High-Yield

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.

Highlights China’s capital spending is likely to gradually recover in the second half of 2020. We project 6-8% growth in Chinese traditional infrastructure investment and a 30-50% increase in tech-related infrastructure investment by the end of 2020. There will not be much stimulus to boost housing demand. Commodities and related global equity sectors as well as global industrial stocks are approaching buy territory in absolute terms. Semiconductor stocks are attractive on a 12-month time horizon but still face near-term risks. Chinese property developer stocks remain at risk. Feature Chart I-1Chinese Growth Is Worse Now Than In 2008 Chinese Growth Is Worse Now Than In 2008 Chinese Growth Is Worse Now Than In 2008 Lockdowns during the Covid-19 outbreak have already caused much larger and more widespread damage to the Chinese economy than what occurred both in 2008 and in 2015 (Chart 1). Even though the spread of Covid-19 looks to be largely under control, China’s domestic economy is only in gradual recovery mode, and Chinese authorities are preparing to inject more stimulus to reinvigorate growth. The important questions are where and how large the stimulus will likely be. Infrastructure development will be the major focus this year, including both traditional and tech-related infrastructure. The former includes three categories: (1) Transport, Storage and Postal Services, (2) Water Conservancy, Environment & Utility Management, and (3) Electricity, Gas and Water Production and Supply. The latter encompasses Information Transmission, Software and Information Technology Services, such as 5G networks, industrial internet, and data centers. The current emphasis of stimulus differs from the 2009 one which was more broad-based and spanned across not only infrastructure but also the property and auto sectors. It also differs from the 2016 stimulus measures, which had a heavy emphasis on the property market. Overall, the scale of combined traditional infrastructure and property market stimulus in 2020 will be smaller than what was put forward in 2009, 2012 and 2015-‘16. We estimate Chinese traditional infrastructure investment will increase by about RMB1 trillion to RMB1.5 trillion (6-8% year-on-year), while tech-related new infrastructure investment will be boosted by RMB 240 billion to RMB400 billion (30-50% year-on-year) (Chart 2).  Together, the infrastructure stimulus will be about RMB1.3 trillion to 1.9 trillion, amounting to 3.2-4.5% of nominal gross fixed capital formation (GFCF) and 1.3-1.9% of nominal GDP (Table 1). The Chinese property market is unlikely to receive much stimulus on the demand side this time as, “houses are for living in, not for speculation,” will remain the main policy mantra. That said, there will be some support for developers, helping somewhat ease extremely tight financing conditions. Chart 2Chinese Infrastructure Investment: A Boost Ahead Chinese Infrastructure Investment: A Boost Ahead Chinese Infrastructure Investment: A Boost Ahead Table 1Projections Of Traditional And Tech Infrastructure Investment In 2020 Chinese Economic Stimulus: How Much For Infrastructure And The Property Market? Chinese Economic Stimulus: How Much For Infrastructure And The Property Market? Restarting The Infrastructure Engine Tech Infrastructure: The authorities recently repeatedly emphasized the importance of “new infrastructure”1 development. This includes 5G networks, the industrial internet, inter-city transit systems, vehicle charging stations, and data centers. Strategic investment in indigenously produced leading technologies, the ongoing geopolitical confrontation with the US and the need to boost growth are behind the government’s aim for an acceleration in “new infrastructure” investment this year. China will significantly boost the pace of its strategic 5G network deployment as well as other tech-related investment. The growth of total tech infrastructure investment was 30-40% during the 4G-network development ramp-up in 2014. As the 5G network is much more costly to build than 4G, we expect growth within tech infrastructure investment to be 30-50% this year. This translates to an increase of RMB 240 billion to RMB400 billion in tech infrastructure investment in 2020, equaling around 0.2% to 0.4% of the country’s 2019 GDP (Table 1 on page 3). Chart 3Components Of Traditional Infrastructure Investment Components Of Traditional Infrastructure Investment Components Of Traditional Infrastructure Investment Traditional Infrastructure: Growth in traditional infrastructure has been weak at around 3% year-on-year in 2019, in line with our analysis last August. However, we are now expecting growth to accelerate to 6-8% by the end of this year, across all three categories of traditional infrastructure (Chart 3). In the past two months, the central government has clearly sped up the pace in reviewing and approving infrastructure projects related to power generation and distribution, transportation (railways, highways, waterways, airports, subways, etc.), and new energy. As the central government enforces increasingly stringent rules on environmental protection, investment in environmental management is likely to accelerate. Public utility management investment, which accounts for a massive 45% of overall infrastructure investment, includes sewer systems, sewer treatment facilities, waste treatment and disposal, streetlights, city roads construction, parks, bridges and tunnels. As the country’s urbanization process continues and more townships and city suburbs are developed, public utility management investment will register solid growth. The 6-8% year-on-year growth in traditional infrastructure investments by the end of this year equals to an increase of RMB1 trillion to RMB1.5 trillion in 2020. Adding up the increase of RMB 240 billion to RMB400 billion for tech-related infrastructure investment, total infrastructure spending will be RMB1.3 trillion to RMB1.9 trillion, or 1.3-1.9% of GDP (Table 1 on page 3). Bottom Line: We project 6-8% year-on-year growth in Chinese traditional infrastructure investment and a 30-50% year-on-year increase in tech-related infrastructure investment. Sources Of Infrastructure Financing Significant increases in special bond issuance, loosening public-private-partnerships (PPP) restrictions and possible Pledged Supplementary Lending (PSL) injections should enable local governments to provide sufficient funding for planned infrastructure investment projects. Net Special Bond Issuance Local government net special bond issuance, which is mainly used to fund infrastructure projects, has been one main source of financing. Last year, the amount of net special bond issuance was about RMB 2 trillion,2 accounting for about 11% of total infrastructure investment (both tech-related and traditional).  This year, the annual quota on local government special bonds is still unknown, as the NPC meeting has been postponed due to the Covid-19 outbreak. Given that last year’s quota was RMB2.15 trillion, RMB 800 billion higher than in the previous year (25% growth over 2018), it is reasonable to expect the quota for 2020 will be set at RMB 3.15-3.65 trillion, a 30-35% increase from 2019. This increase alone will be able to finance 70-80% of the RMB1.3 trillion to RMB1.9 trillion additional funding required for the infrastructure investments planned for this year. Consequently, the share of special bonds in total infrastructure spending in 2020, if these projections materialize, will rise to 15-17% from 11% in 2019. Chart 4Public-Private-Partnerships Financing Will Recover This Year Public-Private-Partnerships Financing Will Recover This Year Public-Private-Partnerships Financing Will Recover This Year   Public-Private-Partnerships (PPP) PPPs involve a collaboration between local governments and private companies. The PPP establishment can allow the local governments to reduce local governments’ burden of financing infrastructure. Due to tightened regulations on PPP projects since late 2017, PPP financing plunged 75% from about RMB 5 trillion in 2017 to RMB 1.2 trillion in 2019. Its share of total infrastructure investment had also tumbled from nearly 30% in early 2017 to 6% in 2019 (Chart 4). However, in recent months, the Chinese government has started to loosen up the restrictions on PPP projects, by releasing three announcements within a month (Box 1). We believe recent government actions will lead to a pickup in PPP financing.             Box 1 The Authorities: Loosening Up of PPP-Related Policies On February 12, the Finance Ministry released a notice demanding local governments “accelerate and strengthen PPP projects’ reserve management.” On February 28, the Finance Ministry released a contract sample of sewage water and garbage disposal projects, aiming to help local governments to more effectively proceed with such projects. On March 10, the website of the National Development and Reform Commission demanded local governments utilize the national PPP project information management and monitoring platform, actively attracting private capital and starting the projects as soon as possible. In addition, the government will likely make efforts to reduce financial and operating costs of some infrastructure projects in order to increase the risk-to-return attractiveness of such projects for private investors. The authorities may order both policy banks and commercial banks to give preferential loans to certain infrastructure projects (i.e., low-interest and long-term loans from policy banks). Moreover, the government can also provide tax breaks, offer land at a reduced cost,  and other supportive policies to certain infrastructure projects. Putting it all together, we expect PPP financing to grow 10-20% and provide additional funding of RMB120 billion to RMB240 billion to China’s infrastructure development in 2020. Pledged Supplementary Lending Chart 5Possible Pledged Supplementary Lending Injections In Infrastructure Projects Possible Pledged Supplementary Lending Injections In Infrastructure Projects Possible Pledged Supplementary Lending Injections In Infrastructure Projects Some Chinese government officials have hinted that policy banks may start using PSL injections to boost domestic infrastructure investment.3  Speculation among China watchers is that the scale of PSL injections will be RMB600 billion this year (Chart 5). In comparison, PSL net lending for the property market ranged from RMB 630 to 980 billion in the years 2015-2018. Bottom Line: Odds are that a significant increase in special bond issuance, loosening PPP restrictions and possible PSL injections will be sufficient to offset the decline in other funding sources. Consequently, a moderate acceleration in traditional infrastructure investment and very strong growth in tech-related infrastructure expenditures is likely. What About Stimulus In The Property Sector? Stimulus for the property sector this time will be less forceful than the ones in both 2009 and 2016. In addition, structural property demand in China has already entered a saturation phase, drastically different from previous episodes when demand still had strong underlying growth. Altogether, the outlook for property sales in China is not promising.  “Houses are for living in, not for speculation” will remain the main policy focus in the Chinese property market. That said, authorities will help ease developers’ extremely tight financing conditions. No stimulus on demand: Three cities (Zhumadian, Baoji, Guangzhou) that had released policies to loosen up restrictions on the demand side (e.g., cutting down payment from 30% to 20%, allowing larger amounts of borrowing for homebuyers) were ordered to retract their announcements within a week. There will be very little PSL lending into the property market in 2020, in line with the government’s goal of curbing speculation in the property market. Some supportive polices for developers: Over 60 cities have released policies on the supply side (e.g., delaying developers’ land transaction payments, waiving fines for breaches of start and completion dates, etc.), mainly helping property developers overcome their extreme funding shortages. Given housing unaffordability and lack of demand, we expect floor space sold to contract slightly in 2020 (Chart 6, top panel). In the meantime, we expect a slight pickup in property starts (Chart 6, middle panel). In order to stay afloat, property developers have to maintain rising floor space starts for presales to gain some funding – a fund-raising scheme for Chinese real estate developers that we discussed in detail in prior reports. In addition, we also expect moderate growth in property completions in the commodity buildings market (Chart 6, bottom panel). The pace of property completion has to be accelerated as property developers are currently under increased pressure to deliver units that were pre-sold about two years ago. This will lift construction activity in the commodity buildings market (Chart 7). Chart 6Commodity Buildings: Divergences Among Sales, Starts And Completions Commodity Buildings: Divergences Among Sales, Starts And Completions Commodity Buildings: Divergences Among Sales, Starts And Completions Chart 7Commodity Buildings: Construction Activities Commodity Buildings: Construction Activities Commodity Buildings: Construction Activities Please