High-Yield

Highlights The Chinese economy is recovering at a slower rate than the equity market has priced in. There is a high likelihood of negative revisions to Q2 EPS estimates and an elevated risk of a near-term price correction in Chinese stocks.  We expect a meaningful pickup in credit growth in H1 to improve domestic demand gain tractions in H2. This supports our overweight stance on Chinese stocks in the next 6-12 months, in both absolute and relative terms. There is still a strong probability that the yield curve will flatten, and the 10-year government bond yield may even dip below 2% in the wake of disappointing economic data in Q2. But our baseline scenario suggests the 10-year government bond yield should bottom no later than Q3 of this year. Feature This week’s report addresses pressing concerns from clients in China’s post-Covid-19 environment. China’s economy contracted by 6.8% in Q1, the largest GDP growth slump since 1976. Furthermore, the IMF’s baseline scenario projects a 3% contraction in global economic growth in 2020, with the Chinese economy growing at a mere 1.2%.1 This dim annual growth outlook means that the contraction in China’s economy will likely extend to Q2, dragging down corporate profit growth. In our April 1st report2 we recommended that investors maintain a neutral stance on Chinese stocks in the next three months due to uncertainties surrounding the pandemic, the oversized passive outperformance in Chinese stocks, and heightened risks for further risk-asset selloffs. On a 6- to 12-month horizon, however, we have a higher conviction that Chinese stocks will outperform global benchmarks. Our view is based on a decisive shift by policymakers to a “whatever it takes” approach to boost the economy. We believe that the speed of China’s economic recovery in the second half of 2020 will outpace other major economies.  Q: China’s economy is recovering ahead of other major economies. Why did you recently downgrade your tactical call on Chinese equities from overweight to neutral relative to global stocks? A: China’s economy is recovering, but it is recovering at a slower rate than the equity market has fully priced in (Chart 1A and 1B). We believe the likelihood of negative revisions to Q2 EPS estimates is high, and the risk of a near-term price correction in Chinese stocks remains elevated.  Chart 1AElevated Chinese Equity Outperformance Relative To Global Stocks Elevated Chinese Equity Outperformance Relative To Global Stocks Elevated Chinese Equity Outperformance Relative To Global Stocks Chart 1BChinese Stocks Largely Ignored Weakness In Domestic Economy Chinese Stocks Largely Ignored Weakness In Domestic Economy Chinese Stocks Largely Ignored Weakness In Domestic Economy The lackluster March data suggests that the pace of China’s economic recovery in April and even May will likely disappoint, weighing on the growth prospects for Q2’s corporate earnings (Chart 2). Chart 2EPS Growth Estimates Likely To Capitulate In Q2 EPS Growth Estimates Likely To Capitulate In Q2 EPS Growth Estimates Likely To Capitulate In Q2 The work resumption rate in China’s 36 provinces jumped sharply between mid-February and mid-March. However, since that time, the resumption rate among large enterprises has hovered around 80% of normal capacity (Chart 3). Chart 3Work Resumption Hardly Improved Since Mid-March Three Questions Following The Coronacrisis Three Questions Following The Coronacrisis The flattening of the work resumption rate curve is due to a lack of strong recovery in demand. Chart 4So Far No Strong Recovery In Domestic Demand So Far No Strong Recovery In Domestic Demand So Far No Strong Recovery In Domestic Demand The flattening of the resumption rate curve is due to a lack of strong recovery in demand. Although there was a surge in Chinese imports in crude oil and raw materials, the increase was the result of China taking advantage of low commodity prices. This surge cannot be sustained without a pickup in domestic demand. The March bounce back in domestic demand from the manufacturing, construction, and household sectors has all been lackluster (Chart 4). External demand, which growth remained in contraction through March, will likely worsen in Q2 (Chart 5). Exports shrunk by 6.6% in March, up from a deep contraction of 17.2% in January-February. Export orders can take more than a month to be processed, therefore, March’s data reflects pent-up orders from the first two months of the year. The US and European economies started their lockdowns in March, so Chinese exports will only feel the full impact of the collapse in demand from its trading partners in April and May. The work resumption rate will advance only if the momentum in domestic demand recovery increases to fully offset the collapse in external demand. The current 83% rate of work resumption implies that industrial output growth in April will remain in contraction on a year-over-year basis (Chart 6). Chart 5External Demand Will Worsen In Q2 External Demand Will Worsen In Q2 External Demand Will Worsen In Q2 Chart 6Will Q2 Industrial Output Growth Remain In Contraction? Will Q2 Industrial Output Growth Remain In Contraction? Will Q2 Industrial Output Growth Remain In Contraction? Although we maintain a constructive outlook on Chinese risk assets in the next 6 to 12 months, the short-term picture remains volatile in view of the emerging economic data. As such, we recommend investors to maintain short-term hedges for risk asset positions. Q: China’s policy response to mitigate the economic blow from COVID-19 has been noticeably smaller than programs rolled out in key developed economies, especially the US. Why do you think such measured stimulus from China warrants an overweight stance on Chinese stocks in the next 6-12 months relative to global benchmarks? A: It is true that the size of existing Chinese stimulus, as a percentage of the Chinese economy, is smaller than that has been announced in the US. But this is due to a different approach China is taking in stimulating its economy. In addition, both the recent policy rhetoric and PBoC actions suggest a large credit expansion is in the works. This will likely overcompensate the damage on China’s aggregate economy, and generate an outperformance in both Chinese economic growth and returns on Chinese risk assets in the next 6 to 12 months. China’s policy responses have an overarching focus on stimulating new demand and investment, which is a different approach from the programs offered by its Western counterparts. In the US, the combination of fiscal and monetary stimulus amounts to 11% of GDP as of April 16, with almost all policy support targeted at keeping companies and individuals afloat. In comparison, China’s policy response accounts for a mere 1.2% of its GDP.3  However, this direct comparison understates the enormous firepower in the Chinese stimulus toolkit, specifically a credit boom. As noted in our February 26 report,4 China has largely resorted to its “old economic playbook” by generating a huge credit wave to ride out the economic turmoil. Our prediction of the policy shift towards a significant escalation in stimulus was confirmed at the March 27 Politburo meeting. Moreover, the April 17 Politburo meeting reinforced a “whatever it takes” policy shift with direct calls on more forceful central bank policy actions, a first since the global financial crisis in 2008.5 Since 2008, the overnight repo rate’s breaking into the IORR-IOER corridor has been a reliable indicator leading to impressive credit upcycles. The PBoC’s recent aggressive easing measures have pushed down the interbank repo rate below the central bank’s interest rate on required reserves (IORR). The price for interbank borrowing is now near the lower range of the rate corridor, between the IORR and the interest rate on excess reserves (IOER).  Since 2008, the overnight repo rate’s breaking into the IORR-IOER corridor has been a reliable indicator leading to impressive credit upcycles (Chart 7).  Such credit super cycles, in turn, have led to both economic booms and an outperformance in Chinese stocks. Chart 7Another Credit Super Cycle Is In The Works Another Credit Super Cycle Is In The Works Another Credit Super Cycle Is In The Works Chart 8Financial Conditions Were Extremely Tight In 2011-2014 Financial Conditions Were Extremely Tight In 2011-2014 Financial Conditions Were Extremely Tight In 2011-2014 The 2012-2015 cycle was an exception to the relationship between the overnight interbank repo rate, credit growth and Chinese stock performance. A steep pickup in credit growth in 2012 coincided with a leap in the overnight interbank repo rate, and the credit boom did not help boost demand in the real economy or improve Chinese stock performance. This is because corporate borrowing was severely curtailed by high lending rates during a four-year monetary tightening cycle from 2011 to 2014 (Chart 8). The credit boom during that cycle was largely driven by explosive growth in short-term shadow-bank lending and wealth management products (WMP), and did not channel into the real economy.6 We do not think such an extreme phenomena will replay under the current circumstances. Monetary stance will likely remain tremendously accommodative through the end of the year to facilitate a continuous rollout of medium- to long-term bank loans and local government bonds. Chinese financial institutions’ “animal spirits” may have been unleashed. But under the scrutiny of the Macro-Prudential Assessment Framework and the New Asset Management Rules,7 the "animal spirits" are unlikely to run up enough risks to prompt the PBoC to prematurely tighten liquidity conditions in the interbank market. Marginal propensity in China is pro-cyclical, which tends to lag credit cycles by 6 months. Chart 9Marginal Propensity In China Is Pro-Cyclical Marginal Propensity In China Is Pro-Cyclical Marginal Propensity In China Is Pro-Cyclical Both corporate and household marginal propensity, a measure of the willingness to spend, will pick up as well. Marginal propensity is pro-cyclical, which tends to lag credit cycles by 6 months (Chart 9). In other words, when interest rates are low and credit growth improves, corporates and households tend to spend more.  The meaningful expansion in credit growth, which started in Q1 and will sustain in the coming two to three quarters, will help corporate and household spending gain tractions in H2. This constructive view on Chinese stimulus and economic recovery supports our overweight stance on Chinese stocks in the next 6-12 months, in both absolute and relative terms.  Q: The yield curve in Chinese government bonds has steepened following PBoC’s aggressive monetary easing announcements. Has the Chinese 10-year bond yield bottomed?   A: No, we do not think the 10-year bond yield has bottomed. There is probability the 10-year government bond yield may briefly dip below 2% in Q2. However, barring a multi-year global economic recession, we think the 10-year government bond yield will bottom no later than Q3 this year. Chart 10A Wide Gap Between The Long and Short A Wide Gap Between The Long and Short A Wide Gap Between The Long and Short The short end of the yield curve dropped disproportionally compared with the long end, following the PBoC’s announcement to place its first IOER cut since 2008 (Chart 10). This led to a rapid steepening in the yield curve. While our view supports a flattening of the yield curve in Q2 and even a 50bps drop in the 10-year government bond yield, we think that the capitulation will be brief. In order for the 10-year government bond yield to remain below 2% for an extended period of time, the market needs to believe one or more of the following will happen: The pandemic will cause a multi-year global economic recession, preventing the PBoC from normalizing its policy stance in the foreseeable future. The duration and depth of the economic impact from the pandemic are still moving targets. Our baseline scenario suggests that the Chinese economic recovery will pick up momentum in H2 this year. The PBoC will not normalize its policy stance even when the economy has stabilized. The PBoC has a track record as a reactive central bank rather than a proactive one. Still, during each of the past three economic and credit cycles, the PBoC has started to normalize its interest rate on average nine months following a bottom in the business cycle (Chart 11). The tightening of interest rate even applied to the prolonged economic downturn and deep deflationary cycle in 2015/16 (Chart 12).    Chart 11The 'Old Faithful' PBoC Policy Normalization Pattern The 'Old Faithful' PBoC Policy Normalization Pattern The 'Old Faithful' PBoC Policy Normalization Pattern Chart 12Policy Normalized Even After A Long Economic Downturn Policy Normalized Even After A Long Economic Downturn Policy Normalized Even After A Long Economic Downturn Chart 132008 Or 2015? 2008 Or 2015? 2008 Or 2015? How the yield curve has historically behaved also depended on the market’s expectations on the speed of the economic recovery, and the timing of the subsequent monetary policy normalization. The yield curved spiked in the wake of substantial monetary easing and pickup in credit growth, in both 2008 and 2015 (Chart 13). While in 2008 the yield curve moved in lockstep with the 3-month SHIBOR with a perfect reverse correlation, in the 2015/16 cycle the yield curve spiked initially but quickly flattened. The long end of the yield curve capitulated as soon as the market realized the economic slowdown was a prolonged one. The 10-year government bond yield, after trending sideways in early 2016, only truly bottomed after the nominal output growth troughed in Q1 2016 (Chart 13, bottom panel). Will the yield curve behave like in 2008, or more like in 2015 in this cycle? We think it will be somewhere in between. The current economic cycle bottomed in Q1, but the economy is only recovering slowly and we expect a U-shaped economic recovery rather than a 2008-style V-shaped one.  At the same time, our baseline scenario does not suggest the current environment will evolve into a 4-year deflationary cycle as in the 2012-2016 period. Therefore, we expect the low interest rate environment to endure for another two to three quarters before the PBoC starts to reverse its policy stance back to the pre-COVID-19 range. As such, the yield on 10-year government bonds will fall, possibly by as much as 50bps, when the economic data disappoint in Q2 and more rate cuts are forthcoming.  But it will bottom when the economic recovery starts to gain traction in H22020 and the market starts to price in a subsequent monetary policy normalization.  When growth slows and debt rises sharply, the PBoC will need to join its western counterparts to permanently maintain an ultra-low interest rate policy to accommodate its high debt level. We acknowledge the fact that China’s potential output growth is trending down (Chart 14).  But it has been trending downwards since 2011. A structurally slowing rate of economic growth has not prevented the PBoC from cyclically raising its policy rate. Hence, unless we see evidence that the pandemic is meaningfully lowering China’s potential growth on par with growth rates in the DMs, our baseline scenario does not support a structural ultra-low interest rate environment in China. China’s debt-to-GDP ratio will most likely rise substantially this year, given that the credit impulse will gain momentum and GDP will grow very modestly. However, this rapid rise in the debt-to-GDP ratio will most likely not be sustained beyond this year. Even if we assume that credit impulse will account for 40% of GDP in 2020 (the same magnitude as in 2008/09), a sharp reversal in the output gap in 2021, as predicted by IMF,8 will flatten the debt-to-GDP ratio curve (Chart 15).  Moreover, following every credit super cycle in the past, Chinese authorities have put a brake on the debt-to-GDP ratio. Chart 14China's Potential Growth Is Likely To Trend Lower... China's Potential Growth Is Likely To Trend Lower... China's Potential Growth Is Likely To Trend Lower... Chart 15...But Has Not Stopped PBoC From Flattening The Debt Curve ...But Has Not Stopped PBoC From Flattening The Debt Curve ...But Has Not Stopped PBoC From Flattening The Debt Curve   All in all, while we see a high possibility for the 10-year government bond yield to fall in Q2, the decline will be limited in terms of duration. Jing Sima China Strategist jings@bcaresearch.com   Footnotes   1IMF World Economic Outlook, April 2020 2Please see China Investment Strategy Weekly Report "Investing During A Global Pandemic," dated April 1, 2020, available at cis.bcaresearch.com 3IMF, Policy Responses To COVID-19 https://www.imf.org/en/Topics/imf-and-covid19/Policy-Responses-to-COVID-19#U 4Please see China Investment Strategy Weekly Report "China: Back To Its Old Economic Playbook?" dated February 26, 2020, available at cis.bcaresearch.com 5“Stable monetary policy must become more flexible” and “use RRR reductions, lower interest rates, re-lending and other measures to preserve adequate liquidity and guide the loan prime rate downwards.” Statements from Xi Jinping, April 17, 2020 Politburo Meeting. http://www.gov.cn/xinwen/2020-04/17/content_5503621.htm  6 Bankers’ acceptances - short-term debt instruments guaranteed by commercial banks - swelled by 887% between end-2008 and 2012. The outstanding amount of WMPs jumped from 1.7 trillion RMB in 2009 to more than 9 trillion RMB by H12013. In contrast, the amount of RMB-denominated bank loans increased by only 67% during the same period. 7The Macro-Prudential Assessment Framework and the New Asset Management Rules were implemented in 2016 and 2018, respectively. They are designed to create additional restrictions to curb shadow-bank lending and broaden the PBoC’s oversight on banks’ WMP holdings. 8The April IMF World Economic Outlook predicts a 1.2% Chinese GDP growth in 2020 and a 9.2% GDP growth in 2021. Cyclical Investment Stance Equity Sector Recommendations

Highlights In mainstream EM, foreign currency debt restructuring is more likely to occur among corporates than governments. Thus, dedicated EM credit investors should overweight mainstream EM sovereign credit and underweight EM corporate debt. Urgency among EM companies and banks to hedge their large foreign currency liabilities will continue exerting downward pressure on EM exchange rates. Ongoing currency depreciation and the lack of buyers of last resort for EM credit underpin the following strategy: short EM sovereign and corporate credit / long US investment-grade corporate credit. Feature Scope And Focus Of Analysis This report re-visits the issue of EM foreign currency debt, assessing EM debt vulnerability. This report focuses on mainstream EM (countries included in Table 1), excluding Gulf countries and frontier markets. Frontier markets like Argentina, Ecuador, Egypt, Ukraine, Lebanon and sub-Saharan African countries occupy somewhat idiosyncratic positions and are therefore not part of this report. Gulf countries on the other hand, are extremely leveraged to oil prices and, unlike mainstream EMs they have currency pegs warranting a separate analysis.1 Chart 1Favor EM Sovereign Against EM Corporate Credit Favor EM Sovereign Against EM Corporate Credit Favor EM Sovereign Against EM Corporate Credit Among mainstream EM countries, public debt restructuring is not imminent and in the majority of cases is unlikely. However, there is a growing risk of foreign currency debt restructuring among EM companies and banks. Hence, we make a new investment recommendation: overweight mainstream EM sovereign credit / underweight EM corporate debt (Chart 1). We also reiterate the short EM sovereign and corporate credit / long US investment-grade corporate credit strategy. In this report, foreign currency debt is defined as the sum of foreign debt securities (i.e., foreign currency bonds) and foreign currency loans. In short, foreign currency debt measures foreign currency borrowing of companies, banks and governments. These statistics do not include foreign holdings of local currency bonds and equities or any other local currency liability of residents to foreigners. Overall, the level of foreign currency debt is pertinent in assessing EM debt vulnerability originating from exchange rate depreciation. Table 12 offers comprehensive foreign currency debt statistics for each individual country and EM as a whole. It details foreign currency debt by type of borrower - the government, corporates and banks – and also reveals the breakdown between foreign debt securities and foreign currency loans for each segment. Table 1EM FX Debt: Who Owes How Much EM: Foreign Currency Debt Strains EM: Foreign Currency Debt Strains Chart 2EM FX Debt Has Doubled Since 2008 EM FX Debt Has Doubled Since 2008 EM FX Debt Has Doubled Since 2008 The foreign currency debt of Chinese companies and banks is quite substantial relative to other EM countries. Hence, including China in the EM aggregates would materially affect these EM aggregates. We thus focus our analysis on EM ex-China and present China’s numbers separately. Since early 2009, EM ex-China aggregate foreign currency debt has doubled to about $3 trillion (Chart 2). Furthermore, this $3 trillion EM ex-China foreign currency debt is split as follows in terms of borrower type: non-financial corporates ($1.25 billion), banks ($846 billion) and governments ($878 billion). Government Foreign Currency Debt Among mainstream EM countries, foreign currency government debt is not vulnerable to restructuring or default. The reason is that the foreign currency debt burden of governments is low, having declined dramatically in the last decade. Table 2 illustrates that the share of local currency government debt is by far greater than the foreign currency debt in each EM country. Table 2EM Public Debt: Local Currency Exceeds FX Debt EM: Foreign Currency Debt Strains EM: Foreign Currency Debt Strains In the past 10 years, EM governments have deliberately replaced their foreign currency debt with local currency debt. Search for yield by international fixed-income investors has facilitated this debt swap: enormous foreign demand for EM domestic bonds has allowed EM governments to issue a considerable amount of local currency bonds. Chart 3EM Foreign Exchange Reserves Are Large EM Foreign Exchange Reserves Are Large EM Foreign Exchange Reserves Are Large In addition, mainstream EM countries, with exception of Turkey and South Africa, hold large foreign currency reserves (Chart 3). Lately, several mainstream EM countries have gained a new defense tool from the Federal Reserves – US dollar swap lines. EM central banks’ swap lines with the Fed are primarily intended to instill confidence among investors in financial markets. They could be used to fend off short-term speculative attacks on EM currencies. Nevertheless, they cannot alleviate insolvency problems. We will elaborate more about these swap lines with the Fed in another report this week. As to local currency public debt, the odds of debt restructuring are also low. First, the majority of EM countries have low aggregate public debt burdens as a share of the GDP (Table 2). Second, the majority of these nations have flexible currency regimes. This means that their central banks control the printing press. In the worst-case scenario - when investors become reluctant to own EM local currency government bonds, EM central banks can buy those bonds in both the secondary or primary markets if needed. In short, EM central banks can resort to a form of quantitative easing, i.e., purchasing local currency government bonds that would amount to public debt monetization. The wild card in this case will be the exchange rate – the currencies could depreciate substantially amid public debt monetization by central banks. Given that government liabilities in foreign currencies have declined substantially, exchange rate depreciation will not be a constraint for policymakers’ ability to monetize local currency debt. Remarkably, in the past two months amid the global indiscriminate selloff, central banks in several EM countries have begun purchasing government bonds or have stated that they will do so if required. This has created a precedent that will be used in future. One country that has large local currency government debt is Brazil. We have previously argued that Brazil requires robust nominal GDP growth to climb out of a public debt trap. With the COVID-19 crisis, the outbreak for its public debt has worsened considerably. Without the central bank monetizing public debt, it will be difficult for Brazil to escape rising government debt strains and, ultimately, local currency debt restructuring. In short, the cost of avoiding local currency public debt restructuring in Brazil could be large currency depreciation. Bottom Line: In mainstream EM, neither foreign currency nor local currency government debt face an imminent risk of restructuring. Public debt restructuring and defaults are occurring in Argentina and among frontier markets like Ecuador, Lebanon and a few sub-Saharan nations that are beyond the scope of this report. If local currency government bond markets become anxious about public debt sustainability, EM central banks could purchase government paper. If done on large scale, this will cause further currency depreciation. Corporate Foreign Currency Debt From a macro perspective, there are presently some pre-conditions that herald rising odds of foreign currency debt restructuring among EM corporates and banks: (1) rapid and massive foreign currency debt built up in the past 10-15 years; (2) substantial plunge in corporate revenues; and (3) massive currency depreciation. Taken together, these create fertile ground for debt restructuring by some corporate debtors. Foreign currency debt of companies and banks in mainstream EM ex-China countries has swelled in the past 10 years reaching $2.1. Bonds account for about $1.4 trillion while foreign currency loans account for the remaining $0.7 trillion. The global recession brought about by the COVID-19 pandemic is producing a collapse in EM companies’ local currency revenues and exports. Notably, EM ex-China exports were contracting even before the COVID-19 outbreak and they are currently crashing (Chart 4). Chart 4EM Exports & Corporate Credit Spreads EM Exports & Corporate Credit Spreads EM Exports & Corporate Credit Spreads Chart 5Commodities Prices And Currencies Drive EM Credit Spreads Commodities Prices And Currencies Drive EM Credit Spreads Commodities Prices And Currencies Drive EM Credit Spreads The top panel of Chart 5 illustrates EM corporate credit spreads (inverted) correlate with commodities prices. Hence, plunging commodities prices entail growing foreign currency debt stress for EM companies and banks. Finally, EM ex-China currencies have depreciated substantially making foreign currency debt more expensive to service (Chart 5, bottom panel). Please refer to Box 1 attesting that for EM debtors with US dollar liabilities, EM exchange rate depreciation is worse than that of higher US bond yields.     Box 1 What Is More Imperative For EM FX Debt: Exchange Rates Or Interest Rates? EM debtors with dollar debt are much more vulnerable to an appreciating dollar than rising US interest rates. Table 3 illustrates this point using the following hypothetical simulation: We consider a conjectural Brazilian debtor with $1,000 in debt with five years remaining to maturity, and a starting point exchange rate of 4 BRL per USD. In our example, a 5% depreciation in local currency against the dollar boosts the overall debt burden by 200 BRL (please refer to row 2 of Table 3). This does not include the rise in local currency costs of interest payments. It reflects only the increased burden of principal. Table 3A Hypothetical Simulation: FX Debt Burden Is More Sensitive To Exchange Rate Than Borrowing Costs EM: Foreign Currency Debt Strains EM: Foreign Currency Debt Strains An equivalent rise in debt servicing costs in local currency will require a 100-basis-point increase in US dollar borrowing costs. In brief, US dollar rates should rise by 100 basis points for interest payments to increase by BRL 200 over a five-year period, the time remaining to maturity. This simulation reveals that a 5% dollar appreciation versus local currency is as painful as a 100 basis points rise in US dollar rates and is more burdensome if the cost of coupon payments is accounted for. Provided there are higher odds of 5% currency depreciation in many EMs than a 100-basis-point rise in US dollar borrowing costs, we infer that EM FX debtors’ creditworthiness is more sensitive to exchange rates than to US Treasury yields. As the bottom panel of Chart 5 above clearly demonstrates, EM corporate and sovereign credit spreads correlate strongly with EM exchange rates. Consequently, the trend in EM exchange rates versus the US dollar is much more important for EM credit spreads than fluctuations in US bond yields. As to the currency composition of EM FX debt, about 82% of EM external debt is in US-dollar terms. Bottom Line: So long as EM currencies depreciate against the greenback, EM FX debt stress will mount, and EM corporate and sovereign credit spreads will widen. This will occur irrespective of whether US Treasury yields rise or drop.   If the bear market in commodities persists and/or EM currencies depreciate further – which is our baseline scenario, defaults on and restructuring of foreign currency debt among EM companies and banks are probable. One avenue to avoid corporate defaults is for the government to guarantee or assume the banks’ and companies’ foreign currency liabilities. It is probable because many of these borrowers are large entities with close links to their governments. However, governments will step in only after a debtor is on the brink default and its credit spreads are very wide. Briefly put, investors should be careful not to bet too early on government backstops of EM corporates’ and banks’ foreign currency debt. Identifying which corporate issuers could default or restructure debt involves bottom-up analysis that is beyond the scope of the macro research that BCA specializes in. An important question is what portion of corporate foreign currency liabilities have these debtors already hedged? Unfortunately, there are no macro data to answer this question either. Judging by the magnitude and speed of EM currency depreciation we have seen in the past two months, odds are that they have already partially hedged their exchange rate risk. Yet, given the sheer size of foreign currency liabilities, it is hard to imagine that corporates and banks have hedged all of them. Below we analyze each countries’ ability to service its foreign currency debt from a macro perspective. Vulnerability Assessment From a macro standpoint, foreign debt servicing vulnerability can be measured by foreign debt obligations (FDOs) and foreign funding requirements (FFRs). Chart 6EM FDOs And FFRs (Annualized) EM FDOs And FFRs (Annualized) EM FDOs And FFRs (Annualized) FDOs are the sum of debt expiring in the next 12 months, and interest as well as amortization payments over the next 12 months. FDO data are available until Q3 of 2019 (Chart 6, top panel). Hence, using this latest datapoint is pertinent to gauging the ability of individual countries to service their foreign debt over the coming six months. FFRs are the sum of FDOs in the next 12 months and current account balance (Chart 6, bottom panel). It measures the amount of foreign capital inflows required in the next 12 months for a country to cover any shortfalls in its balance of payment dynamics. Exports Coverage Of FDO: This measure compares annualized US dollar export revenues available to each country to its foreign debt service obligations in the next 12 months (Chart 7). The most vulnerable countries according to this measure are Brazil, Colombia, Turkey and Peru. On the other hand, Russia, Mexico, India & Korea have higher exports-to-FDO ratios. Chart 7Exports-To-Foreign Debt Obligations Ratio EM: Foreign Currency Debt Strains EM: Foreign Currency Debt Strains Foreign Exchange Reserves-to-FFRs Ratio: These metrics compare the size of foreign exchange reserves held by each nation’s central bank to its FFRs in the next 12 months (Chart 8). By this measure, Chile, Colombia, Turkey, Indonesia and Mexico have large FFRs relative to their central bank foreign exchange reserves. Meanwhile, Russia, Korea and Thailand fare well on this metric. Chart 8FX Reserves-To-Foreign Funding Requirements EM: Foreign Currency Debt Strains EM: Foreign Currency Debt Strains On the whole, Chart 9 is a scatter plot combining both FDO and FFR measures to determine the most and least vulnerable EMs. The most vulnerable EMs are Brazil, Turkey, Colombia and Chile. Meanwhile, Russia, Korea, India and the Philippines are the least vulnerable. Chart 9EM FX Debt And Currency Vulnerability EM: Foreign Currency Debt Strains EM: Foreign Currency Debt Strains Investment Recommendations So long as EM currencies depreciate against the greenback, EM foreign currency debt stress will mount, and EM corporate and sovereign credit spreads will widen. We remain bearish on EM currencies. They usually trade with the global business cycle and the latter remains in free fall. We continue recommending shorting a basket of the following currencies versus the US dollar: BRL, CLP, ZAR, IDR, PHP and KRW. There will likely be no imminent restructuring or default on public debt in mainstream EM countries, outside frontier markets like Argentina, Ecuador, Lebanon and sub-Saharan African countries. However, there could be meaningful credit stress among EM corporate issuers. Consequently, dedicated EM credit investors should overweight mainstream EM sovereign credit and underweight EM corporate debt. We continue to recommend underweighting EM sovereign and corporate credit versus US investment-grade corporate credit (Chart 10). Not only is the Fed buying US investment-grade and some high-yield bonds but US companies will also benefit from the substantial fiscal stimulus. In EM, corporates and banks lack such support. Crucially, in contrast to US corporates, EM issuers also suffer from currency depreciation. Within the EM sovereign credit universe, our overweights are Russia, Mexico, Peru, Thailand and Malaysia. Underweights include South Africa, Brazil, Indonesia, the Philippines and Turkey. The rest warrant a neutral allocation within an EM sovereign credit portfolio. Finally, within corporate credit, we reiterate our long-standing recommendation of long Asian investment-grade corporates / Asian short high-yield corporate (Chart 11). We continue recommending shorting a basket of the following currencies versus the US dollar: BRL, CLP, ZAR, IDR, PHP and KRW. Chart 10Remain Underweight EM Credit Versus US IG Credit Remain Underweight EM Credit Versus US IG Credit Remain Underweight EM Credit Versus US IG Credit Chart 11Long Asian IG Corporate / Short Asian HY Corporate Long Asian IG Corporate / Short Asian HY Corporate Long Asian IG Corporate / Short Asian HY Corporate     Andrija Vesic Associate Editor andrijav@bcaresearch.com Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Footnotes 1We will publish a report on Saudi Arabia in the coming weeks. 2We have compiled data on foreign currency securities issued by non-financial companies and banks from Bloomberg. Bloomberg data accounts for the nationality of debt issuers. For instance, a US dollar bond issued by a Brazilian corporate subsidiary or a shell company located in the Cayman Islands is counted as Brazilian foreign corporate debt, rather than a Cayman Island debt security. For foreign loans, we use the Bank of International Settlements (BIS) datasets on Banking Statistics.

