1918.23 The Federal Reserve played an active role in funding the government’s spending on the war, and so monetary policy was very easy during the pandemic – but for other reasons. The Fed used its position as a lender to the banking system to facilitate war bond sales.16 Interest rates were cut in 1914 and 1915 even before the US entered the war. The US economy had been in recession between January 1913 and December 1914. Policy rates remained low throughout 1916 and 1917 and slightly rose in 1918 and 1919. It was not until 1920 that Federal Reserve Bank System tightened policy rapidly to choke off inflation, which accelerated to over 20% in mid-1920 – rising inflation being a common post-war phenomenon (Chart II-14). The Lessons Of 1918-19 For The Coronavirus Pandemic Non-pharmaceutical interventions should continue to be implemented until a vaccine, effective therapeutic drugs, or mass testing is available. Relaxing measures prematurely is as damaging as a tardy reaction to the pandemic. Reacting quickly and imposing multiple measures for longer periods not only reduces mortality rates, but also improves economic outcomes post-crisis. The economy suffers in the short-term: supply and demand shocks lead to lower output. The demand shock however is larger leading to lower prices and disinflationary pressures, at least during and immediately after the pandemic.   Amr Hanafy Senior Analyst Global Asset Allocation III. Indicators And Reference Charts Last month, we maintained a positive disposition toward stocks, especially at the expense of government bonds. The global economy may be in the midst of its most severe contraction since the Great Depression, but betting against stocks is too dangerous when fiscal and monetary policy are both as easy as they are today. In essence, don’t fight the Fed. This view remains in place, even if the short-term risk/reward ratio for holding stocks is deteriorating. On a cyclical basis, the same factors that made us willing buyers of stocks remain broadly in place. Stocks are not as cheap as they were in late March, but monetary conditions have only eased further as real interest rates weakened. Additionally, our Speculation Indicator has eased, which indicates that contrary to many commentators’ perceptions, speculation is not rampant. Confirming this intuition, the equity risk premium remains elevated (even when one takes into account its lack of stationarity) and expected growth rates of earnings are still very low. Finally, our Revealed Preference Indicator is finally flashing a strong buy signal. Tactically, equities are still overbought. We have had four 5% or more corrections since March 23. More of them are in the cards. However, the most likely outcome for the S&P 500 this summer is a churning pattern, not a major downward move below 2700. The median stock is still 26% below its August 2018 low and only a fraction of equities on the NYSE trade above their 30-week moving average. These indicators do not scream that a major correction is on the horizon, especially when policy is as accommodative as it is today. We continue to recommend investors take advantage of the supportive backdrop for stocks by buying equities relative to bonds. In contrast to global bourses, government bonds are still massively overbought on a cyclical basis and trading at their largest premium to fair value since Q4 2008 and late 1985. Additionally, the vast sums of both monetary and fiscal stimulus injected in the economy should lift inflation expectations and thus, bond yields. The yield curve is therefore slated to steepen further. Since we last published, the dollar has not meaningfully depreciated, but the DXY is trying to breakdown while our composite technical indicator is making lower highs. It is too early to gauge whether the recent rebound in the IDR, the MXN, or the ZAR is anything more than an oversold bounce, but if it were to continue, it would indicate that the expensive greenback is starting to buckle under the weight of the quickly expanding twin deficit. The widening in the current account deficit that will result from extraordinarily loose fiscal policy means that the large increase in money supply by the Fed will leak out of the US economy. This process is highly bearish for the dollar. Ultimately, the timing of the dollar’s weakness will all boil down to global growth. As signs are building up that global growth is bottoming, odds are rising that the dollar will finally breakdown. Get ready for a meaningful downward move over the coming months. Finally, commodities seem to be gaining traction. The Continuous Commodity Index’s A/D line is quickly moving up and our Composite Technical Indicator is quickly rising from extremely oversold levels. Oil will hold the key for the broad complex. Oil supply has started to adjust lower and oil demand is set to improve starting June/July as the global economy re-opens, fueled with massive amounts of stimulus. As a result, inventories should start to meaningfully decline this summer, which will support the recent recovery in oil prices. If oil can rebound further, industrial commodities will follow. Finally, gold is a mixed bag in the near term. The dollar is set to weaken significantly and inflation breakevens to move higher, which will mitigate the negative impact of declining risk aversion. Silver is a superior play to gold as it will benefit from a recovery in global growth. EQUITIES: Chart III-1US Equity Indicators US Equity Indicators US Equity Indicators Chart III-2Willingness To Pay For Risk Willingness To Pay For Risk Willingness To Pay For Risk Chart III-3US Equity Sentiment Indicators US Equity Sentiment Indicators US Equity Sentiment Indicators   Chart III-4Revealed Preference Indicator Revealed Preference Indicator Revealed Preference