note that commodity buildings are a small subset of total constructed buildings in China, and as a subset do not provide a full picture of construction activity. The official data show that commodity buildings account for only 24% of total constructed buildings in terms of floor space area completed. In terms of a broader measure of the Chinese property market, we still expect a continuing contraction – albeit less than last year – in “building construction” floor area started and completed (Chart 8). Bottom Line: There will not be much stimulus to boost housing demand. Yet authorities will ease financial constraints on property developers that will allow them to complete housing currently under construction. Chart 8Building Construction Versus Commodity Housing Building Construction Versus Commodity Housing Building Construction Versus Commodity Housing Chart 9Commodities And Related Equity Sectors Are Approaching A Bottom Commodities And Related Equity Sectors Are Approaching A Bottom Commodities And Related Equity Sectors Are Approaching A Bottom Investment Implications Traditional infrastructure spending in China will post a moderate recovery in 2020, with most gains occurring in the second half of the year. Consistently, we believe the segments of Chinese and global markets leveraged to the infrastructure cycle – commodities and related equity sectors as well as industrial stocks – are approaching buying territory in absolute terms. Prices of segments have collapsed, creating a good entry point in the coming weeks (Chart 9, 10 and 11). Chart 10A Buying Time May Be Not Far For Industrial Stocks… A Buying Time May Be Not Far For Industrial Stocks... A Buying Time May Be Not Far For Industrial Stocks... Chart 11…And Machinery Stocks ...And Machinery Stocks ...And Machinery Stocks China’s spending on itech-related infrastructure will post very strong growth in 2020. Even though global semiconductor stocks have sold off considerably, they have not underperformed the global equity benchmark. In the near term, we believe risks are still to the downside for technology and semi stocks (Chart 12). However, this down-leg will create a good buying opportunity. We are watching for signs of capitulation in this sector to buy. Finally, concerning Chinese property developers, their share prices will likely underperform their respective Chinese equity benchmarks in the next nine months (Chart 13). Meanwhile, the absolute performance of property stocks listed on the domestic A-share market remains at risk (Chart 13, bottom panel). Chart 12Semi Stocks: Final Down-leg Is Possible Semi Stocks: Final Down-leg Is Possible Semi Stocks: Final Down-leg Is Possible Chart 13Chinese Property Developers Are Still At Risk Chinese Property Developers Are Still At Risk Chinese Property Developers Are Still At Risk  Ellen JingYuan He Associate Vice President ellenj@bcaresearch.com   Footnotes   1    To gauge the scale of the “new infrastructure”, we are using the National Bureau of Statistics data of “investment in information transmission, software and information technology service”. This tech-related infrastructure investment measure includes 5G networks, industrial internet, and data centers, while inter-city transit systems and vehicle charging stations may be included in the transportation investment. 2   Please note that the amount of net special bond issuance was the actual amount of funding used in infrastructure projects. It was smaller than the RMB 2.15 trillion quota because a small proportion of issuance were used to repay some existing special bonds due in the year. 3   http://www.xinhuanet.com/money/2020-02/19/c_1125593807.htm

Highlights Duration: Last week’s bond market sell-off was a headfake and does not portend a sustained move higher in Treasury yields. We will need to see a stabilization in confirmed COVID-19 cases and signs of improving global growth before calling the bottom in yields. Keep portfolio duration close to benchmark. Yield Curve: A fed funds rate pinned at zero means that the yield curve will trade directionally with yields for the foreseeable future. The yield curve’s recent re-shaping also means that a barbelled Treasury portfolio now only offers a small yield advantage. We recommend shifting out of a barbell and into a position long the 5-year bullet and short a duration-matched 2/10 barbell. Corporate Spreads: High-yield spreads are now fairly priced for a default cycle of similar magnitude to the 2001/02 recession, and the Fed’s entrance into the corporate bond market is a potential game changer for investment grade spreads. Investors should increase exposure to investment grade corporates from neutral to overweight. High-yield investors with horizons of 12 months or more should also start adding exposure. Fed Policy: The Fed is frantically trying to mitigate the impact of three different (though related) shocks: An economic shock, a liquidity shock and a credit shock. We assess its progress to date and discuss what could be done next. Feature Headfake Chart 1Not A Reflationary Environment Not A Reflationary Environment Not A Reflationary Environment Bond yields jumped early last week, shortly after the Fed cut rates back to the zero bound. At one point the 10-year Treasury yield reached as high as 1.18%. But make no mistake, this was not the start of a protracted bond sell off. By Monday morning, the 10-year was back down to 0.75%. Evidently, the conditions for a sustained move higher in Treasury yields are not yet in place. To see why this is so, we need to look a little bit beyond the headline grabbing change in nominal yields and notice that, even when the nominal 10-year yield moved up early last week, the 10-year real yield increased much more quickly, causing the implied cost of inflation protection to fall (Chart 1). This is unusual behavior. Typically, real yields, nominal yields and breakeven inflation rates are all positively correlated. This is because an improving economic outlook usually leads investors to expect both higher inflation and a higher fed funds rate in the future, and vice-versa. When the correlation breaks down it is usually related to some policy action or constraint. For example, investors could come to believe that the Fed will keep interest rates too low for far too long, causing real yields to fall even as inflation expectations jump. Or, as is the case right now, the market could recognize the zero-lower-bound constraint on Fed policy and start to price-in a scenario where the Fed can’t cut rates far enough to jumpstart economic growth. Real yields move higher in this scenario, but inflation expectations crash. We are seeing the same dynamic of rising real yields and falling inflation expectations that was witnessed in 2008. This same dynamic of rising real yields and falling inflation expectations was witnessed in 2008, when the Fed was rapidly cutting rates but investors did not view that action as sufficient (Chart 2). Falling equity prices and a rising dollar further underscored that the environment was becoming more deflationary, not reflationary. A sustained rise in bond yields can only be caused by a reflationary environment. Chart 2Shades Of 2008 Shades Of 2008 Shades Of 2008 How Close To The Bottom? The relevant question then becomes: How close are we to returning to a reflationary environment? To answer this question we will rely on the checklist to call the bottom in bond yields that we unveiled two weeks ago.1 That checklist contains four factors: A stabilization in confirmed COVID-19 cases Improving global economic growth (particularly in China) Weaker US economic data A trigger from one or more technical trading rules Last week we started to see the first signs of weaker US economic data. Initial jobless claims spiked to 281k and both the New York and Philadelphia Fed regional manufacturing surveys plunged (Chart 3). We expect the bottom in bond yields will occur when the US economic data are very weak and when economies that experienced the outbreak earlier – such as China – are showing signs of rebounding. Investors will superimpose the Chinese experience onto the US. But it is still too early for that. Global growth bellwethers such as the CRB Raw Industrials commodity price index remain in freefall (Chart 3, bottom panel). We also noted that we want to see stabilization in the global number of confirmed COVID-19 cases. Essentially, this would mean the number of daily new cases falling close to zero. We are far from that point, as the daily number of new cases continues to rise exponentially (Chart 4). Chart 3Weaker US Data, But No Global Recovery Weaker US Data, But No Global Recovery Weaker US Data, But No Global Recovery Chart 4New Cases Still Rising New Cases Still Rising New Cases Still Rising We should also mention that we expect risk assets – equities and corporate credit – to bottom before Treasury yields, as the Fed will take care not to signal a premature removal of crisis stimulus measures. Finally, two weeks ago we described several technical trading rules that have demonstrated some success at calling troughs in Treasury yields in the past. Since last week, one of our three proposed trading rules was briefly triggered, but that signal was quickly reversed. Bottom Line: Last week’s bond market sell-off was a headfake and does not portend a sustained move higher in Treasury yields. We will need to see a stabilization in confirmed COVID-19 cases and signs of improving global growth before calling the bottom in yields. Keep portfolio duration close to benchmark. A Quick Note On TIPS In last week’s report we made the case for long-term investors to buy TIPS relative to equivalent-maturity nominal Treasuries.2  The reasoning is that TIPS breakeven inflation rates offer exceptional value relative to likely future inflation outcomes. For example, the 5-year TIPS breakeven inflation rate is currently 0.31% and the 10-year rate is 0.75%. This means that a buy-and-hold investor will make money owning TIPS versus nominals if inflation averages more than 0.31% per year for the next five years, or 0.75% per year for the next decade. Chart 51-Year TIPS Return Scenarios Life At The Zero Bound Life At The Zero Bound We also observed last week that TIPS breakeven inflation rates have turned negative at the front-end of the curve. We described this pricing as irrational because of the embedded deflation floors in TIPS. This was incorrect. While TIPS will always pay at least par at maturity, seasoned TIPS with only a year or two left to maturity already have inflation-adjusted principal values that are well above par. In other words, there is room for deflation to influence the returns from these securities before any floor is triggered. Specifically, we can take a look at the TIPS maturing in just over one year, on April 15 2021 (Chart 5). This note has an accumulated principal of just under $109 and is currently trading at an ask price of $97.63.3 According to our calculations, this security will earn 2.55% if headline CPI inflation is 0% over the next 12 months. It will only lose money if headline CPI inflation comes in at -2.49% or below. What’s more, it will return more than a 12-month nominal T-bill as long as inflation is above -2.4%. Note that the lowest year-over-year headline CPI inflation print during the Great Financial Crisis was -2.1%. TIPS offer exceptional value relative to nominal Treasuries for investors who are able to hold the trade for at least one year. Bottom Line: TIPS offer exceptional value relative to nominal Treasuries for investors who are able to hold the trade for at least one year.  