Highlights The Fed has been awfully busy since the middle of March, … : Over the last 30 days, the Fed has unleashed a barrage of measures to support market liquidity and alleviate economic hardship. … unveiling a package of facilities to keep credit flowing to consumers, businesses and municipalities, … : The Fed is building a sizable firewall against market seizure, touching on commercial paper, money market funds, asset-backed securities, small business loans, municipal notes, investment-grade corporate bonds and ETFs and high-yield corporate ETFs. … and loosening regulatory strictures to encourage banks to put their capital buffers to work: The Fed and other major bank regulators have eased some of the post-2008 rules to encourage banks to ramp up market-making activity and increase lending to cushion the shock to the economy. Investors should buy what the Fed is buying: Fixed income investors should look to capture excess spreads in markets that have not yet priced in the full effect of the Fed’s indemnity. Banks and agency mortgage REITs offer a way to implement this theme in equities. Feature What A Difference A Pandemic Makes “Whatever it takes” is clearly the order of the day for Jay Powell and company, as well as Congress and the White House, to mitigate the potentially pernicious second-round economic damage from COVID-19. In this Special Report, we detail the Fed’s key initiatives. Central banks are neither omniscient nor omnipotent, and they cannot stave off all of the pressure from mass quarantines, but we do expect the Fed’s measures will cushion the economic blow, and reflate prices in targeted asset markets. The Fed began pulling out all the stops to fight the virus on Sunday, March 15th with what have now become stock emergency responses: zero rates and purchases of Treasuries and agency mortgage-backed securities (MBS). Although the MBS purchases began the week of March 23rd, and have continued at a steady clip despite appearing to have swiftly surpassed their $200 billion target, they have not yet achieved much traction in the mortgage market. The spread between the current coupon agency MBS and the 10-year Treasury yield has come down a bit, but the average 30-year fixed-rate home mortgage rate does not reflect the 150 basis points ("bps") of rate cuts since the beginning of March (Chart 1). The Fed’s measures are intended to help direct the flow of credit to adversely affected constituencies with a pressing need for it. Other measures to relieve liquidity pressures, like the Fed’s ongoing overnight repo operations, have achieved their aim. The signal indicator of liquidity strains, the effective fed funds rate, was bumping up against the top of the Fed’s target range for several days after the return to zero interest rate policy. Over the last week, however, it has settled around 5 bps, near the bottom of its range (Chart 2), suggesting that the formerly tight overnight funding market is now amply supplied. Chart 1MBS Purchases Haven't Helped Main Street Yet MBS Purchases Haven't Helped Main Street Yet MBS Purchases Haven't Helped Main Street Yet Chart 2Overnight Funding Stresses ##br##Have Eased Overnight Funding Stresses Have Eased Overnight Funding Stresses Have Eased The rest of the Fed’s measures (Table 1) have been more finely targeted, intended to help direct the flow of credit to adversely affected constituencies with a pressing need for it. We focus on the most important measures in the following section and summarize their common elements in Table 2. The following discussions of the individual programs highlight their intent, their chances of success, and yardsticks for tracking their progress. We conclude with the fixed income and equity niches that are most likely to benefit from the Fed’s efforts. Table 1A Frenzied Month Of Activity Alphabet Soup: A Summary Of The Fed's Anti-Virus Measures Alphabet Soup: A Summary Of The Fed's Anti-Virus Measures Table 2The 2020 Federal Reserve Emergency Programs Alphabet Soup: A Summary Of The Fed's Anti-Virus Measures Alphabet Soup: A Summary Of The Fed's Anti-Virus Measures A Field Guide To The Acronym Jungle Money Market Mutual Fund Liquidity Facility (MMLF) Under the MMLF, which started on March 23rd, US banks can borrow from the Fed to purchase eligible assets mainly from prime money market funds. These assets are in turn pledged to the Fed as collateral, effectively allowing the Fed to lend to prime money market funds via banks. Assets eligible for purchase from these funds include: US Treasuries & fully guaranteed agencies Securities issued by US GSEs Asset-backed commercial paper (ABCP) rated A1 or its equivalent, issued by a US issuer US municipal short-term debt (excluding variable rate demand notes) Backed by $10 billion of credit protection from the Treasury, the Fed will lend at the primary credit rate (the discount rate, currently 0.25%) for pledged asset purchases of US Treasuries, fully guaranteed agencies or securities issued by US GSEs. For any other assets pledged, the Fed will charge an additional 100 bps – with the exception of US municipal short-term debt to which the Fed only applies a 25-bps surcharge. Chart 3The MMLF Already Providing Some Relief The MMLF Already Providing Some Relief The MMLF Already Providing Some Relief Loans made under the MMLF are fully non-recourse (the Fed can recover nothing more from the borrower than the pledged collateral). Banks borrowing from the Fed under the MMLF bear no credit risk and have therefore been exempted from risk-based capital and leverage requirements for any asset pledged to the MMLF, an important element that should promote MMLF participation. This facility is a direct descendant of the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility (AMLF), which operated from September 2008 to February 2010 to prevent a run on prime money market funds after a prominent fund “broke the buck.” Its objective is to help prime money market funds meet redemption requests from investors and increase liquidity in the markets for the assets held by these funds – most notably commercial paper where prime money market funds represent 21% of the market. Those funds have experienced large outflows in the midst of the coronavirus pandemic and building economic crisis – erasing $140 billion, or 18%, of the fund segment’s total net assets in a matter of days (Chart 3, top panel). Since it started, the MMLF has extended $53 billion of credit to prime money funds, about a third of AMLF’s output in its first 10 days of operation. The financial sector is suffering a big shock, but it is not the source of the problem like it was in 2008, so the situation is not as dire as it was in late 2008, and we are already seeing a tentative stabilization of asset outflows from money market funds. Commercial paper spreads have also narrowed, implying that the combination of the MMLF and the CPFF (see below) is having the intended effect (Chart 3, bottom panel). Commercial Paper Funding Facility (CPFF) Starting today, April 14th, the Fed will revive 2008’s Commercial Paper Funding Facility (CPFF) with the aim of restoring liquidity to a market where investment grade corporate borrowers raise cash to finance payroll, inventories, accounts payable and other short-term liabilities. The 2020 iteration applies to municipalities as well, extending its reach across the real economy. Via a Special Purpose Vehicle (SPV) (see Box) funded with a $10 billion equity investment from the Treasury Department, the CPFF will purchase US dollar-denominated investment-grade (A1/P1/F1) three-month asset-backed, corporate and municipal commercial paper priced at the overnight index swap rate (OIS) plus 110 bps. Lower-rated issuers are not eligible, but investment-grade borrowers who were downgraded to A2/P2/F2 after March 17th, 2020 can be grandfathered into the program at a higher spread of OIS+200 bps. The pricing is tighter than it was in 2008, when unsecured investment grade and asset-backed issues were priced at OIS+100 bps and OIS+300 bps, respectively, and the Fed did not have the loss protection provided by an equity investment in the SPV.   Box 1 - SPV Mechanics The Fed has set up Special Purpose Vehicles (SPV) in connection with most of the facilities we examine here. Each SPV has been seeded by the Treasury department to carry out the facility’s work. The Fed lends several multiples of the Treasury’s initial equity investment to each SPV to provide it with a total capacity of anywhere from eight to fourteen times its equity capital, based on the riskiness of the assets the SPV is purchasing or lending against. The result is that most of the cash used to operate the facilities will come from the Fed in the form of loans with full recourse to the SPVs’ assets, but the Treasury department will own the equity tranche. The Treasury therefore bears the first credit losses, should any occur. Issuers are only eligible if they have issued three-month commercial paper in the twelve months preceding the March 17th announcement of the program. The Federal Reserve did not set an explicit limit on the size of the program, but funding for any single issuer is limited to the amount of outstanding commercial paper it had during that twelve-month period. The 2020 CPFF could therefore max out above $750 billion, the peak size of the domestic commercial paper market over the past year (Chart 4). If the first CPFF’s experience is any guide, however, it’s unlikely that its full capacity will be needed. Its assets peaked at $350 billion in January 2009, around a quarter of 2008’s $1.5 trillion average outstanding balance. A similar proportion today would cap the fund at $175-200 billion. As in 2008 (Chart 5, bottom panel), the mere announcement of the program has driven commercial paper spreads significantly below their previously stressed levels (Chart 5, top panel). Chart 4Pressure On The Domestic Commercial Paper Market... Pressure On The Domestic Commercial Paper Market... Pressure On The Domestic Commercial Paper Market... Chart 5...Is Being Relieved Ahead Of The CPFF Implementation ...Is Being Relieved Ahead Of The CPFF Implementation ...Is Being Relieved Ahead Of The CPFF Implementation Term Asset-Backed Securities Loan Facility (TALF) The asset-backed securities (ABS) market funds a significant share of the credit extended to consumers and small businesses. The Fed’s TALF program that started on March 23rd aims to provide US companies holding AAA collateral with funding of up to $100 billion, in the form of 3-year non-recourse loans secured by AAA-rated ABS. It will be conducted via an SPV backed by a $10 billion equity investment from the US Treasury Department. Chart 6Narrower Spreads Promote Easier Financial Conditions At The Margin Narrower Spreads Promote Easier Financial Conditions At The Margin Narrower Spreads Promote Easier Financial Conditions At The Margin Eligible collateral includes ABS with exposure to auto loans, student loans, credit card receivables, equipment loans, floorplan loans, insurance premium finance loans, SBA-guaranteed loans and leveraged loans issued after March 23rd, 2020. Last week, the Fed added agency CMBS issued before March 23rd, 2020 and left the door open to further expansion of the pool of eligible securities. The rate charged on the loans is based on the type of collateral and its weighted average life. Depending on the ABS, the spreads will range from 75 bps to 150 bps over one of four different benchmarks (LIBOR, SOFR, OIS or the upper 25-bps bound of the target fed funds range). The spreads are reasonable, and will not keep ABS holders away from the facility, but they’re not meant to be giveaways. The 2009 TALF program originally had a $200 billion capacity, which was later expanded to $1 trillion. Those numbers make the current iteration’s $100 billion limit look awfully modest, but only $71 billion worth of loans were eventually granted the first time around. ABS spreads have already narrowed significantly (Chart 6), suggesting the program is already making a difference. Although an incremental $100 billion of loans is not likely to move the needle much for the US economy, narrower spreads will promote easier financial conditions at the margin. Secondary Market Corporate Credit Facility (SMCCF) Though no firm start date has been given, the Fed will soon enter the secondary market and start purchasing corporate bonds. As with all of the other facilities discussed in this section except the MMLF, the SMCCF is set up as an SPV. It will have up to $250 billion of buying power, anchored by $25 billion of equity funding from the Treasury department. Once it’s up and running, the SMCCF will buy non-bank corporate bonds in the secondary market that meet the following criteria: Issuer rated at least BBB-/Baa3 (the lowest investment grade tier) as of March 22nd, 2020 A remaining maturity of 5 years or less Issuer is a US business with material operations, and a majority of its employees, in the US Issuer is not expected to receive direct financial assistance from the federal government The SMCCF can own a maximum of 10% of any single firm’s outstanding debt, and it may dip into the BB-rated market for securities that were downgraded from BBB after March 22nd. In addition to cash bonds, the SMCCF will also buy ETFs that track the broad corporate bond market. The Fed says that the “preponderance” of SMCCF ETF purchases will be of ETFs tracking investment grade corporate bond benchmarks (like LQD), but it will also buy some high-yield ETFs (like HYG). We expect that the SMCCF will be able to achieve its direct goal of driving down borrowing costs for otherwise healthy firms that may struggle to access credit markets in the current environment. One way to track the program’s success is to monitor investment grade corporate credit spreads (Chart 7). Spreads have been tightening aggressively since the Fed announced the program on March 23rd but are still elevated compared to average historical levels. The slope of the line of investment grade corporate bond spreads plotted by maturity will be another important metric (Chart 8). An inverted spread slope tends to coincide with a sharply rising default rate, since it signals that investors are worried about near-term default risk. By purchasing investment grade bonds with maturities of 5 years or less, the Fed hopes to maintain a positively sloped spread curve. Chart 7SMCCF Announcement Marked The Peak In Spreads SMCCF Announcement Marked The Peak In Spreads SMCCF Announcement Marked The Peak In Spreads Chart 8Fed Wants A Positive ##br##Spread Slope Fed Wants A Positive Spread Slope Fed Wants A Positive Spread Slope Primary Market Corporate Credit Facility (PMCCF) The PMCCF employs the same structure as the SMCCF, but it is twice as large. The Treasury’s initial equity investment will be $50 billion and Fed loans will scale its capacity up to $500 billion. As a complement to the SMCCF, the PMCCF will purchase newly issued non-bank corporate bonds. The eligibility criteria are the same as the SMCCF’s, but the PMCCF will only buy bonds with a maturity of 4 years or less. The new issuance purchased by the PMCCF can be new debt or it can be used to refinance existing debt. The only caveat is that the maximum amount of borrowing from the facility cannot exceed 130% of the issuer’s maximum debt outstanding on any day between March 22nd, 2019 and March 22nd, 2020. Essentially, eligible firms can use the facility to refinance their entire stock of debt and then top it up by another 30% if they so choose. The goals of the PMCCF are to keep the primary issuance markets open and to prevent bankruptcy for firms that were rated investment grade before the virus outbreak. Investment grade corporate bond issuance shut down completely for a stretch in early March, but then surged once the Fed announced the PMCCF and SMCCF on March 23rd. The PMCCF will have achieved lasting traction if gross corporate bond issuance holds up in the coming months (Chart 9). It should also meet its bankruptcy-prevention goal, since firms will be able to refinance their maturing obligations and tack on some new debt to get through the next few months. Given the large amount of outstanding BBB-rated debt, a lot of fallen angel supply is poised to hit the high-yield bond market. While we expect the PMCCF will succeed in achieving its primary aims, it is unlikely to prevent a large number of ratings downgrades. If a given firm only makes use of the facility to refinance its existing debt at a lower rate, then its ability to service its debt will improve at the margin and its rating should be safe. However, any firm that increases its debt load via this facility will end up with a riskier balance sheet. Ratings agencies will not look through an increased debt burden, and we expect a significant number of ratings downgrades in the coming months (Chart 10, top panel). Chart 9Primary Markets Have Re-Opened Primary Markets Have Re-Opened Primary Markets Have Re-Opened Chart 10Fed Actions Won't Prevent Downgrades Fed Actions Won't Prevent Downgrades Fed Actions Won't Prevent Downgrades Given the large amount of outstanding BBB-rated debt, a lot of fallen angel supply is poised to hit the high-yield bond market (Chart 10, middle and bottom panels). The Fed will try to contain the surge by allowing the SMCCF to purchase fallen angel debt, and by providing some support to the upper tiers of high-yield credits through its Main Street Lending Programs. Main Street New Loan Facility (MSNLF) and Main Street Expanded Loan Facility (MSELF) The goal of the MSNLF and MSELF is to provide relief to large firms that are not investment grade credits. Both facilities will draw from the same SPV, which will be funded by a $75 billion equity stake from the Treasury and will then be levered up to a total size of “up to $600 billion” by the Fed. The Main Street facilities are structured differently than the PMCCF and SMCCF in that the Fed will not transact directly with nonfinancial corporate issuers. Rather, the Fed will purchase 95% of the par value of eligible loans from banks (which will retain 5% of the credit risk of each loan), hoping to free up enough extra room on bank balance sheets to promote more lending. To be eligible for purchase by the Main Street New Loan Facility, loans must be issued after April 8th, 2020 and meet the following criteria: Borrowers have less than 10,000 employees or $2.5 billion of 2019 revenue Borrowers are US firms with significant operations, and a majority of employees, in the US Loans are unsecured and have a maturity of 4 years Loans are made at an adjustable rate of SOFR + 250-400 bps Principal and interest payments are deferred for one year Loan size of $1 million to the lesser of $25 million or the amount that keeps the borrower’s Debt-to-EBITDA ratio below 4.01 Loan proceeds cannot be used to refinance existing debt Borrowers must commit to “make reasonable efforts to maintain payroll and retain employees during the term of the loan” The Main Street Expanded Loan Facility applies similar criteria to existing loans that banks will upsize before transferring 95% of the incremental risk to the Fed. The MSELF allows for loans up to the lesser of $150 million, 30% of the borrower’s existing debt (including undrawn commitments) or the amount keeps the borrower’s Debt-to-EBITDA ratio below 6.0. Borrowers can participate in only one of the MSNLF, MSELF and PMCCF, though they can tap the PPP alongside one of the Main Street lending facilities. Chart 11Main Street Programs Will Spur Bank Lending Main Street Programs Will Spur Bank Lending Main Street Programs Will Spur Bank Lending The Main Street facilities endeavor to have banks adopt an “originate to distribute” model. With the Fed assuming 95% of each loan’s credit risk, banks will have nearly unlimited balance sheet capacity to continue originating these sorts of loans. Retaining 5% of each loan ensures that the banks will have enough skin in the game to perform proper due diligence. We expect to see a significant increase in commercial bank C&I loan growth in the coming months once these facilities are up to speed (Chart 11). Crucially for high-yield investors, the debt-to-EBITDA constraints ensure that the Main Street facilities will aid BB- and some B-rated issuers but will not bail out high-default-risk issuers rated CCC and below. BB-rated firms typically have debt-to-EBITDA ratios between 3 and 4, while B-rated issuers typically fall in a range of 4 to 6. For the most part, BB-rated firms will be able to make use of either the MSNLF or MSELF, while B-rated firms will be limited to the MSELF. By leaving out issuers rated CCC & below, the Fed is acquiescing to a significant spike in corporate defaults over the next 12 months. The bulk of corporate defaults come from firms that were rated CCC or below 12 months prior (Chart 12). Chart 12A Significant Increase In Corporate Defaults Is Coming A Significant Increase In Corporate Defaults Is Coming A Significant Increase In Corporate Defaults Is Coming As with the PMCCF, we note that the Main Street facilities offer loans, not grants. While they will address firms’ immediate liquidity issues, they will do so at the cost of more indebted balance sheets. Downgrade risk remains high for BB- and B-rated companies. Paycheck Protection Program Liquidity Facility (PPPLF) The Paycheck Protection Program (PPP) is a component of the CARES Act that was designed to forestall layoffs by small businesses.  PPP loans are fully guaranteed by the Small Business Association (SBA), which will forgive them if the borrower maintains its employee headcount for eight weeks. The size of the PPPLF has yet to be announced, along with the details of its funding, but its intent is to get PPP loans off of issuers’ balance sheets so as to free up their capital and allow them to make more loans, expanding the PPP’s reach. The Fed will lend on a non-recourse basis at a rate of 0.35% to any depository institution making PPP loans,2 taking PPP loans as collateral at their full face value. PPP loans placed with the Fed are exempt from both risk-weighted and leverage-based capital adequacy measures (please see “Easing Up On The Regulatory Reins,” below). PPP is meant to be no less than a lifeline for households and small businesses, but the devil is in the details. Banks were reportedly overwhelmed with demand for PPP loans over the first five business days that they were available, suggesting that many small businesses still qualify, despite 17 million initial unemployment claims over the last three weeks. Media reports about the program highlighted that there are quite a few kinks yet to be worked out, and it has arrived too late to stave off the first waves of layoffs. Success may be most easily measured by the size of the PPPLF, which should eventually translate into fewer layoffs and bankruptcies than would otherwise have occurred. Municipal Liquidity Facility (MLF) Chart 13State & Local Governments Need Support State & Local Governments Need Support State & Local Governments Need Support The Municipal Liquidity Facility is similar in structure to the PMCCF, only it is designed to support state and local governments. The MLF SPV will be funded by a $35 billion equity investment from the Treasury, and the Fed will lever it up to a maximum size of $500 billion to purchase newly issued securities directly from state and local governments that meet the following criteria: All states (including D.C.) are eligible, as are cities with populations above 1 million and counties with populations above 2 million. The newly issued notes will have a maximum maturity of 2 years. The MLF can buy new issuance from any one state, city or county up to an amount equal to 20% of that borrower’s fiscal year 2017 general revenue. States can request a higher limit to procure funds for political subdivisions or instrumentalities that aren’t eligible themselves for the MLF. The MLF’s goal is to keep state and local governments liquid as they deal with the COVID-19 pandemic. The large size of the facility – $500 billion is five times 2019’s aggregate muni issuance – should allow it to meet its goal. However, as with the Fed’s other facilities, the support comes in the form of loans, not grants. The lost tax revenue and increased pandemic expenditures cannot be recovered. State and local government balance sheets will emerge from the recession weaker. We can track the program’s success by looking at the spread between municipal bond yields and comparable US Treasury yields. These spreads widened to all-time highs in March, but have since come in significantly, even for longer maturities (Chart 13). If this tightening does not continue, the Fed may eventually enter the secondary market to purchase long-maturity municipal bonds. Supporting such a fragmented market will be tricky, and the Fed may be hoping that more aid will come from Capitol Hill. Central Bank Liquidity Swaps Chart 14US Dollar Debt Is A Global Problem US Dollar Debt Is A Global Problem US Dollar Debt Is A Global Problem The global economy is loaded with USD-denominated debt issued by entities outside of the US. As of 3Q19, there was roughly $12 trillion of outstanding foreign-issued US dollar debt, exceeding the domestic nonfinancial corporate sector’s total issuance (Chart 14). As the sole provider of US dollars, the Fed has a role to play in supporting foreign dollar-debt issuers during this tumultuous period. Currency swap lines linking the Fed with other central banks can help alleviate the pressure on foreign borrowers to access the US dollars they need to service their debt. For example, once the Fed exchanges dollars for euros using its swap line with the European Central Bank (ECB), the ECB can then direct those US dollars toward USD-denominated borrowers within the Euro Area. Widening cross-currency basis swap spreads are a tried-and-true signal that US dollars are becoming too scarce. The Fed responded to widening basis swap spreads by instituting swap lines during the financial crisis and again during the Eurozone debt crisis of 2011. In both instances, the swap lines eventually calmed the market and basis swap spreads moved back toward zero (Chart 15). Chart 15The Cost Of US Dollars The Cost Of US Dollars The Cost Of US Dollars Since 2013, the Fed has maintained unlimited swap lines with the central banks of the Euro Area, Canada, UK, Japan and Switzerland. On March 19th, it extended limited swap lines to the central banks of Australia, Brazil, Denmark, Korea, Mexico, Norway, New Zealand, Singapore and Sweden. These swap lines will help ease stresses for some foreign issuers of US dollar debt, but not all. One potential problem is that the foreign central banks that acquire dollars via the swap lines may be unwilling or unable to direct those dollars to debtors in their countries. Another problem is that several emerging markets (EM) countries do not have access to the Fed’s swap facility. EM issuers account for roughly one-third of foreign-issued dollar debt (Chart 14, bottom panel). For example, the governments of the Philippines, Colombia, Indonesia and Turkey all carry large US dollar debt balances, not to mention US dollar debt issued by the EM corporate sector in non-swap line