Indicator Chart III-5US Stock Market Valuation US Stock Market Valuation US Stock Market Valuation Chart III-6US Earnings US Earnings US Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance   FIXED INCOME: Chart III-9US Treasurys And Valuations US Treasurys And Valuations US Treasurys And Valuations Chart III-10Yield Curve Slopes Yield Curve Slopes Yield Curve Slopes Chart III-11Selected US Bond Yields Selected US Bond Yields Selected US Bond Yields Chart III-1210-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components Chart III-13US Corporate Bonds And Health Monitor US Corporate Bonds And Health Monitor US Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Global Bonds: Developed Markets Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets Global Bonds: Emerging Markets Global Bonds: Emerging Markets   CURRENCIES: Chart III-16US Dollar And PPP US Dollar And PPP US Dollar And PPP Chart III-17US Dollar And Indicator US Dollar And Indicator US Dollar And Indicator Chart III-18US Dollar Fundamentals US Dollar Fundamentals US Dollar Fundamentals Chart III-19Japanese Yen Technicals Japanese Yen Technicals Japanese Yen Technicals Chart III-20Euro Technicals Euro Technicals Euro Technicals Chart III-21Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart III-22Euro/Pound Technicals Euro/Pound Technicals Euro/Pound Technicals   COMMODITIES: Chart III-23Broad Commodity Indicators Broad Commodity Indicators Broad Commodity Indicators Chart III-24Commodity Prices Commodity Prices Commodity Prices Chart III-25Commodity Prices Commodity Prices Commodity Prices Chart III-26Commodity Sentiment Commodity Sentiment Commodity Sentiment Chart III-27Speculative Positioning Speculative Positioning Speculative Positioning   ECONOMY: Chart III-28US And Global Macro Backdrop US And Global Macro Backdrop US And Global Macro Backdrop Chart III-29US Macro Snapshot US Macro Snapshot US Macro Snapshot Chart III-30US Growth Outlook US Growth Outlook US Growth Outlook Chart III-31US Cyclical Spending US Cyclical Spending US Cyclical Spending Chart III-32US Labor Market US Labor Market US Labor Market Chart III-33US Consumption US Consumption US Consumption Chart III-34US Housing US Housing US Housing Chart III-35US Debt And Deleveraging US Debt And Deleveraging US Debt And Deleveraging   Chart III-36US Financial Conditions US Financial Conditions US Financial Conditions Chart III-37Global Economic Snapshot: Europe Global Economic Snapshot: Europe Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Global Economic Snapshot: China Global Economic Snapshot: China   Mathieu Savary Vice President The Bank Credit Analyst Footnotes 1 Reid Cramer et al., The Emerging Millennial Wealth Gap, Divergent Trajectories, Weak Balance Sheets, and Implications for Social Policy, New America, Oct 2019. 2 https://www.wsj.com/articles/new-normal-amid-coronavirus-working-from-home-while-schooling-the-kids-11584437400 3 Please see Geopolitical Strategy Special Report "The Apex Of Globalization - All Downhill From Here," dated November 12, 2014, available at gps.bcaresearch.com 4  Please see The Bank Credit Analyst Special Report "The Productivity Puzzle: Competition Is The Missing Ingredient," dated June 27, 2019, available at bca.bcaresearch.com 5  Please see The Bank Credit Analyst Monthly Report "May 2020," dated April 30, 2020, available at bca.bcaresearch.com 6 Please see Foreign Exchange Strategy Weekly Report "A Few Trades Amidst A Pandemic," dated May 22, 2020, available at fes.bcaresearch.com 7 Please see European Investment Strategy Weekly Report "European Investors Left Defenceless," dated May 21, 2020, available at eis.bcaresearch.com 8 Please see US Equity Strategy Special Report "Debunking Earnings," dated May 19, 2020, available at uses.bcaresearch.com 9 Please see the Q&A with immunologist and Nobel laureate Professor Peter Doherty, published by BCA Research April 1st 2020: BCA Research Special Report, “Questions On The Coronavirus: An Expert Answers,” available at bcaresearch.com 10 Please see “Leading Cause of Death, 1990-1998,” CDC Centers for Disease Control and Prevention. 11 Please see Ansart S, Pelat C, Boelle PY, Carrat F, Flahault A, Valleron AJ, “Mortality burden of the 1918-1919 influenza pandemic in Europe,” NCBI. 12 Please see Public Health Report, vol. 34, No. 38, Sept. 19, 1919. 13 Please see Qiang Liu, Yuan-hong Zhou, Zhan-qiu Yang Cell Mol Immunol. 2016 Jan; 13(1): 3–10. 14 Please see Shope, R. (1958) Public Health Rep. 73, 165–178. 15 The Liberty Loans Parade was intended to promote the sale of government bonds to pay for World War One. 16 Please see Hatchett RJ, Mecher CE, Lipsitch M (2007) "Public health interventions and epidemic intensity during the 1918 influenza pandemic,"PNAS 104: 7582–7587. 17 Please see Bootsma M, Ferguson N, “The Effect Of Public Health Measures On The 1918 Influenza Pandemic In U.S. Cities,” PNAS (2007). 18 Please see https://www.nber.org/cycles.html 19 Please see https://www.stlouisfed.org/~/media/files/pdfs/community-development/res…12               Please see https://libertystreeteconomics.newyorkfed.org/2020/03/fight-the-pandemic-save-the-economy-lessons-from-the-1918-flu.html. 20 Please see Correia, Sergio and Luck, Stephan and Verner, Emil, Pandemics Depress the Economy, Public Health Interventions Do Not: Evidence from the 1918 Flu (March 30, 2020). Available at SSRN: https://ssrn.com/abstract=3561560 or http://dx.doi.org/10.2139/ssrn.3561560. 21 Please see Board of Governors of the Federal Reserve System (U.S.), 1935- and Federal Reserve Board, 1914-1935. "November 1918," Federal Reserve Bulletin (November 1918). 22 Please see https://newrepublic.com/article/157094/americas-newspapers-covered-pandemic. 23 Please see https://www.federalreservehistory.org/essays/feds_role_during_wwi.