Treasury Curve: Re-Visiting The Zero-Lower-Bound Playbook Chart 6Curve Will Trade Directionally With Yields Curve Will Trade Directionally With Yields Curve Will Trade Directionally With Yields The Fed’s aggressive policy easing has caused the yield curve to re-shape dramatically during the past few weeks. The 2/10 Treasury slope is up to 55 bps from a 2019 low of -4 bps. The 2/30 Treasury slope is up to 118 bps from a 2019 low of 42 bps, and the 2/5 Treasury slope is up to 15 bps from a 2019 low of -13 bps. Looking through the recent volatility, the fact that the fed funds rate is back to a range between 0% and 0.25% means that we can dust off our yield curve playbook from the last zero-lower-bound period. Fortunately, that playbook is quite straightforward. With the front-end of the curve pinned near zero, the slope of the yield curve will essentially trade directionally with the level of Treasury yields for the foreseeable future. Chart 6 shows that during the last zero-lower-bound period, the 2/30, 2/10 and 2/5 slopes were all positively correlated with the 5-year Treasury yield. This correlation suggests one obvious strategy. If you think yields will rise, put on steepeners. If you think they will fall, put on flatteners. Or if, like us, you suspect that bond yields will be higher in 12 months but are not quite ready to call the bottom, you could hedge benchmark or above-benchmark portfolio duration by entering a duration-neutral steepener. What About Value Across The Curve? Chart 7Bullets Looking Less Expensive Bullets Looking Less Expensive Bullets Looking Less Expensive Until recently, investors could earn large positive carry by owning a barbell consisting of the long and short ends of the Treasury curve (e.g. 2/30) and shorting the belly (e.g. 5yr), in duration-matched terms. But this has changed. The 2/10 barbell now only offers 6 bps of positive carry versus the 5-year bullet, while the 2/30 barbell and 5-year bullet offer approximately the same yield. Both the 2/5/10 and 2/5/30 butterfly spreads are also much closer to the fair values suggested by our models (Chart 7).4 Though we are not ready to call the bottom in Treasury yields, we think the 5-year yield is sufficiently attractive to initiate a duration-neutral curve steepener trade: go long the 5-year bullet and short a duration-matched 2/10 barbell. This trade should perform well if the 2/10 slope steepens going forward. Since a steeper curve is now positively correlated with the level of yields, this trade will profit if yields move higher. Viewed this way, the trade acts as a hedge when implemented alongside our conservative ‘At Benchmark’ portfolio duration recommendation. Bottom Line: A fed funds rate pinned at zero means that the yield curve will trade directionally with yields for the foreseeable future. The yield curve’s recent re-shaping also means that a barbelled Treasury portfolio now only offers a small yield advantage. We recommend shifting out of a barbell and into a position long the 5-year bullet and short a duration-matched 2/10 barbell. Corporate Spread Update Corporate spreads continue to widen very quickly. As such, our conclusions from last week about the amount of value in corporate bonds are already out of date. Our value assessment is based on our High-Yield Default-Adjusted Spread, which is the excess spread left over in the high-yield index after removing actual 12-month default losses. Table 1 shows how often the Default-Adjusted Spread has been in different 50 basis point intervals, and what sort of 12-month junk excess returns occurred during those periods. One conclusion from the table: To be confident that high-yield will outperform duration-matched Treasuries on a 12-month horizon, we would need to expect a Default-Adjusted Spread of at least 150 bps. Preferably, the spread would be greater than or equal to 250 bps, the historical average. The red numbers down the right-hand side of Table 1 indicate what the Default-Adjusted Spread will be for the next 12 months if the speculative grade default rate hits a specific value. For example, a default rate of 6%, which would correspond to a default cycle of a similar magnitude as 2015/16, implies a very attractive Default-Adjusted Spread of +633 bps. In contrast, a default rate of 14% or greater would lead to a negative Default-Adjusted Spread. For context, the default rate peaked at 15% and 11% in the 2008 and 2001/2 recessions, respectively. Table 1What's Priced In Credit Spreads? Life At The Zero Bound Life At The Zero Bound As of now, our base case scenario is that the current default cycle will be more severe than the 2015/16 episode but probably not as bad as the 2008 financial crisis. Something on the order of 9% - 11% seems plausible. If that’s the case, then the Default-Adjusted Spread will be somewhere between 216 bps and 394 bps. This looks quite attractive. Additionally, yesterday’s announcement that the Fed will effectively be entering the investment grade corporate bond market could be a game changer. As a result, we recommend increasing exposure to investment grade corporate bonds from neutral to overweight. For high-yield, it is possible that spreads will widen more in the near-term, but value is now sufficiently attractive for investors with investment horizons of 12 months or more to start adding exposure. We retain our neutral 6-12 month recommended allocation for now, but will re-visit the question in more detail in next week’s report.  To be confident that high-yield will outper­form duration-matched Treasuries on a 12-month horizon, we would need to expect a Default-Adjusted Spread of at least 150 bps.  Bottom Line: High-yield spreads are now fairly priced for a default cycle of similar magnitude to the 2001/02 recession, and the Fed’s entrance into the corporate bond market is a potential game changer for investment grade spreads. Investors should increase exposure to investment grade corporates from neutral to overweight. High-yield investors with horizons of 12 months or more should also start adding exposure. The Fed’s War On Three Fronts   Events continue to unfold rapidly in financial markets and in terms of the Fed’s response to the market turmoil. We conclude this week’s report with a brief discussion of the three main shocks that the Fed is frantically trying to contain. We also assess how successful the Fed’s responses might be. #1: The Economic Shock The first shock that the Fed is trying to contain is the pure shock to aggregate demand that is occurring as a result of widespread quarantine measures. In cutting rates to zero and signaling that rates will not rise any time soon, the Fed has effectively done all it can to help fight the economic shock. It should help a little. Lower interest rates will ease the debt burden of homeowners who can refinance their mortgages. They may also lower costs for firms that are able to issue debt to weather the current storm. But these effects are minor compared to the fiscal measures currently making their way through Congress.5 Next steps for the Fed: None. The Fed is effectively out of bullets to contain the economic shock. It’s all about fiscal policy now. #2: Market Liquidity Shock Chart 8Bond Market Liquidity Shock Bond Market Liquidity Shock Bond Market Liquidity Shock In addition to the economic shock, the Fed is also responding to a severe market liquidity shock. What we mean by a “market liquidity shock” is that investors are finding it more expensive (or difficult) to transact in certain markets because of the scarce amount of capital being deployed to those areas. This is different than credit risk (see Shock #3). We are not talking about investors having trouble transacting because there are few willing buyers of credit risk. We are talking about high transaction costs in otherwise risk-free parts of the bond market. The issue is critical because these risk-free parts of the bond market (overnight repo, for example) are often used to fund riskier investments. Disruption in funding markets can have ripple-on effects into other, less opaque, areas. We currently see several examples of disruptions to bond market liquidity (Chart 8): Repo rates have spiked relative to the overnight index swap curve (Chart 8, top panel). The iShares 20+ year Treasury Bond ETF (TLT) is suddenly trading at a huge discount to its net asset value (Chart 8, panel 2). Cross-currency basis swap spreads have turned deeply negative, meaning that it is more expensive for non-US actors to obtain US dollar funding (Chart 8, bottom panel). Wider-than-normal bid/ask spreads are being reported in the Treasury market (not shown). These disruptions are occurring because the financial system is not deploying enough capital to market-making activities in these areas. Essentially, nonfinancial firms have drawn on their revolving credit lines during the past few weeks and this has left the financial system short of cash to deploy toward market-making activities. To fix the problem, the Fed has started to transact directly (in large amounts) in both the repo and Treasury markets. This essentially replaces the function that banks were performing until a few weeks ago. But perhaps more importantly, the Fed is also encouraging banks to deploy the capital that already sits on their balance sheets. Unlike during the 2008 financial crisis, banks now carry a lot of capital – the result of Dodd-Frank and Basel III regulations. What the banks need now is tacit permission from regulators to deploy that capital into financial markets, without concern that they will face consequences during a future stress test. Table 2Banks Have Excess Capital Life At The Zero Bound Life At The Zero Bound Even without any specific changes to regulation, Table 2 shows that the big 5 US financial institutions all carry significant buffers above the regulatory minimum 100% Liquidity Coverage Ratio and 6% Supplementary Leverage Ratio. At a minimum, these excess buffers must be deployed to aid market liquidity. Next steps: The Fed is already transacting directly in both the repo and Treasury markets, and behind closed doors it is most certainly encouraging banks to deploy more capital toward market-making activities. If these actions prove insufficient, the next step would be for the Fed – along with other regulators and possibly Congress – to offer temporary regulatory relief for banks, lowering the required Liquidity Coverage and Supplementary Leverage ratios. We view this market liquidity problem as one that regulators will be able to solve. And given the Fed’s aggressive policy response to date, we expect that regulators will get a handle on the issue and restore bond market liquidity fairly soon. #3 Credit Shock Chart 9Can The Credit Shock Be Contained? Can The Credit Shock Be Contained? Can The Credit Shock Be Contained? We draw a distinction between spreads widening because of a lack of market liquidity and spreads widening because investors are unwilling to take credit risk. Though admittedly, it is not always easy to distinguish between these two factors in real time. But there is no doubt that the economy is also grappling with a credit shock, in addition to the economic and liquidity shocks we already mentioned. Some evidence that market players are less willing to take credit risk (Chart 9): The average option-adjusted spread on the Bloomberg Barclays Investment Grade Corporate Bond index has spiked (Chart 9, top panel). The spread between the 3-month commercial paper rate and the overnight index swap rate has surged (Chart 9, panel 2). The Municipal / Treasury yield ratio is higher than it was during the financial crisis (Chart 9, panel 3). The 30-year mortgage rate has so far not followed Treasury yields lower (Chart 9, bottom panel). The Fed can take some measures to mitigate the negative impacts of a credit shock, and it has already taken quite a few. The Fed has set up facilities to back-stop commercial paper and short-maturity municipal debt. It also announced yesterday morning that it will, in conjunction with the Treasury department, enter the investment grade corporate bond market out to the 5-year maturity point, effectively back-stopping a large portion of corporate issuance. The Fed has not yet set up a facility to purchase longer-maturity municipal bonds, but this could be forthcoming. The Fed is also directly purchasing large amounts of Agency MBS in an effort to tighten the spread between the mortgage rate and Treasury yields. The Fed’s measures to guarantee some risky debt can help solve some problems related to a credit shock. For example, if Fed purchases increase asset values for corporate and municipal bonds, then it lessens the risk of bankruptcy both for the issuing firms and for any systemically-important investment fund that may be levered to those markets. However, Fed purchases do not guarantee that stressed firms will be able to take out new debt, nor do they prevent firms from cutting payrolls in the face of lower demand. Only direct cash bailouts from the government can fix those problems. Next steps: The Fed could add another facility to purchase long-maturity municipal bonds. It could also implement a “funding for lending” scheme similar to what the Bank of England has done. These measures, along with what has already been announced, will help ease the credit shock at the margin. But ultimately, cash bailouts from Congress to firms and state & local governments will be required.    Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “When And Where Will Bond Yields Trough?”, dated March 10, 2020, available at usbs.bcaresearch.com 2 Please see US Bond Strategy Weekly Report, “Buying Opportunities & Worst-Case Scenarios”, dated March 17, 2020, available at usbs.bcaresearch.com 3 Numbers quoted assuming a par value of $100. 4 For details on our yield curve models please see US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com 5 The global fiscal response to the COVID crisis is discussed in more detail in Geopolitical Strategy Weekly Report, “De-Globalization Confirmed”, dated March 20, 2020, available at gps.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Our short EM equity index recommendation has reached our target and we are booking profits on this trade. The halt to economic activity will produce a global recession that will be worse than the one that took place in late 2008. We continue to recommend short positions in a basket of EM currencies versus the US dollar. In EM fixed-income markets, the duration of the ongoing selloff has been short, and large losses will trigger more outflows ensuring further carnage. Stay defensive for now. Russia is unlikely to make a deal with Saudi Arabia to restrain oil output for now. Feature The global economy is experiencing a sudden, jarring halt. The only comparison for such a sudden stop is the one that occurred in the fall of 2008, following Lehman’s bankruptcy. In our opinion, the global economic impact of the current sudden stop is shaping up to be worse than the one that occurred in 2008. That said, we are taking profits on our short position in EM equities. This position – recommended on January 30, 2020 – has produced a 30% gain.   