countries. Currency swap lines linking the Fed with other central banks can help alleviate the pressure on foreign borrowers to access the US dollars they need to service their debt. The swap lines that are already in place have led to basis swap spread tightening in developed markets. If global growth eventually rebounds and the dollar weakens, EM dollar-debt burdens will become easier to service. However, until that happens, a default by some foreign issuer of US dollar debt remains a non-trivial tail risk. The Fed may need to extend swap lines to more countries to mitigate this risk in the months ahead. Easing Up On The Regulatory Reins As we’ve argued in US Investment Strategy Special Reports the last two weeks, the largest US banks are extremely well capitalized.3 The Fed agrees, and over the last 30 days, it has issued six separate statements encouraging the banks to lend or to work with struggling borrowers, all but one of them in concert with its fellow banking regulators. Although the largest banks have amassed sizable capital cushions that would support increased lending, post-GFC regulations often crimp incentives to deploy them. Over the last 30 days, the Fed and the other federal regulators have granted banks relief from the key binding constraints. Those constraints fall into two broad categories: risk-based requirements, which are based on risk weightings assigned to individual assets, and leverage requirements, which are based on total assets or total leverage exposure. All banks are required to maintain minimum ratios of equity capital to risk-weighted assets under the former and to total leverage, which includes some off-balance-sheet exposures, under the latter. The three federal banking regulators have amended rules to exclude MMLF and PPP exposures from the regulatory capital denominator used to calculate risk-weighted and leverage ratios. The Fed also made a similar move by excluding Treasury securities and deposits held at the Fed from the denominator of the supplementary leverage ratio large banks must maintain (3% for banks with greater than $250 billion in assets, 5% for SIFIs). Reducing the denominators increases the banks’ ratios and expands their lending capacity. Community banks’ capital adequacy is determined by their leverage ratio (equity to total assets), and regulators have temporarily cut it to 8% from 9%. We expect that easing capital constraints will spur the banks to lend more in the coming weeks and months, but it’s not a sure thing. A clear lesson from the Bernanke Fed’s three rounds of quantitative easing is that the Fed can lead banks to water, but it can’t make them drink. A considerable amount of the funds the Fed deployed to buy Treasury and agency securities was simply squirreled away by banks, and wound up being neither lent nor spent. Lending is not the Fed’s sole focus, though: it hopes that easing capital regulations will also encourage banks and broker-dealers to ramp up their market-making activity, improving capital market liquidity across a range of instruments. Investment Implications While all of the programs discussed above have expiration dates, they can be extended if necessary. Flexible end dates illustrate the open-ended nature of the Fed’s (and Congress’) support, and help underpin our contention that more aid will be forthcoming at the drop of a hat. Confronting the most severe recession in 90 years and an especially competitive election, policymakers can be counted upon to err to the side of providing too much stimulus. That is not to say, however, that the measures amount to a justification for loading up on all risk assets. Every space will not be helped equally. Spreads for all corporate credit tiers are cheap compared to history, but only BB-rated and higher benefit from the Fed’s programs. Within US fixed income, investors should look for opportunities in sectors that offer attractive spreads and directly benefit from Fed support. In the corporate bond market this means owning securities rated BB or higher and avoiding debt rated B and below. Spreads for all corporate credit tiers are cheap compared to history (Charts 16A & 16B), but only BB-rated and higher benefit from the Fed’s programs. Some B-rated issuers will be able to access the MSELF, but Fed support for the B-rated credit tier is limited. Fed support is non-existent for securities rated CCC or lower. Chart 16AInvestment Grade Valuation Investment Grade Valuation Investment Grade Valuation Chart 16BHigh-Yield Valuation High-Yield Valuation High-Yield Valuation Elsewhere, several traditionally low-risk spread sectors also meet our criteria of offering attractive spreads and benefitting from Fed support. AAA-rated Consumer ABS spreads are wide and will benefit from TALF. Agency CMBS spreads are also attractive and those securities are being directly purchased by the Fed (Chart 17). We also like the opportunity in Agency bonds (the debt of Fannie Mae and Freddie Mac) and Supranationals, where spreads are currently well above historical levels (Chart 17, third panel). Chart 17Opportunities In Low-Risk Spread Product Opportunities In Low-Risk Spread Product Opportunities In Low-Risk Spread Product Chart 18Not Enough Value In Agency MBS Not Enough Value In Agency MBS Not Enough Value In Agency MBS Agency MBS are less appealing. Spreads have already tightened back to pre-COVID levels and while continued Fed buying should keep them low, returns will be much better in the investment grade corporate space (Chart 18).  Meanwhile, we would also advocate long positions in municipal bonds. Spreads are wide and the Fed is now providing support out to the 2-year maturity point (see Chart 13). We also see potential for the Fed to start purchasing longer-maturity municipal debt if spreads don’t tighten quickly enough. Chart 19Look For Attractive Spreads In Countries With Swap Lines Look For Attractive Spreads In Countries With Swap Lines Look For Attractive Spreads In Countries With Swap Lines Finally, we would also consider the USD-denominated sovereign debt of countries to which the Fed has extended swap lines, with Mexico offering a prime example. Its USD-denominated debt offers an attractive spread and it has been extended a swap line (Chart 19). In equities, agency mortgage REITs – monoline lenders that manage MBS portfolios 8-10 times the size of their equity capital – are a levered play on buying what the Fed’s buying. They were beaten up quite badly throughout March, and have been de-rated enough to deliver double-digit total returns as long as the repo market doesn’t flare up again, and agency MBS spreads do not widen anew. We see large banks as a direct beneficiary of policymakers’ efforts to limit credit distress and expect that their loan losses could ultimately be less than markets fear. While lenders have an incentive to be the first to push secured borrowers into default in a normal recession to ensure they’re first in line to liquidate collateral, they now have an incentive to keep borrowers from defaulting lest they end up having to carry the millstone of seized collateral on their balance sheets for an indefinite period. Regulatory forbearance may end up being every bit as helpful for bank book values as the ability to move securities into the Fed’s non-recourse facilities. Footnotes 1 This calculation uses 2019 EBITDA and includes undrawn loan commitments in total debt. 2 The Fed plans to expand the program to include non-bank SBA-approved lenders in the near future. 3 Please see the US Investment Strategy Special Reports, “How Vulnerable Are US Banks? Part 1: A 50-Year Bottom-Up Case Study,” and “How Vulnerable Are US Banks? Part 2: It’s Complicated,” published March 30 and April 6, 2020, respectively, available at usis.bcaresearch.com. Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Ryan Swift US Bond Strategist rswift@bcaresearch.com Jennifer Lacombe Associate Editor jenniferl@bcaresearch.com Jeremie Peloso Senior Analyst jeremiep@bcaresearch.com

Highlights US Corporates: The Fed continues to expand the reach of its extraordinary monetary policies designed to combat the COVID-19 recession, now giving itself the ability to hold BB-rated US high-yield bonds within its corporate bond buying programs. Raise allocations to US BB-rated corporates to overweight, within a neutral overall strategic (6-12 months) allocation to US high-yield. Euro Area Corporates: European investment grade corporate debt has seen significant spread widening over the past month, but spreads have stabilized with the ECB introducing a new asset purchase program with fewer restrictions. Upgrade euro area investment grade corporates to neutral from underweight on both a tactical (0-6 months) and strategic (6-12 months) basis. Favor debt from beaten-up sectors that are already priced for severe economic weakness like Energy, Transportation and non-bank Financials. Central Banks Are A Corporate Bond Investor’s Best Friend Right Now Chart of the WeekThe Fed & ECB Are Supporting Bond Markets The Fed & ECB Are Supporting Bond Markets The Fed & ECB Are Supporting Bond Markets The actions of policymakers worldwide to help mitigate the severe economic shock from the COVID-19 recession have helped boost global risk assets over the past couple of weeks. This is particularly notable in US corporate bond markets, where credit spreads have tightened for both shorter-maturity investment grade bonds and Ba-rated high-yield (Chart of the Week). It is not a coincidence that those are the parts of the US corporate bond market that the Fed is now explicitly backstopping through its off-balance-sheet investment programs. Last week, the Fed unveiled yet another “bazooka” to help ease US financial conditions, broadening the scope of its previously investment grade-only corporate bond purchase programs to include Ba-rated high-yield corporate bonds and high-yield ETFs. In Europe, meanwhile, the European Central Bank (ECB) is also providing additional monetary support through increased asset purchases of both government and corporate debt. Those purchases are focused more on the weakest links in the euro area financial and economic chain like Italian sovereign bonds. This has helped to stabilize credit spreads for both Italian government bonds and euro area investment grade corporate debt. This support from policymakers is critical to prevent a further tightening of financial conditions during a severe global recession (Chart 2). The excess return (over government bonds) for the Bloomberg Barclays global high-yield bond index is now down 15% on a year-over-year basis. High-yield corporate bond spreads are well above the lows seen earlier this year on both sides of the Atlantic, across all credit quality tiers. In the US, spreads between credit quality tiers had widened to levels not seen in several years. Within the US investment grade universe, the gap between Baa-rated and Aa-rated spreads had widened from 20bps to 60bps (Chart 3), a level last seen in September 2011, but now sits at 39bps. Chart 2Junk Bonds Already Discount A Big Recession Junk Bonds Already Discount A Big Recession Junk Bonds Already Discount A Big Recession Chart 3The Fed Wants These Spreads To Tighten The Fed Wants These Spreads To Tighten The Fed Wants These Spreads To Tighten Looking in the other direction of the credit quality spectrum, the spread between Baa-rated and Ba-rated corporates – the line of demarcation between investment grade and high-yield bonds – had blown out from 132bps in February to 556bps, but is now at 360bps. This is the market pricing in the growing risk of fallen angels being downgraded from investment grade to junk. In our view, the Ba-Baa spread is the best indicator to follow to see if the Fed’s extension of its bond purchase program to high-yield is working to reduce borrowing costs for lower-rated US companies. Both in the US and Europe, we continue to recommend a credit investment strategy that favors the parts of the markets that the Fed and ECB are most directly involved in now. That means staying overweight US investment grade corporate bonds with maturities of less than five years (the Fed’s maturity limit for its bond buying program). It also means staying overweight Italian government debt versus core European equivalents. The Fed’s new extension into high-yield corporates within its buying programs means we need to upgrade our recommendation on US BB-rated high-yield to overweight within our recommended neutral strategic (6-12 months) allocation to US junk bonds. We are making that change on a tactical basis in our model bond portfolio, as well, as can be seen on pages 14-15. As the title of this Weekly Report suggests, buy what the central banks are buying. The Fed’s new extension into high-yield corporates within its buying programs means we need to upgrade our recommendation on US BB-rated high-yield to overweight within our recommended neutral strategic (6-12 months) allocation to US junk bonds. In Europe, there is now scope to also raise allocations to euro area corporate bonds, as well, as we discuss over the remainder of this report. Bottom Line: The Fed continues to expand the reach of its extraordinary monetary policies designed to combat the COVID-19 recession, now giving itself the ability to hold BB-rated US high-yield bonds within its corporate bond buying programs. Raise allocations to US BB-rated corporates to overweight within a neutral overall strategic (6-12 months) allocation to US high-yield. Looking For Value In Euro Area Investment Grade Bonds The outlook for euro area spread product does not have as clean-cut a story as is the case for US credit. The ECB is not explicitly supporting European corporate credit markets to the same degree as the Fed is with its open-ended off-balance sheet investment vehicles. While the ECB has introduced a new large €750bn asset purchase program, the Pandemic Emergency Purchase Program (PEPP), to help ease financial conditions in the euro area, no specific details have yet been provided specifying how much of the PEPP will go towards corporate debt versus sovereign bonds. The ECB has already loosened the country and issuer limit restrictions it has imposed on its existing Asset Purchase Program (APP), however, which means that the central bank will be very flexible with the PEPP purchases. That means helping reduce sovereign risk premiums in Peripheral Europe by buying greater amounts of Italian, Spanish and even Greek government debt. That also likely means buying more corporate debt in the most stressed sectors of the euro area economy, as needed. Greater ECB bond purchases would make euro area investment grade credit – which has seen some value restored after the recent bout of spread widening - more attractive over both tactical and strategic investment horizons. This is true even with much of the euro area now in a deep recession because of COVID-19 lockdowns, which has already been discounted in the poor investment performance of euro area corporates. Greater ECB bond purchases would make euro area investment grade credit – which has seen some value restored after the recent bout of spread widening - more attractive over both tactical and strategic investment horizons. Year-to-date, euro area corporate credit markets have been hit hard by the global credit selloff (Table 1). In total return terms denominated in euros, the Bloomberg Barclays euro area investment grade corporate bond index is down -5.0% so far in 2020. The numbers are slightly better relative to duration-matched euro area government bonds (the pure credit component), with the index excess return down -5.5% year-to-date. At the broad sector level, the laggards so far in 2020 have been the sectors most exposed to the sharp downturn in European (and global) economic growth. In excess return terms, the worst performing sectors year-to-date within the eleven major groupings shown in Table 1 have been Consumer Cyclicals (-8.5%), Transportation (-8.1%), Energy (-7.2%). The best performing sectors are those that would be categorized as less cyclical and more “defensive”, like Utilities (-4.3%), Technology (-4.3%) and Financials (-4.7%). In many ways, this is a mirror image of 2019, when Consumer Cyclicals and Transportation were among the top performers while Technology was the worst performer. Table 1Euro Area Investment Grade Corporate Bond Returns Buy What The Central Banks Are Buying Buy What The Central Banks Are Buying Chart 4Euro Area Corporate Spreads Are Relatively Subdued Vs. Past Credit Cycles Euro Area Corporate Spreads Are Relatively Subdued Vs. Past Credit Cycles Euro Area Corporate Spreads Are Relatively Subdued Vs. Past Credit Cycles When looking at the differences in spreads between credit tiers in the euro area, the gaps are not as wide as in the US (Chart 4). The index spread on Baa-rated euro area corporates is only 44bps above that of Aa-rated credit, far below the 100bps gap seen at the peak of the 2001 and 2011 spread widening episodes and well below the 200bps witnessed in 2008. Looking at the difference between Ba-rated and Baa-rated euro area spreads paints a similar picture, with the gap between the highest high-yield credit tier and lowest investment grade credit tier now sitting at 297bps after getting as wide as 431bps in late March – close to the 500bps peak seen in 2011 but far below the 1000bps levels seen in 2001 and 2007 The broad conclusion looking strictly at credit tiers is that euro area corporates have cheapened up a bit during the COVID-19 selloff, but on a more modest scale compared to previous euro area credit cycles. A similar conclusion is reached when looking at industry-level credit spreads. The broad conclusion looking strictly at credit tiers is that euro area corporates have cheapened up a bit during the COVID-19 selloff, but on a more modest scale compared to previous euro area credit cycles. A similar conclusion is reached when looking at industry-level credit spreads. In Charts 5 & 6, we show the history of option-adjusted spreads (OAS) for the major industrial sub-groupings of the Bloomberg Barclays euro area investment grade corporate indices. Unsurprisingly, spreads look relatively wide for the biggest underperforming sectors like Energy, Consumer Cyclicals and Transportation. The spread widening has been more contained in the better performing sectors like Technology. Chart 5A Mixed Performance For Euro Area Investment Grade Spreads By Industry … A Mixed Performance For Euro Area Investment Grade Spreads By Industry ... A Mixed Performance For Euro Area Investment Grade Spreads By Industry ... Chart 6…. With Spreads Well Below 2001 And 2008 Credit Cycle Peaks ... With Spreads Well Below 2001 And 2008 Credit Cycle Peaks ... With Spreads Well Below 2001 And 2008 Credit Cycle Peaks When looking at the individual country corporate bond indices within the euro area, the current levels of spreads do not look particularly wide in an historical context. In Chart 7, we show a bar chart of the range of index OAS for the six largest euro area countries (Germany, France, Italy, Spain, the Netherlands, Belgium and Austria). The current OAS is shown within that historical range. The chart shows that current spreads are in the middle of that range for most countries, suggesting some better value has been restored by the COVID-19 selloff but with spreads remaining relatively subdued compared to past euro area credit cycles.1 Chart 7Euro Area Investment Grade Corporate Spreads By Country Buy What The Central Banks Are Buying Buy What The Central Banks Are Buying On a relative basis, investment grade spreads are tightest in France (203bps), the Netherlands (202bps) and Belgium (226bps), and widest in Germany (255bps), Italy (255bps), Austria (251bps) and Spain (234bps). With the ECB already promising greater flexibility in the country allocations of its sovereign bond purchases within the PEPP, Italian corporates may offer the best value within the major euro area countries. With the ECB already promising greater flexibility in the country allocations of its sovereign bond purchases within the PEPP, Italian corporates may offer the best value within the major euro area countries. We can get a better sense of relative corporate bond spread valuation at the country level by looking at the 12-month breakeven spread percentile rankings of those spreads. This is one of the tools we use to assess value in global credit spreads, as measured by historical “spread cushions”. Specifically, we calculate how much spread widening is required over a one-year horizon to eliminate the yield advantage of owning corporate bonds versus duration-matched government debt. We then show those breakeven spreads as a percentile ranking versus its own history, to allow comparisons over periods with differing underlying spread volatility. In Charts 8 & 9, we show the 12-month breakeven spread percentile rankings for Germany, France, Italy, Spain, Belgium and Austria. On this basis, the current level of spreads looks most historically attractive in Germany, Italy and France, with the breakeven spread in the upper quartile versus its history dating back to the year 2000. Spreads in Spain, Belgium and Austria also look relatively wide versus their own history, but to a lesser extent than in Germany, France and Italy. Chart 8German, Italian & French Investment Grade Corporates Offer Better Value On A Breakeven Spread Basis …. German, Italian & French Investment Grade Corporates Offer Better Value On A Breakeven Spread Basis ... German, Italian & French Investment Grade Corporates Offer Better Value On A Breakeven Spread Basis ... Chart 9… Than Spanish, Belgian & Austrian Investment Grade Corporates Buy What The Central Banks Are Buying Buy What The Central Banks Are Buying Chart 10Euro Area Investment Grade Corporate Spreads Are Relatively Wide Across All Credit Tiers Euro Area Investment Grade Corporate Spreads Are Relatively Wide Across All Credit Tiers Euro Area Investment Grade Corporate Spreads Are Relatively Wide Across All Credit Tiers So while there are some modest differences in value to exploit within the euro area investment grade corporate bond universe at the country level, there is less to choose from across credit tiers. The 12-month breakeven spreads for Aaa-rated, Aa-rated, A-rated and Baa-rated euro area corporates are all within the upper quartiles of their own history (Chart 10). One other tool we can use to assess value across euro area investment grade corporates is our sector relative value framework. Borrowing from the methodology used by our colleagues at BCA Research US Bond Strategy to assess US investment grade corporates, the sector relative value framework determines “fair value” spreads for each of the major and minor industry level sub-indices of the overall euro area investment grade universe. The methodology takes each sector's individual OAS and regresses it in a cross-sectional regression with all other sectors. The independent variables in the model are each sector's duration, trailing 12-month spread volatility, and credit rating - the primary risk factors for any corporate bond. Using the common coefficients from that regression, a risk-adjusted "fair value" spread is calculated. The difference between the actual OAS and fair value OAS is our valuation metric used to inform our sector allocation ranking. The latest output from the euro area relative value spread model can be found in Table 2. We also show the duration-times-spread (DTS) for each sector in those tables, which we use as the primary way to measure the riskiness (volatility) of each sector. The scatterplot in Chart 11 shows the tradeoff between the valuation residual from our model and each sector's DTS. Table 2Euro Area Investment Grade Corporate Sector Valuation & Recommended Allocation Buy What The Central Banks Are Buying Buy What The Central Banks Are Buying We can then apply individual sector weights based on the model output and our desired level of overall spread risk to come up with a recommended credit portfolio. The weights are determined at our discretion and are not the output from any quantitative portfolio optimization process. The only constraints are that all sector weights must add to 100% (i.e. the portfolio is fully invested with no use of leverage) and the overall level of spread risk (DTS) must equal our desired target. The strongest overweight candidates (a DTS score equal to or greater than that of the overall index with the highest positive valuation residual) are the following euro area investment grade sectors: Packaging, Tobacco, Other Industrials, Media Entertainment, Supermarkets, Integrated Energy, Consumer Cyclical Services and all non-bank Financials (Insurance, REITs, Brokerages and Finance Companies). Against the current backdrop of euro area corporate spreads offering relatively wide spreads on a breakeven spread basis, and with the ECB providing a highly accommodative monetary backdrop that includes more purchases of both government and corporate debt, we think targeting an overall portfolio DTS greater than that of the euro area investment grade corporate bond index is reasonable. On that basis, we are looking to go overweight sectors with relatively higher DTS and positive risk-adjusted spread residuals from our relative value model (and vice versa). Those overweight candidates would ideally be located in the upper right quadrant of Chart 11. Chart 11Euro Area Investment Grade Corporate Sectors: Valuation Versus Risk Buy What The Central Banks Are Buying Buy What The Central Banks Are Buying Based on the latest output from the relative value model, the strongest overweight candidates (a DTS score equal to or greater than that of the overall index with the highest positive valuation residual) are the following euro area investment grade sectors: Packaging, Tobacco, Other Industrials, Media Entertainment, Supermarkets, Integrated Energy, Consumer Cyclical Services and all non-bank Financials (Insurance, REITs, Brokerages and Finance Companies). The least attractive sectors within this framework (negative risk-adjusted valuations) are: Senior Bank Debt, Natural Gas, Other Utilities, Metals and Mining, Chemicals, Construction Machinery, Lodging, Cable and Satellite, Restaurants, Food/Beverage, Health Care, Oil Field Services, Building Materials and Aerospace/Defense. Bottom Line: European investment grade corporate debt has seen significant spread widening over the past month, but spreads should stabilize with the ECB introducing a new asset purchase program with fewer restrictions. Upgrade euro area investment grade corporates to neutral from underweight on both a tactical (0-6 months) and strategic (6-12 months) basis. Favor debt from beaten-up sectors that are already priced for severe economic weakness like Energy, Transportation and non-bank Financials.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 For the Netherlands, there is a much shorter history of corporate bond index data available from Bloomberg Barclays than the other euro area countries shown in Chart 7. The OAS range only encompasses about seven years of data, while the other countries go back as far as the early 2000s. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Buy What The Central Banks Are Buying Buy What The Central Banks Are Buying Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Please note that we are publishing an analysis on Vietnam below. The unprecedented depth of this recession entails that many businesses will likely be operating below their break-evens for a while, even after the confinement measures are eased. Consequently, the process of bottoming in this bear market will be drawn out, and share prices will gyrate substantially in the interim. Elevated foreign currency debt levels among some EM corporations, plunging revenues and local currency depreciation combine for a perfect storm in EM corporate credit. Continue underweighting EM stocks and credit within global equity and credit portfolios, respectively. Take profits on the long EM currency volatility trade. Feature If history is any guide, the speed of the rebound in global equities is more consistent with a bear market rally than the beginning of a new bull market. Typically, for a new durable bull market to emerge after a vicious bear market, a consolidation period or a base-building phase is needed. As of now, share prices have not formed such a base. Playing bear market rallies is all about timing, in which fundamental analysis is not useful. Rebounds die as abruptly as they begin. Hence, it is all about chasing momentum on either side. The unprecedented depth of this recession heralds that many businesses will likely be operating below their break-evens for a while, even after the confinement measures are eased. We closed our absolute short position in EM equities on March 19 but we have continued shorting EM currencies versus the US dollar. Even though EM share prices have become cheap based on their cyclically-adjusted P/E ratio (Chart I-1), valuation is not a good timing tool. This is especially true for this structural valuation indicator. Chart I-1EM Equities Are As Cheap As In Previous Bottoms EM Equities Are As Cheap As In Previous Bottoms EM Equities Are Cheap According To The Cyclically-Adjusted P/E Ratio EM Equities Are As Cheap As In Previous Bottoms EM Equities Are Cheap According To The Cyclically-Adjusted P/E Ratio Why The Rebound? After the massive selloff, investor sentiment on risk assets in general, and cyclicals specifically, has become very depressed. In particular: Sentiment of traders and investment advisors on US stocks has plummeted (Chart I-2). That said, net long positions in US equity futures are still above their 2016 and 2011 lows, as we noted last week. Traders’ sentiment on cyclical currencies such as the CAD and AUD as well as on copper and oil has dropped to their previous lows (Chart I-3).  Chart I-2Investor Sentiment On US Equities Is Poor Investor Sentiment On US Equities Is Poor Investor Sentiment On US Equities Is Poor Chart I-3Investor Sentiment On Copper And Oil Is Depressed Investor Sentiment On Copper And Oil Are Depressed Investor Sentiment On Copper And Oil Are Depressed   Consistently, net long positions of investors in both copper and oil have been trimmed substantially (Chart I-4A and I-4B). Chart I-4AInvestors’ Net Long Positions In Copper... Investors Net Long Positions In Copper... Investors Net Long Positions In Copper... Chart I-4B…And Oil ...And Oil ...And Oil   On the whole, it should not be surprising that after having become very oversold, risk assets rebounded in the past two weeks. Nevertheless, depressed investor sentiment is a necessary but not sufficient condition for a major bear market bottom. As illustrated in Chart I-3, sentiment on oil and copper was extremely depressed in late 2014. Yet with the exception of brief rebounds, both oil and copper prices continued to plunge for about a year before bottoming in January 2016. The necessary and sufficient condition for a durable bottom in global cyclical assets is an improvement in global demand. Chart I-5The S&P 500 And VIX In The Last Two Bear Markets The S&P 500 And VIX In The Last Two Bear Markets The S&P 500 And VIX In The Last Two Bear Markets Given the US and Europe are still in strict confinement and the Chinese economy remains quite weak (please see our more detailed discussion on this below), the global recession is still deepening. Further, while the enormous amounts of stimulus injected by policymakers is certainly positive, it is not yet clear whether these efforts are sufficient to entirely offset the collapse in the level of economic activity and its second round effects. Nevertheless, the Federal Reserve and the European Central Bank have probably contained the acute phase of the financial market crisis by buying financial assets and providing credit to the real economy. Odds are that the VIX and other volatility measures will not retest their recent highs. However, this does not mean that risk assets cannot retest their lows or make fresh ones. For example, in the previous 2001-2002 and 2008 bear markets, the S&P 500 re-tested its low in early 2003 and made a deeper trough in early 2009 even though the VIX drifted lower (Chart I-5). Finally, as we discuss below, a unique feature of this recession makes it unlikely that a definite equity market bottom has been established so quickly. How This Recession Is Distinct From an investor viewpoint, this global recession stands out from others in a particularly distinct way: In an average recession, nominal output levels do not contract. In the US, since 1960 it was only during 2008 that the level of nominal GDP contracted (Chart I-6). Presently, we are experiencing the gravest collapse in nominal output/sales since the 1930s – much worse than what transpired in 2008. Chart I-6US Nominal GDP And Corporate Profits Growth US Nominal GDP And Corporate Profits Growth US Nominal GDP And Corporate Profits Growth When a company’s sales shrink, a critical threshold for sustainability is the level of its revenues relative to its break-even point. The latter is the level of sales where total revenue is equal to total cost – i.e., where profits are nil. Break-even points have ramifications for share prices and the shape of a potential recovery. In an average recession, break-even points for the majority of companies are not breached – i.e., they remain profitable. As a result, a moderate and sequential revival in sales boosts profits, often exponentially. Share prices react positively to even modest sequential growth. Besides, when profits are expanding, managers and owners of these businesses are often quick to augment their capital spending and hiring. A marginal and sequential recovery from this very low point is not sufficient to produce a durable bull market for stocks or corporate credit. When a company’s sales drop below its break-even level, a moderate sequential recovery in sales could be insufficient to make the company profitable. In such a case, the share price may not rally vigorously unless they had priced in a much worse outcome – i.e., a bankruptcy. Crucially, a moderate sequential revival in activity may not lead to more capital spending and hiring. Given US and global nominal GDP are presently contracting at an unprecedented double-digit pace, the revenue of a majority of companies has fallen below costs – i.e., they are presently operating below their break-evens (experiencing losses). This makes this recession distinct from others. On the whole, the loosening of confinement measures and the resumption of business operations may not be sufficient reasons to turn bullish on equities. So long as a company operates below its break-even, its share price may not rally much in response to marginal sequential growth. In short, the pace of recovery will be crucial. Yet, there is considerable uncertainty with respect to these dynamics. Such uncertainty also warrants a high equity risk premium. A U-shaped recovery is most likely, but the latter assumes that many companies will be operating with losses for some time. Consequently, odds are that the process of bottoming in this bear market will be drawn out, and share prices will gyrate substantially in the interim. Taking Pulse Of The Global Economy In our March 19 report, we argued that this global recession is much worse than the one in 2008. High-frequency data are confirming our view: The weekly US economic index from the New York Fed has plunged more than it did in 2008 (Chart I-7). Capital spending plans have been shelved around the world. Odds are many businesses will be operating below their break-evens even after confinement measures are eased. Therefore, they will not rush to invest in new capacity and equipment, or rush to hire. China is a case in point. Commodities prices on the mainland remain in a downtrend, despite the resumption of business activity (Chart I-8). This is a sign of lingering weakness in construction/capital spending. Chart I-7An Unprecedented Plunge In Economic Activity An Unprecedented Plunge In Economic Activity An Unprecedented Plunge In Economic Activity Chart I-8Commodities Prices In China Are Drifting Lower Commodities Prices In China Are Drifting Lower Commodities Prices In China Are Drifting Lower   The world’s oil consumption is presently probably down by more than 35%.  According to INRIX, US car traffic last week was 47% below its level in late February before the confinement measures were introduced. Plus, airline travel has literally ground to a halt worldwide. In China’s major cities, traffic during rush hour is re-approaching its pre-pandemic levels. However, automobile congestion data from TomTom shows that in the afternoons and evenings, traffic remains well below where it was before the lockdown. This reveals that people go to work, spend most of their time at the office, and then quickly return home. They do not go out during lunch time or in the evenings. Hence, we infer that China’s service sector remains in recession.  Chart I-9EM ex-China, Korea And Taiwan: Nominal Growth Was Very Weak Before The Pandemic EM ex-China, Korea And Taiwan: Nominal Growth Was Very Weak Before The Pandemic EM ex-China, Korea And Taiwan: Nominal Growth Was Very Weak Before The Pandemic  The Chinese manufacturing and service PMI indexes registered 51 and 47 respectively in March, revealing that their economic recoveries are very subdued. As per our discussion above, we suspect revenues for many businesses in February dropped below break-even levels. The fact that only about a half of both manufacturing and service sector companies said their March activity improved from February is rather underwhelming. EM ex-China, Korea and Taiwan nominal GDP and core consumer price inflation were at very low levels before the pandemic (Chart I-9). The ongoing plunge in economic activity will produce the worst nominal output recession for many developing economies. Consequently, corporate profits of companies exposed to domestic demand will crash in local currency terms. Bottom Line: The unprecedented depth of this recession heralds that many businesses will likely be operating below their break-evens for a while, even after the confinement measures are eased. Thus, a marginal and sequential recovery from this very low point is not sufficient to produce a durable bull market for stocks or corporate credit. Credit Markets Hold The Key Solvency concerns for companies become acute and doubt about their debt sustainability persist when their revenues drop below their break-evens. Thus, a marginal improvement in revenue – as lockdowns worldwide are relaxed – may not suffice to produce a material tightening in EM corporate credit spreads. Playing bear market rallies is all about timing, in which fundamental analysis is not useful. Rebounds die as abruptly as they begin. Interestingly, equity markets often take their cues from credit markets. Chart I-10 demonstrates that EM US dollar corporate bond yields (inverted on the chart) correlate with equity prices. This chart unambiguously expounds that what matters for EM share prices is not US Treasurys yields but rather their own borrowing costs in US dollars. Chart I-10EM US Dollar Corporate Bond Yields And Stock Prices EM US Dollar Corporate Bond Yields And Stock Prices EM US Dollar Corporate Bond Yields And Stock Prices Presently, there are no substantive signs that US dollar borrowing costs for EM companies or sovereigns are declining. Chart I-11 illustrates that investment and high-yield corporate bond yields for aggregate EM and emerging Asia remain elevated. Remarkably, bank bond yields in overall EM and emerging Asia have not eased much (Chart I-12). The latter is crucial as banks’ external high borrowing costs will dampen their appetite to originate credit domestically. Chart I-11EM US Dollar Corporate Bond Yields EM US Dollar Corporate Bond Yields EM US Dollar Corporate Bond Yields Chart I-12EM Banks US Dollar Bond Yields EM Banks US Dollar Bond Yields EM Banks US Dollar Bond Yields Chart I-13EM Credit Spreads, Currencies And Commodities EM Credit Spreads, Currencies And Commodities EM Credit Spreads, Currencies And Commodities In turn, the direction of EM corporate and sovereign credit spreads is contingent on EM exchange rates and commodities prices, as demonstrated in Chart I-13. Credit spreads are shown inverted in both panels of this chart. We remain negative on both EM currencies and commodities prices, and argue for a cautious approach to EM credit markets.  Bottom Line: Elevated foreign currency debt levels among some EM corporations, plunging revenues and local currency depreciation combine for a perfect storm in EM corporate credit. To make matters worse, this asset class as well as EM sovereign credit were extremely overbought before this selloff. Therefore, there could be more outflows from these markets as adverse fundamentals persist.  Investment Strategy And Positions We continue to recommend underweighting EM stocks and credit versus their DM counterparts. Importantly, the EM equity index has been underperforming the global equity benchmark in the recent rebound (Chart I-14). Aggressive policy stimulus in the US and Europe have improved investor sentiment towards their credit and equity markets. Yet, the Chinese stimulus has so far been less aggressive than in the past. This will weigh on the growth outlook for emerging Asia and Latin America. The outlook for oil prices is currently a coin toss. Price volatility will remain enormous and it is not worth betting on either the long or short side of crude. Apart from oil, industrial metal prices remain at risk due to subdued demand from China. In general, this is consistent with lower EM currencies (Chart I-15).   Chart I-14Continue Underweighting EM Stocks Versus The Global Benchmark Continue Underweighting EM Stocks Versus The Global Benchmark Continue Underweighting EM Stocks Versus The Global Benchmark Chart I-15EM Currencies Correlate With Industrial Metals Prices EM Currencies Correlate With Industrial Metals Prices EM Currencies Correlate With Industrial Metals Prices Chart I-16Book Profits On Long EM Currency Volatility Trade Book Profits On Long EM Currency Volatility Trade Book Profits On Long EM Currency Volatility Trade In accordance with our discussion above that the most acute phase of this crisis might be over, we are booking profits on our long EM currency volatility trade. We recommended this trade on January 23, 2020 and the JP Morgan EM currency implied volatility measure has risen from 6% to 12% (Chart I-16). While EM currencies could still sell off, we doubt this volatility measure will make a new high. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Vietnamese Stocks: Stay Overweight Like many EM bourses, Vietnamese stocks have plunged 35% over the past two months in US dollar terms. How should investors now position themselves with regard to Vietnamese equities, in both absolute and relative terms? In absolute terms, there are near-term risks to Vietnamese equities: Vietnam’s economy is highly dependent on exports, which amount to more than 100% of the country’s GDP. The deepening global recession entails that overseas demand for Vietnamese exports will be decimated. Chart II-1 illustrates how share prices often swing along with export cycles. Customers from the US and EU, which together account for 40% of Vietnamese exports, have been cancelling their orders. In addition, the number of visitor arrivals has already dropped significantly, and tourism revenue – which amounts to about 14% of GDP – will continue to contract (Chart II-2). Chart II-1Vietnamese Stocks: Risks Are External Vietnamese Stocks: Risks Are External Vietnamese Stocks: Risks Are External Chart II-2Tourism Has Crashed Tourism Has Crashed Tourism Has Crashed   Nevertheless, we expect Vietnamese stocks to outperform the EM benchmark, in USD terms, both cyclically and structurally. First, Vietnam has solid macro fundamentals. The country’s annualized trade surplus has ballooned, reaching $12 billion in March (Chart II-3). Even as exports contract, the current account balance is unlikely to turn negative. Notably, Vietnam imports many of the materials required to produce its exported goods. As such, its imports will shrink along with its exports, which will support its current account balance. Meanwhile, the year-on-year growth of domestic nominal retail sales of goods has slowed down, but remains at 8% as of March, which is quite remarkable (Chart II-4). Chart II-3Vietnam Has Large Trade Surplus Vietnam Has Large Trade Surplus Vietnam Has Large Trade Surplus Chart II-4Consumer Spending To Slow But Not Contract Consumer Spending To Slow But Not Contract Consumer Spending To Slow But Not Contract   Second, the government has announced a sizable policy stimulus package. On March 16, the State Bank of Vietnam cut its policy rate by 50bps, from 4% to 3.5%, and its refinancing rate by 100bps, from 6% to 5%. On April 3, Vietnam's Ministry of Finance passed a fiscal stimulus package worth VND180 trillion (equal to US$7.64 billion, or 2.9% of its GDP). Third, Vietnam has contained the COVID-19 outbreak better than many other countries. With aggressive testing and isolation, the country has so far limited the infection rate to only three out of one million citizens, and reported zero deaths. This reduces the probability that Vietnam will be forced to adopt severe confinement measures that would derail its economy. This nation’s success also contrasts with the difficulties that many emerging and frontier economies are having in their struggle with COVID-19 containment.  We continue to overweight Vietnamese stocks relative to EM due to healthy fundamentals, attractive valuations, a large current account balance and a successful economic and health response to the COVID-19 outbreak. Fourth, the country remains quite competitive in global trade. For some time, multinational companies have been moving their supply chains to Vietnam in order to take advantage of its cheap and productive labor, inexpensive land and supportive government policies. As a result, Vietnamese exports have been outpacing those of China across many industries (Chart II-5). Given the geopolitical confrontation between the US and China is likely to persist over many years, more manufacturing will shift from China to Vietnam. Investment Recommendations In absolute terms, we believe Vietnamese stocks are still at risk. Stock prices falling to their 2016 low is possible over the coming weeks and months, which corresponds to a 10-15% downslide from current levels (Chart II-6, top panel). Chart II-5Vietnam Continues Gaining Export Market Share Vietnam Continues Gaining Export Market Share Vietnam Continues Gaining Export Market Share Chart II-6Vietnamese Stocks: Absolute & Relative Performance Vietnamese Stocks: Absolute & Relative Performance Vietnamese Stocks: Absolute & Relative Performance   Relative to the EM equity benchmark, however, we continue overweighting Vietnam equities, both cyclically and structurally. Technically, this bourse’s relative performance has declined to a major support line and it could be bottoming at current levels (Chart II-6, bottom panel). Ellen JingYuan He Associate Vice President ellenj@bcaresearch.com     Footnotes   Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights Chart 1Will Fed Purchases Mark The Top? Will Fed Purchases Mark The Top? Will Fed Purchases Mark The Top? Policymakers can’t do much to boost economic activity when the entire population is under quarantine, but they can take steps to contain the ongoing credit shock and mitigate the risk of widespread corporate bankruptcy. If most firms can stay afloat, then at least there will be jobs to return to when shelter in place restrictions are lifted. Are the steps taken so far by the Federal Reserve and Congress sufficient in this regard? We expect that the Fed’s announcement of investment grade corporate bond purchases will mark the peak in investment grade corporate bond spreads (Chart 1). However, the Fed is doing nothing for high-yield issuers and its purchases only lower borrowing costs for investment grade firms, they don’t clean up highly levered balance sheets. Similarly, much of Congress’ fiscal stimulus package comes in the form of loans instead of grants. As such, ratings downgrades will surge and high-yield spreads probably have more near-term upside. Investors should keep portfolio duration close to benchmark, overweight investment grade corporate bonds and remain cautious vis-à-vis high-yield. Investors should also take advantage of the attractive long-run value in TIPS. Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment grade corporate bonds underperformed the duration-equivalent Treasury index by 1040 basis points in March, dragging year-to-date excess returns down to -1268 bps. The average index spread widened 251 bps from the beginning of the month until the Fed announced its corporate bond purchase programs. It then tightened by 90 bps. It currently sits at 283 bps. Even after the recent tightening, investment grade spreads are extremely high relative to history. Our measure of the 12-month breakeven spread adjusted for changing index credit quality ranks at its 89th percentile since 1989 (Chart 2).1 This means that the sector has only been cheaper 11% of the time since 1989. As we wrote in last week’s Special Report, the Fed’s two new corporate bond purchase programs could be thought of as adding an agency guarantee to eligible securities (those with 5-years to maturity or less).2  We would also expect ineligible (longer maturity) securities to benefit from some knock-on effects, since many firms issue at both the short and long ends of the curve. As such, we recommend an overweight allocation to investment grade corporate bonds, with a preference for the short-end of the curve (5-years or less). The Fed’s purchases should lead to spread tightening, and a steepening of the spread curve (panel 4).  Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Containing The Credit Shock Containing The Credit Shock Table 3BCorporate Sector Risk Vs. Reward* Containing The Credit Shock Containing The Credit Shock High-Yield: Neutral Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield underperformed the duration-equivalent Treasury index by 1330 basis points in March, dragging year-to-date excess returns down to -1659 bps. The average index spread widened 600 bps from the beginning of the month until the Fed announced its corporate bond purchase programs. It then tightened by 158 bps. It currently sits at 942 bps. As we wrote in last week’s Special Report, the Fed’s corporate bond purchases will cause investment grade corporate spreads to tighten, but so far, high-yield has been left out in the cold.3 This means that we must view high-yield spreads in the context of what sort of default cycle we expect for the next 12 months. To do that, we use our Default-Adjusted Spread – the excess spread available in the index after accounting for default losses. At current spreads, our base case expectation of an 11%-13% default rate and 20%-25% recovery rate implies a Default-Adjusted Spread between -98 bps and +117bps (Chart 3). For a true buying opportunity, we would prefer a Default-Adjusted Spread above its historical average of 250 bps. This means that we would consider upgrading high-yield to overweight if the index spread widens to a range of 1075 bps – 1290 bps, in the near-term. Until then, junk investors should stay cautious. MBS: Underweight Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 22 basis points in March, dragging year-to-date excess returns down to -81 bps. The conventional 30-year zero-volatility spread widened 13 bps on the month, driven by a 16 bps widening of the option-adjusted spread that was offset by a 3 bps decline in expected prepayment losses (aka option cost). Like investment grade corporates, MBS spreads will benefit from aggressive Fed purchases for the foreseeable future. However, we prefer investment grade corporates over MBS because of much more attractive valuations. Notice that the option-adjusted spread offered by a Aa-rated corporate bond is 98 bps greater than that offered by a conventional 30-year MBS (Chart 4). Further, servicer back-log is currently keeping primary mortgage rates elevated compared to both Treasury and MBS yields (panels 4 & 5). This is preventing many homeowners from refinancing, despite the Fed’s dramatic rate cuts. However, we expect these homeowners will eventually get their chance. The Fed will be very cautious about raising rates in the future, and primary mortgage spreads will tighten as servicers add capacity. This means that there is a significant amount of refi risk that is not yet priced into MBS. Government-Related: Underweight Chart 5Government-Related Market Overview Government-Related Market Overview Government-Related Market Overview The Government-Related Index underperformed the duration-equivalent Treasury index by 574 basis points in March, dragging year-to-date excess returns down to -667 bps. Sovereign debt underperformed duration-equivalent Treasuries by 1046 bps in March, dragging year-to-date excess returns down to -1375 bps. Foreign Agencies underperformed the Treasury benchmark by 850 bps on the month, dragging year-to-date excess returns down to -1023 bps. Local Authority debt underperformed Treasuries by 990 bps in March, dragging year-to-date excess returns down to -948 bps. Domestic Agency bonds underperformed by 96 bps in March, dragging year-to-date excess returns down to -103 bps. Supranationals underperformed by 70 bps on the month, dragging year-to-date excess returns down to -63 bps. USD-denominated Sovereigns handily outperformed Baa-rated corporate bonds during last month’s market riot (Chart 5). But going forward, we prefer to grab the extra spread available in Baa-rated corporates, with the added bonus that the corporate sector now benefits from direct Fed purchases. The Fed’s dollar swap lines should remove some of the liquidity premium priced into sovereign spreads, but these swap lines only extend to 14 countries (Euro Area, Canada, UK, Japan, Switzerland, Australia, Brazil, Denmark, Korea, Mexico, Norway, New Zealand, Singapore and Sweden) and further dollar appreciation is possible until global growth recovers. One silver lining of last month’s indiscriminate spread widening is that some value has been created in traditionally low-risk sectors. Specifically, the Domestic Agency and Supranational option-adjusted spreads are at 46 bps and 31 bps, respectively (bottom panel). Both look like attractive buying opportunities. Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds underperformed the duration-equivalent Treasury index by a whopping 649 basis points in March, dragging year-to-date excess returns down to -755 bps (before adjusting for the tax advantage). In fact, Aaa-rated Municipal / Treasury yield ratios have blown out across the entire curve and have made new all-time highs, above where they were during the 2008 financial crisis (Chart 6). While the spread levels are alarming, it’s not hard to understand why muni spread widening has been so dramatic. State and local governments are not only shouldering massive expenses fighting the COVID-19 crisis, but will also see tax revenues plunge as economic activity grinds to a halt. This opens up a massive whole in state & local government budgets and municipal bond prices are reacting in kind. Support in the form of Fed municipal bond purchases and direct cash injections from the federal government is required to right the ship. So far, the Fed is only supporting municipal debt with less than six months to maturity and federal government aid has come in the form of grants directed at specific spending areas. Ideally, the Fed will start purchasing long-dated municipal bonds (as it is doing with corporates) and the federal government will provide more direct aid to fill budget gaps. We expect both of those policies to be launched in the coming weeks, and thus think it is a good time to buy municipal bonds on the expectation that the “policy put” will drive spreads lower. Treasury Curve: Buy 5-Year Bullet Versus 2/10 Barbell Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve underwent a massive bull-steepening in March, as the Fed cut rates by 100 bps, all the way back to the zero bound. The 2-year/10-year Treasury slope steepened 20 bps on the month. It currently sits at 39 bps. The 5-year/30-year Treasury slope steepened 22 bps on the month. It currently sits at 85 bps. One good thing about the fed funds rate being pinned at zero is that it greatly simplifies yield curve strategy. As we showed in a recent report, when the funds rate is at its lower bound the Treasury slope will trade directionally with yields.4 That is, the yield curve will steepen when yields rise and flatten when they fall. Therefore, if you want to put on a position that will profit from lower yields but that doesn’t increase the average duration of your portfolio, you can enter a duration-neutral flattener: long a 2/10 or 2/30 barbell and short the 5-year or 7-year bullet, in duration-matched terms. Or, if like us, you do not want to make a large duration bet but suspect that Treasury yields will be higher in 12 months, you can enter a duration-neutral steepener: long the 5-year bullet and short a duration-matched 2/10 barbell.5 In terms of value, the 5-year yield no longer trades deeply negative relative to the 2/10 and 2/30 barbells (Chart 7), though it remains somewhat expensive according to our models (see Appendix B). TIPS: Overweight Chart 8Inflation Compensation Inflation Compensation Inflation Compensation TIPS underperformed the duration-equivalent nominal Treasury index by 515 basis points in March, dragging year-to-date excess returns down to -735 bps. The 10-year TIPS breakeven inflation rate fell 55 bps on the month. It currently sits at 1.09%. The 5-year/5-year forward TIPS breakeven inflation rate fell 24 bps on the month. It currently sits at 1.39%. As we noted in a recent report, the market crash has created an extraordinary amount of long-run value in TIPS.6 For example, the 10-year and 5-year TIPS breakeven inflation rates have fallen to 1.09% and 0.78%, respectively. This means that a buy & hold position long the TIPS and short the equivalent-maturity nominal Treasury will make money if average annual inflation is greater than 0.78% for the next five years, or greater than 1.09% for the next ten (Chart 8). This seems like a slam dunk. Even on a 1-year horizon, we would argue that TIPS trades make sense. We calculate that the TIPS note maturing in April 2021 will deliver greater returns than a 12-month T-bill as long as headline CPI inflation is above -1.25% during the next 12 months (panel 4). Granted, the oil price collapse is a significant drag on CPI (bottom panel). But, we would also note that the worst year-over-year CPI print during the 2008 financial crisis was -2.1% and this included deflation in the shelter component. Shelter accounts for 33% of the CPI, compared to only 7% for Energy. ABS: Underweight  Overweight Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities underperformed the duration-equivalent Treasury index by 342 basis points in March, dragging year-to-date excess returns down to -317 bps. The index option-adjusted spread for Aaa-rated ABS soared 158 bps on the month. It currently sits at 163 bps, well above average historical levels (Chart 9). Aaa-rated consumer ABS were not immune to the recent sell-off, but we think today’s elevated spreads signal an opportunity to increase exposure to the sector. In addition to the value argument, the Fed’s re-launched Term Asset-Backed Securities Loan Facility (TALF) should cause Aaa-rated ABS spreads to tighten in the coming months. Through TALF, eligible private investors can take out non-recourse loans from the Fed and use the proceeds to purchase Aaa-rated ABS. In our view, the combination of elevated spreads and direct Fed support for the sector suggests a buying opportunity in Aaa-rated consumer ABS. Non-Agency CMBS: Neutral  Underweight Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-agency Commercial Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 786 basis points in March, dragging year-to-date excess returns down to -785 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS widened 133 bps on the month. It currently sits at 217 bps, well above typical historical levels (Chart 10). Despite wide spreads, we are hesitant about stepping into the sector. The Fed has so far not extended its asset purchases to non-agency CMBS. There are other sectors – such as consumer ABS, Agency CMBS, and investment grade corporate bonds – that also offer attractive spreads and are benefitting directly from Fed support. Agency CMBS: Overweight Agency CMBS underperformed the duration-equivalent Treasury index by 394 basis points in March, dragging year-to-date excess returns down to -361 bps. The average index spread for Agency CMBS widened 74 bps on the month. It currently sits at 121 bps, well above typical historical levels (panel 3). Unlike its non-agency counterpart, the Fed is buying Agency CMBS as part of its mortgage-backed securities purchase program. The combination of an elevated spread and direct Fed support makes the Agency CMBS sector a high conviction overweight. Appendix A: The Golden Rule Of Bond Investing With the federal funds rate pinned at its effective lower bound for the foreseeable future, yield volatility at the front-end of the curve will decline markedly. This means that the 12-month fed funds rate expectations embedded in the yield curve provide little useful information. As such, our Golden Rule of Bond Investing is not a useful framework for implementing duration trades when the fed funds rate is pinned at zero. We will therefore temporarily stop updating the Golden Rule tables that were previously shown in Appendix A of our monthly Portfolio Allocation Summary. The Golden Rule framework will return when the fed funds rate is close to lifting off from zero. Please feel free to contact us if you have any questions.     Appendix B: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of April 3, 2020) Containing The Credit Shock Containing The Credit Shock Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 5Butterfly Strategy Valuation: Standardized Residuals (As Of April 3, 2020) Containing The Credit Shock Containing The Credit Shock Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of 46 bps in the 5 over 2/10 cell means that we would only expect the 5-year to outperform the 2/10 if the 2/10 slope steepens by more than 46 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) Containing The Credit Shock Containing The Credit Shock Appendix C: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Chart 11Excess Return Bond Map (As Of April 3, 2020) The Golden Rule's Track Record The Golden Rule's Track Record   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 The 12-month breakeven spread is the spread widening required to deliver negative excess returns versus duration-matched Treasuries on a 12-month horizon. 2 Please see US Bond Strategy/Global Fixed Income Strategy Special Report, “Trading The US Corporate Bond Market In A Time Of Crisis”, dated March 31, 2020, available at usbs.bcaresearch.com 3 Please see US Bond Strategy/Global Fixed Income Strategy Special Report, “Trading The US Corporate Bond Market In A Time Of Crisis”, dated March 31, 2020, available at usbs.bcaresearch.com 4 Please see US Bond Strategy Weekly Report, “Life At The Zero Bound”, dated March 24, 2020, available at usbs.bcaresearch.com 5 The rationale for why barbell positions profit from curve flattening and bullet positions profit from curve steepening is found in US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation

Highlights Please note that we published a Special Report early this week titled Brazilian Banks: Falling Angels, and an analysis on India. Please also note that we are publishing an analysis on Indonesia below. Given uncertainty over the depth and duration of the unfolding global recession, a sustainable equity bull run is now unlikely. It is still early to lift EM equity and EM credit allocations from underweight to overweight within global equity and global credit portfolios, respectively. EM currencies and EM fixed-income markets will remain under selling pressure. Feature The question investors now face is whether the recent rebound will endure for a few months or it will just be a bear market rebound that is already fading. BCA’s Emerging Market Strategy service believes it is the latter. EM and DM share prices will likely make new lows.  A Tale Of Two Charts Chart I-1and I-2 overlay the current S&P 500 selloff with the market crashes of 1987 and 1929, respectively. The speed and ferocity of the current selloff is on a par with both. In 1987, following the 33% crash, share prices rebounded 14% but then relapsed without breaking below previous lows (Chart I-1). That was a hint that US share prices were entering a major bull market that indeed ensued. We do not know if the S&P 500 will make a lower low, but a retest of the recent lows is very likely. In 1929, US share prices collapsed by 36% over several weeks. Then, the overall index staged an 18% rebound within a couple of weeks, rolled over and plunged to new lows. The magnitude of the second downleg was 27% (Chart I-2). Chart I-1S&P 500: Now Versus 1987 S&P 500: Now Versus 1987 S&P 500: Now Versus 1987 Chart I-2S&P 500: Now Versus 1929 S&P 500: Now Versus 1929 S&P 500: Now Versus 1929   Fast forward to today, the S&P 500 plummeted 34% in a matter of only four weeks and then staged a 17.5% rebound in only a few days. We do not know if the S&P 500 will make a lower low, but a retest of the recent lows is very likely. In fact, we are assigning a higher probability to share prices in EM and DM breaking down to new lows than for the recent lows to hold. Chart I-3S&P 500: Now Versus 1929-32 S&P 500: Now Versus 1929-32 S&P 500: Now Versus 1929-32 Readers may question why we are comparing the current episode with the 1929 bear market. The argument against this comparison stresses that policymakers made numerous mistakes between 1929 and 1932, refusing to ease policy even after the crisis commenced. That led to debt deflation and a banking crisis, which in turn produced a vicious equity bear market of 85% lasting 3 years. At present, authorities around the world have reacted swiftly, providing enormous fiscal and monetary stimulus. We agree with this reasoning, but our point is as follows: Due to the US’s ongoing aggressive and timely policy response, stocks will avoid the protracted second phase of the 1930-‘32 bear market when share prices plummeted by another 80% (Chart I-3). Nonetheless, the US equity market could still repeat what occurred in the initial part of the 1929 bear market, as illustrated in Chart I-2 and Chart I-3. The Fundamentals The basis for our expectations of continued weakness in share prices is as follows: The selloff in the S&P 500 began from overbought and expensive levels (Chart I-4). The duration of the selloff so far has been only four weeks. We doubt that such a short, albeit vicious, selloff was enough to clear out valuation and positioning excesses. For example, even though by March 24 net long positions in US equity futures had dropped significantly, they were still above their 2011 and 2015/16 lows (Chart I-5). Chart I-4S&P 500: Correcting From Expensive Levels S&P 500: Correcting From Expensive Levels S&P 500: Correcting From Expensive Levels Chart I-5Net Long Positions In US Equity Indexes Futures Net Long Positions In US Equity Indexes Futures Net Long Positions In US Equity Indexes Futures   Besides, US equity valuations are still elevated. The cyclically adjusted P/E ratio for the S&P 500 – based on operating profits – is 25 compared with its historical mean of 16.5, as demonstrated in the top panel of Chart I-4. While this valuation model does not take into account interest rates, our hunch is as follows: facing such high uncertainty over the profit outlook, investors will require higher than usual risk premiums to invest in equities. In short, the ongoing profit collapse and the extreme uncertainty over the cyclical outlook heralds a higher risk premium. The discount rate – which is the sum of the risk-free rate and risk premium – presently should not be lower than its average over the past 20 years. We are experiencing a sort of natural disaster, and there is little policymakers can do amid lockdowns. Natural disasters require time to play out, and financial markets are attempting to price in this downturn.  Most stimulus measures taken worldwide to boost demand will only gain traction after the lockdowns are over. At the moment, global output and demand remain in freefall. The recovery will be hesitant and is unlikely to be V-shaped for two reasons: (1) social distancing measures will be eased only gradually; and (2) the lost household income and corporate profits from weeks and months of shutdowns will continue to weigh on consumer and business sentiment and their spending patterns for several months. China’s economy is a case in point. Both manufacturing and services PMIs for March posted readings in the 50-52 range. These are rather underwhelming numbers. Following stringent lockdowns in February when the level of economic output literally collapsed, only 52% of companies surveyed reported an improvement in their business activity/new orders in March relative to February. Chart I-6Our Reflation Confirming Indicator Is Downbeat Our Reflation Confirming Indicator Is Downbeat Our Reflation Confirming Indicator Is Downbeat If true, these PMI readings imply a level of output and demand in China that is still well below March 2019 levels. It seems China has not been able to engineer a V-shaped recovery in demand and output. Therefore, the odds are that, outside China, economic activity will come back only slowly. This entails that some businesses will not reach their breakeven points anytime soon, and that their profits will be contracting for some time to come. We do not think this is reflected in today’s asset prices.       Finally, our Reflation Confirming Indicator – which is composed of equally-weighted prices of industrial metals, platinum and US lumber – is pointing down (Chart I-6). Bottom Line: This bear market has been ferocious, but too short in duration. It is unlikely that share prices have already bottomed, given uncertainty over the depth and duration of the unfolding global recession. EM Versus DM: Stay Underweight Chart I-7EM Versus DM: Relative Equity Prices EM Versus DM: Relative Equity Prices EM Versus DM: Relative Equity Prices EM stocks have failed to outperform DM equities in the recent rebound. As a result, EM versus DM relative share prices are testing new lows (Chart I-7). Odds are that EM will underperform DM in the coming weeks or months. Outside North Asian economies (China, Korea and Taiwan), EM countries have less capacity to deal with the COVID-19 pandemic than advanced countries. First, health care systems in developing countries are far less equipped to deal with the pandemic than DM ones. Chart I-8 shows the number of hospital beds per 1,000 people in India, Indonesia, Brazil and Mexico are significantly lower than in Europe and the US. Chart I-8Many EMs Have Poor Health Infrastructure Downside Risks Prevail Downside Risks Prevail Second, EM ex-North Asian economies lack both the social safety net of Europe and the US’s capacity to inject large amounts of fiscal and monetary stimulus into the system. With the US dollar being the world reserve currency, the US has no problem monetizing its public debt and fiscal deficits. The same is true for the European Central Bank (ECB). If current account-deficit EM countries following in the footsteps of the US and monetize fiscal deficits/public debt, their currencies will likely depreciate. Last week, the South African central bank announced that it will buy local currency government bonds to cap their yields and inject liquidity into the system. This is of little help to foreign investors in domestic bonds because the rand has continued to sell off, eroding the US dollar value of their government bond holdings. Hence, the foreign investor exodus from the local currency bond market will likely continue. The same would be true for many other EM countries if they contemplate QE-type policies. Most stimulus measures taken worldwide to boost demand will only gain traction after the lockdowns are over. Third, unlike the Fed and the ECB, EM ex-North Asia central banks have limited capacity to alleviate funding stress for their companies. The Fed is also purchasing investment-grade corporate bonds and is setting up structures to channel credit to companies. All of this will marginally help ease financial and credit stress in the US. In contrast, central banks in EM ex-North Asia are unlikely to adopt similar policies on a comparable scale as the US. While DM countries do not mind seeing their currencies depreciate, authorities in many developing countries are fearful of further depreciation. The latter will inflict more stress on EM companies and banks that have large foreign currency debt. We will publish a report on EM foreign currency debt next week. Further, corporate bonds in DM are issued in local currency, allowing their central banks to purchase corporate bonds in unlimited quantities by creating money “out of thin air.” Chart I-9EM Performance Correlates With Commodities EM Performance Correlates With Commodities EM Performance Correlates With Commodities In contrast, outside of China and Korea, the majority of EM corporate bonds are issued in US dollars. This means that to bring down their corporate US borrowing costs, central banks in developing countries need to spend their finite US dollar reserves. Finally, commodities prices are critical to EM financial markets’ absolute and relative performance (Chart I-9). The outlook for commodities prices remains dismal. As the global economy has experienced a sudden stop, demand for raw materials and energy has literally evaporated. Liquidity provisions by the Fed and other key central banks may at a certain point help financial assets but will not help commodities. The basis is that demand for equities and bonds is entirely driven by investors, but in the case of commodities a large share of demand comes from the real economy. In bad times like these, central banks’ liquidity provisions can at a certain point persuade investors to look through the recession and begin buying financial assets before the real economy bottoms. In the case of commodities, when real demand is collapsing, financial demand will not be able to revive commodities prices. Bottom Line: It is still early to lift EM equity and EM credit allocations from underweight to overweight within global equity and global credit portfolios, respectively. Technicals: Old Support = New Resistance? Calling tops and bottoms in financial markets is never easy. When formulating investment strategy it is helpful to examine both market price actions and other subtle clues that financial markets often provide. The global equity index and global industrial stocks have rebounded to levels that acted as supports during previous selloffs. We have detected the following patterns that suggest the recent rebound is facing major resistance, and new lower lows are likely: The global equity index and global industrial stocks have rebounded to levels that acted as supports during previous selloffs (Chart I-10). Unless these equity indexes decisively break above these lines, the odds favor retesting their recent lows or even falling to new lows. Many other equity indexes and individual stocks are also displaying similar technical patterns. The Korean won versus the US dollar as well as silver prices exhibit a similar technical profile (Chart I-11). Chart I-10Ominous Technical Signals Ominous Technical Signals Ominous Technical Signals Chart I-11New Lows Ahead New Lows Ahead New Lows Ahead   Global materials have decisively broken below their long-term moving average that served as a major support in 2002, 2008 and 2015 (Chart I-12). The same multi-year moving average is now likely to act as a resistance. Hence, any rebound in global materials stocks – that extremely closely correlate with EM share prices – is very unlikely to prove durable until this support-turned-resistance level is decisively breached. US FAANGM (FB, AMZN, APPL, NFLX, GOOG, MSFT) equally-weighted stock prices have dropped below their 200-day moving average that served as a major support in recent years (Chart I-13). They did rebound but have not yet broken above the same line. Odds are that this line will become a resistance. If true, this will entail new lows in FAANGM stocks. Chart I-12Global Materials Broke Below Their Long-Term Defense Line Global Materials Broke Below Their Long-Term Defense Line Global Materials Broke Below Their Long-Term Defense Line Chart I-13FAANGM: Previous Support Has Become New Resistance FAANGM: Previous Support Has Become New Resistance FAANGM: Previous Support Has Become New Resistance   Bottom Line: Various financial markets are exhibiting technical patterns consistent with retesting recent lows or making lower lows. Stay put. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Indonesia: A Fallen Angel Chart II-1Indonesian Equities Are In Freefall In Absolute & Relative Terms Indonesian Equities Are In Freefall In Absolute & Relative Terms Indonesian Equities Are In Freefall In Absolute & Relative Terms Indonesian stock prices are in freefall - both in absolute terms and relative to EM - with no visible support (Chart II-1). We recommend that investors maintain an underweight position in both Indonesian equities and fixed-income and continue to short the rupiah versus the US dollar. We explain the reasoning behind this recommendation below. First, the key vulnerability of Indonesian financial markets is that they had been supported by massive foreign inflows stirred by falling US interest rates, despite deteriorating domestic fundamentals and falling commodities prices. We discussed this at length in our previous reports. However, the COVID-19 pandemic has brought these weak fundamentals to light. The latter have overshadowed falling US interest rates (Chart II-2) triggering an exodus of foreign portfolio capital and a plunge in the exchange rate. Currency depreciation has in turn mounted foreign investors losses resulting in a vicious feedback loop. As of the end of February, foreigners held about 37% of local currency bonds. Meanwhile, they held 56% of equities as of last week. Ongoing currency weakness and continued jitters in global financial markets will likely generate more foreign capital outflows.                    Second, the Indonesian economy - both domestic demand and exports - were already weak even before the breakout of COVID-19 occurred (Chart II-3).  Chart II-2Indonesia: Falling US Rates Stopped Mattering Indonesia: Falling US Rates Stopped Mattering Indonesia: Falling US Rates Stopped Mattering Chart II-3Indonesia: Domestic Demand Was Weak Before COVID-19 Outbreak Indonesia: Domestic Demand Was Weak Before COVID-19 Outbreak Indonesia: Domestic Demand Was Weak Before COVID-19 Outbreak   Chart II-4Indonesia: Struggling Under High Lending Rates Indonesia: Struggling Under High Lending Rates Indonesia: Struggling Under High Lending Rates With imposition of social distancing measures, output and nominal incomes will contract (Chart II-4). Third, the nation’s very underdeveloped health care system makes it more vulnerable to a pandemic compared to other mainstream EM countries. For example, the number of hospital beds per 1000 people - at 1.2 - is among the lowest within the mainstream EM universe. We discuss this issue for EM in greater detail in our most recent weekly report. In brief, it will take a longer time for this nation to overcome the pandemic and get its economy back on track. Fourth, Indonesia - as with many EM countries - is short on both social safety programs and fiscal stabilizers that are available in North Asian countries, Europe and the US. Moreover, the country lacks the administrative system needed to promptly execute fiscal stimulus. Besides, the economic stimulus announced by the Indonesian authorities is so far insufficient to meaningfully moderate the economic blow. The government announced a fiscal stimulus that barely amounts to 1% of GDP. This will do little to counter the recession that the nation’s economy is now entering. On the monetary policy front, though the central bank has been cutting policy rates and injecting local currency liquidity into the system, this will only help reduce liquidity stress. It will not directly aid ailing households and small businesses suffering from an income shock. Critically, prime lending rates have not dropped despite dramatic cuts in policy rates (Chart II-4). Chart II-5Bank Stocks - Last Shoe To Drop - Are Unraveling Now Bank Stocks - Last Shoe To Drop - Are Unraveling Now Bank Stocks - Last Shoe To Drop - Are Unraveling Now Meanwhile, the government’s decision to grant a debt servicing holiday to borrowers will only help temporarily. These borrowers will still need to repay their debts at some point down the line. Given the magnitude and uncertain duration of their income loss, there is no guarantee they will be in a position to service their debt after the pandemic is over. Eventually, Indonesian commercial banks will experience a large increase in non-performing loans (NPLs). Overall, the plunge in domestic demand combined with the fall in global trade and commodities prices entails that Indonesia is heading into its first recession since 1998. Given Indonesia has for many years been one of the darlings of EM investors, a recession in Indonesia and global flight to safety herald continued liquidation in its financial markets. Both local government bond yields and corporate US dollar bonds yields are breaking out. Rising borrowing costs amidst the recession will escalate the selloff in equities. Remarkably, non-financial stocks and small-caps have already fallen by 40% and 55% in US dollar terms, respectively (Chart II-5, top two panels). It was banks stocks – which comprise 35% of total market cap – that were holding up the overall index (Chart II-5, bottom panel). Given banks will likely experience rising defaults as discussed above, their share prices have more risk to the downside. Bottom Line: Absolute return investors should stay put on Indonesian risk assets for now. We maintain our short position on the rupiah versus the US dollar. EM-dedicated equity investors should keep underweighting Indonesian equities within an EM equity portfolio. Meanwhile, EM-dedicated fixed income investors should continue to underweight Indonesian local currency bonds as well as sovereign and corporate credit. Ayman Kawtharani Editor/Strategist ayman@bcaresearch.com   Footnotes Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights Recommended Allocation Quarterly Portfolio Outlook: Playing The Optionality Quarterly Portfolio Outlook: Playing The Optionality The outlook for markets over the next few months is highly uncertain. On the optimistic side, new COVID-19 cases are probably close to peaking (for now), and so equities could continue to rally. But there are many risks too. Growth numbers will be horrendous for some months. Second-round effects (corporate defaults, problems in EM and with euro zone banks, for example) will emerge. We recommend a balanced portfolio, robust both for risk-on rallies and a further sell-off. We stay overweight equities versus bonds. Government bonds will not provide significantly positive returns even in a severe recession. Thus, over the next 12-months, equities are likely to outperform them. But we leaven the equity overweight with a “minimum volatility” strategy, overweight the low-beta US market, and more stable sectors such as Healthcare and Technology. Within bonds, we stay underweight government bonds, and raise Investment Grade credit to overweight, given the Fed’s backstop. Even in a risk-on rally, government yields will not rise quickly so we recommend a neutral stance on duration. The massive stimulus will eventually be inflationary, so we recommend TIPS, which are very cheaply valued. We are overweight cash and gold as hedges against further market turbulence. Among alternatives, macro hedge funds and farmland look attractively defensive now. We would start to look for opportunities in private debt (especially distressed debt) as the recession advances. Commodity futures are attractive as an inflation hedge. Overview Playing The Optionality From the start of the crisis, we argued that markets would bottom around the time when new cases of COVID-19 peaked. At the end of March, there were clear signs that this would happen in April, with Italy and Spain having probably already peaked and the US, if it follows the same trajectory, being only two or three weeks away (Chart 1). Chart 1Close To A Peak In New Cases? Quarterly Portfolio Outlook: Playing The Optionality Quarterly Portfolio Outlook: Playing The Optionality But what happens next? A relief rally is likely, as often happens in bear markets – and indeed one probably started with the three-day 18% rise in US equities in the last week of March. Note, for example, the strong rallies in spring 2008 and summer 2000 before the second leg down in those bear markets (Chart 2). Chart 2Mid Bear Market Rallies Are Common Mid Bear Market Rallies Are Common Mid Bear Market Rallies Are Common However, there is still a lot of potential bad news for markets to digest. Global growth has collapsed, as a result of people in many countries being forced to stay at home. US GDP growth in Q2 could fall by as much as 10% quarter-on-quarter (unannualized). Horrendously bad data will come as a shock to investors over the coming months. Despite the unprecedented stimulus measures from central banks and governments worldwide (Chart 3), nasty second-round effects are inevitable. Given the high level of corporate debt in the US, defaults will rise, to perhaps above the level of 2008-9 (Chart 4). EM borrowers have almost $4 trillion of foreign-currency debt outstanding, and will struggle to service this after the rise in the dollar and wider credit spreads. Euro area banks are poorly capitalized and have high non-performing debt levels left over from the last recession; they will be hit by a new wave of bankruptcies. Undoubtedly, there are some banks and hedge funds sitting on big trading losses after the drastic sell-off and stomach-churning volatility. Mid-East sovereign wealth funds will unload more assets to fill fiscal holes left by the collapsed oil price. Chart 3Massive Stimulus Everywhere Quarterly Portfolio Outlook: Playing The Optionality Quarterly Portfolio Outlook: Playing The Optionality Chart 4Possible Second-Round Effects Possible Second-Round Effects Possible Second-Round Effects     There is also the question of when the pandemic will end. We are not epidemiologists, so find this hard to judge (but please refer to the answers from an authority in our recent Special Report1). The coronavirus will disappear only when either enough people in a community have had the disease to produce “herd immunity,” or there is a vaccine – which is probably 18 months away.  Some epidemiologists argue that in the UK and Italy 40%-60% of the population may have already had COVID-19 and are therefore immune.2 But an influential paper from researchers at Imperial College suggested that repeated periods of lockdown will be necessary each time a new wave of cases emerges3 (Chart 5). Chart 5More Waves Of The Pandemic To Come? Quarterly Portfolio Outlook: Playing The Optionality Quarterly Portfolio Outlook: Playing The Optionality At the end of March, global equities were only 23% off their mid-February record high – and were down only 34% even at their low point. That doesn’t seem like enough to fully discount all the potential pitfalls over coming months. This sort of highly uncertain environment is where portfolio construction comes in. We recommend that clients position their portfolios with optionality to remain robust in any likely outcome. There are likely to be rallies in risk assets over coming months, particularly when the coronavirus shows signs of petering out. There is significant asymmetric career risk for portfolio managers here. No portfolio manager will be fired for missing the pandemic and underperforming year-to-date (though some may because their firms go out of business or retrench). But a PM who misses a V-shaped rebound in risk assets over the rest of the year could lose their job.  This will provide a strong incentive to try to pick the bottom. Chart 6Bond Yields Can't Go Much Lower Bond Yields Can't Go Much Lower Bond Yields Can't Go Much Lower Government bond yields are close to their theoretical lows. The 10-year US Treasury yield is 0.6% and it unlikely to fall below 0% even in a severe recession (since the Fed has stated that it will not cut short-term rates below 0%). In other countries, the low for yields has turned out to be around -0.3% to -0.9% (Chart 6). The total return from risk-free bonds, therefore, will be close to zero even in a dire economic environment (Table 1). This means that the call between bonds and equities comes down to whether equity prices will be higher or lower in 12-months. Quite likely, they will be higher. Given this, and the optionality of participating in rebounds, we maintain our overweight on equities versus bonds. We would, however, be inclined to lower our equity weighting in the event of a big rally in stocks over the next few months.   Table 1Not Much Room For Upside From Bonds Quarterly Portfolio Outlook: Playing The Optionality Quarterly Portfolio Outlook: Playing The Optionality Table 2Bear Markets Are Often Much Worse Quarterly Portfolio Outlook: Playing The Optionality Quarterly Portfolio Outlook: Playing The Optionality But there are also many downside risks. In the past two recessions, global equities fell by 50%-60% (Table 2). Despite the much worse economic environment this time, the peak-to-trough decline is so far much more limited. Moreover, valuations are not particularly compelling yet (Chart 7). To leaven our overall overweight on equities, we recommend a “minimum volatility” strategy, with tilts towards the low-beta US market, and some more defensive sectors such as Healthcare and Technology. China and China-related stocks also look somewhat attractive, since that country got over the coronavirus first, and is responding with a big increase in infrastructure spending (Chart 8). To hedge against downside risk, we also leave in place our overweights in cash and gold. Chart 7Equities Are Not Yet Super Cheap Equities Are Not Yet Super Cheap Equities Are Not Yet Super Cheap Chart 8China Infra Spending To Rise China Infra Spending To Rise China Infra Spending To Rise Garry Evans, Senior Vice President Chief Global Asset Allocation Strategist garry@bcaresearch.com What Our Clients Are Asking – About The Coronavirus Have We Seen The Bottom In Equity Markets?  Chart 9Watch Closely COVID-19 Quarterly Portfolio Outlook: Playing The Optionality Quarterly Portfolio Outlook: Playing The Optionality After hitting a low on March 23, global equities have recovered more than one-third of their loss during this particularly rapid bear market, in response to the massive monetary and fiscal stimulus around the globe. It’s very hard to pinpoint the exact bottom of any equity bear market.  The current one is particularly difficult in two ways: First, it was largely due to the exogenous shock from the COVID-19 pandemic. If history is any guide, we will first need to see a peak in infected cases globally before we can call a true bottom in equities (Chart 9). Second, the massive and coordinated response from central banks and governments around the world is unprecedented, as the global “lockdown” freezes the global economy. It’s encouraging to see the Chinese PMI bouncing back to 52 in March after a sharp drop to deep contraction level in February. However, the bounce back was mostly from production. Both export orders and imports remain weak. US initial jobless claims have skyrocketed to 3.3 million. If the peak of infection in the US follows similar patterns in China and Italy, then it would be another encouraging sign even if the US economic data continued to get worse. BCA Research’s base-case is for this recession to have a U-shaped recovery. This means that equity markets are likely to be range bound until we have a better handle on the future course of the pandemic. As such, we suggest investors actively manage risk by adding to positions when the S&P 500 gets close to 2250 and reducing risk when it gets close to 2750 during the bottoming process. What Will Be The Long-Term Consequences? Maybe it seems too early to think about this, but the coronavirus pandemic will change the world at least as profoundly as did the 1970s inflation, 9/11, and the Global Financial Crisis (GFC). Here are some things that might change: Chart 10Government Debt Will Rise Significantly Government Debt Will Rise Significantly Government Debt Will Rise Significantly Government debt levels will rise dramatically, as a result of the huge fiscal packages being (rightly) implemented by many countries. In the US, after the $2 trillion spending increase and a fall in tax revenues, the annual fiscal deficit will rise from 6% of GDP to 15%-20%. Government debt/GDP could exceed the 122% reached at the end of WW2 (Chart 10). Ultimately, central banks will have to monetize this debt, perhaps by capping long-term rates or by buying a substantial part of issuance. This could prove to be inflationary. Households and companies may want to build in greater cushions and no longer live “on the edge”. US households have repaired their balance-sheets since 2009, raising the savings rate to 8% (Chart 11). But surveys suggest that almost one-third of US households have less than $1,000 in savings. They may, therefore, now save more. This could depress consumption further in coming years. Companies have maximized profitability over the past decades, under pressure from shareholders, by keeping inventories, spare cash, and excess workers to a minimum. Given the sudden stop caused by the pandemic (and who is to say that there will not be more pandemics in future), companies may want to protect themselves from future shocks. The inventory/sales ratio, which had been falling for decades, has picked up a little since the GFC (Chart 12). Inventory levels are likely to be raised further. Companies may also run less leveraged balance-sheets, rather than hold the maximum amount of debt their targeted credit rating can bear. This is all likely to reduce long-term profit growth. Chart 11Households May Become Even More Cautious Households May Become Even More Cautious Households May Become Even More Cautious Chart 12Companies Will Run With Higher Inventories Companies Will Run With Higher Inventories Companies Will Run With Higher Inventories The pandemic has highlighted the vulnerability of healthcare systems. China still spends only 5% of GDP on health, compared to 9% in Brazil and 8% in South Africa (Chart 13). The lack of intensive care beds and woefully inadequate epidemic plans in the US and other developed countries will also need to be tackled. Healthcare stocks should benefit. Chart 13Healthcare Spending Will Need To Rise Healthcare Spending Will Need To Rise Healthcare Spending Will Need To Rise How Risky Are Euro Area Banks? Chart 14Euro Area Banks Are Quite Fragile Euro Area Banks Are Quite Fragile Euro Area Banks Are Quite Fragile Banks in the euro area have underperformed their developed market peers by over 65% since the Global Financial Crisis (GFC) (Chart 14, panel 1). Their structural issues – many of which we highlighted in a previous Special Report – remain unsolved.  Euro area banks remain highly leveraged compared to their US counterparts (panel 2). Their exposure to emerging economies is high (panel 3), and they continue to be a major provider of European corporate funding. US corporates, by contrast, are mainly funded through capital markets. The sector is also highly fragmented with both outward and inward M&A activity declining post the GFC. Profitability continues to be a key long-term concern, despite having recently stabilized (panel 4). The ECB’s ultra-dovish monetary stance and negative policy rates do not help banks’ performance either.  Banks’ relative return has been correlated to the ECB policy rate since the GFC (panel 5). Following the coronavirus outbreak, the ECB is likely to remain dovish for a prolonged period. The ECB’s recently announced measures should, however, provide banks with ample liquidity to hold and spur economic activity through increased lending to households and corporates. Absent consolidation in the European banking sector, competition is likely to dampen banks’ profits. Additionally, the severity of the economic downturn caused by the coronavirus outbreak will determine if their significant exposure to emerging economies, the energy sector, and domestic corporates will hurt them further. For now, we would recommend investors underweight euro area banks. Where Can I Get Income In This Low-Yield World? Chart 15The Bear Market Has Unveiled Attractive Income Opportunities The Bear Market Has Unveiled Attractive Income Opportunities The Bear Market Has Unveiled Attractive Income Opportunities For long-term investors who can tolerate price volatility, there is currently an opportunity to invest in high-income securities at relatively cheap prices. Below we list three of our favorite assets to obtain income returns: Dividend Aristocrats: The S&P 500 Dividend Aristocrats Index is composed of S&P 500 companies which have increased dividend payouts for 25 consecutive years or more. In order to provide such a steady stream of income through a such long timeframe, and even provide dividend increases in recessions, the companies in this index need to have a track record of running cashflow-rich businesses. Thus, the risk of dividend cuts is relatively low in these companies. Currently, the Dividend Aristocrat Index has a trailing dividend yield of 3.2% (Chart 15 – top panel). Fallen Angels: As we discussed in our November Special Report, fallen angels have attractive characteristics that separate them from the rest of the junk market. They tend to have longer maturities as well as a higher credit quality than the overall index. Crucially, fallen angels often enter the high-yield index at a discount, since certain institutional investors are forced to sell them when they are no longer IG-rated (middle panel). Thus, selected fallen angels which are not at a substantial risk of default could be a tremendous income opportunity. Currently fallen angels have a yield to worst of 10.65%. Sovereign US dollar EM debt: Our Emerging Markets Strategy service has argued that most EM sovereigns are unlikely to default on their debts, and instead will use their currencies as a release valve to ease financial conditions in their economies. Thus, hard-currency sovereign issues could prove to be attractive income investments if held to maturity. The bottom panel of Chart 15 (panel 3) shows the current yield-to-worst of the EM sovereign hard currency debt that has an overweight rating by our Emerging Markets service. Global Economy Chart 16The Collapse Begins The Collapse Begins The Collapse Begins Overview: The global economy in early January looked on the cusp of a strong manufacturing pickup, driven by the natural cycle and by moderate fiscal stimulus out of China. The coronavirus changed all that. We now face a recession of a severity unseen since the 1930s. The fiscal and monetary response has been similarly rapid and radical. This will tackle immediate liquidity and even solvency risks. But, with consumers in many countries confined to their homes, a recovery is entirely dependent on when the number of new cases of COVID-19 peaks. In an optimistic scenario, this might be in late April or May. On a pessimistic one, the pandemic will continue in waves for several quarters.  US: It is highly likely that the NBER will eventually declare that the US entered recession in March 2020. With many states in lockdown, consumption (which comprises 70% of GDP) will slump: only half of consumption is non-discretionary (rent, food, utility bills etc.); the other half is likely to shrink significantly while lockdowns continue. Judged by the 3.3 million initial claims in the week of March 16-21, unemployment will jump from its February level of 3.5% very rapidly towards 10%. Fiscal and monetary stimulus measures will cushion the downside (enabling households to pay rent and companies to service debt). But whether the recession is V-shaped or prolonged will be dependent on the length of the pandemic. Euro Area: European manufacturing growth was showing clear signs of picking up before the coronavirus pandemic hit (Chart 16 panel 1). But lockdowns in Italy, Spain and other countries will clearly push growth way into negative territory. The severity is clear from the first datapoints to reflect March activity, such as the ZEW survey. The ECB, after an initially disappointing response, has promised EUR750 billion (and more if needed) in bond purchases. The fiscal response so far has been more lukewarm, although Germany has now scrapped its requirement to run a budget surplus. One key question: will the stronger nothern European economies agree to “euro bonds”, joint and severally guaranteed, to finance fiscal spending in the weaker periphery?   Chart 17...With Chinese Data Leading The Way ...With Chinese Data Leading The Way ...With Chinese Data Leading The Way Japan: Japan’s economy was performing poorly even before the coronavirus pandemic, mainly because of the side-effects of last October’s consumption tax hike, and the slowdown in China (Chart 17, panel 2). So far, Japan has seen fewer cases of COIVD-19 than other large countries, but this may just reflect a lack of testing. Japan also has less room for policy response. Government debt is already 250% of GDP. The Bank of Japan has moderately increased purchases of equity ETFs and remains committed to maintaining government bonds yields around 0%. But Japan seems culturally and institutionally unable to roll out the sort of ultra-radical measures taken in other developed economies. Emerging Markets: China’s economy was severely disrupted in January and February, as reflected in an unprecedented collapse of the Caixin Services PMI to 26.5 (Chart 17, panel 3). However, big data (such as traffic congestion) suggest that in March people were gradually returning to work and companies restarting manufacturing operations. Q1 GDP growth will clearly be negative, and growth for the year may be barely above 0%. The authorities are ramping up infrastructure spending, which BCA expects to grow by 6-8% this year.4 Interest rates have also fallen below their 2015 levels, but not yet to their 2009 lows. Both fiscal and monetary policy are likely to be eased further. Elsewhere in Emerging Markets, the key question is whether central banks will cut rates to support rapidly weakening economies, or keep rates steady to prop up collapsing currencies. This is not an easy choice. Interest Rates: Central banks in developed markets have cut rates to their lowest possible levels with the Fed, for example, slashing from 1.25%-1.5% to 0%-0.25% within just 10 days in March. The Fed has signalled that it will not go below zero. Short-term policy rates globally, therefore, have essentially hit their lower bounds. Long-term rates have been volatile, with the 10-year US Treasury yield swinging down to 0.6% before jumping to 1.2%. While uncertainty continues, long-term risk-free rates are unlikely to rise substantially and, in the event of a prolonged severe recession, we would see the US 10-year yield falling to zero – but no lower. Global Equities Chart 18Is The V-Shaped Recovery Sustainable? Quarterly Portfolio Outlook: Playing The Optionality Quarterly Portfolio Outlook: Playing The Optionality What’s Next?  Global equities lost 32.8% year-to-date as of March 23, 2020. All countries and sectors in our coverage were in the red. Even the best performing country (Japan) and the best performing global sector (Consumer Staples) lost 26.7% and 23.2% respectively.  From March 24 to March 26, however, equities made the best three-day gains since the Great Depression, recouping about one-third of the loss,  even though US initial jobless claims came in at 3.3 million and also the US reported a higher number of cumulative infected people than China, with a much higher number of deaths per million people (Chart 18). So have we reached the bottom of the bear market? Is this “V-shaped” recovery sustainable? How should an investor construct a multi-asset global portfolio that’s sound for the next 9-12 months given the uncertainty associated with COVID-19 and the massive monetary and fiscal stimulus around the world? Based on our long-held philosophy of taking risks where risks will most likely be rewarded, we are most comfortable taking risk at the asset class level, by overweighting equities versus bonds, together with overweights in cash and gold as hedges. Within the equity portfolio, we are reducing risk by making the following adjustments: Upgrade US to overweight from underweight financed by downgrading the euro zone to underweight from overweight. Upgrade Tech to overweight, while closing two overweight bets on Financials and Energy and one underweight on consumer staples to benchmark weighting.   Country Allocation: Becoming More Defensive Chart 19US And Euro Area: Trading Places US And Euro Area: Trading Places US And Euro Area: Trading Places In December 2019 we added risk by upgrading the euro area to overweight and Emerging Markets to neutral based on our macro view that the global economy was on its way to recovery.  Data releases in January did show signs of recovery in the global economy. However, the COVID-19 outbreak has changed the global landscape, and we are clearly in a recession now.  When conditions change, we change our recommendations. We must make a judgment call because the economic data will not give us any timely, useful readings for some time to come. Back in December, the key reason to upgrade the euro area was the recovery of China which flows into the exports of the euro area. We think China will continue to stimulate its economy. However, given the global growth collapse, the “flow through” effect to the euro area will be delayed for some time. We prefer to play the China effect directly rather than indirectly. That’s why we maintain the neutral weighting of EM versus DM, but downgrade the euro area to underweight, and upgrade US to overweight. We also note the two following factors: First, as shown in Chart 19, panel 1, the relative performance between the euro area and the US is highly correlated with the relative performance between global Financials and Technology. This is not surprising given the sector composition of the two region’s equity indices. As such, this country adjustment is in line with our sector adjustment of upgrading Technology and downgrading Financials. Second, with a lower beta, US equities provide a better defense when economic uncertainty and financial market volatility are high. The risk to this adjustment, however, is valuation. As shown in panel 4, euro area valuation is extremely cheap compared to the US. However, PMI releases as well as forward earnings estimates are likely to get worse again before they get better, given the region’s reliance on exports to China and the structural issues in its banking system. Global Sector Allocation: Getting Closer To Benchmark Chart 20Reducing Sector Bets Reducing Sector Bets Reducing Sector Bets We make four changes in the global sector portfolio to reduce sector bets, since we do not have a high conviction given market volatility and our house view that recovery out of this recession will be U-shaped. These are downgrading Financials to neutral, while upgrading Technology to overweight. We also close the overweight in Energy and underweight in Consumer Staples, leaving them both at benchmark weighting. Financials: We upgraded Financials in October last year as an upside hedge. This move did not pan out as bond yields plummeted. BCA Research’s US Bond Strategy service upgraded duration to neutral from underweight on March 10 as they do not see a high likelihood for yields to move significantly higher over the next 9-12 months. This does not bode well for Financials’ performance (Chart 20, panel 1). Even though the Fed and other central banks have come in as the lenders of last resort, loan growth could be weak going forward and non-performing loans could increase, especially in the euro area. Valuation, however, is very attractive. Technology: DRAM prices started to improve even before the COVID-19 outbreak. The global lockdown to fight against the pandemic is further spurring demand for both software and hardware, which should support better earnings growth (panel 2). The risk is that relative valuation is still not cheap, even though absolute valuation has come down after the recent selloff. Energy:  The outlook for oil prices is too uncertain. The fight between Saudi Arabia and Russia is weighing on the supply side, while the global lockdown is denting demand prospect. The earnings outlook for energy companies is dire, while valuations are very attractive (panel 3). Consumer Staples: This is a classic defensive sector that does well in recessions. In addition, its relative valuation has improved to neutral from very expensive (panel 4).   Government Bonds Chart 21Stay Aside On Duration Stay Aside On Duration Stay Aside On Duration Upgrade Duration To Neutral. Global bond yields had a wild ride in Q1 as equities plummeted into bear market territory. The 10-year US Treasury yield made an historical low of 0.32% overnight on March 9, then quickly reversed back up to 1.27% on March 18, closing the quarter at 0.67%, compared to 1.88% at the beginning of the quarter (Chart 21). We are already in a recession and BCA’s house view is for a U-shaped recovery. This implies that global bond yields will likely follow a bottoming process similar to global equities, as new infections peak and high-frequency economic data start to recover. As such, we upgrade our duration call to neutral, to be in line with the position of BCA Research’s US Bond Strategy (USBS) service. Favor Linkers Vs. Nominal Bonds.  The combined effect of the plummet in oil prices and the coronavirus outbreak has crushed inflation expectation to an extremely low level. As shown in Chart 22, the 10-year breakeven inflation rate is currently at 0.95%, 88 bps lower than its fair value. The fair value is estimated based on USBS’s Adaptive Expectations Model.  Investors with a 12-month investment horizon should continue to favor TIPS over nominal Treasuries, but those with shorter horizons may be advised to stand aside and wait for the daily number of new COVID-19 cases to reach zero before re-initiating the position. Chart 22TIPS Offer A Ton Of Long-Run Value Extremely Cheap Inflation Protection TIPS Offer A Ton Of Long-Run Value Extremely Cheap Inflation Protection TIPS Offer A Ton Of Long-Run Value Extremely Cheap Inflation Protection   Corporate Bonds Chart 23High Quality Junk High Quality Junk High Quality Junk It is undeniable that the dearth of cashflow caused by the lockdowns will spur a ferocious wave of defaults, particularly in the high-yield sector. It also is not clear that this risk is adequately compensated for. Currently, our US bond strategist believes that spreads are pricing an 11% default rate – in line with the default rate of the 2000/2001 recession. While it is not our base case, a default cycle like 2008, where 14% of companies in the index defaulted is a very clear possibility, as revenues have ground to a halt. However, several positive factors in the junk space must also be considered. Roughly 1% of the high-yield index matures in less than one year, which means that refinancing risk for junk credits should remain relatively subdued (Chart 23, top panel). Moreover, the quality of junk bonds is relatively high compared to previous periods of stress: when the market peaked in 2000 and 2007, Ba-rated credit (the highest quality of high yield) stood at 30% and 37% of the overall index respectively (middle panel). Today this credit quality stands at 49% of the high yield market, indicating a relatively healthier credit profile for junk. Additionally, the high-risk energy sector, which is likely to experience a substantial amount of defaults given the collapse in oil prices, now represents less than 8% of the market capitalization of the whole index (bottom panel). Taking these positive factors into consideration, we believe that a downgrade to underweight is not warranted, and instead we are downgrading high-yield credit from overweight to neutral. What about the investment-grade space? the massive stimulus package announced by the Fed, which effectively allows IG issuers to roll over their entire stock of debt, should provide a backstop to this market. One valid concern is that credit agencies can still downgrade a large number of issuers, making them ineligible to receive support. However, it seems that the credit agencies are aware of how much hinges on their ratings, and are communicating that they will factor the measures taken by various government programs into their credit analysis.5 Thus, considering that spreads are already extended, the Fed is providing unprecedent support and credit agencies are unlikely to knock out many companies out of investment-grade ratings, we are upgrading investment-grade credit from neutral to overweight.   Commodities Chart 24Oil Prices & Politics Do Not Mix Oil Prices & Politics Do Not Mix Oil Prices & Politics Do Not Mix Energy (Overweight): Oil markets were driven by supply/demand dynamics until a third factor, politics, shifted the market equilibrium. The recent clash between Saudi Arabia and Russia led to the breakdown of the OPEC 2.0 coalition and to Brent prices tanking by over 60% to $26 in March. The length of this breakdown is unknown. However, we believe the parties are likely to return to the negotiation table within the next months as the damage to countries which are dependent on oil begins to appear. The fiscal budget breakeven point remains much higher than the current oil price – it is around $83 for Saudi Arabia and $47 for Russia. Weakness in global crude demand will continue to put further downward pressure on prices, until economic activity recovers from the COVID-19 slowdown. Our Commodity & Energy Strategists expect the Brent crude oil price to average $36/bbl, with WTI trading some $3-$4 below that, in 2020 (Chart 24, panels 1 & 2). Industrial Metals (Neutral): Industrial metals prices were on track to pick up until the coronavirus hit global activity at the beginning of the year. Prices face further short-term headwinds as global manufacturing remains suppressed. Once the global social distancing ends and activity resumes, industrial metal prices should pick up as fiscal stimulus and infrastructure spending, especially in China, is implemented (panel 3). Precious Metals (Neutral):  As the coronavirus spread, global risk assets have tumbled. Over the past 12 months, we have recommended investors increase their allocation to gold as both an inflation hedge and a beneficiary of accommodative monetary policy globally. However, we also recently highlighted that gold was reaching overbought territory and that a pullback was possible in the short-term. Nevertheless, investors should continue to maintain gold exposure to hedge against the eventuality that the pandemic is not contained within the coming weeks (panels 4 & 5).   Currencies Chart 25Competing Forces Pushing The US Dollar In Different Directions Competing Forces Pushing The US Dollar In Different Directions Competing Forces Pushing The US Dollar In Different Directions The USD has gone through a rollercoaster during the coronavirus crisis. Initially, the DXY fell by 4.8%, as rate differentials moved violently against the dollar when the Fed cut rates to zero. But this fall didn’t last long: as liquidity dried up, the cost for dollar funding surged, causing the dollar to skyrocket by almost 8.3%. Since then, the liquidity measures taken by monetary authorities have made the dollar reverse course once more. At this point there are multiple forces pulling the greenback in opposing directions. On the one hand, the collapse in global growth caused by the shutdowns should push the dollar higher. Moreover, momentum – one of the most reliable directional indicators for the dollar – continues to point to further upside (Chart 25, panels 1 and 2). However, the Fed’s generous USD swap lines with other major central banks as well as the massive pool of liquidity deployed have already stabilized funding costs in European and British currency markets, and look poised to do the same in others (Chart 25, panel 3). Thus, since there is no clarity on which force will prevail in this tug of war, we are remaining neutral on the US dollar. That being said, long-term investors can begin to buy some of the most depressed currencies, such as AUD/USD. This cross is currently trading at a 12% discount to PPP according to the OECD – the steepest discount that this currency has had in 17 years. Additionally, our China Investment Strategy projects that China will accelerate infrastructure investment this year to counteract the negative economic effects of the lockdown. This pick up in investment should increase base-metal demand, proving a boost to the Australian dollar in the process.   Alternatives Chart 26Favor Macro Hedge Funds Over Private Equity During Recessions Favor Macro Hedge Funds Over Private Equity During Recessions Favor Macro Hedge Funds Over Private Equity During Recessions Intro: The coronavirus outbreak caused tremendous market volatility and huge declines in liquid assets. Many clients have asked over the past few weeks which illiquid assets make sense in the current environment. To answer that, we stick to our usual recommendation framework, dividing illiquid assets into three buckets: Return Enhancers: Over the past year, we have been recommending clients to pare back private-equity exposure and increase allocation to hedge funds – particularly macro hedge funds, which often outperform other risky alternative assets during economic slowdowns and recessions (Chart 26, panel 1). Private debt – particularly distressed debt – could become a beneficiary of the current environment. The market turmoil will leave some assets heavily discounted, which can provide an opportunity for nimble funds to make investments at attractive valuations. In a previous Special Report, we highlighted Business Development Companies (BDCs) as a liquid alternative to direct private lending.6 They have taken a hit over the past month, even compared to equities and junk bonds. However, their recovery as markets bottom is usually significant (panels 2 & 3). Inflation Hedges: The coordinated “whatever-it-takes” stance implemented by global governments and central banks to mitigate the coronavirus crisis is likely to have inflationary consequences in the long-term. In that environment, investors should favor commodity futures over real estate (panel 4). As global growth reaccelerates in response to stimulus and resumed manufacturing activity over the next 12 months, the USD should weaken, and commodity prices should rise. Volatility Dampeners: Timberland and farmland remain our long-time favorite assets within this bucket. We have previously shown that both assets outperform other traditional and alternative assets during recessions and equity bear markets (panel 5). Farmland particularly should fare well in this environment, being more insulated from the economy, given food’s inelastic demand Risks To Our View Chart 27Dollar Would Fall In A Strong Recovery Dollar Would Fall In A Strong Recovery Dollar Would Fall In A Strong Recovery Since our recommendations are based on a middle course, hedging both upside and downside risks, we need to consider how extreme these two eventualities could be. On the upside, the most optimistic scenario would be one in which the coronavirus largely disappears after April or May. The massive amount of fiscal and monetary stimulus would produce a jet-fuelled rally in risk assets. The dollar has soared over the past few weeks, as a risk-off currency (Chart 27), and would likely fall sharply. This would be very positive for commodities and Emerging Markets assets. The strong cyclical recovery would also help euro zone and Japanese equities relative to the more defensive US. Value stocks and small caps would outperform. Chart 28Could It Get Worse Than 2008 - Or Even 1932? Could It Get Worse Than 2008 - Or Even 1932? Could It Get Worse Than 2008 - Or Even 1932? Downside risks are less easy to forecast. As Warren Buffet wrote in 2002: “you only find out who is swimming naked when the tide goes out.” The shock to the system caused by the coronavirus is certainly larger than the Global Financial Crisis of 2007-9 and could approach that caused by the Great Depression (Chart 28), though hopefully without the egregious policy errors of the latter. It is hard, therefore, to know where problems will emerge: US corporate debt, EM borrowers, and euro zone banks would be our most likely candidates. But there could be others. The oil price is another key uncertainty. Demand could collapse by at least 10% as a result of the severe recession. The breakdown of the production agreement between Saudi Arabia and Russia could produce a supply increase of 4-5%.  Given this, Brent crude would fall to $20 a barrel. That would represent a strong tailwind to global recovery (Chart 29). On the other hand, a rapprochement between Saudi and Russia (and even with regulators in Texas) could push oil prices back up again – a positive for markets such as Canada and Mexico. Chart 29Cheap Oil Boosts Growth Cheap Oil Boosts Growth Cheap Oil Boosts Growth   Footnotes 1   Please see BCA Special Report, "Questions On The Coronavirus: An Expert Answers," dated 31 March 2020, available at bcaresearch.com 2   https://www.medrxiv.org/content/10.1101/2020.03.24.20042291v1 3    https://www.imperial.ac.uk/media/imperial-college/medicine/sph/ide/gida-fellowships/Imperial-College-COVID19-NPI-modelling-16-03-2020.pdf 4    Please see China Investment Strategy Weekly Report, “Chinese Economic Stimulus: How Much For Infrastructure And The Property Market,” dated 25th March 2020, available at cis.bcaresarch.com 5    A release by Moody’s on March 25 stated that their actions “will be more tempered for higher-rated companies that are likely to benefit from policy intervention or extraordinary government support.” 6    Please see Global Asset Allocation Special Report, “Private Debt: An Investment Primer,” dated June 6, 2018, available at gaa.bcaresearch.com GAA Asset Allocation  

Highlights Chinese stocks have outperformed global benchmarks by a wide margin. We are taking profits on our overweight position, and downgrading our tactical call on Chinese stocks to neutral. In absolute terms, Chinese stocks have failed to buck the trend in a global selloff of risk assets. This suggests Chinese stocks are not immune to worldwide panics. Investors should wait for a peak in the global pandemic before going long on Chinese equities. Chinese stocks have become less cheap relative to global benchmarks. The size of Chinese stimulus is also less impressive compared with other major economies such as the US. Therefore, in order to maintain an overweight stance on Chinese risk assets in a global portfolio, Chinese stocks need to either offer a better price entry point, or a more upside potential in earnings outlook relative to their global peers. Feature Chart I-1Chinese Stocks Have Significantly Outperformed Global Benchmarks... Chinese Stocks Have Significantly Outperformed Global Benchmarks... Chinese Stocks Have Significantly Outperformed Global Benchmarks... In the current pandemic environment, economic fundamentals mean little to panicked investors who have mostly ignored the unprecedented degree of monetary and fiscal stimulus pouring into the global economy. Investors are looking for clear signs that the COVID-19 crisis can be brought under control, but medical experts have been unable to predict the timing of a peak in the pandemic. Policymakers around the world are beginning to address investors’ concerns that substantial and timely fiscal policy supports are needed to offset the knock-on effects on businesses and individuals.1 However, until the number of new infections in major economies peaks, the erratic trading behavior among global investors will persist. Given the lack of near-term certainty, we are downgrading our tactical stance on Chinese stocks from overweight to neutral. Chart 1 highlights since we upgraded our tactical call to overweight in end-2019, Chinese stocks have significantly outperformed global stocks. This outperformance has been passive in nature; Chinese stocks are down about 10% year-to-date in US$ terms, versus a 23% decline in global stocks. We are also closing 7 of our 10 high-conviction investment calls from our trade book, for reasons cited here and then detailed in the next sections. Of the 10 active trades in our book, 7 have generated a positive return since their inceptions, including 3 that have recorded double-digit gains.2 Investors should wait for clarity on the peak of the global pandemic before going long on risk assets. Investors should wait for more signs of an upside potential in earnings and/or a better price entry point to go long on Chinese stocks. China Is Not Immune To A Global Pandemic Chart I-2...But Their Prices Have Also Plunged In Absolute Terms ...But Their Prices Have Also Plunged In Absolute Terms ...But Their Prices Have Also Plunged In Absolute Terms Chinese equities have not been immune from the gyrations in the global financial markets, which have not responded to monetary and fiscal stimulus measures in either a customary or predictive manner. Unlike the 2008 global recession triggered by a financial crisis, public health crises damage the economy by reducing human activity and, therefore, erode both supply and demand. A return to normalcy depends almost entirely on whether the pandemic can be contained. Even though Chinese business activities are gradually resuming, Chinese stocks failed to buck the worldwide trend of a liquidation in risk assets. While Chinese stocks have outperformed global benchmarks by a wide margin, the relative gains have mostly been passive since early March. In absolute terms, Chinese domestic stocks have lost all their gains from February and investable stock prices have fallen back to their November 2018 level (Chart 2). Chart I-3Number Of Imported Cases Now On The Rise Investing During A Global Pandemic Investing During A Global Pandemic China is not immune to a second COVID-19 wave. China has been reporting zero-to-low single-digit numbers of locally transmitted cases since mid-March, but it is now experiencing an increase in imported cases from overseas travelers (Chart 3). The mounting numbers have led the Chinese government to shut its borders to non-Chinese citizens.3 This indicates that it is still too early to claim a victory in China’s virus containment efforts.  Given that China’s domestic businesses are open, the trajectory of new cases also remains unknown. These lingering doubts will slow the pace in the resumption of Chinese production (Chart 4).   Chart I-4Chinese Companies Operating At 80% Capacity Investing During A Global Pandemic Investing During A Global Pandemic Moreover, China is not immune to qualms about the depth and duration of a global recession. China has the political will and policy room to stimulate its economy, and the country’s dominant domestic demand makes the economy relatively insulated from a global recession. However, when more than 40% of China’s trading partners (including Europe and the US) remain under lockdown, a collapse of external demand will weigh on China’s economic and corporate profit recovery in the next quarter or two. Therefore, short-term risks on Chinese stocks are tilted to the downside. Bottom Line: Chinese stocks have failed to buck the trend in the global pandemic and the tsunami selloff in risk assets. Investors should wait for a peak in the outbreak before going long on Chinese equities. Chinese Stocks Have Become Less Cheap Relative To Global Benchmarks Chart I-5Outperformance In Chinese Stocks Seems Quite Extended Outperformance In Chinese Stocks Seems Quite Extended Outperformance In Chinese Stocks Seems Quite Extended Chinese stocks, particularly in the domestic market, are no longer priced at deep discounts compared with global equities (Chart 5). The recent outperformance of Chinese stocks has brought the relative performance trend in both investable and domestic stocks back close to late-2017/early-2018 levels. That was before the US-China trade war began, and at a point where China’s economy was close to peak strength for the cycle. Although a passive outperformance does not automatically warrant an underweight stance on Chinese stocks, investors will demand a higher upside potential in Chinese corporate earnings to justify an overweight position in Chinese equities. Therefore, we will watch for the following signs before buying Chinese stocks: a strengthening in China’s economy and corporate profits outpacing recoveries in other major economies, and/or a near-term drop in Chinese stock prices outsizing the decline in global stock prices. Given the exceedingly strong policy responses from G20 economies (particularly the US), China’s stimulus will need to be amplified so that investors are confident that the rate of Chinese corporate profit recovery will surpass their global counterparts.4 In a recent Politburo meeting, Chinese policymakers signaled their willingness to expand stimulus, including much larger fiscal deficits and local-government special bond issuance quotas in 2020, along with further interest rate cuts.5 An escalation in policy support will probably bring China’s stimulus in line with that extended in the 2008-2009 global financial crisis. However, the size of the stimulus package will be determined at the National People’s Congress (NPC) meeting, which is delayed to end-April or early May. In the near term, the selloff in Chinese stocks will likely persist as financial markets continue to price in bad news in the global economy. Chinese investable stock prices continue to be priced at a discount relative to global benchmarks, although the discount is much smaller than it was three months ago. In absolute terms, Chinese investable stock prices have not reached their technical support levels.  The offshore market historically rebounds when prices approach a major defense line, measured by a 12-year moving average. This technical support for the MSCI China Index is currently 65, still about 13% below the March 30 close (Chart 6). Chart I-6Investable Stock Prices Not Yet At Their Long-Term Support Investable Stock Prices Not Yet At Their Long-Term Support Investable Stock Prices Not Yet At Their Long-Term Support The prices in Chinese domestic stocks have reached their 12-year moving average, although A-share prices are not decisively in a structural “cheap” territory yet (Chart 7).  Investors should wait on the sidelines for now, since the full effects of any enhanced stimulus in China will be felt in the real economy with a time lag. China’s production supply side is only operating at about 80% of normal capacity, and demand has yet to catch up (Chart 4 and Chart 8).  This suggests the rebound in economic activities in Q2 will likely be gradual, and corporate profits are likely to remain depressed. Chart I-7Domestic Stock Prices Approaching A Structural "Cheap" Territory Domestic Stock Prices Approaching A Structural "Cheap" Territory Domestic Stock Prices Approaching A Structural "Cheap" Territory Chart I-8Demand In Manufacturing Remains Sluggish Demand In Manufacturing Remains Sluggish Demand In Manufacturing Remains Sluggish Bottom Line: Chinese stocks have become less cheap against the backdrop of a massive liquidation of global equities. Chinese existing stimulus also appears moderate compared with other major economies. Therefore, in order for investors to overweight Chinese risk assets in a global portfolio, Chinese stocks either will have to offer a better entry price point or more upside corporate earnings potential. Both are currently missing. Investment Conclusions Investors should stay neutral on Chinese stocks in the next 3 months, and we are closing 7 out of the 10 active positions in our trade book. These trades are especially vulnerable to a protracted global recession and more selloffs in the domestic stock market. We will look for opportunities to incrementally add new trades to our book in the coming months. Here are our reasons for retaining or closing some of our positions: Long China Onshore Corporate Bonds (Maintain): The trade has yielded a handsome return of 16% since its inception in June 2017, (Chart 9). Although the spread in Chinese onshore corporate bond yields has widened sharply in the past few weeks, it has been the result of an indiscriminate global selloff of financial assets rather than the market pricing in any China-centric credit risks (Chart 10). In the next 6 to 12 months, corporate credit spreads should normalize as we expect monetary policies in major economies to remain ultra-loose, the global economy to recover and investors’ risk sentiment to improve. Chinese onshore corporate bonds will likely continue to offer a better risk-reward profile relative to other economies, with a higher risk premium and relatively stable default rate. Chart I-9Chinese Onshore Corporate Bonds Remain Attractive Chinese Onshore Corporate Bonds Remain Attractive Chinese Onshore Corporate Bonds Remain Attractive Chart I-10Corporate Credit Spreads Should Narrow Over A 12-Month Horizon Corporate Credit Spreads Should Narrow Over A 12-Month Horizon Corporate Credit Spreads Should Narrow Over A 12-Month Horizon     Long MSCI China Energy Stocks (Close): This trade has had the worst performance among our positions due to consistently falling oil prices since October 2018 (Chart 11). Although BCA’s commodity strategists expect Brent prices to average $36/barrel in 2020, $3 higher than the average oil prices in March, it is still at a 50% discount from the $70 price tag just 3 months ago. Such a minor improvement in the price outlook does not offer enough upside potentials to offset downside risks in earnings in the next 9 months. Therefore, we would rather cut the losses. Long China Domestic Consumer Discretionary Equities Versus Benchmark and Long China Domestic Consumer Discretionary Equities/Short China Domestic Consumer Staples Equities (Close): As explained in the previous sections, we think there will be better entry price points for Chinese stocks as well as cyclical stocks. Besides, discretionary consumption in China has yet to show signs of a meaningful rebound. In the near term, we will also look for opportunities to go long position in domestic consumer staple stocks because we think that food and beverage price inflation will persist well into the second half of this year (Chart 12).  Chart I-11Depressed Oil Prices Lead To Significant Underperformance In Energy Stocks Depressed Oil Prices Lead To Significant Underperformance In Energy Stocks Depressed Oil Prices Lead To Significant Underperformance In Energy Stocks Chart I-12Consumer Staple Stocks Should Benefit From Stubbornly High Food Prices Consumer Staple Stocks Should Benefit From Stubbornly High Food Prices Consumer Staple Stocks Should Benefit From Stubbornly High Food Prices   Long MSCI China Index, Long MSCI China Onshore Index, Long MSCI China Growth Index/ Short MSCI All Country World (Close): We will need to see more stable sentiment in the global financial markets, a better entry price point for Chinese stocks and a sure sign of outsized Chinese stimulus before reinitiating a long position on Chinese stocks. Jing Sima China Strategist jings@bcaresearch.com   Appendix Table 1Massive Stimulus In Response To Pandemic Investing During A Global Pandemic Investing During A Global Pandemic Footnotes 1  Please see Table 1 in the Appendix. 2  Please see the trade table at the end of the report. 3  https://www.bloomberg.com/news/articles/2020-03-26/china-to-suspend-foreigners-entry-starting-saturday?mc_cid=1bdcd29ddd&mc_eid=9da16a4859 4  The stimulus package announced in the US amounts to 9% of the country’s 2019 GDP, whereas China’s stimulus would be about 3% of its 2019 GDP. 5  http://www.xinhuanet.com/politics/leaders/2020-03/27/c_1125778940.htm Cyclical Investment Stance Equity Sector Recommendations

Highlights Investment Grade: Investors should overweight investment grade corporate bonds relative to a duration-matched position in Treasury securities, with a particular focus on bonds that are eligible for the Fed’s purchase programs. High-Yield: Caution is still warranted in the high-yield market. At current levels, spreads do not adequately compensate investors for the coming default cycle. We would recommend buying high-yield if the average index spread rises to a range of 1075 bps – 1290 bps. Fed Purchases: Fed corporate bond purchases will cause investment grade spreads to tighten, particularly out to the 5-year maturity point. However, the program won’t stop the coming onslaught of ratings downgrades. High-Yield Sectors: The Energy, Transportation, Capital Goods, Consumer Cyclical and Consumer Noncyclical sectors are all highly exposed to the looming default cycle. Financials and Utilities look like the best places to hide out. Feature Chart 1Will The Fed's Corporate QE Mark The Top In Spreads? Will The Fed's Corporate QE Mark The Top In Spreads? Will The Fed's Corporate QE Mark The Top In Spreads? The COVID pandemic and associated recession have already caused turmoil in financial markets and prompted a policy response from the Federal Reserve that is unprecedented in its aggressiveness. US investment grade and high-yield corporate spreads widened 280 bps and 764 bps, respectively, to start the year. Then, they tightened by 78 bps and 179 bps, respectively, after the Fed announced it is stepping into the corporate bond market for the first time (Chart 1). Clearly, this is a challenging time for corporate bond investors. But sifting through all the noise, we think there are three key questions to stay focused on: How will the Federal Reserve’s support for the corporate bond market impact spreads? At what level do spreads fully discount the looming default cycle? What sectors within the corporate bond market are most/least at risk of experiencing large-scale defaults? What Can The Fed Hope To Accomplish By Buying Corporate Debt? As part of its package of monetary policy stimulus measures to combat the US COVID-19 recession, the Fed has undertaken a dramatic new step to try and lower borrowing costs for US businesses – the outright buying of US investment grade corporate bonds. The main details of these new programs are as follows: The Fed will purchase investment grade corporate bonds, loans and related exchange-traded funds (ETFs) as part of these programs. Bonds can be purchased in the primary (newly-issued) and secondary markets. The purchases will not be held on the Fed’s balance sheet. Instead, two off-balance sheet Special Purpose Vehicles (SPVs), one for primary market purchases and one for secondary market purchases, will buy the bonds. Both SPVs are initially funded by the US Treasury and will be levered up via loans from the Fed. The primary market SPV will buy newly-issued bonds with credit ratings as low as BBB- and maturities of four years or less.  Eligible issuers are US businesses with material operations in the United States; that list of companies may be expanded in the future. Eligible issuers do not include companies that are expected to receive direct financial assistance from the US government (i.e. no buying of bonds from companies getting bailout funds). The secondary market SPV will buy bonds with maturities of up to five years and credit ratings as low as BBB-, with a buying limit of 10% of the entire stock of eligible debt of any single company. This secondary market SPV will also buy investment grade bond ETFs, up to 20% of the outstanding shares of any single ETF. Through the primary market facility, any eligible company can “borrow” from the Fed, through bond purchases or direct loans, an amount greater than its maximum outstanding debt (bonds plus loans) on any day over the past twelve months. Specifically: 140% of all debt for AAA-rated issuers, 130% for AA-rated issuers, 120% for A-rated issuers and 110% for BBB-rated issuers. Since those percentages are all greater than 100, this effectively means that the Fed will allow eligible companies to potentially roll over their entire stocks of debt through this program, plus some net new borrowing. With the primary market facility, issuers can even defer interest payments on the funds borrowed from the Fed for up to six months, with the interest payments added to the final repayment amount (any company choosing this option cannot do share buybacks or make dividend payments). These programs are set to run until September 30 of this year, with an option to extend as needed. The Fed’s new initiatives represent a new step for the central bank, providing direct lending to any company that needs it. The Fed had to do this through off-balance-sheet SPVs, since direct buying of corporates is not permitted under the Federal Reserve Act. With this structure, it is technically the US Treasury department that bears the initial credit risk through its seed funding of each SPV. The BoJ was the first of the major central banks to start buying corporate bonds. This structure is different than the recent corporate bond QE programs of the European Central Bank (ECB), Bank of England (BoE) and Bank of Japan (BoJ), where the credit risk was directly taken onto the central bank balance sheets. But from an investment perspective, the difference in structure between the Fed’s corporate bond buying program and that of other central banks is nothing more than a technicality. It is still worthwhile to see if any lessons can be learned from these other countries.     The Corporate Bond Buying Experience Of Other Central Banks The BoJ was the first of the major central banks to start buying corporate bonds, in a program that began in February 2009 and continued until October 2012. The program initially involved only the purchase of very high-quality corporate debt (rated A or higher) and only for maturities up to one year. The pool of eligible bonds was later increased to allow for lower credit quality (rated BBB or higher) and longer maturities (up to three years). The BoJ ended up buying a total of 3.2 trillion yen (US$30 billion) of bonds during that program, representing nearly 50% of total Japanese investment grade nonfinancial debt (Chart 2). Credit spreads tightened modestly over the life of the program, particularly for the shorter maturity debt that the BoJ was directly buying.1 Research from the BoJ concluded that the corporate bond buying did improve liquidity for the bonds that were eligible for the program, although there was no discernable pickup in overall Japanese corporate bond issuance.2 The BoE started its Corporate Bond Purchase Scheme (CBPS) in August 2016, as part of a package of stimulus measures to cushion the economic blow from the UK’s stunning vote to leave the European Union. The CBPS bought £10bn of UK nonfinancial investment grade corporate bonds over a period of 18 months, with ratings as low as BBB-. This was a relatively modest share of all eligible nonfinancial bonds (4.7%), but UK credit spreads did tighten over the life of the program (Chart 3). The BoE’s own research has determined that the spread tightening was due to lower downgrade/default risk premiums, and that the program triggered a surge in investment grade issuance in the weeks and months following its launch.3 Chart 2The BoJ's Corporate Bond Buying Experience The BoJ's Corporate Bond Buying Experience The BoJ's Corporate Bond Buying Experience Chart 3The BoE's Corporate Bond Buying Experience The BoE's Corporate Bond Buying Experience The BoE's Corporate Bond Buying Experience The ECB announced its Corporate Sector Purchase Program (CSPP) in March 2016, with the actual bond purchases beginning three months later. This was an expansion of the ECB’s overall Asset Purchase Program that had previously been focused on government debt. Like the BoJ and BoE programs, only nonfinancial debt of domestic euro area companies rated BBB- or higher was eligible. The ECB did buy bonds across a wide maturity spectrum of 1-30 years. The ECB’s purchases in the first 18 months of the CSPP were sizeable, between €60-80bn per month, reaching a cumulative total of nearly 20% of the stock of eligible bonds (Chart 4). This not only drove credit spreads tighter for bonds in the CSPP, but also pushed spreads lower for bonds that were not directly purchased by the ECB, like bank debt. The ECB described this as evidence of a strong “portfolio balance effect”, where investors who sold their bonds to the central bank ended up redeploying the proceeds into other parts of the euro area corporate bond market.4  One major difference between the ECB CSPP and the BoJ and BoE programs was that the ECB could conduct the necessary purchases in the primary market, if necessary. This represented a major new source of funding for smaller euro area companies that did not previously issue corporate bonds, preferring to get most of their debt financing through bank loans. As evidence of this, the year-over-year growth rate of euro area corporate bond issuance soared from 2.5% to 10% in the first year of the CSPP (Chart 5). Chart 4The ECB's Corporate Bond ##br##Buying Experience The ECB's Corporate Bond Buying Experience The ECB's Corporate Bond Buying Experience Chart 5ECB Primary Market Buying Spurred A Boom In Issuance ECB Primary Market Buying Spurred A Boom In Issuance ECB Primary Market Buying Spurred A Boom In Issuance Investment Conclusions Applying these lessons to the US, the first conclusion we reach is that Fed corporate bond purchases will tighten spreads for eligible securities. In this case, eligible securities include all investment grade rated US corporate bonds with maturities less than five years. In effect, the Fed’s primary market facility could be thought of as adding an agency backing to these eligible bonds since the Fed has effectively guaranteed that this debt can be rolled over and that bond investors will be made whole. It’s noteworthy that last week saw a record amount of new investment grade corporate bond issuance as firms rushed to take advantage of the program.    Second, we should see some positive knock-on effects on spreads of ineligible investment grade securities, i.e. investment grade corporate bonds with maturities greater than five years. The impact will not be as large as for eligible securities, but since many of the same issuers operate at both ends of the curve, long-maturity spreads will benefit at the margin from any reduction in interest expense for the issuer. Third, any trickle-down effects to high-yield spreads will be much smaller. No high-yield issuers can benefit from the program, and while the Fed could eventually open up its facilities to include high-yield debt, we wouldn’t count on it. We suspect the moral hazard of “bailing out the junk bond market” would simply be a step too far for the Federal Reserve. We should see some positive knock-on effects on spreads of ineligible securities. In sum, we would advocate an overweight allocation to US investment grade corporate bonds today – especially on securities eligible for the Fed’s programs. We do not recommend a similar overweight stance on US high-yield, where spreads will continue to fluctuate based on the fundamental default outlook (see section titled “Assessing The Value In High-Yield” below). Can The Fed Re-Steepen US Credit Spread Curves And Prevent Ratings Downgrades? Prior to the Fed’s announcement of the new programs, the US investment grade corporate spread curve had become inverted, with shorter maturity spreads exceeding longer maturity ones. This has historically been a harbinger of increased investment grade downgrades and high-yield defaults (Chart 6). With the Fed’s new programs focusing on bonds with maturities of up to five years, the Fed’s buying can potentially lead to a re-steepening of the investment grade spread curve by driving down shorter maturity spreads. Chart 6Inverted US Credit Spread Curves Are Flashing An Ominous Message Inverted US Credit Spread Curves Are Flashing An Ominous Message Inverted US Credit Spread Curves Are Flashing An Ominous Message Already, the investment grade spread curve has begun to disinvert in the first week of the Fed’s programs (Chart 7). At the same time, the bond rating agencies are moving aggressively to adjust credit opinions in light of the US recession. Already, downgrades from Moody’s and S&P are outpacing upgrades by a 3-1 ratio year-to-date – a pace not seen since the depths of the financial crisis, according to Bloomberg.5  Chart 7The Fed's New Programs Are Already Helping Disinvert Investment Grade Spread Curves The Fed's New Programs Are Already Helping Disinvert Investment Grade Spread Curves The Fed's New Programs Are Already Helping Disinvert Investment Grade Spread Curves The Fed’s actions should be successful at re-steepening the investment grade credit curve. However, we doubt that they will have much impact on ratings decisions. While the Fed can reduce borrowing costs and prevent default by rolling over maturing debt for investment grade issuers, this has a relatively minor impact on corporate balance sheet health. In fact, the Fed's programs will only improve balance sheet health for firms that just roll over existing debt loads and don’t take on any new debt. Any firm that takes on new debt during this period will come out of the crisis with more leverage than when it entered. All else equal, that should warrant a downgrade. Bottom Line: Fed corporate bond purchases will cause investment grade spreads to tighten, particularly out to the 5-year maturity point. However, the program won’t stop the coming onslaught of ratings downgrades. Assessing The Value In High-Yield What Kind Of Default Cycle Is Already “In The Price”? High-yield debt may not benefit from the Fed’s corporate bond-buying programs. But, as in every other cycle, there will come a time when spreads discount the full extent of future default losses. At that point it will be appropriate to increase allocations to the sector. Our Default-Adjusted Spread will guide us as we make that determination. Our Default-Adjusted Spread is the excess spread available in the Bloomberg Barclays High-Yield index after subtracting realized default losses. Specifically, we calculate the Default-Adjusted Spread as: Index OAS – [Default Rate x (1 – Recovery Rate)] The default and recovery rates apply to the 12-month period that follows the index spread reading. For example, the Default-Adjusted Spread for January 2019 uses the index OAS from January 2019 and default losses incurred between February 2019 and January 2020. Table 1 shows that there is a strong link between the Default-Adjusted Spread and excess High-Yield returns relative to duration-matched Treasuries. Specifically, we see that losses are a near certainty if the Default-Adjusted Spread is negative and that return prospects are poor for spreads below 150 bps. A Default-Adjusted Spread above its historical average of 250 bps is an obvious buying opportunity, while a spread above 400 bps virtually guarantees strong returns. Table 1The Default-Adjusted Spread & High-Yield Excess Returns Trading The US Corporate Bond Market In A Time Of Crisis Trading The US Corporate Bond Market In A Time Of Crisis This helps clarify the task at hand. We must make an assumption about what the default and recovery rates will be for the next 12 months, then apply those assumptions to the current index spread. The resulting Default-Adjusted Spread will tell us if High-Yield bonds are worth a look. Table 2 shows the Default-Adjusted Spread that results from different combinations of default and recovery rates.6 For example, a 10% default rate and 35% recovery rate together imply a Default-Adjusted Spread of 271 bps, suggesting an attractive buying opportunity. Table 2Default-Adjusted Spread (BPs) Given Different Assumptions For Default And Recovery Rates Trading The US Corporate Bond Market In A Time Of Crisis Trading The US Corporate Bond Market In A Time Of Crisis What Sort Of Default Cycle Should We Expect? To answer this question we turn to Table 3. Table 3 lists periods since the mid-1980s when the default rate rose above 4%, along with several factors that influence the level of default losses: The magnitude of the economic downturn, proxied by the worst year-over-year real GDP growth reading recorded during that timeframe. The duration of the economic downturn, measured as the number of quarters from the peak to trough in real GDP. Nonfinancial corporate leverage – measured as total debt divided by book value of equity – at the cycle peak. Table 3A Brief History Of Default Cycles Trading The US Corporate Bond Market In A Time Of Crisis Trading The US Corporate Bond Market In A Time Of Crisis Alongside these determining factors, the table also shows the peak 12-month default rate seen during the cycle and the recovery rate that occurred alongside it. First, we notice a strong relationship between the magnitude of the economic shock and the peak default rate. Meanwhile, corporate leverage does a better job explaining the recovery rate. Notice that recoveries were greater in 2008 than in 2001, despite 2008’s larger economic shock. Turning to the current situation, our base case assumption is that we will see severe economic contraction in Q1 and Q2 of this year followed by some recovery in the third and fourth quarters. All told, 2020 annual GDP growth could be close to the -3.9% seen in 2008, though the duration of the peak-to-trough economic shock will be only two quarters instead of six.7 Based on the historical comparables listed in Table 3, this sort of economic shock could generate a peak default rate somewhere between 11% and 13%. As for recoveries, nonfinancial corporate leverage is currently higher than during any of the prior episodes in our study. It follows that the recovery rate will be very low, perhaps on the order of 20%-25%. Turning back to Table 2, we see that our default and recovery rate assumptions imply a Default-Adjusted Spread somewhere between -119 bps and +96 bps. This is too low to be considered a buying opportunity. A Default-Adjusted Spread above its historical average of 250 bps is an obvious buying opportunity, while a spread above 400 bps virtually guarantees strong returns. Table 4 flips this analysis around and shows the option-adjusted-spread on the Bloomberg Barclays High-Yield index that would generate a Default-Adjusted Spread of 250 bps based on different assumptions for the default and recovery rates. Recall that we consider a Default-Adjusted Spread of 250 bps or above as a buying opportunity. Using the aforementioned default and recovery rate assumptions, we would see a buying opportunity in high-yield if the average index spread rose to a range of 1075 bps – 1290 bps, or above. As of Friday’s close, the index option-adjusted spread was 921 bps. Table 4High-Yield Index Spread (BPs) That Would Imply A Buying Opportunity* In Different Default Loss Scenarios Trading The US Corporate Bond Market In A Time Of Crisis Trading The US Corporate Bond Market In A Time Of Crisis Bottom Line: High-yield spreads do not discount the full extent of the looming default cycle and will not benefit from the Fed’s asset purchase programs. Investors should stay cautious on high-yield for now and look to increase allocations when the average index spread moves into a range of 1075 bps to 1290 bps. Which High-Yield Sectors Are Most Exposed? Even during a period of large-scale defaults, sector and firm selection are vital in the high-yield bond market. In fact, you could argue that sector selection becomes even more important during a default cycle, as some sectors bear the brunt of default losses while others skate through relatively unscathed. To wit, Chart 8plots the 12-month trailing speculative grade default rate alongside a diffusion index that shows the percentage of 30 high-yield industry groups – as defined by Moody’s Investors Service – that have a trailing 12-month default rate above 4%. Even at the peaks of the default cycles during the last two recessions, only 47% and 63% of industry groups experienced significant default waves. Chart 8Sector Selection Is Vital In A Default Cycle Sector Selection Is Vital In A Default Cycle Sector Selection Is Vital In A Default Cycle To help identify which sectors are most at risk during the current default cycle, we consider how the 10 main high-yield industry groups, as defined by Bloomberg Barclays, stack up on three crucial credit metrics: The share of firms rated Caa Growth in par value of debt outstanding since the last recession Change in the median firm’s net debt-to-EBITDA ratio since the last recession8 Charts A1-A10 in the Appendix show how the three credit metrics for each industry group have evolved over time. In the remainder of this report we compare the sectors against each other across each of the above three dimensions. Note that Box 1 provides a legend for the sector name abbreviations used in Charts 9, 10 and 11. Box 1Sector Abbreviations Trading The US Corporate Bond Market In A Time Of Crisis Trading The US Corporate Bond Market In A Time Of Crisis Chart 9OAS Versus Share Of Caa-Rated Debt Trading The US Corporate Bond Market In A Time Of Crisis Trading The US Corporate Bond Market In A Time Of Crisis Chart 10OAS Versus Debt Growth Trading The US Corporate Bond Market In A Time Of Crisis Trading The US Corporate Bond Market In A Time Of Crisis   Chart 11OAS Versus Net Debt-To-EBITDA Trading The US Corporate Bond Market In A Time Of Crisis Trading The US Corporate Bond Market In A Time Of Crisis Share Of Caa-Rated Debt Even during a large default cycle the bulk of default losses will be borne by firms rated Caa and below. In Chart 9, we see that if we ignore the outlying Technology, Transportation and Energy sectors, there is a fairly linear relationship between credit spreads and the share of firms rated Caa in each sector. Transportation and Energy currently trade at very wide spreads because those sectors’ revenues are heavily impacted by the current crisis. Technology spreads remain low because, despite the high percentage of Caa-rated debt, the sector has one of the lower net debt-to-EBITDA ratios (see Chart A6). All in all, Chart 9 suggests that Capital Goods, Communications, Consumer Cyclicals and Consumer Noncyclicals all carry a large proportion of low-rated debt. In contrast, Financials and Utilities appear much safer. Debt Growth Another good way to assess which sectors are most likely to experience defaults is to look at which sectors added the most debt during the economic recovery (Chart 10). On that note, the rapid levering-up of the Energy sector clearly sticks out. Beyond that, Capital Goods, Consumer Noncyclicals and Technology also added significant amounts of debt during the recovery. In contrast, the Utilities sector actually reduced its debt load. Change In Net Debt-to-EBITDA Finally, it’s important to note that simply adding debt does not necessarily put a sector at greater risk of default if earnings are rising even more quickly. For this reason we also look at recent trends in net debt-to-EBITDA (Chart 11). Here, we see that wide spreads in Energy and Transportation are justified by large increases in net debt-to-EBITDA. Conversely, Financials and Communications have seen improvement. Bottom Line: Based on a survey of three important credit metrics: The Energy, Transportation, Capital Goods, Consumer Cyclical and Consumer Noncyclical sectors are all highly exposed to the looming default cycle. In contrast, Financials and Utilities look like the best places to hide out. Appendix Chart A1Basic Industry Credit Metrics Basic Industry Credit Metrics Basic Industry Credit Metrics Chart A2Capital Goods Credit Metrics Capital Goods Credit Metrics Capital Goods Credit Metrics Chart A3Consumer Cyclical Credit Metrics Consumer Cyclical Credit Metrics Consumer Cyclical Credit Metrics Chart A4Consumer Non-Cyclical Credit Metrics Consumer Non-Cyclical Credit Metrics Consumer Non-Cyclical Credit Metrics Chart A5Energy Credit Metrics Energy Credit Metrics Energy Credit Metrics Chart A6Technology Credit Metrics Technology Credit Metrics Technology Credit Metrics Chart A7Transportation Credit Metrics Transportation Credit Metrics Transportation Credit Metrics Chart A8Communications Credit Metrics Communications Credit Metrics Communications Credit Metrics Chart A9Utilities Credit Metrics Utilities Credit Metrics Utilities Credit Metrics Chart A10Financial Institutions Credit Metrics Financial Institutions Credit Metrics Financial Institutions Credit Metrics     Ryan Swift US Bond Strategist rswift@bcaresearch.com Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Jeremie Peloso Senior Analyst jeremiep@bcaresearch.com Footnotes  1 The March 2011 earthquake and tsunami in Japan created a lot of short-term credit spread volatility, but even then, shorter-maturity bonds saw less spread widening than the overall index. 2 https://www.imes.boj.or.jp/research/papers/english/18-E-04.pdf 3  https://www.bankofengland.co.uk/quarterly-bulletin/2017/q3/corporate-bond-purchase-scheme-design-operation-and-impact 4 The ECB described this effect in a 2018 report that can be accessed here: https://www.ecb.europa.eu/pub/pdf/other/ecb/ebart201803_02.en.pdf 5  https://www.bloomberg.com/news/articles/2020-03-26/s-p-moody-s-cut-credit-grades-at-fastest-pace-since-2008-crisis 6 Calculations are based on the index spread as of market close on Friday March 27. 7 For more details on BCA’s assessment of the economic outlook please see Global Investment Strategy Second Quarter 2020 Strategy Outlook, “World War V”, dated March 27, 2020, available at gis.bcaresearch.com 8 Median net debt-to-EBITDA is calculated from our bottom-up sample of high-yield firms that consists of all the firms in the Bloomberg Barclays High-Yield index for which data are available. Data are retrieved on a quarterly basis and the sample is adjusted once per year based on changes in the composition of the Barclays indexes. As of Q2 2019, this sample includes 354 companies.