EM share prices have reached the long-term support that acted as the ultimate floor during the bear markets in 1997-‘98, 2001-‘02, 2007-‘08 and 2015. Our decision to take profits reflects investment discipline. The MSCI EM stock index in US dollar terms has reached our target. In addition, this decision is consistent with two important indicators that we follow and respect: 1. EM stocks have become meaningfully cheap. Chart I-1 illustrates that our cyclically-adjusted P/E (CAPE) ratio for EM equities is about one standard deviation below its fair value – the same level when the EM equity market bottomed in 1998, 2008 and 2015. Chart I-1EM Equities Are Cheap According To The Cyclically-Adjusted P/E Ratio EM Equities Are Cheap According To The Cyclically-Adjusted P/E Ratio EM Equities Are Cheap According To The Cyclically-Adjusted P/E Ratio For this EM CAPE ratio to reach 1.5 standard deviations below its fair value – the level that is consistent with EM’s 2001-02 lows – EM share prices need to drop another 15%. 2. In term of the next technical support, EM share prices have reached the long-term support that acted as the ultimate floor during the bear markets in 1997-‘98, 2001-‘02, 2007-‘08 and 2015 (Chart I-2). Chart I-2EM Share Prices Are At Their Long-Term Support EM Share Prices Are At Their Long-Term Support EM Share Prices Are At Their Long-Term Support While share prices are likely to undershoot, it is risky to bet on a further decline amid current extremely elevated uncertainty and market volatility. The Global Downturn Will Be Worse Than In Late 2008 Odds are that the current global downturn is shaping up to be worse than the one that occurred in late 2008. From a global business cycle perspective, the current sudden halt is beginning from a weaker starting point. Global trade growth was positive back in August-September 2008 – just prior to the Lehman bankruptcy – despite the ongoing US recession (Chart I-3A). In comparison, global trade was shrinking in December 2019, before the COVID-19 outbreak (Chart I-3B). Chart I-3AGlobal Trade Growth Was Positive In September 2008… Global Trade Growth Was Positive In September 2008... Global Trade Growth Was Positive In September 2008... Chart I-3B…But Was Negative In December 2019 ...But Was Negative In December 2019 ...But Was Negative In December 2019   This is because growth in EM and Chinese economies was still very robust in the middle of 2008. Moreover, the economies of EM and China were structurally very healthy and were anchored by solid fundamentals. Still, the blow to confidence emanating from the crash in global financial markets and plunge in US domestic demand in the fall of 2008 produced major shockwaves in EM/Chinese financial markets. Provided the ongoing negative confidence shock and lingering uncertainty persist, odds are that the risk premium will initially overshoot before settling down. Consistently, risk markets will undershoot in the interim. This is in contrast with current cyclical growth conditions and structural economic health, both of which are very poor in EM/China going into this sudden stop.   In China, economic growth in January-February 2020 was much worse than at the trough of the Lehman crisis in the fourth quarter of 2008. Chart I-4 reveals that industrial production, auto sales and retail sales volumes all contracted in January-February 2020 from a year ago. The same variables held up much better in the fourth quarter of 2008 (Chart I-4). Business activity in China is recovering in March, but from very low levels. Reports and evidence from the ground suggest that many companies are operating well below their ordinary capacity – the level of economic activity remains well below March 2019 levels. US real GDP, consumer spending and capital expenditure shrunk by 4%, 2.5% and 17% at the trough of 2008 recession (Chart I-5). Odds are that these variables will plunge by an even greater magnitude in the coming months as the US reinforces lockdowns and public health safety measures. Chart I-4China Business Cycle Was Much Stronger In Q4 2008 Than Now China Business Cycle Was Much Stronger In Q4 2008 Than Now China Business Cycle Was Much Stronger In Q4 2008 Than Now Chart I-5US Growth At Trough Of 2008 Recession US Growth At Trough Of 2008 Recession US Growth At Trough Of 2008 Recession   Chart I-6US Small Caps: Overlay Of 2008 And 2020 US Small Caps: Overlay Of 2008 And 2020 US Small Caps: Overlay Of 2008 And 2020 About 50% of consumer spending in the US is attributed to people over 55 years of age. Provided COVID-19’s fatality rate is high among the elderly, odds are this cohort will not risk going out and spending. How bad will domestic demand in the US be? It is impossible to forecast with any certainty, but our sense is that it will plunge by more than it did in the late 2008-early-2009 period, i.e., by more than 4% (Chart I-5, bottom panel). Interestingly, the crash in US small-cap stocks resembles the one that occurred in the wake of the Lehman bankruptcy (Chart I-6). If US small-cap stocks follow their Q4 2008 - Q1 2009 trajectory, potential declines from current levels will be in the 10%-18% range. Bottom Line: The current halt in economic activity and impending global recession will be worse than the one that took place in late 2008. Reasons Not To Jump Into The Water…Yet Even though EM equities have become cheap and oversold and we are booking profits on our short position in EM stocks, conditions for a sustainable rally do not exist yet: So long as EM corporate US dollar bond yields are rising, EM share prices will remain under selling pressure (Chart I-7). Corporate bond yields are shown inverted in this chart. Chart I-7EM Stocks Fall When EM Corporate Bond Yields Rise EM Stocks Fall When EM Corporate Bond Yields Rise EM Stocks Fall When EM Corporate Bond Yields Rise Chart I-8Chinese And Emerging Asian Corporate Bond Yields Are Spiking Chinese And Emerging Asian Corporate Bond Yields Are Spiking Chinese And Emerging Asian Corporate Bond Yields Are Spiking The selloff in both global and EM credit markets began only a few weeks ago from very overbought levels. Many investors have probably not yet trimmed their positions. Hence, EM sovereign and corporate credit spreads and yields will likely rise further as liquidation in the global and EM credit markets persists. Consistently, bond yields for Chinese offshore corporates as well as emerging Asian high-yield and investment-grade corporates are rising (Chart I-8). EM local currency bond yields have also spiked recently as rapidly depreciating EM currencies have triggered an exodus of foreign investors. Rising local currency bond yields are not conducive for EM share prices (Chart I-9). Chart I-9EM Equities Drop When EM Local Bond Yields Rise EM Equities Drop When EM Local Bond Yields Rise EM Equities Drop When EM Local Bond Yields Rise EM ex-China currencies correlate with commodities prices (Chart I-10). Both industrial commodities and oil prices have broken down and have further downside. The path of least resistance for oil prices is down, given anemic global demand and our expectation that Russia and Saudi Arabia will not reach any oil production cutting agreement for several months (please refer to our discussion on this topic below). Finally, our Risk-On/Safe-Haven currency ratio1 is in free fall and will likely reach its 2015 lows before troughing (Chart I-11). This ratio tightly correlates with EM share prices, and the latter remains vulnerable to further downside as long as this ratio is falling. Chart I-10EM Currencies Move In Tandem With Commodities Prices EM Currencies Move In Tandem With Commodities Prices EM Currencies Move In Tandem With Commodities Prices Chart I-11More Downside In Risk-On/ Safe-Haven Currency Ratio More Downside In Risk-On/ Safe-Haven Currency Ratio More Downside In Risk-On/ Safe-Haven Currency Ratio   Bottom Line: Although we are taking profits on the short EM equity position, we continue to recommend short positions in a basket of EM currencies – BRL, CLP, ZAR, IDR, PHP and KRW – versus the US dollar. Liquidation in EM fixed-income markets has been sharp, but the duration has been short –only a few weeks. Large losses will trigger more outflows from EM fixed-income markets. Stay defensive for now. What We Do Know And What We Cannot Know Amid such extreme uncertainty, it is critical for investors to distinguish between what we know and what we cannot know. What we cannot know: With regards to COVID-19: The speed of its spread, the ultimate number of victims it claims and – finally – its impact on consumer and business confidence and psyche. Related to lockdowns: Their duration in key economies. These questions will largely determine this year’s economic growth trajectory: Will it be V-, U-, W-, or L-shaped? Unfortunately, no one knows the answers to the above questions to have any certainty in projecting this year’s global growth. The key factor that gives Russia an advantage over Saudi Arabia in terms of its ability to deal with a negative terms-of-trade shock is not only its better fiscal position but also its ability to depreciate its currency. What we do know: Authorities in all countries will stimulate aggressively so long as financial markets are rioting. Nonetheless, these stimulus measures will not boost growth immediately. With entire countries locked down and plunging consumer and business confidence, stimulus will not have much impact on growth in the near term. In brief, all policy stimulus will boost growth only when worries about the pandemic subside and the economy begins to function again. Both are not imminent. Hence, we are looking at an air pocket with respect to near-term global economic growth. As we argued in our March 11 report titled, Unraveling Of The Policy Put, the pre-coronavirus financial market paradigm – where stocks and credit markets were priced to perfection because of the notion that policymakers would not allow asset prices to drop – has unravelled.   In recent weeks, policymakers around the world have announced plans to deploy massive amounts of stimulus, yet the reaction of financial markets has been underwhelming. The reason is two-fold: Both demand shrinkage and production shutdowns have just started, and they will run their due course regardless of announced policy stimulus measures. Equity and credit markets were priced for perfection before this selloff, and investors are in the process of recalibrating risk premiums. Provided the ongoing negative confidence shock and lingering uncertainty persist, odds are that the risk premium will initially overshoot before settling down. Consistently, risk markets will undershoot in the interim. Bottom Line: DM’s domestic demand downturn is still in its initial phase, and there is little foresight in terms of the pandemic’s evolution. These are natural forces, and any stimulus policymakers enact are unlikely to preclude them from occurring. Reflecting the economic contraction and heightened uncertainty, the selloff in risk assets will likely continue for now. Do Not Bet On An Early Resuscitation Of OPEC 2.0 As we argued in our March 11 report, Russia is unlikely to make a deal with Saudi Arabia to restrain oil output in the immediate term. Russia may agree to restart negotiations, but it will not agree to reverse its position for some time. Both nations will be increasing crude output (Chart I-12). As a result, a full-fledged oil market share war is underway. Consistently, crude prices have experienced a structural breakdown (Chart I-13).  Chart I-12The Largest Oil Producers Are Ramping Up Output The Largest Oil Producers Are Ramping Up Output The Largest Oil Producers Are Ramping Up Output Chart I-13Structural Breakdown In Oil Prices Structural Breakdown In Oil Prices Structural Breakdown In Oil Prices   The key factor that gives Russia an advantage over Saudi Arabia in terms of its ability to deal with a negative terms-of-trade shock is not only its better fiscal position but also its ability to depreciate its currency. Russia has a flexible exchange rate, which will allow the currency to depreciate in order to soften the blow from lower oil prices on the real economy and fiscal accounts. The Russian economy and financial system have learned to operate with recurring major currency depreciations. Saudi Arabia has been running a fixed exchange rate regime since 1986 and cannot use currency depreciation to mitigate the negative terms-of-trade shock on its end. Even though Russia’s fiscal budget break-even oil price is much lower than that of Saudi Arabia’s, it is not the most important variable to consider in this confrontation. The fiscal situation in both Russia and Saudi Arabia will not be a major problem for now. Both governments can issue local currency and US dollar bonds, and there will be sufficient demand for these bonds from foreign and local investors. This is especially true with DM interest rates sitting at the zero-negative territory. Falling oil prices and downward pressure on exchange rates will trigger capital outflows in both countries. Russia has learned to live with persistent capital flight. In the meantime, capital outflows will stress Saudi Arabia’s financial system and, eventually, its real economy. This is in fact the country’s key vulnerability. We will be publishing a Special Report on Saudi Arabia in the coming weeks.  Bottom Line: Do not expect a quick recovery in oil prices. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Footnotes 1     Average of CAD, AUD, NZD, BRL, RUB, CLP, MXN & ZAR total return indices relative to average of CHF & JPY total returns.   Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights Policy Responses: The COVID-19 pandemic has become a full-blown global crisis and recession. Governments and central bankers worldwide are now responding with aggressive monetary easing and fiscal stimulus. Markets will not respond positively to such stimulus, however, until there is some visibility on the true depth, and duration, of the economic downturn. Fixed Income Strategy: With a global recession now a certainty, bond yields will remain under downward pressure and credit spreads should widen further. Given how far yields have already fallen, we recommend emphasizing country and credit allocation in global bond portfolios, while keeping overall duration exposure around benchmark levels. Model Portfolio Changes: Following up on our tactical changes last week, we continue to recommend overweighting government debt versus spread product. Specifically, overweighting US & Canadian government bonds versus Japan and core Europe, and underweighting US high-yield and all euro area and EM credit. Feature In stunning fashion, the sudden stop in the global economy due to the COVID-19 pandemic has triggered a rapid return to crisis-era monetary and fiscal policies. The battle has now shifted to trying to fill the massive hole in global private sector demand left by efforts to contain the spread of the virus. It is unlikely that lower interest rates and more quantitative easing can mitigate the negative growth effects from travel bans, closing of bars and restaurants, and full scale lockdowns of cities. Fiscal policy, combined with efforts to boost market liquidity and ease the coming collapse of cash flows for the majority of global businesses, are the only plausible options remaining. It is unlikely that lower interest rates and more quantitative easing can mitigate the negative growth effects from travel bans, closing of bars and restaurants, and full scale lockdowns of cities. While the speed of these dramatic policy moves is unprecedented, the reason for them is obvious. Plunging equities and surging corporate bond credit spreads are signaling a global recession, but one of uncertain depth and duration given the uncertainties surrounding the spread of COVID-19 (Chart of the Week). Chart of the WeekCan Crisis-Era Monetary Policies Be Effective During A Pandemic? Can Crisis-Era Monetary Policies Be Effective During A Pandemic? Can Crisis-Era Monetary Policies Be Effective During A Pandemic? Chart 2Risk Assets Will Not Bottom Until New COVID-19 Cases Ex-China Peak Risk Assets Will Not Bottom Until New COVID-19 Cases Ex-China Peak Risk Assets Will Not Bottom Until New COVID-19 Cases Ex-China Peak The ability for policymakers to calibrate stimulus measures is pure guesswork at this point. The same thing goes for investors who see zero visibility on global growth, with the full extent of the virus yet to be felt in large economies like the United States and Germany – even as new cases in China, where the epidemic began, approach zero. The response from central bankers has been swift and bold – rapid rate cuts, increased liquidity programs for bank funding and increased asset purchases. The fact that global financial markets have remained volatile, even after what is a clear coordinated effort from policymakers, highlights how the unique threats to growth from the COVID-19 pandemic may be beyond fighting with traditional demand-side stimulus measures. We continue to recommend a cautious near-term investment stance, particular with regards to corporate bond exposure, until there is clear evidence that the growth rate of new COVID-19 cases outside China has peaked (Chart 2). Policymakers Throw The Kitchen Sink At The Problem The market moves and policy announcements have come fast and furious this past week, from virtually all major economies. We summarize some of the moves below: United States The Fed cut rates by -100bps in a Sunday night emergency move, taking the funds rate back to the effective lower bound of 0% - 0.25%. Importantly, Fed Chair Powell made it clear at his press conference that negative rates are not on the table, suggesting that we may have seen the last of the rate cuts for this cycle. A new round of quantitative easing (QE) was also announced, with purchases of $500 billion of Treasury securities and $200 billion of agency MBS that will occur in the “coming months”; Powell hinted that those amounts could be increased, if necessary (Chart 3). The MBS purchases are a clear effort to help bring down mortgage rates, which have not declined anywhere near as rapidly as US Treasury yields during the market rout (bottom panel). The Fed also cut the discount window rate – the rate at which banks can borrow from the Fed for periods of up to 90 days – by -150bps, bringing it down to 0.25%. The Fed said it is “encouraging banks to use their capital and liquidity buffers” – essentially telling banks to hold less cash for regulatory purposes. The Fed also reduced the rate on its US dollar swap lines with other central banks. The new rate is OIS +25bps. Coming on top of the massive increase in existing repo lines last week, the Fed is attempting to ensure that banks, both in the US and globally, that need USD funding have more liquidity available to support lending. Already, there are signs of worsening liquidity in the bank funding markets, like widening FRA-OIS spreads, but also evidence of illiquidity in financial markets like wide bid-ask spreads on longer-maturity US Treasuries and the growing basis between high-yield bonds and equivalent credit default swaps (Chart 4). Chart 3A Return To Fed QE A Return To Fed QE A Return To Fed QE Chart 4Market Liquidity Issues Forced The Fed's Hand Market Liquidity Issues Forced The Fed's Hand Market Liquidity Issues Forced The Fed's Hand Turning to fiscal policy, the full response of the Trump administration is still being formed, but a major $850bn spending package has been proposed that would provide tax relief for American households and businesses while also including a $50bn bailout of the US airline industry. This comes on top of previously announced plans to offer free testing for the virus, paid sick leave, business tax credits and a temporary suspension of student loan interest payments. Chart 5The ECB Has Limited Policy Options The ECB Has Limited Policy Options The ECB Has Limited Policy Options Euro Area The European Central Bank (ECB) unexpectedly made no changes to policy interest rates last week. It opted instead to increase asset purchases by €120bn until the end of 2020 (both for government bonds and investment grade corporates), while introducing more long-term refinancing operations (LTROs) to “provide a bridge” to the targeted LTRO (TLTRO-3) that is set to begin in June. The terms of TLTRO-3 were improved, as well; banks that accessed the liquidity to maintain existing lending could do so at a rate up to -25bps below the current ECB deposit rate of -0.5%, for up to 50% of the existing stock of bank loans. The ECB obviously had to do something, given the coordinated nature of the global monetary policy response to COVID-19. Yet the decisions taken show that the ECB is much more limited in its ability to ease policy further, with interest rates already negative, asset purchases approaching self-imposed country limits and, most worryingly, inflation expectations falling to fresh lows (Chart 5). The bigger responses to date have come on the fiscal front, with stimulus packages proposed by France (€45bn), Italy (€25bn), Spain (€3bn) and the European Commission (€37bn). The biggest news, however, came from Germany which has offered affected businesses tax breaks and cheap loans through the state development bank, KfW – the latter with an planned upper limit of €550bn (and with the German government assuming a greater share of risk on those new KfW loans). The German government has also vaguely promised to temporarily suspend its so-called “debt brake” to allow deficit financing of virus-related stimulus programs, if necessary. Other Countries The Bank of England cut interest rates by -50bps last week, while also lowering capital requirements for UK banks by allowing use of counter-cyclical buffers for lending. On the fiscal side, a £30bn package was introduced last week that included a tax cut for retailers, cash grants to small business, sick pay for those with COVID-19 and extended unemployment benefits. The Bank of Japan held an emergency meeting this past Sunday night, announcing no changes in policy rates but doubling the size of its ETF purchase program to $56 billion a year to $112 billion, while also increasing purchases of corporate bonds and commercial paper. The central bank also announced a new program of 0% interest loans to increase lending to businesses hurt by the virus. The Bank of Canada delivered an emergency -50bps cut in its policy rate last Friday, coming soon after the -50bp reduction from the previous week. The central bank also introduced operations to boost the liquidity of Canadian financial markets. The Canadian government also announced a fiscal package of up to C$20bn, including increased money for the state business funding agencies. The Reserve Bank of Australia did not cut its Cash Rate last week, which was already at a record-low 0.5%. It did, however, signal that it would begin a quantitative easing program for the first time, and introduce Fed-like repo operations, to provide more liquidity to the economy and local financial markets. The Australian government has also announced A$17bn of fiscal stimulus. Fiscal packages have also been introduced in New Zealand (where the Reserve Bank of New Zealand just cut its policy rate by -75bps), Sweden, Switzerland, Norway, and South Korea. To date, China has leaned more on monetary and liquidity measures – lowering interest rates and cutting reserve requirements – rather than a big fiscal stimulus package. Will all these policy measures be enough to offset the hit to global growth from COVID-19 and help stabilize financial markets? It is certainly a good start, particularly in countries with low government and deficit levels that have the fiscal space for even more stimulus, like Germany, Australia and Canada (Chart 6). Given these competing forces of global recession and monetary policy exhaustion on one side, but with increasingly more expansive fiscal policy on the other, we recommend a neutral (at benchmark) stance on overall global duration exposure on both a tactical and strategic basis. The ability to calibrate the necessary policy response is impossible to assess without knowing the full impact of COVID-19 pandemic on the global economy – including the size of related job losses and corporate defaults/bankruptcies. Policymakers are likely to listen to the combined message of financial markets – equity prices, credit spreads and government bond yields. The low level of yields and flat yield curves, despite near-0% policy rates across the developed world (Chart 7), suggests that investors see monetary policy as “tapped out”, leaving fiscal stimulus as the only way to fight the economic war against COVID-19. Chart 6At Global ZIRP, The Policy Focus Shifts To Fiscal At Global ZIRP, The Policy Focus Shifts To Fiscal At Global ZIRP, The Policy Focus Shifts To Fiscal Chart 7Are Bond Yields Discounting A Global Liquidity Trap? Are Bond Yields Discounting A Global Liquidity Trap? Are Bond Yields Discounting A Global Liquidity Trap? Given these competing forces of global recession and monetary policy exhaustion on one side, but with increasingly more expansive fiscal policy on the other, we recommend a neutral (at benchmark) stance on overall global duration exposure on both a tactical and strategic basis. Bottom Line: The COVID-19 pandemic has become a full-blown global crisis and recession. Governments and central bankers worldwide are now responding with aggressive monetary easing and fiscal stimulus. Markets will not respond positively to such stimulus, however, until there is some visibility on the true depth, and duration, of the economic downturn. Corporate Bonds In The US & Europe – Stay Tactically Defensive Chart 8This Crisis Is Different Than 2008 This Crisis Is Different Than 2008 This Crisis Is Different Than 2008 The COVID-19 global market rout has generated levels of market volatility not seen since the 2008 Global Financial Crisis. The US VIX index of option-implied equity volatility spiked to a high of 84, while the equivalent German VDAX measure reached a shocking high of 93. Equity valuations in both the US and Europe remain much higher on a forward price/earnings ratio basis compared to the troughs seen in 2008, even after the COVID-19 bear market. Yet even though volatility has returned to crisis-era extremes, and corporate credit has sold off hard in both the US and Europe, credit spreads remain well below the 2008 highs (Chart 8). Nonetheless, the credit selloff seen over the past few weeks has still been intense. Both investment grade and high-yield spreads have blown out, and across all credit tiers in both the US (Chart 9) and euro area (Chart 10). Even the highest-rated segments of the corporate bond universe have seen spreads explode, with AAA-rated investment grade spreads having doubled in both the US and Europe. Chart 9Broad-Based Spread Widening For Both Investment Grade... Broad-Based Spread Widening For Both Investment Grade... Broad-Based Spread Widening For Both Investment Grade... Chart 10...And High-Yield ...And High-Yield ...And High-Yield With the COVID-19 pandemic tipping the global economy into recession, it is not clear that the spread widening seen to date has been enough to compensate for the typical surge in downgrades and defaults seen during recessions – even though spreads do look wide on a duration-adjusted basis. With the COVID-19 pandemic tipping the global economy into recession, it is not clear that the spread widening seen to date has been enough to compensate for the typical surge in downgrades and defaults seen during recessions – even though spreads do look wide on a duration-adjusted basis.  One of our favorite metrics to value corporate bonds is to look at option-adjusted spreads, adjusted for interest rate duration risk. We call this the 12-month breakeven spread, as it measures the amount of spread widening over one year that would leave corporate bond returns equal to those of duration-matched US Treasuries. We then look at the percentile rankings of those breakeven spreads versus their history as one indicator of corporate bond value. Chart 11US Corporates Look Cheaper On A Duration-Adjusted Basis US Corporates Look Cheaper On A Duration-Adjusted Basis US Corporates Look Cheaper On A Duration-Adjusted Basis For the US, the 12-month breakeven spreads for the overall Bloomberg Barclays investment grade and high-yield indices are in the 82nd and 97th percentiles, respectively (Chart 11). This suggests that the latest credit selloff has made corporate debt quite cheap, although only looking through the prism of spread risk rather than potential default losses. Another of our preferred valuation metrics for high-yield debt is the duration-adjusted spread, or the high-yield index option-adjusted spread minus default losses. We then look at that default-adjusted spread versus its long-run average (+250bps) as a measure of high-yield value. To assess the current level of spreads, we use a one-year ahead forecast of the expected default rate using our own macro model. Over the past 12 months, the high-yield default rate was 4.5% and our macro model is currently calling for a rise to 6.2%. That estimate, however, does not yet include the certain hit to corporate profits from the COVID-19 recession. By way of comparison, the default rate peaked at 11.2% during the 2001/02 default cycle and at 14.6% during the 2008 financial crisis. In Chart 12, we show the historical default rate, our macro model for the default rate, and the history of the default-adjusted spread. We also show what the default-adjusted spread would look like in four different scenarios for the default rate over the next 12 months: 6%, 9%, 11% and 15%. The placement of these numbers in the bottom panel of Chart 12 indicates where the Default-Adjusted Spread will be if each scenario is realized. Chart 12US High-Yield Is Not Cheap On A Default-Adjusted Basis US High-Yield Is Not Cheap On A Default-Adjusted Basis US High-Yield Is Not Cheap On A Default-Adjusted Basis Right now, our expectation is that there will be a virus driven US recession, but it will be shorter in magnitude than past recessions; this suggests a peak default rate closer to 9%. Such a scenario would still be consistent with a positive default-adjusted spread and likely positive excess returns for US high-yield relative to US Treasuries on a 12-month horizon. However, if a default rate similar to that seen during past recessions (11% or 15%) is realized, that would lead to a negative default-adjusted spread. Adding up both pieces of our valuation framework suggests that, while US high-yield spreads offer value on a duration-adjusted basis, spreads do not compensate enough for potential default losses if the US recession lasts longer than we expect. Thus, we recommend a tactical underweight position in US high-yield until we see better visibility on the severity, and duration, of the US recession. Adding up both pieces of our valuation framework suggests that, while US high-yield spreads offer value on a duration-adjusted basis, spreads do not compensate enough for potential default losses if the US recession lasts longer than we expect.  As for euro area corporates, spreads for both investment grade and high-yield do look relatively wide on a breakeven spread basis, although less so than US credit (Chart 13). However, with the World Health Organization declaring Europe as the new epicenter of the COVID-19 pandemic, the harsh containment measures seen in Italy, Germany, France and elsewhere – coming from a starting point of weak overall economic growth – suggest that euro area spreads need to be wider to fully reflect downgrade and default risks. Chart 13Euro Area Corporates Look A Bit Cheaper On A Duration-Adjusted Basis Euro Area Corporates Look A Bit Cheaper On A Duration-Adjusted Basis Euro Area Corporates Look A Bit Cheaper On A Duration-Adjusted Basis We recommend a tactical underweight allocation to both euro area corporate debt and Italian sovereign debt, as spreads have room to reprice wider to reflect a deeper recession (Chart 14). Chart 14Stay Underweight Euro Area Spread Product Stay Underweight Euro Area Spread Product Stay Underweight Euro Area Spread Product Bottom Line: Corporate bond spreads on both sides of the Atlantic discount a sharp economic slowdown, but the odds of a deeper recession – and more spread widening - are greater in Europe relative to the US. A Quick Note On Recent Changes To Our Model Bond Portfolio In last week’s report, we made several adjustments to our model bond portfolio recommended allocations on a tactical (0-6 months) basis.1 Specifically, we downgraded our overall recommended exposure to global spread product to underweight, while increasing the overall allocation to government debt to overweight. The specific changes made to the model bond portfolio are presented in tables on pages 14 & 15. Within the country allocation of the government bond side of the portfolio, we upgraded US and Canada (markets more sensitive to changes in global bond yields, and with central banks that still had room to ease policy) to overweight, while downgrading core Europe to underweight and Japan to maximum underweight (both markets less sensitive to global yields and with no room to cut rates). On the credit side of the portfolio, we downgraded US high-yield to underweight (with a 0% allocation to Caa-rated debt), while also downgrading euro area investment grade and high-yield debt to underweight. We also lowered allocations to emerging market USD denominated debt, both sovereign and corporate, to underweight. We left the allocation to US investment grade debt at neutral, as the other reductions left our overall spread product allocation at the desired level (35% versus the 43% spread product weighting in our custom benchmark portfolio index). In terms of the specific weightings, the portfolio is now +11% overweight US fixed income versus the benchmark, coming most through US Treasury exposure. The portfolio is now -7% underweight euro area versus the benchmark, equally thorough government bond and corporate debt exposure. The portfolio is now also has a -7% weight in Japan versus the benchmark, entirely from government bonds. Note that these weightings represent a tactical allocation only, as we are recommending a defensive stance on spread product exposure given the near-term uncertainties over COVID-19 and global growth. On a strategic (6-12 months) horizon, however, we are neutral overall spread product exposure versus government bonds. Corporate bond spreads already discount a sharp economic slowdown and some increase in defaults. However, the rapid shift to aggressive monetary and fiscal easing by global policymakers to combat the virus will likely limit the duration and, potentially, the severity of the global slowdown currently discounted in wide credit spreads.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Please see BCA Global Fixed Income Strategy Weekly Report, "The Train Is Empty", dated March 10, 2020, available at gfis.bcarsearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Panicked Policymakers Move To A Wartime Footing Panicked Policymakers Move To A Wartime Footing Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Bear markets occur in phases, and their narrative can mutate. What began as a selloff caused by the coronavirus outbreak could well mutate into an oil crash-led selloff, and then mutate again into a selloff due to policy omnipotence, or something else. We are reiterating our short positions in the EM equity index and a basket of EM currencies versus the US dollar as well as our defensive positioning in EM domestic bonds and credit markets. We are taking profits on our long gold/short oil and copper trade. Oil prices may stabilize, but risks are still skewed to the downside. We are also booking gains on our long Russian domestic bonds/short oil position. Feature Chart I-1A Record Low Currency VOL Is Followed By Major Market Disturbances A Record Low Currency VOL Is Followed By Major Market Disturbances A Record Low Currency VOL Is Followed By Major Market Disturbances Global financial markets are witnessing the unwinding of the policy put. For the past several years, the consensus in the global investment community was that risk assets could not go down because of policy puts from the Federal Reserve, the US Treasury and President Trump, the European Central Bank and the Chinese authorities. Similarly, crude oil prices had been supported by OPEC 2.0’s put from December 2016 until recently. The latest panic and broad-based liquidation of risk assets has been due not only to fear and uncertainty related to the rapid escalation in COVID-19 cases around the world, but also to investor realization that these policy puts are ineffectual. The Fed’s 50-basis-point intra-meeting rate cut proved incapable of stabilizing global risk assets. Investors have begun to doubt the efficacy of policy puts and have thrown in the proverbial towel. Crucially, the high-speed and intensity of the selloff was due to widespread complacency and overbought conditions in risk assets. In our January 23 report, we quoted Bob Prince, co-CIO of Bridgewater, who stated in Davos that “…we have probably seen the end of the boom-bust cycle.” This comment was consistent with prevalent complacency in global financial markets, reflected in very tight credit spreads worldwide, high US equity multiples and record-low implied volatility in various asset classes. In the same January 23 report, we wrote: “Any time an influential person has made a similar declaration in the past, it marked a major turning point in financial markets. Remarkably, implied volatility for the US dollar has plummeted to a record low, as it has for EM currencies and a wide range of equity markets. Chart I-1 illustrates the implied volatility for EM currencies and the US dollar. Such low levels of implied currency market volatility historically preceded major moves in currency markets and often led to a material selloff in broad EM financial markets.” In that same report , we recommended going long implied EM currency volatility. Since then JP Morgan’s EM currency volatility has risen from 6% to 10%. What began as a selloff caused by the coronavirus outbreak could well mutate into an oil crash-led selloff, and then mutate again into a selloff due to policy omnipotence, or something else. Consistent with this thesis, we reinstated our short EM equity index recommendation in the following week’s report – on January 30. The MSCI EM stock index is down 11% since then. Our target is 800, which is 18% below current levels (Chart I-2, top panel). Chart I-2EM Stocks: A Breakdown In The Making EM Stocks: A Breakdown In The Making EM Stocks: A Breakdown In The Making Market Narratives Mutate Chart I-3VIX Surge In Early 2018 Was A Trigger Not Cause Of Selloff VIX Surge In Early 2018 Was A Trigger Not Cause Of Selloff VIX Surge In Early 2018 Was A Trigger Not Cause Of Selloff Narratives of all large market moves are always expounded in retrospect. Only after a selloff is well-advanced do investors and commentators come up with reasons for it and build a plausible narrative describing it. Critically, bear markets occur in phases, and their narrative can evolve. What began as a selloff caused by the coronavirus outbreak could well mutate into an oil crash-led selloff, and then mutate again into a selloff due to policy omnipotence, or something else. For example, the early 2018 selloff in global equities and industrial commodities was at the time attributed to the spike in US equity volatility (Chart I-3, top and middle panels). In retrospect, January 2018 marked a major top in the global business cycle (Chart I-3, bottom line). Hence, the true reason for the late-January 2018 top in global stocks and industrial commodities was a downturn in global manufacturing and trade and not the surge in the VIX. The key question investors are currently wrestling with is the following: How deep will this selloff be, and how long will it last? Our view is that the selloff in EM and global risk assets is not yet over. As such, we are reiterating our short positions in the EM equity index and a basket of EM currencies versus the US dollar, as well as our defensive positioning in EM domestic bonds and credit markets. Gauging The Downside There is no doubt that global growth will be affected by the spread of COVID-19 and the precautionary measures taken by the authorities, companies and households around the world to contain the outbreak.   Further, growth visibility is extremely low, and that uncertainty is raising the risk premiums that investors demand. The latter is weighing on risk assets in general and global share prices in particular.  Presently, precise forecasts for GDP growth and a potential trajectory of COVID-19 cases are not credible, and hence cannot be relied upon to formulate a sound investment strategy. If the current bloodbath in risk assets persists, a market bottom could be reached well before bad economic data are released or COVID-19 infection cases peak. Given the uncertainty related to both the global growth trajectory and the Covid-19 epidemic, the only way for investors to gauge a market bottom is to continuously examine valuations, technicals and market internals. With respect to valuations and technicals, we have the following observations: The EM equity index seems to breaking below its major support lines. If this breakdowns transpires, there is an air pocket until the index reaches its next technical support, which is 18% below its current level (please refer to the top panel of Chart I-2 on page 3). If the EM MSCI equity index drops to this support range, it would be trading at 11 times its trailing earnings (please refer to the bottom panel of Chart I-2 on page 3). At those levels, the EM equity index would be discounting a lot of bad news, making it immune to dismal economic data and general uncertainty. For the S&P 500, if the current defense line – which held been during 2011, 2015 and 2018 selloffs – is violated, the next long-term technical support is around 2400-2500 (Chart I-4). Inflows to EM fixed-income funds were enormous in 2019. Meanwhile, EM corporate and sovereign spreads have broken out (Chart I-5). Provided this selloff commenced from very overbought and expensive levels, the odds are that liquidation forces will not abate right now and that the selloff in EM fixed income has further to go. Chart I-4S&P 500: Where Technical Support Lies? S&P 500: Where Technical Support Lies? S&P 500: Where Technical Support Lies? Chart I-5EM Sovereign And Corporate Spreads Have Broken Out EM Sovereign And Corporate Spreads Have Broken Out EM Sovereign And Corporate Spreads Have Broken Out   In a nutshell, we suspect that EM local currency bonds and credit markets received a lot of inflows from European investors in recent years because yields were negative across European fixed-income markets. A weak euro was a boon for European investors investing in EM. That, however, is reversing. Since the recent sharp appreciation in the euro and the nosedive in EM currencies, EM financial market returns in euros have collapsed. This will likely prompt an exodus of European investors from EM financial markets. Chart I-6A Major Breakdown In This Cyclical Indicator A Major Breakdown In This Cyclical Indicator A Major Breakdown In This Cyclical Indicator Even though the EM equity index is not expensive or overbought, rising EM USD and local currency bond yields herald lower share prices, as we discussed at length in last week’s report. Our Risk-On/Safe-Haven currency ratio1  has plummeted below its major technical support and the next level is significantly lower. In other words, this indicator is also in an air pocket (Chart I-6). Given it is extremely well-correlated with EM share prices, the latter will not bottom until this indicator stabilizes. Technical configurations of high-beta and cyclical segments of the global equity universe are consistent with failed breakouts. Such a profile is typically not followed by a correction, but by a major drawdown. These include the European aggregate equity index, the Nikkei, global industrials and US high-beta stocks (Chart I-7). Chart I-7AFailed Breakouts Are Often Followed By Large Drawdowns Failed Breakouts Are Often Followed By Large Drawdowns Failed Breakouts Are Often Followed By Large Drawdowns Chart I-7BFailed Breakouts Are Often Followed By Large Drawdowns Failed Breakouts Are Often Followed By Large Drawdowns Failed Breakouts Are Often Followed By Large Drawdowns Chart I-8The Global Stocks-To-Bonds Ratio Is Back To 2011 Levels The Global Stocks-To-Bonds Ratio Is Back To 2011 Levels The Global Stocks-To-Bonds Ratio Is Back To 2011 Levels Finally, the global stock-to-bond ratio has decisively broken below the upward sloping channel that has been in place since 2009 (Chart I-8). Typically, when a market or ratio experiences such a major breakdown, the recovery does not occur quickly and is unlikely to be V-shaped. In short, the structural breakdown in the global stocks-to-bond ratio suggests that global share prices will likely stay under downward pressure for some time. Bottom Line: Odds are that risk assets remain in a liquidation phase and investors should avoid catching a falling knife. The odds are also high that EM share prices in US dollar terms have another 18% downside. We reckon at those levels – where the MSCI EM equity index is around 800 – it would be safe to start accumulating EM equities, even if the global growth outlook remains mired in uncertainty. For now, we recommend playing EM on the short side. What To Do With Oil Plays Despite periodic spikes in crude prices over the past few years, we have held our conviction that oil is in a structural bear market. We doubted the sustainability of the OPEC 2.0 arrangement, arguing that Russia would not cooperate with Saudi Arabia in the long term. Russia did cooperate much longer than we had expected, temporarily supporting oil prices. Ultimately, Russian President Vladimir Putin abandoned the cartel late last week, and the Saudis have hit back with massive price discounts amid large output increases. Consequently, oil prices have crashed and are presently oversold (Chart I-9). Given the uncertainty related to both the global growth trajectory and the Covid-19 epidemic, the only way for investors to gauge a market bottom is to continuously examine valuations, technicals and market internals. However, there will be no rapprochement between the Saudis and the Russians for some time. Given the drop in demand amid sharp increases in supply, crude oil prices may well slide further. Since July 11, 2019, we have been recommending a long gold/short oil and copper trade (Chart I-10). This position has generated a large 40% gain. Today, we are taking profits on this trade. Instead, we are replacing it with a new position: long gold/short copper. Chart I-9A Long-Term Profile Of Oil Prices A Long-Term Profile Of Oil Prices A Long-Term Profile Of Oil Prices Chart I-10Book Profits On Long Gold / Short Oil And Copper Trade Book Profits On Long Gold / Short Oil And Copper Trade Book Profits On Long Gold / Short Oil And Copper Trade   Among oil plays, we have been overweight Mexico and Russia within EM, both in fixed income and equity universes. That said, for absolute return investors, we have not been recommending unhedged long positions in either Mexico or Russia because of our expectation of a drop in oil prices and the ensuing broad-based EM selloff. Regarding Russia, for investors who were looking to gain exposure to local currency bonds, we have been recommending that they hedge this position by shorting oil since November 14, 2019. This recommendation has paid off well, and we are closing this position with a 26% gain. We will be looking to buy Russian local bonds unhedged in the weeks ahead. Chart I-11Relative Performance Of Russian And Mexican Domestic Bonds Is Facing Near-Term Headwinds Relative Performance Of Russian And Mexican Domestic Bonds Is Facing Near-Term Headwinds Relative Performance Of Russian And Mexican Domestic Bonds Is Facing Near-Term Headwinds In Mexico, we have also been reluctant to recommend naked exposure to local currency or US dollar bonds because of our bearish view on oil and the risk of large outflows from EM that would hurt the peso. Indeed, the oil crash and outflows from EM have led to a plunge in the Mexican currency. Instead, in Mexico we have been recommending betting on yield curve steepening. The proposition has been that short rates are anchored by a disinflationary backdrop and tight fiscal policy in Mexico while the long end of the curve could sell off in a scenario of capital outflows from EM. As with Russia, we are monitoring Mexican markets and are looking to recommend buying domestic bonds without hedging the currency risk in the weeks or months ahead. Bottom Line: We are taking profits on our long gold/short oil and copper trade. Oil prices may stabilize, but risks are still skewed to the downside. In the near term, the relative performance of Mexican and Russian stocks and local currency bonds versus their respective EM benchmarks could be undermined by capital outflows from EM in general and these countries in particular (Chart I-11). Nevertheless, both nations’ macro fundamentals remain benign, and their fixed-income and equity markets will outperform their EM peers in the medium term. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Footnotes   1     Calculated as ratio of equal-weighted average of total return indices of cad, aud, nzd, brl, idr, mxn, rub, clp & zar relative to average of jpy & chf total returns (including carry); rebased to 100 at January 2000. Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights Uncertainty & Yields: Global bond yields, driven to all-time lows as investors seek safety amid rioting markets, now discount a multi-year period of very weak global growth and inflation. Bond Portfolio Strategy: Maintain overall neutral portfolio duration exposure with so much bad news already priced into yields. Downgrade overall global spread product exposure to underweight versus governments on a tactical (0-3 months) basis given intense uncertainties on COVID-19 and oil markets. Model Bond Portfolio Changes – Governments: Upgrade countries that are more responsive to changes in the level of overall global bond yields and with room to cut interest rates (the US & Canada) to overweight, while downgrading sovereign debt with a lower “global yield beta” and less policy flexibility (Germany, France, Japan) to underweight. Model Bond Portfolio Changes – Credit: Downgrade US high-yield, euro area corporates and emerging market USD sovereigns & corporates to underweight. Feature Chart of the WeekOn The Verge Of Global ZIRP On The Verge Of Global ZIRP On The Verge Of Global ZIRP The title of this report is a quote from a worried BCA client this morning, discussing his daily commute into Manhattan from the New York suburbs. We can think of no better analogy for the mood of investors in the current market panic. After having enjoyed a decade of riding the gravy train of recession-free growth and robust returns on risk assets, all underwritten by accommodative monetary policies, worries about a deflationary bust following the boom have intensified. The global spread of COVID-19, the ebbs and flows of the US presidential election and, now, a stunning collapse in oil prices – markets have simply been unable to process the investment implications of these unpredictable events all at once. At times of such stress, the obvious thing to do is to stand aside and hedge portfolios while awaiting better visibility on the uncertainties. At times of such stress, the obvious thing to do is to stand aside and hedge portfolios while awaiting better visibility on the uncertainties. It is clear that global government bonds have been a preferred hedge, with yields collapsing to record lows worldwide. While most of the market attention has been on the breathtaking fall in US yields that has pushed the entire Treasury curve below 1% as the market has moved to discount a swift move to a 0% fed funds rate. New lows were also hit yesterday in countries that had been lagging the Treasury rally: the 10-year German bund reached -0.85% yesterday, while the 10-year UK Gilt fell to an intraday all-time low of 0.08% with some shorter-maturity Gilt yields actually dipping into negative territory (Chart of the Week). The common driver of yesterday’s yield declines was the 25% plunge in global oil prices after the weekend collapse of the OPEC 2.0 alliance between Russia and Saudi Arabia. The inflation expectations component of global bond yields fell accordingly, continuing the correlation with energy prices seen over the past decade. Yet the real component of global bond yields has also been falling, with markets increasingly pricing in an extended period of weak growth and negative real interest rates – especially in the US. Collapsing US Treasury Yields Discount A Recession, Not A Financial Crisis Chart 2Re-opening Old Wounds Re-opening Old Wounds Re-opening Old Wounds While this latest plunge in US equity markets has been both rapid and powerful, the damage only takes us back to levels on the S&P 500 last seen as recently as January 2019 (Chart 2). The turmoil, however, has reopened old wounds in markets that had suffered their own crises over the past decade, with European bank stocks hitting new all-time lows and credit spreads on US high-yield Energy bonds and Italian sovereign debt (versus Germany) sharply blowing out. The backdrop remains treacherous and global equity markets will likely remain under pressure until the number of new COVID-19 cases peaks outside of China (especially in the US). If there is one silver lining amidst the market carnage, it is that there appears to be few signs of 2008-style systemic financial stress. If there is one silver lining amidst the market carnage, it is that there appears to be few signs of 2008-style systemic financial stress. Bank funding indicators like Libor-OIS spreads and bank debt spreads have widened a bit over the past week but remain at very subdued levels (Chart 3). This is in sharp contrast to classic risk aversion indicators like the price of gold and the value of the Japanese yen versus the Australian dollar, which are closing in on the highs seen during the 2008 global financial crisis and 2012 European debt crisis. Chart 3A Growth Downturn, Not A Systemic Crisis A Growth Downturn, Not A Systemic Crisis A Growth Downturn, Not A Systemic Crisis We interpret this as investors being far more worried about a deep global recession than another major financial crisis. That is also confirmed in the pricing of US Treasury yields, especially when looking at the real yield. Chart 4Does The UST Market Think R* Is Negative? Does The UST Market Think R* Is Negative? Does The UST Market Think R* Is Negative? Chart 5Another Convexity-Fueled Bond Rally Another Convexity-Fueled Bond Rally Another Convexity-Fueled Bond Rally The entire TIPS yield curve is now negative for the first time, even with the real fed funds rate below the Fed’s estimate of the “r*” neutral real rate (Chart 4). The combination of low and falling inflation expectations, and plunging real yields, indicates that the Treasury market now believes that the neutral real funds rate is not 0.8%, as suggested by the Fed’s estimate of r*, but is somewhere well below 0%. With the fed funds rate now down to 0.75% after last week’s intermeeting 50bps cut, the Treasury market is not only pricing the Fed quickly returning to the zero lower bound on the funds rate, but staying trapped at zero for a very long time. The Treasury market is not only pricing the Fed quickly returning to the zero lower bound on the funds rate, but staying trapped at zero for a very long time. Yet that may be too literal an interpretation of the incredible collapse of US Treasury yields. The power of negative convexity is also at work, driving intense demand for long-duration bonds that puts additional downward pressure on yields. Large owners of US mortgage backed securities (MBS) like the big commercial banks have seen the duration of their MBS holdings collapse as yields have fallen. The result is that banks are forced to buy huge amounts of Treasuries (or receive US dollar interest rate swaps) to hedge their duration exposure of negative convexity MBS, hyper-charging the fall in Treasury yields – perhaps over $1 trillion worth of buying, by some estimates.1 This is a similar dynamic to what occurred last summer in Europe, when sharply falling bond yields triggered convexity-related demand for duration from large asset-liability managers like pension funds, further fueling the decline in bond yields (Chart 5). Yet even allowing that some of the Treasury yield decline has been driven by a mechanical demand for duration, a 10-year US Treasury yield of 0.56% clearly discounts expectations of a US recession, as well – which appears justified by the recent performance of some critical US economic data. In Charts 6 & 7, we show a “cycle-on-cycle” analysis of some key US financial and indicators and how they behave before and after the start of the past five US recessions. The charts are set up so the vertical line represents the start of the recession, and we line up the data for the current business cycle as if the latest data point represents the start of a recession. Done this way, we can see if the current data is evolving in a similar fashion to past US economic downturns. Chart 6The US Business Cycle Looks Toppy The US Business Cycle Looks Toppy The US Business Cycle Looks Toppy Chart 7COVID-19 Will Likely Trigger A Confidence-Driven US Recession COVID-19 Will Likely Trigger A Confidence-Driven US Recession COVID-19 Will Likely Trigger A Confidence-Driven US Recession The charts show that the current flat 10-year/3-month US Treasury curve and steady decline in corporate profit growth are both accurately following the path entering past US recessions. Other indicators like the NFIB Small Business confidence survey, the Conference Board’s leading economic indicator and consumer confidence series typically peak between 12-18 months prior to the start of a recession, but appear to be only be peaking now. The same argument goes for initial jobless claims, which are usually rising for several months heading into a recession but remain surprisingly steady of late – a condition that seems unlikely to continue as more companies suffer virus-related hits to their sales and profits and begin to shed labor. Net-net, these reliable cyclical US data suggest that the Treasury market is right to be pricing in elevated recession risk – especially with US cases of COVID-19 starting to increase more rapidly and US financial conditions having tightened sharply in the latest market rout. Bottom Line: Global bond yields, driven to all-time lows as investors seek safety amid rioting markets, now discount a multi-year period of very weak global growth and inflation – most notably in the US. Allocation Changes To Our Model Bond Portfolio The stunning fall in global bond yields has already gone a long way. Yet it is very difficult to forecast a bottom in yields, even with central banks easing monetary policy to try and boost confidence, before there is evidence that the global COVID-19 outbreak is being contained (i.e. a decreasing total number of confirmed cases). By the same token, corporate bonds (and equities) will continue to be under selling pressure until the worst of the viral outbreak has passed. We raised our recommended overall global duration stance to neutral last week – a move that was more tactical in nature as a near-term hedge to our strategic overweight corporate bond allocations in our Model Bond Portfolio amid growing market volatility. Yet with the new stresses coming from the collapse in oil prices and increasing spread of COVID-19 in the US and Europe, we are moving to a much more cautious near-term stance on global credit. Yet with the new stresses coming from the collapse in oil prices and increasing spread of COVID-19 in the US and Europe, we are moving to a much more cautious near-term stance on global credit. This week, we are making the following additional changes to our model bond portfolio to reflect the growing odds of a global recession: Downgrade global corporates to underweight versus global governments Maintain a neutral overall portfolio duration, but favor countries within the government bond allocation that are more highly correlated to changes in to the overall level of global bond yields. Chart 8Favor Higher-Beta Bond Markets With Room To Cut Rates Favor Higher-Beta Bond Markets With Room To Cut Rates Favor Higher-Beta Bond Markets With Room To Cut Rates Given how far yields have declined already, we think raising allocations to “high yield beta” countries that can still cut interest rates, at the expense of reduced weightings toward low beta countries that have limited scope to ease policy, offers a better risk/reward profile than simply raising duration exposure across the board. Such a nuanced argument is less applicable to global corporates, where elevated market volatility, poor investor risk appetite and deteriorating global growth momentum all argue for continued near-term underperformance of corporates versus government bonds. Specifically, we are making the following changes to our recommended allocations, presented with a brief rationale for each move: Upgrade US Treasuries and Canadian government bonds to overweight: Both Treasuries and Canadian bonds are higher beta markets, as we define by a regression of monthly yield changes to changes in the yield of the overall Bloomberg Barclays Global Treasury index (Chart 8). The Fed cut 50bps last week as an emergency measure and has 75bps to go before reaching the zero bound, which the market now expects by mid-year. Additional bond bullish moves after reaching the zero bound, like aggressive forward guidance, restarting quantitative easing and even anchoring Treasury yields in a BoJ-like form of yield curve control, are all possible if the US enters a recession. Meanwhile, the Bank of Canada (BoC) followed the Fed’s cut with a 50bp easing the next day and signaled that additional rate cuts are likely to prevent a plunge in Canadian consumer confidence. The collapsing oil price likely seals the deal for additional rate cuts by the BoC in the next few months. Downgrade Japanese government bonds to maximum underweight: Japanese government bonds (JGBs) are the most defensive low-beta market in model bond portfolio universe, thanks to the Bank of Japan’s Yield Curve Control policy that anchors the 10yr JGB yield around 0%. This makes JGBs the best candidate for a maximum underweight stance when global bond yields are not expected to rise in the near term, as we expect. Downgrade Germany and France to Underweight: The ECB meets this week and will be under pressure to ease policy given recent moves by other major central banks. A -10bps rate cut is expected, which may happen to counteract the recent increase in the euro versus the US dollar, but there is also possibility that ECB will increase and/or extend the size and scope of its current Asset Purchase Program. Given the ECB’s lack of overall monetary policy flexibility, and low level of inflation expectations, we see limited scope for the lower-beta German and French government bonds to outperform their global peers. Remain overweight UK and Australia: While both Australian government bonds and UK Gilts have a “median” yield beta in our model bond portfolio universe, both deserve moderate overweights as there is still the potential for rate cuts in both countries. The Reserve Bank of Australia (RBA) cut the Cash Rate by -25bps last week and they are still open to cut further to boost a sluggish economy hurt by wildfires and weak export demand from China. The RBA will stay more dovish for longer until we will see clear signs of a rebound of the Chinese economy from the COVID-19 outbreak. The Bank of England (BoE) will likely cut its policy rate later this month, or even before the next scheduled policy meeting, as COVID-19 is starting to spread through the UK. Downgrade US High-Yield To Underweight: US junk bonds had already taken a hit during the global market selloff in recent weeks, but the collapse in oil prices pummeled the market given the high weighting of US shale producers in the index (Chart 9). With additional weakness in oil prices likely as Russia and Saudi Arabia are now in a full-fledged price war, US high-yield will come under additional spread widening pressure focused on the weaker Caa-rated segment that contains most of the energy names. We recommend a zero weight in the Caa-rated US junk bonds, within an overall underweight allocation to the entire asset class. Downgrade euro area investment grade and high-yield corporates to underweight: COVID-19 is now spreading faster in Germany and France, after leaving Italy in a full-blown national crisis. The export-oriented economies of the euro area were already vulnerable to a global growth slowdown, but now domestic growth weakness raises the odds of a full-blown recession – not a good environment to own corporate bonds, especially with the euro now appreciating. Downgrade emerging market (EM) USD-denominated sovereigns and corporates to underweight: EM debt remains a levered play on global growth, so the increased odds of a global recession are a problem for the asset class – even with sharply lower interest rates and early signs of a softening in the US dollar (Chart 10). Chart 9Downgrade US Junk Bonds To Underweight Downgrade US Junk Bonds To Underweight Downgrade US Junk Bonds To Underweight Chart 10Still Not Much Broad-Based Weakness In The USD Still Not Much Broad-Based Weakness In The USD Still Not Much Broad-Based Weakness In The USD We will present the new specific model bond portfolio weightings, along with a discussion of the risk management implications of these changes, in next week’s report. Bottom Line: Maintain overall neutral portfolio duration exposure with so much bad news already priced into yields. Downgrade overall global spread product exposure to underweight versus governments on a tactical (0-3 months) basis given intense uncertainties on COVID-19 and oil markets. Upgrade high-beta countries with room to cut interest rates (the US & Canada) to overweight, while downgrading lower-beta countries with less policy flexibility (Germany, France, Japan) to underweight. Downgrade US high-yield, euro area corporates and emerging market USD sovereigns & corporates to underweight.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com   Ray Park, CFA Research Analyst ray@bcaresearch.com Footnotes 1https://www.wsj.com/articles/fear-isnt-the-only-driver-of-the-treasury-rally-banks-need-to-hedge-their-mortgages-1158347080 Recommendations Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns