Monetary

Dear Client, US Investment Strategy will take the first of two summer breaks next week, so there will be no publication on July 13th. We will return on July 20th with the latest installment of our Big Bank Beige Book, reviewing the five largest banks’ second quarter earnings calls. Best regards, Doug Peta   Highlights Bottom-up S&P 500 earnings expectations for 2021 are probably high: I/B/E/S expectations incorporating periods six or seven quarters away are little more than extrapolations and investors shouldn’t get hung up on them. The higher corporate income tax rates that would follow a Democratic sweep are a bigger concern. Policymakers have decisively won the early rounds of their bout with the pandemic’s economic effects, … : Transfer payments pushed April and May personal income well above its February level, and households have accordingly stayed current on their rent and other financial obligations. … and they will win the fight provided Congress doesn’t tire, … : Volatility may rise amidst the back and forth of negotiations, but Republican Senators cannot risk allowing aid to elapse three months before the election. … but what’s good for the economy in the long run may come at the expense of active managers’ performance: Value investors can’t catch a break, and all stock pickers will have to contend with a policy backdrop that challenges their established modus operandi.   Feature We have not traveled any farther for work than the kitchen table in three and a half months. Renewing our expiring passport could take a year, and the clock is ticking on our ability to fly domestically on a driver’s license from the persona non grata state of New York. Unless the administration or the electorate has a change of heart, the REAL ID rules may prevent us from seeing a client in person until well into 2021. At least the construction at LaGuardia may be finished by then. Even if we’re not seeing clients face to face, however, communication continues. Several topics have come up repeatedly in virtual discussions and we devote this week’s report to examining them. Our overriding impression is that global investors have been surprised by risk assets’ resilience and are skeptical that it can be sustained. We share the surprise and some measure of the skepticism, though we are more constructive than most BCA clients because of our conviction that policymakers can bridge the economic gap created by the pandemic and the commercially restrictive measures undertaken to combat it. Yes, Estimates Are Too High (But It’s Mainly An Election Story) Q: Consensus S&P 500 earnings estimates for next year are in line with actual 2019 earnings, yet 2019 was the tenth full year of an expansion and we’re likely to begin 2021 with an unemployment rate close to 10%. Isn’t there something wrong with this picture? We agree that consensus estimates for 2021 S&P 500 earnings are too high. It seems unlikely on its face that 2021 earnings, currently estimated at $163, will match 2018 ($162) and 2019 ($163) when the public health and economic backdrops are so uncertain. An additional 14% of EPS growth in 2022 seems like a pipe dream. We put very little stock in consensus estimates more than two quarters into the future, however, because analysts put very little effort into producing them. They focus on the current quarter and the following quarter; estimates beyond that range are nothing more than simple extrapolation. Investors familiar with sell-side analysts’ processes presumably don’t look beyond near two-quarter estimates themselves. We therefore doubt that the equity market is hanging on stated 2021 estimates and will be at risk when they are eventually revised down. We simply conclude that the S&P 500’s forward four-quarter earnings multiple of 24 is somewhat more elevated than it appears to the naked eye. Stocks are not cheap, and investors have probably gotten somewhat complacent. Equities have little margin for safety now and are therefore vulnerable to a near-term decline. Valuation is a notoriously poor timing tool, however, and we are content to remain neutral on equities over the tactical zero-to-three-month timeframe. A much stronger case against the earnings outlook for 2021 and beyond comes from the president’s flagging re-election prospects. Our Geopolitical Strategy service continues to estimate Joe Biden’s probability of winning the election at 65%. The virtual betting market PredictIt places Biden’s odds at 62%, and has had him as the favorite since May 30th. It is too simplistic to say that a Democratic president, backed by majorities in both houses of Congress,1 would be bad for the economy, but a Biden victory would introduce two profit headwinds. First, reversing half of the decline in the top marginal corporate tax rate, as the Biden campaign has proposed, would directly strike at the earnings stream available to common shareholders. Precisely quantifying that drop is not easy. S&P 500 constituents’ effective tax rates vary widely, with only a small proportion paying the statutory rate, and they do not disclose the federal component of their tax bill. We make the simple back-of-the-envelope assumption that the maximum net earnings impact of the cut in the top marginal rate from 35% to 21%, beginning in 2018, was 21.5%, as .79 (1-.21) is 21.5% greater than .65 (1-.35). Similarly, the maximum net earnings impact of hiking the top marginal rate to 28% from 21%, beginning in 2021, would be -9%, as .72 (1-.28) is nearly 9% less than .79 (1-.21). Equities seem to be ignoring the negative profit margin consequences of an increasingly likely Democratic sweep. Chart 1The Tax Cut Materially Boosted Median S&P 500 Earnings Q&A Q&A The change in effective tax rates before and after the 2018 tax cuts was about half of our maximum ballpark estimate. In the two years before the rate cut, excluding 4Q17 and its myriad one-time adjustments, the median effective tax rate for S&P 500 constituents was around 28%; in the two subsequent years, excluding 1Q18, the median rate has hovered near 20% (Chart 1). The change suggests that the tax cuts have boosted median S&P 500 earnings by about 11%.2 In addition to raising taxes, a Biden administration would be considerably more friendly to labor than the Trump administration. A soft labor market in which full employment is at least a few years away argues against broad wage gains, but companies that have benefitted from a complaisant National Labor Relations Board for the last four years could face a rude awakening. If Biden wins, we wager that McDonald’s workers will be unionized before next summer,3 a scenario that McDonald’s stock clearly does not anticipate (Chart 2). Chart 2For McDonald's, A Biden Win Means An NLRB Reversal For McDonald's, A Biden Win Means An NLRB Reversal For McDonald's, A Biden Win Means An NLRB Reversal Bottom Line: A Democratic sweep would weigh on earnings via higher corporate income tax rates and revived advocacy for labor at executive branch departments like the NLRB. Considering these incremental drags, it is unlikely that S&P 500 earnings will match their 2019 levels in 2021. Policymakers Versus The Virus: The Fight So Far Chart 3D.C. Is Keeping Households Afloat ... D.C. Is Keeping Households Afloat ... D.C. Is Keeping Households Afloat ... Q: Your constructive cyclical take depends on policymakers’ ability to offset the pandemic’s economic consequences. How do the data say that’s going so far? The data say that it’s going swimmingly. Thanks to generous transfer payments from the federal government, personal income in April and May comfortably surpassed February’s pre-pandemic peak (Chart 3). Households have not spent much of their windfall (Chart 4), choosing instead to squirrel it away, driving the savings rate to 32% in April and 23% in May. The mountain of savings will make it easy for households to service their debt (Chart 5), which they have been paying down. Chart 4... And They're Saving The Money, ... ... And They're Saving The Money, ... ... And They're Saving The Money, ... Chart 5... Much To Their Creditors' Relief ... Much To Their Creditors' Relief ... Much To Their Creditors' Relief The apartment REITs will not likely disclose June rent collection data before their earnings calls, but the National Multifamily Housing Council rent tracker shows that June collections have built on May’s month-over-month improvement. Through June 27th, June collections are tracking ahead of April and May collections and are barely off of last year’s pace (Table 1). Table 1Apartment Tenants Are Paying Their Rent Q&A Q&A Table 2Consumer Borrowers Are Making Their Payments Q&A Q&A TransUnion’s monthly consumer loan delinquency data for May reinforce the conclusion that policymakers are achieving their goal of preventing a default spiral. Auto loan delinquencies rose sharply in May, but delinquencies in all other personal loan categories fell on a month-over-month basis (Table 2). Mortgage delinquencies are below their year-ago level, while credit cards and other personal loans have risen only slightly from a low base. Auto loan delinquencies are up appreciably from May 2019, but TransUnion’s data show that the true rot is concentrated in loans made by independent lenders. Their 60-day delinquencies rose to 7.2% in May from 4.5% in April, while bank (0.62%) and credit union delinquencies (0.51%) eased slightly in May. Bottom Line: Extremely generous income assistance has helped households amass formidable cash reserves. The aid has allowed households to pay their rent and service their debt, shielding landlords, banks and many specialty lenders from pressure. Policymakers Versus The Virus: Going The Distance Q: What might cause the Fed to waver in its resolution to help the economy battle the virus? Will the Senate block future stimulus efforts? Nothing will cause the Fed to waver in its resolution to shield the economy from the virus; investors can take Chair Powell’s pledge to do whatever it takes for as long as it takes to the bank. Capitol Hill’s commitment is much less certain and public posturing during Senate negotiations could stoke market volatility. Elected officials reliably respond to career incentives, however, and those incentives will keep recalcitrant Senate Republicans from blocking another round of fiscal largesse. Investors need not worry that Republicans in the Senate will pull the rug out from under the economy and markets – doing so would wreck their own political fortunes. The Republicans’ election prospects have been sliding for a month. Four months is an eternity in a campaign, and they have ample time to reverse their fortunes. But if Republican Senators were to obstruct the passage of the next aid bill, they would be signing their own death warrant. They simply cannot cut off ailing households’ lifeline, or strip municipalities of essential services, as the campaign enters the homestretch. Any individual Senator would be imperiling his/her own quest for influence, and the party’s majority status and relevance, if s/he were to cast one of the votes that blocked a new spending round, and it would be folly to do so over a minor matter like principle. Policymakers Versus Active Managers Q: If valuations no longer matter, how do we show our clients that we’re adding value? It chagrined us to acknowledge on a call last week that equity valuations have been greatly deemphasized in our base case scenario. That scenario calls for overweighting equities in balanced portfolios over a twelve-month timeframe on the view that the flood of emergency stimulus will linger in the system long after it’s needed, stoking aggregate demand and pushing up the prices of cyclically exposed assets. Provided that policymakers succeed in limiting defaults and bankruptcies, thus preventing a pernicious chain reaction from taking hold, we are willing to overlook elevated valuations. Massive accommodation makes active managers' jobs harder because there's no telling who's swimming naked when policymakers won't let the tide go out. Those valuations are supported arithmetically by discount rates which appear as if they will remain very low for an extended period as long as investors don’t become nervous and demand a higher equity risk premium, diluting the impact of nominally lower interest rates. Our base case is that they won’t, but there is no doubt that equity investors’ margin of safety is quite thin. We cannot use the term margin of safety without thinking of Benjamin Graham, and it gives us a pang to think that his disciples may face another few years of wandering in the wilderness. Value investing is predicated on making distinctions between individual companies, as is security analysis more generally. A rising tide lifts all boats, however, and the massive stimulus efforts that have been unleashed in all the major economies (Chart 6) have the effect of obliterating differences between companies. That potentially limits the value that skilled active managers can add to an investment portfolio via a focus on traditional bottom-up metrics. Chart 6All Together Now Q&A Q&A Our solution is to try to focus on the varying impact top-down factors will have on different companies and sub-industry groups. We are overweight the SIFI banks because we view them as the biggest beneficiary of policymakers’ attempt to suppress defaults and their rock-bottom valuations stand in sharp contrast with the rest of the market. We echo our fixed income strategists’ recommendations to buy the bonds the Fed is buying. We also think that positioning portfolios for regulatory changes that might ensue in 2021 and beyond could be a rich source of alpha if a blue wave really is poised to strike the US on the first Tuesday in November.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com     Footnotes 1 Our geopolitical team expects the Democrats to take the Senate if they win the White House. PredictIt markets imply that Democrats have a 61% probability of winning a Senate majority. 2After-tax earnings before the tax cut were 72 cents on the dollar (1-28%) = .72. After the tax cut, they rose to 80 cents (1-20%) = .80. 80 is 11.11% greater than 72. 3Please see the NLRB/McDonald’s discussion on pp.7-9 of the February 3, 2020 US Investment Strategy Special Report, “Labor Strikes Back, Part 3: The Public-Approval Contest,” available at usis.bcaresearch.com.

Highlights Global Growth & Inflation: An increasing number of growth indicators worldwide are tracing out a “v”-shaped pattern from the COVID-19 recession. However, high unemployment and a lack of inflationary pressure will ensure that global monetary policies remain highly stimulative for some time. Duration:  Maintain a neutral duration stance in global fixed income portfolios, as the recent negative correlation between inflation expectations and real yields is likely to continue.  Stay overweight higher-yielding government bonds in the US, Canada and Italy versus core Europe and Japan.  Also, favor inflation-linked bonds over nominals - particularly in the US, Canada and euro area – as breakevens will continue drifting higher over the next 6-12 months. Corporate Credit: Maintain a neutral overall allocation to global spread product, focused on overweights in markets directly supported by central bank purchases (US investment grade corporates of maturities up to five years, US Ba-rated high-yield). Feature Today marks the midway point of what has already become one the most eventful years of our lifetimes. Investors have had to process multiple massive shocks: a global pandemic; a historically deep worldwide recession; and in the US, nationwide social unrest and a now politically vulnerable president.  Yet despite the severe economic shock and persistent uncertainties, financial market performance over the entire first six months of the year has not been terrible. The S&P 500 index is only down -5.5% year-to-date, while the NASDAQ index is up +10.5% over the same period. Meanwhile, the Barclays Global Aggregate benchmark fixed income index is up +3.9% so far in 2020 (in hedged US dollar terms).  In light of the magnitude of losses suffered by global equity and credit markets in February and March, those are impressive year-to-date returns. CHART OF THE WEEKA Tug Of War A Tug Of War A Tug Of War Falling government bond yields, driven lower by an aggressive easing of global monetary policies through rate cuts and quantitative easing (QE), have played a major role in driving the recovery in risk assets. With the number of global COVID-19 cases now accelerating rapidly once again, however, the odds are increasing that investors become more reluctant to drive equity and credit valuations even higher (Chart of the Week). At the halfway point of the calendar year, this is a good time to review our most trusted indicators, and current investment recommendations, for global government debt and corporate credit. Duration Allocation: A Non-Inflationary Growth Recovery – But With Higher Inflation Expectations Our current recommended overall global duration stance is NEUTRAL. Global growth has started to recover from the sharp COVID-19 recession.  Survey data like manufacturing and services purchasing managers indices (PMIs) have rapidly rebounded from the huge March/April drops, although most PMIs remain below the 50 level suggesting accelerating economic growth (Chart 2). While there is less timely “hard data” available due to reporting lags, there are signs of improvement in critical measures like US durable goods orders, which soared +15.8% in May after falling by similar amounts in both March and April.  Global realized inflation data remains very weak, however, with headline CPI flirting with deflation in most major develop economies.  Combined with still very high levels of unemployment, which will take years to return anywhere close to pre-COVID levels, the backdrop will keep central banks highly dovish for a long time. The US Federal Reserve has already signaled that the fed funds rate will remain near 0% until the end of 2022, while the Bank of Japan has said no rate hikes will happen before 2023 at the earliest. Our Global Duration Indicator, comprised of three elements - our global leading economic indicator and its diffusion index, along with the global ZEW measure of economic expectations - has already returned to pre-COVID levels (Chart 3).  This leading, directional indicator of bond yields suggests that the downward pressure on yields seen over the first half of 2020 is over.   Chart 2Growth, But Not Inflation, Is Recovering Growth, But Not Inflation, Is Recovering Growth, But Not Inflation, Is Recovering Chart 3Our Global Duration Indicator Says Bond Yields Will Bottom Out In H2/2020 Our Global Duration Indicator Says Bond Yields Will Bottom Out In H2/2020 Our Global Duration Indicator Says Bond Yields Will Bottom Out In H2/2020 However, it is far too soon to expect a big bond selloff, with nominal government bond yields now pulled in opposing directions by their real yield and inflation expectations components. As we discussed in last week’s report, our models for market-based inflation expectations indicate that breakevens derived from inflation-linked bonds are too low.1 Hyper-easy monetary policies from the Fed, ECB and other major central banks will help lift inflation expectations, especially with oil prices likely to continue rising over the next 12-18 months according to BCA’s commodity strategists.  Chart 4Higher Inflation Breakevens Should Eventually Help Steepen Yield Curves Higher Inflation Breakevens Should Eventually Help Steepen Yield Curves Higher Inflation Breakevens Should Eventually Help Steepen Yield Curves The rise in inflation breakevens already seen over the past three months in places like the US, Canada and Australia – combined with dovish forward guidance on future interest rates that has kept shorter-maturity bond yields anchored -  should have resulted in a bearish steepening of government bond yield curves.  Yet the differences between 10-year and 2-year yields across the major developed markets have gone sideways since the beginning of April, even as 10-year inflation breakevens have increased (Chart 4). This has also kept the overall level of nominal 10-year yields nearly unchanged over the same period; for example, the 10-year US Treasury yield is now at 0.64% compared to the 0.58% closing level seen back on April 1. An outcome of rising inflation expectations with stable nominal yields must mean that real bond yields have declined by nearly as much as breakeven inflation rates have increased.  That is exactly what has happened when looking at the actual real yield on 10-year inflation-linked bonds in the US, euro area, Canada, Japan, the UK and Australia. Using the US as an example, the 10-year inflation breakeven has increased +44bps since April 1, while the 10-year real yield has declined by -38bps. The decline in global real bond yields has coincided with the major central banks aggressively easing monetary policy, including large-scale purchases of government bonds.  This occurred even in countries that had not engaged in major QE programs before, like Australia and Canada. The sizes involved for the new QE purchases have been massive, given the significant increase in the size of central bank balance sheets in absolute terms and relative to GDP (Chart 5).  An outcome of rising inflation expectations with stable nominal yields must mean that real bond yields have declined by nearly as much as breakeven inflation rates have increased.   Chart 5Global QE Is Helping Drive Real Bond Yields Lower Global QE Is Helping Drive Real Bond Yields Lower Global QE Is Helping Drive Real Bond Yields Lower It is possible that the decline in real yields is due to other factors besides QE purchases, like markets pricing in structurally slower economic growth (and lower neutral interest rates) following the severe COVID-19 recession.  Or perhaps it is more fundamentally economic in nature, reflecting a surge in domestic savings at a time of falling investment spending.  The key takeaway for investors is that rising inflation expectations do not necessarily have to translate into higher nominal bond yields if the markets do not expect central banks to signal a need to tighten monetary policy in the near future, which would push real bond yields higher. For this reason, we continue to prefer structural allocations to inflation-linked bonds out of nominal government debt, rather than maintaining below-benchmark duration exposure in fixed income portfolios.  That is a position that benefits from both higher inflation breakevens and lower real yields, while still having the benefit of maintaining a neutral level of safe-haven duration exposure given the lingering uncertainties over the accelerating global spread of COVID-19. At the specific country level, we recommend overweighting inflation-linked bonds over nominals in the US, Italy and Canada where breakevens appear most cheap on our models. Bottom Line: Maintain a neutral duration stance in global fixed income portfolios, as the recent negative correlation between inflation expectations and real yields is likely to continue.  Stay overweight higher-yielding government bonds in the US, Canada and Italy versus core Europe and Japan.  Also, favor inflation-linked bonds over nominals - particularly in the US, Canada and euro area – as breakevens will continue drifting higher over the next 6-12 months. Corporate Credit Allocation: Keep Buying What The Central Banks Are Buying Our current recommended overall stance on global corporate credit is NEUTRAL. The same reflationary arguments underlying our recommended inflation-linked bond positions also help support our views on global corporate debt.  Aggressively easy monetary policies, combined with some recovery in global economic growth, will help minimize the risk premium on corporate debt.  Yield-starved investors will continue to have no choice but to look to corporate bond markets for income over the next 6-12 months. The same reflationary arguments under-lying our recommended inflation-linked bond positions also help support our views on global corporate debt.   The combined growth rate of the balance sheets for the major central banks (the Fed, ECB, Bank of Japan and Bank of England) has been a reliable leading indicator of excess returns for global investment grade and high-yield debt since the 2008 financial crisis (Chart 6). With that combined balance sheet now expanding at a 34% year-over-year pace after the ramp up of global QE, this suggests continued support for global corporate outperformance versus government bonds over the next year. Corporate debt is also benefitting from direct central bank purchases by the Fed, ECB and Bank of England. Unsurprisingly, the 2020 peak in US investment grade and high-yield corporate spreads occurred on March 20, literally the last trading day before the Fed announced its corporate bond purchase programs (Chart 7).  Chart 6Global QE Will Continue To Support Risk Assets Global QE Will Continue To Support Risk Assets Global QE Will Continue To Support Risk Assets Chart 7The Fed Has Removed The 'Left Tail' Risk Of US Credit The Fed Has Removed The 'Left Tail' Risk Of US Credit The Fed Has Removed The 'Left Tail' Risk Of US Credit   The Fed’s announced plan for its corporate bond buying was to have it focused on shorter maturity (1-5 year) investment grade credit.  Later, the Fed allowed the programs to buy high-yield ETFs while also allowing “fallen angel” debt of investment grade credits downgrade to junk to be held within the programs.  Since that announcement in late March, risk premiums for US corporate debt across all credit tiers and maturities have narrowed.  However, the limits of that broad-based spread tightening may have now been reached, as some of the dislocations in US corporate bond markets created by the global market rout in February and early March have now been corrected.  Chart 8Relative US Corporate Spread Relationships Have Normalized Relative US Corporate Spread Relationships Have Normalized Relative US Corporate Spread Relationships Have Normalized For example, the spread on the Bloomberg Barclays 1-5 year US investment grade index – a proxy for the universe of bonds the Fed is buying – has moved from a level 25bps above that of the 5-10 year US investment grade index, seen before the Fed announced its purchase programs, to 53bps below the longer maturity index (Chart 8, top panel). This is a more normal “slope” for that spread maturity curve relationship, in line with levels seen over the past decade. This suggests that additional spread tightening in US investment grade corporates may be more widespread across all maturities, even with the Fed still focusing its own purchases on shorter-maturity bonds. A similar dynamic is evident in the US high-yield universe.  The spread between the riskier B-rated and Caa-rated credit tiers to Ba-rated names has narrowed since late March to the lower bound of a rising trend channel in place since mid-2018 (bottom panel).  The market appears to be pricing in a structurally rising risk premium between lower-rated junk and higher-rated US high-yield debt – likely a sign of a US credit cycle that was already maturing before COVID-19. The implication going forward is that additional outperformance of lower-rated US junk bonds will be difficult to achieve. The market appears to be pricing in a structurally rising risk premium between lower-rated junk and higher-rated US high-yield debt – likely a sign of a US credit cycle that was already maturing before COVID-19.  European corporate debt has also been witnessing similar trends to those seen in the US.  Euro area investment grade corporate spreads have tightened alongside US spreads since the March 20 peak, but that trend has now stabilized given the recent uptick in market volatility measures like the VIX and VStoxx index (Chart 9).  The spread tightening in euro area high yield has also stalled, with spreads seeing a slight uptick alongside the recent increase in market volatility (Chart 10). Chart 9Global IG Spread Tightening Has Stalled Global IG Spread Tightening Has Stalled Global IG Spread Tightening Has Stalled Chart 10Have Global HY Spreads Bottomed? Have Global HY Spreads Bottomed? Have Global HY Spreads Bottomed? Given the renewed uncertainty over the accelerating number of global COVID-19 cases, hitting large US population areas in the US southern states and across the emerging economies, it will be difficult for global market volatility and credit spreads to return to even the recent lows, much less the pre-COVID levels. Thus, we continue to recommend a “selective” approach to global corporate bond allocations, based on valuations, while maintaining a neutral exposure to credit versus government bonds. Our preferred method for evaluating the attractiveness of credit spreads is to look at 12-month breakeven spreads, or the amount of spread widening that would make corporate bond returns equal to duration-matched government debt over a one-year horizon.  We compare those breakeven spreads to their own history to determine if the current level of credit spreads offer value, while adjusting for the underlying spread volatility backdrop. In the US, the 12-month breakeven spread for investment grade corporates is now less attractive than was the case back in March, now sitting at the long-run median level (Chart 11, top panel). The 12-month breakeven for US high-yield is much more attractive, sitting near the highest readings dating back to the mid-1990s (bottom panel).  Of course, this approach only looks at spreads relative to their volatility and does not incorporate credit risk, which is an obvious risk after the recent collapse in US economic growth. In other words, high-yield needs to offer very high 12-month breakeven spreads to be attractive in the current environment. In the euro area, 12-month breakevens for high-yield are only at long-run median levels, while the breakevens for investment grade are a bit more attractive sitting at the 65th percentile of its own history (Chart 12). Chart 11US Corporate Breakeven Spreads: HY Looks Attractive, But Beware Defaults US Corporate Breakeven Spreads: HY Looks Attractive, But Beware Defaults US Corporate Breakeven Spreads: HY Looks Attractive, But Beware Defaults Chart 12European Corporate Breakeven Spreads: Now At Median Levels European Corporate Breakeven Spreads: Now At Median Levels European Corporate Breakeven Spreads: Now At Median Levels Importantly, 12-month breakeven spreads in both the US and euro area, for investment grade and high-yield, have not fallen into the lower quartile rankings, even after the sharp tightening of spreads since late March. This is a sign the current rally in global corporates has more room to run, strictly from a spread compression perspective.  For high-yield credit, however, the risk of default losses coming after a short, but intense, recession must be factored into any assessment of valuation. Chart 13Default-Adjusted HY Spreads In The US & Europe Are Unattractive Default-Adjusted HY Spreads In The US & Europe Are Unattractive Default-Adjusted HY Spreads In The US & Europe Are Unattractive Looking at default-adjusted spreads – spread in excess of realized and expected credit losses – shows that the current level of junk spreads on both sides of the Atlantic offers little-to-no compensation for credit losses (Chart 13).  Default-adjusted spreads are already well below long-run median levels, but if a typical 10-12% recessionary default rate is applied, expected credit losses over the next twelve months will exceed the current level of spreads, thus ensuring negative excess returns on allocations to junk bonds versus government bonds. Tying it all together, our valuation metrics for corporates suggest the following recommended allocations: Overweight US investment grade corporates, but focused on the 1-5 year maturity range that is supported by Fed purchases Overweight US Ba-rated high-yield (also eligible for Fed holdings), while underweighting lower-rated B- and Caa-rated junk Neutral allocation to euro area investment grade Underweight euro area high-yield across all credit tiers This allocation is in line with our current allocations within our model bond portfolio, which are on pages 13-14. Bottom Line: Maintain a neutral overall allocation to global spread product, focused on overweights in markets directly supported by central bank purchases (US investment grade corporates of maturities up to five years, US Ba-rated high-yield).   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com   Footnotes 1  Please see BCA Research Global Fixed Income Strategy Weekly Report, “How To Play The Revival Of Global Inflation Expectations”, dated June 23, 2020, available at gfis.bcaresearch.com Recommendations Contagion Vs. Reflation: The Battle Of 2020 Rages On Contagion Vs. Reflation: The Battle Of 2020 Rages On Contagion Vs. Reflation: The Battle Of 2020 Rages On Contagion Vs. Reflation: The Battle Of 2020 Rages On Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Money Supply Drivers: About 70% of the unprecedented increase in broad money supply is the result of the Fed’s asset purchase activity. The remaining 30% is due to an uptick in C&I loan growth, almost all of which is from nonfinancial firms tapping existing credit lines, an activity that will taper off in the coming months. Money Supply Impact: We don’t find broad money supply measures (M1 and M2) to be useful indicators of economic growth, inflation or financial asset performance. Bank Bonds: After viewing the results of the Fed’s stress tests, we still think the odds of bank ratings downgrades this year are low. Investors should stay overweight subordinate bank bonds. Feature The COVID-19 recession and associated policy response have led to unprecedented moves in a number of economic indicators. In this week’s report we focus on one such move that is particularly difficult to square with the rest of the economic landscape, at least judging by the large volume of client questions we’ve received on the topic. The move in question: Broad money supply growth (M1 & M2) is faster today than at any time since the mid-1940s (Chart 1). This week, we look at what has driven money growth to such heights and consider what it might mean for bond investors. We also update our call to overweight subordinate bank bonds based on last week’s release of the Fed’s bank stress tests. Chart 1Massive Money Growth! Massive Money Growth! Massive Money Growth! Money Supply Drivers The US economy’s broad money supply is more or less the sum total of all the money sitting in bank deposits at any point in time. More specifically, the M1 measure includes currency in circulation, demand deposits and traveler’s checks. The M2 measure includes all of M1 plus savings accounts, time deposits and retail money market funds. Fed asset purchases and bank lending are the two drivers of money supply growth. There are two ways for these broad money supply measures to grow. First, the Fed can purchase securities from the private market. Second, banks can lend money to the private sector. We consider both of these drivers in turn. The Federal Reserve’s Contribution To Money Growth The Fed influences the money supply by changing the amount of reserves in the banking system. To see how this works, Table 1 shows recent balance sheets for both the Fed and the aggregate US banking system. Table 1The Link Between The Fed’s Balance Sheet And The Aggregate US Banking System The Case Against The Money Supply The Case Against The Money Supply The largest line items on the Fed’s balance sheet are the securities it owns (on the asset side) and the reserves it supplies to the banking system (on the liability side). The Treasury Department’s General Account has also become a sizeable liability for the Fed during the past couple of months (see Box). Box 1: The Large Treasury General Account Is Not Stimulus Waiting To Be Deployed The Treasury General Account (TGA), aka the Treasury Department’s cash account at the Fed, has skyrocketed during the past couple of months and now totals $1.6 trillion (Chart 3). This has prompted more than a few client questions, mostly asking whether this large amount of money represents fiscal stimulus that is waiting to be deployed. Chart 3Treasury Holds A Huge Cash Buffer Treasury Holds A Huge Cash Buffer Treasury Holds A Huge Cash Buffer It does not. Any new fiscal stimulus must be authorized by Congress and with most of the funds from the CARES act having already been paid out, any further fiscal stimulus is contingent upon Congress passing a follow-up bill. So why is the TGA balance so large? The Treasury Department’s job is to finance the federal government’s deficit by issuing bonds. To do this, it must make estimates about what tax revenues and government spending will be in the future. To avoid a situation where it has not issued enough bonds to finance the deficit, it will typically err on the side of caution and issue some extra bonds, holding the proceeds in cash in its account at the Fed. Due to the heightened uncertainty of the current macro environment, it recently decided to target a larger-than-usual cash balance of $800 billion. It even overshot that target during the past couple of months, likely because tax revenues came in higher than expected. Going forward, heightened uncertainty about federal deficit projections will ensure that the Treasury continues to hold an elevated cash balance. However, it will probably try to bring the TGA balance down a bit in the second half of the year, closer to its stated $800 billion target. It will accomplish this by simply issuing fewer T-bills in the second half of the year. This will have the result of increasing the broad money supply through the same mechanism as Fed asset purchases. That is, any drawdown in the TGA increases the amount of reserves supplied on the liability side of the Fed’s balance sheet. When the Fed buys a Treasury security it removes that security from the private market and replaces it with cash in the form of a bank reserve. Those bank reserves are a liability for the Fed, but appear on the asset side of the banking sector’s aggregate balance sheet. Please note that the amount of reserves supplied on the Fed’s balance sheet in Table 1 doesn’t exactly match the amount of reserves shown on the banking sector’s balance sheet. This is only because the numbers were recorded on different days. Turning to the banking sector’s balance sheet, we see that when the amount of reserves increases there are only a few different things that can occur to keep the balance sheet in balance. Banks can accommodate the increase in reserves by reducing the amount of loans or securities they hold. Alternatively, banks can raise capital, borrow in private debt markets or show an increase in deposits. When banks accommodate the increase in reserves by raising deposits, the money supply rises. Charts 2A and 2B show the change in the main items on the aggregate banking system balance sheet since the end of February. First, we see that banks did not reduce their other asset holdings in response to the sharp increase in reserves. Neither did they raise capital or debt. Rather, deposit growth accommodated the entire increase in bank reserves. Chart 2AChange In Commercial Bank Assets: February 26 To June 17, 2020 The Case Against The Money Supply The Case Against The Money Supply Chart 2BChange In Commercial Bank Liabilities & Capital: February 26 To June 17, 2020 The Case Against The Money Supply The Case Against The Money Supply In fact, deposits have grown by about $2 trillion since February compared to reserve growth of $1.4 trillion. Roughly, we can say that Fed asset purchases are responsible for 70% of the growth in the money supply since then. The remaining 30% is attributable to the second driver of the money supply: bank lending. Bank Lending’s Contribution To Money Growth Looking again at Table 1, we see that an increase in bank loans must also lead to an increase in deposits, unless the bank raises debt and/or capital instead. Further, Chart 2A shows that increased bank lending since February accounts for about 30% of the growth in deposits. However, we expect bank loan growth to moderate in the coming months, easing some of the upward pressure on the money supply. This year's increase in bank loan growth has been driven entirely by C&I loans. A look at bank loan growth by category shows that this year’s increase has been driven entirely by Commercial & Industrial (C&I) loans (Chart 4). Growth in other major loan categories – commercial real estate, residential real estate and consumer – has flagged. Further, the increase in C&I lending has been mostly due to firms drawing on existing credit lines. Chart 4A Spike In C&I Lending A Spike In C&I Lending A Spike In C&I Lending The Fed’s Senior Loan Officer Survey for the first quarter of 2020 showed a small increase in C&I loan demand. But the survey also asked about potential reasons for the demand uptick (Chart 5). When faced with that question, 95% of respondents reported that “precautionary demand for cash” was a “very important” reason for increased C&I loan demand in Q1. 71% of respondents also pointed to a lack of internally generated funds as a “very important” reason. Importantly, no respondents reported increased C&I loan demand due to investment needs or M&A activity. Chart 5Possible Reasons For Greater C&I Loan Demand In Q1 2020 The Case Against The Money Supply The Case Against The Money Supply The distinction is important. Greater investment needs and M&A activity would suggest an improving economic back-drop, and would imply a more sustainable increase in bank lending. In contrast, there is a limit to how much firms can tap existing credit lines for immediate cash needs, and this activity should taper off during the next few months. Bottom Line: About 70% of the unprecedented increase in broad money supply is the result of the Fed’s asset purchase activity. The remaining 30% is due to an uptick in C&I loan growth, almost all of which is from nonfinancial firms tapping existing credit lines, an activity that will taper off in the coming months. The Implications Of Rapid Money Growth According to some theory and popular thought, there are three possible channels through which rapid money growth could impact the economy and financial markets: Fast money growth could lead to stronger economic growth in the future. Fast money growth could lead to rising inflationary pressures. A larger money supply could suggest that there are more funds available to deploy in financial markets. As such, it could lead to price appreciation in risky financial assets. We are inclined to downplay the importance of M1 and M2 as indicators in all three of these areas, for reasons discussed below. The Money Supply’s Impact On Economic Growth In the past, measures of the broad money supply (M1 and M2) did a good job of forecasting economic growth and were tracked closely (and at times targeted) by the Federal Reserve. But as the banking and monetary systems evolved, M1 and M2 became less important. As Fed Chairman Alan Greenspan explained in 1996:1 At different times in our history a varying set of simple indicators seemed successfully to summarize the state of monetary policy and its relationship to the economy. Thus, during the decades of the 1970s and 1980s, trends in money supply, first M1, then M2, were useful guides. […] Unfortunately, money supply trends veered off path several years ago as a useful summary of the overall economy. Chairman Greenspan’s insight is backed up by the empirical data (Chart 6). Real M2 growth was an excellent leading indicator of economic growth until the early 1990s. The relationship has broken down since then, and in fact, the only reliable trend in Real M2 since the 1990s is that it tends to spike during recessions. Chart 6Broad Money Growth Has Been A Poor Indicator For Economic Activity Since The 1990s Broad Money Growth Has Been A Poor Indicator For Economic Activity Since The 1990s Broad Money Growth Has Been A Poor Indicator For Economic Activity Since The 1990s The Conference Board also noticed this trend and removed Real M2 from its Leading Economic Indicator in 2012. According to the Conference Board, Real M2 ceased to function as a leading economic indicator because (i) the Fed began targeting interest rates instead of monetary aggregates and (ii) the creation of interest-bearing checking accounts and money market funds increased safe haven demand for M2. The latter helps explain why money growth has surged during the last three recessions. All in all, broad money growth is now a poor indicator for GDP. The Money Supply’s Impact On Inflation Another popular theory is that money growth is a leading indicator of inflation. This stems from the following identity, aka the Equation of Exchange: MV = PY Where: M = money supply, V = velocity of money, P = price level and Y = real output The identity holds, but is of little practical value, mainly because there is no good way to measure (or model) velocity (V) without relying on money growth and nominal GDP (P*Y). This means that an increase in the money supply doesn’t necessarily tell us anything about inflation, because we have no idea how velocity will respond. In fact, many commentators have observed that the stronger empirical correlation is actually between money velocity (PY/M) and core inflation (Chart 7). When nominal GDP growth exceeds money growth, core inflation tends to rise 18 months later. However, this relationship also holds if we remove money supply from the equation entirely (Chart 7, bottom panel). What we’re actually observing is that core inflation tends to lag economic growth by about 18 months. Chart 7Inflation Lags Economic Growth, Not Broad Money Growth Inflation Lags Economic Growth, Not Broad Money Growth Inflation Lags Economic Growth, Not Broad Money Growth Since we’ve already seen that money supply does a poor job forecasting economic growth, it’s clear that indicators such as M1 and M2 don’t improve our ability to forecast inflation, and in fact probably only confuse the picture. The Money Supply’s Impact On Financial Markets BCA’s US Bond Strategy definitely subscribes to the notion that the stance of monetary policy is one of the most important drivers of financial market performance. If the Fed keeps interest rates low and signals to the market that rates will stay low for a long time, then we would expect investors to chase greater returns in riskier assets, driving up the prices of corporate bonds and equities. That being said, the appropriate way to measure the stance of monetary policy is with interest rates. Money supply measures like M1 and M2 are not helpful guides for risk asset performance. We have already seen that an increase in the money supply can only arise via (i) greater bank lending or (ii) the Fed’s purchase of securities and injection of reserves into the banking system. Both of these things are likely to occur when interest rates are low and monetary policy is accommodative. Low interest rates boost loan demand, and large-scale Fed asset purchases are more likely to occur when interest rates are already at the zero-lower-bound. We would argue that it is, in fact, low interest rates that influence both money growth and financial asset prices. The drivers of money supply growth – bank lending and Fed asset purchases – don’t offer any new information beyond what the interest rate already tells us. On loan growth, both loan demand and risk asset price appreciation are functions of low interest rates. In fact, financial markets will respond more quickly to changes in interest rates than will bank lending: Stock prices are included in the Conference Board’s Leading Economic Indicator, while C&I bank lending is included in the Lagging Economic Indicator.2 This means that, practically, any money supply growth that is driven by bank lending is not useful as an indicator for financial asset prices. What about money growth that is driven by Fed asset purchases? Here, we need to distinguish between the signaling impact of Fed asset purchases and any other potential impact that purchases might have on asset prices. In the first half of 2019, financial markets responded to the Fed's dovish interest rate policy, not to its shrinking balance sheet. Though the data are difficult to parse, our reading is that the only meaningful impact of Fed purchases on financial asset prices is through what the purchase announcements signal to markets about the future path of interest rates. To test this theory, we need to search for periods when the Fed’s signaling about its future interest rate policy diverges from its balance sheet policy. That is, we need to find periods when the balance sheet is shrinking and Fed rate guidance is becoming more dovish, or periods when the balance sheet is growing and rate policy is becoming more hawkish. Unfortunately, we can only identify one such period and that is the first half of 2019 when the Fed was simultaneously shrinking its balance sheet and signaling to markets that interest rate policy was becoming more dovish (Chart 8A). During that period, financial markets responded to the more dovish interest rate policy and not to the shrinking of the Fed’s balance sheet (Chart 8B). Bond yields fell, the dollar weakened and both corporate bonds and equities delivered strong returns. Chart 8ARates Policy Trumps Balance Sheet Part I Rates Policy Trumps Balance Sheet Part I Rates Policy Trumps Balance Sheet Part I Chart 8BRates Policy Trumps Balance Sheet Part II Rates Policy Trumps Balance Sheet Part II Rates Policy Trumps Balance Sheet Part II Bottom Line: We don’t find broad money supply measures (M1 and M2) to be useful indicators of economic growth, inflation or financial asset performance. Subordinate Bank Bonds: Still In The Sweet Spot Chart 9Still In The Sweet Spot Still In The Sweet Spot Still In The Sweet Spot Two months ago we made the case for owning subordinate bank bonds.3 The premise for this call is that subordinate bank bonds are a high-quality cyclical sector, exactly the sweet spot of the investment grade corporate bond market that we want to own in the current environment. We expect that extraordinary Fed support for the market will cause investment grade corporate bond spreads to tighten during the next 6-12 months. In that environment we want to focus on cyclical (or “high beta”) bond sectors, ones that outperform the index during periods of spread tightening. However, we also recognize that the Fed’s emergency lending facilities will not prevent a surge in ratings downgrades. Therefore, the sweet spot we want to own is cyclical bonds that are unlikely to be downgraded. High-quality Baa-rated securities, like subordinate bank bonds, fit the bill nicely. Chart 9 shows that the subordinate bank bond index has a duration-times-spread ratio above 1.0.4 This confirms that the sector will trade cyclically relative to the corporate benchmark. We also see that subordinate bank bonds have outperformed both the overall corporate index and other Baa-rated bonds since the start of the year (Chart 9, panel 2). Further, subordinate bank bonds offer a spread pick-up versus the corporate index in both option-adjusted spread terms (Chart 9, panel 3) and 12-month breakeven spread terms (Chart 9, bottom panel).   What Did We Learn From The Stress Tests? Last week the Fed released the results of its 2020 bank stress tests. Results for individual banks were released for a “severely adverse scenario”, the details of which had been publicly available since February. However, because of concern that the “severely adverse scenario” wasn’t dire enough to capture the potential fallout from the pandemic, the Fed also stress tested three COVID-specific scenarios and released results only for the banking system in aggregate. The three scenarios are: A ‘V’-shaped recovery, where economic growth recovers in Q3 and Q4 of this year after contracting significantly in the first half. A ‘U’-shaped recovery, where the growth pick-up in the second half of 2020 is much milder. A ‘W’-shaped recovery, where economic growth recovers in Q3 but then dips again near the end of the year. Table 2 shows a few key assumptions of the three scenarios along with how the actual economy is tracking. It seems that, absent the re-imposition of lock-down measures, the economy is tracking to be in a slightly better place than in any of the three scenarios. Note that the unemployment rate has already peaked below 15%, lower than assumed by any of the three scenarios. Table 2Three Stress Test Scenarios* The Case Against The Money Supply The Case Against The Money Supply Chart 10Banks Have Huge Capital Buffers Banks Have Huge Capital Buffers Banks Have Huge Capital Buffers Chart 10 shows the Common Equity Tier 1 Capital Ratio for the aggregate banking sector, and the dashed horizontal lines show how far it would fall in the three different COVID scenarios. The results show that the ‘V’-shaped scenario is manageable for the banking system, but a significant number of banks would run into trouble in the ‘U’ and ‘W’ shaped scenarios.   The good news for bank credit quality is that, based on how the economy is tracking and the prospects for further fiscal stimulus, the worst ‘U’ and ‘W’ shaped scenarios will probably be avoided. Further, the Fed has already suspended share buybacks and capped dividend payouts. It will also re-run the stress tests later this year. Another round of stress tests this year is credit positive, as it will encourage banks to strengthen their capital buffers during the next few months. Bottom Line: After viewing the results of the Fed’s stress tests, we still think the odds of bank ratings downgrades this year are low. Investors should stay overweight subordinate bank bonds. Appendix A: Buy What The Fed Is Buying The Fed rolled out a number of aggressive lending facilities on March 23. These facilities focused on different specific sectors of the US bond market. The fact that the Fed has decided to support some parts of the market and not others has caused some traditional bond market correlations to break down. It has also led us to adopt of a strategy of “Buy What The Fed Is Buying”. That is, we favor those sectors that offer attractive spreads and that benefit from Fed support. The below Table tracks the performance of different bond sectors since the March 23 announcement. We will use this to monitor bond market correlations and evaluate our strategy’s success. Table 3Performance Since March 23 Announcement Of Emergency Fed Facilities The Case Against The Money Supply The Case Against The Money Supply Footnotes 1 https://www.federalreserve.gov/BOARDDOCS/SPEECHES/19961205.htm 2 https://www.conference-board.org/data/bci/index.cfm?id=2160 3 Please see US Bond Strategy Weekly Report, “Negative Oil, The Zero Lower Bound And The Fisher Equation”, dated April 28, 2020, available at usbs.bcaresearch.com 4 Duration-Times-Spread (DTS) is a simple measure that is highly correlated with excess return volatility for corporate bonds. The DTS ratio is the ratio of a sector’s DTS to that of the benchmark index. It can be thought of like the beta of a stock. A DTS ratio above 1.0 signals that the sector is cyclical (or “high beta”), a DTS ratio below 1.0 signals that the sector is defensive or (“low beta”). For more details on the DTS measure please see: Arik Ben Dor, Lev Dynkin, Jay Hyman, Patrick Houweling, Erik van Leeuwen & Olaf Penninga, “DTS (Duration-Times-Spread)”, Journal of Portfolio Management 33(2), January 2007. Ryan Swift US Bond Strategist rswift@bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights When retail investors invest aggressively and central banks buy assets en masse, economic fundamentals take the back seat and momentum becomes king. Global risk assets are at a fork in the road: either they will relapse meaningfully as they have run well ahead of fundamentals or a budding mania will push global share prices to fresh new highs.   A budding mania is the basis behind our strategy of chasing momentum from this point on. Investors should adjust their strategy based on momentum in global stocks and the broad trade-weighted US dollar in the coming weeks. We are upgrading Chinese stocks from neutral to overweight and downgrading the Korean bourse from overweight to neutral within an EM equity portfolio. Feature Chart I-1Make It Or Break It Moment For US Dollar Make It Or Break It Moment For US Dollar Make It Or Break It Moment For US Dollar Global share prices have reached a point where they are no longer oversold. In turn, the trade-weighted US dollar has worked out its overbought conditions and is sitting on major defensive lines (Chart I-1). If the dollar relapses below its technical resistances, it will enter a bear market. Consistently, EM risk assets will enter a bull market. The trajectory of EM risk assets and currencies in the coming months will ultimately depend on what happens to the ongoing global FOMO (fear-of-missing-out) rally. We refer to it as a FOMO rally because both the DM and EM equity rallies have been taking place despite deteriorating corporate profit expectations, as we documented in our June 4 report. Why The FOMO Rally May Still Have Legs There are a number of reasons why this FOMO-driven rally could persist: Chart I-2Helicopter Money In The US Helicopter Money In The US Helicopter Money In The US First, the Federal Reserve is explicitly targeting higher asset prices, and to achieve this goal it is deploying its “nuclear” arsenal – printing money and monetizing public debt, lending to the private sector as well as buying corporate bonds. US broad money growth is at an all-time high (Chart I-2). Consequently, the risk of a full-blown equity bubble formation in the US cannot be ruled out. If this occurs, all EM risk assets will rally along with the S&P 500. US policymakers are throwing everything into the system to keep financial asset prices inflated. It seems that after any day that the S&P 500 sells off, the Fed or the US administration comes up with some sort of new measure to support the economy and asset prices. Historically, investors have placed a lot of weight on the Fed’s actions. Aggressive measures by the Fed have recently led investors to purchase stocks and corporate bonds, irrespective of the condition of the underlying economy. As a result, share prices worldwide have decoupled from corporate profit expectations (Chart I-3A and I-3B). If US policymakers succeed in lifting US share prices further, every investor will likely chase the rally and the US equity market will become a full-scale bubble. Chart I-3AGlobal Stocks Are Pricing In A Lot Of Good News Global Stocks Are Pricing In A Lot Of Good News Global Stocks Are Pricing In A Lot Of Good News Chart I-3BSurging EM Share Prices Amid Plunging Forward EPS Surging EM Share Prices Amid Plunging Forward EPS Surging EM Share Prices Amid Plunging Forward EPS Chart I-4Retail Investors Have Driven Up Trading Volumes Retail Investors Have Driven Up Trading Volumes Retail Investors Have Driven Up Trading Volumes At some point, the bubble will start cracking even if corporate earnings find their way back to a recovery path. When equities make up a large share of investors’ assets, any trigger could lead to marginal sellers outnumbering marginal buyers. As we discuss below, there are plenty of risks that could result in a trigger. Both retail and institutional investors are very averse to losses, and when the market begins to slide, investors will sell their shares simultaneously. The market will plunge. The Fed will be forced to buy stocks to avert the negative impact of falling share prices on the economy. In a nutshell, US equities and corporate bonds have become extremely dependent on the Fed. This might be good news in the short and medium term. Nevertheless, it is negative for the US in the long run. Second, when retail investors rush into the market and actively trade, fundamentals take the back seat. This is what has been occurring since March. Retail investors appear to be especially attracted to crushed or near-bankrupt US stocks as well as popular tech stocks. This is illustrated by the surge in turnover volumes on the Nasdaq as well as in Southwest Airline, Norwegian Cruise Lines and Chesapeake Energy stocks (Chart I-4). Yet the impact of their actions is not limited to these stocks. Stocks are fungible. When retail investors purchase shares of near-bankrupt companies at elevated prices (at higher than fundamentals warrant), institutional investors sell those stocks and move capital to other companies. In aggregate, the stock market index rises.  The ongoing retail investor mania is not solely a US phenomenon. It has become prevalent in many other countries. There are anecdotes that Japanese retail investors have been actively trading Jasdaq stocks, while Korean, Taiwanese and Filipino retail investors have been buying local shares en masse.1  The top panel of Chart I-5 illustrates that Korean individual investors have been accumulating stocks while foreigners have been selling out. In Taiwan, the share of individual investors in equity trading has been rising at the expense of domestic institutional investors (Chart I-5, bottom panel). Retail investors do not do much fundamental analysis, and it should not come as a surprise that share prices have decoupled from their fundamentals (profits) and have gained despite lingering massive risks. Retail investors appear to be especially attracted to crushed or near-bankrupt US stocks as well as popular tech stocks.  Third, the mania phase – the last and most speculative stage – in bubble formation typically lasts between nine and 18 months. This is based on the duration of the mania phase in the Nikkei (1989), the NASDAQ (1999-2000), oil (2008) and Chinese A shares (2014-‘15) (Chart I-6). The retail investor-driven equity mania began in March and is now three months old. If the duration of previous manias is any guide, the current rally could last another six months at least. Chart I-5Strong Retail Buying Is Also Evident In Korea And Taiwan Strong Retail Buying Is Also Evident In Korea And Taiwan Strong Retail Buying Is Also Evident In Korea And Taiwan Chart I-6How Long Mania Phase Lasted During Previous Bubbles? How Long Mania Phase Lasted During Previous Bubbles? How Long Mania Phase Lasted During Previous Bubbles? Chart I-7China A-Share Bubble: A Divergence Between Stocks And EPS China A-Share Bubble: A Divergence Between Stocks And EPS China A-Share Bubble: A Divergence Between Stocks And EPS The current equity mania resembles the one in China’s A-share market in 2014-‘15 in two aspects: (1) it is driven by retail investors and (2) it is occurring amid very underwhelming corporate profits. Chart I-7 demonstrates that Chinese A-share prices skyrocketed in H1 2015, despite a deteriorating corporate profit picture. It lasted for a while and ended with a bust without any policy tightening taking place. Finally, retail investors are not quick to give up when they lose money. Having acquired a taste for capital gains over the past few months, retail investors will likely become even more aggressive and will keep buying the dips. In such a scenario, institutional and professional investors may be forced to capitulate and chase risk assets higher. We are at a fork in the road: either retail investors will begin reducing their equity holdings soon, or institutional and professional investors will capitulate and start buying en masse. In the first scenario, stocks will tumble as retail investors rapidly head for the exits. The latter scenario on the other hand will push share prices considerably higher. This is the basis behind our strategy of chasing momentum from this point on. Bottom Line: All financial market manias eventually crash. However, if the market breaks out, the rally could endure for several months. Not chasing the rally will be very painful for portfolio managers. This is why even though we believe the current global equity rally has been a FOMO-driven mania, we recommend to play it if EM share prices break above, and the broad-trade weighted dollar relapses below, current levels. Plenty Of (Disregarded) Risks Chart I-8Number Of New Inflections Is Rising In Large EM Countries Number Of New Inflections Is Rising In Large EM Countries Number Of New Inflections Is Rising In Large EM Countries Even though global risk assets have been rallying, the global investment landscape remains poor, with plenty of risks. In particular: Geopolitical tensions are bound to rise between the US and China. Taiwan and its semiconductor sector are at the epicenter of the US-China technological and geopolitical standoffs. Timing any escalation is tricky, but Taiwanese stocks are not pricing in these risks. Further, odds are high that North Korea will test a strategic weapon, which will undermine the credibility of President Trump’s foreign policy. This is negative for the KOSPI and the Korean won. An escalation in US-China tensions encompassing technology, Hong Kong, Taiwan and the Koreas is negative for equity markets in China, South Korea and Taiwan alike. Together they account for about 60% of the EM MSCI equity benchmark market cap. Moreover, the China-India skirmish is a risk for Indian stocks. The number of new Covid-19 infections is rising in the majority of EM countries excluding China, Korea and Taiwan as demonstrated in Chart I-8. It will be hard to ameliorate consumer and business confidence and thereby boost spending in these countries amid a worsening trend in the global pandemic. Indeed, a second wave of the coronavirus now hitting Beijing is evidence that even the very efficient Chinese system is not able to prevent pockets of renewed infection outbreaks. This risk still looms large over many advanced and developing nations after the first wave subsides. The post-lockdown natural snapback in economic activity is creating a mirage of a V-shaped recovery. Like any mirage, it can last and drive markets for a while. However, it will eventually fade. When that happens, misalignments in financial markets will be ironed out rather abruptly. A snapback in economic activity around the world is natural following the unwinding of strict lockdowns. Nevertheless, the level of business activity remains very low. Going forward, persistent social distancing, the threat of a second wave and an initial substantial income drawdown will cap the speed of recovery in household and business spending around the world. In our February 20 report titled EM: Growing Risk Of A Breakdown, we contended that the most likely trajectory for Chinese growth is the one demonstrated in Chart I-9. It assumed the plunge in business activity would be succeeded by a rather sharp snap-back due to pent-up demand. However, this snapback would likely be followed by weaker growth in the following months. This is also our roadmap for the business cycles of many DM and EM economies. Even though on May 28 we upgraded our economic outlook for Chinese growth from negative to mildly positive, near-term risks for China-related plays remain. Consistent with the trajectory described above, the Chinese economy has been coming back to life, aided in large part by significant credit and fiscal stimulus (Chart I-10, top and middle panel). Traditional infrastructure investment has accelerated strongly (Chart I-10, bottom panel). Chart I-9Our Roadmap For China’s Business Cycle EM: Follow The Momentum EM: Follow The Momentum Chart I-10China: Money/Credit And Infrastructure Are Accelerating China: Money/Credit And Infrastructure Are Accelerating China: Money/Credit And Infrastructure Are Accelerating   Consequently, mainland demand for commodities has been very robust and raw materials prices have rallied. However, it remains to be seen if the recent strength in commodities purchases can be maintained going forward. A couple of our indicators and market price signals are also suggesting that caution is warranted in the near term with respect to China-related plays. First, our indicators for marginal propensity to spend among households and enterprises continue to deteriorate, even when May data points are included (Chart I-11). These indicators have been good pointers for consumer discretionary spending and business investment/demand for industrial metals, as illustrated in Chart I-11. Chart I-11Marginal Propensity To Spend Is Falling For Consumers And Enterprises Marginal Propensity To Spend Is Falling For Consumers And Enterprises Marginal Propensity To Spend Is Falling For Consumers And Enterprises Chart I-12Copper: Shanghai/London Premium And Prices Copper: Shanghai/London Premium And Prices Copper: Shanghai/London Premium And Prices   Second, the copper price premium in Shanghai over London has been a good coincident indicator for copper prices and has recently been flagging short-term risks to copper prices (Chart I-12). A rising Shanghai/London copper premium implies more robust demand in China, while a declining premium signals weaker copper demand in the mainland. Finally, share prices of property developers, industrials and materials in the onshore market have failed to advance much (Chart I-13). This fact does not corroborate that there is a strong recovery occurring in China’s broad capital spending outside infrastructure. Chart I-13Chinese Stocks Do Not Corroborate A Strong Recovery Chinese Stocks Do Not Corroborate A Strong Recovery Chinese Stocks Do Not Corroborate A Strong Recovery A similar message stems from the investable universe of Chinese stocks. We are using the sector indexes from the onshore market because they are less hyped by the global FOMO rally, and the number of companies included in these onshore sector indexes is larger than in the investable indexes. Bank share prices have done even worse (Chart I-13, bottom panel). Overall, near-term risks to China-plays remain and we are looking for a better entry point in the weeks and months ahead. The trend-setting US equity market is expensive, as we corroborated in our report on EM and US equity valuations a month ago. The forward P/E ratio stands at 22, using analysts’ 12-month forward EPS expectations that we believe are still optimistic. Global financial market correlations are presently high, and domestic conditions in EM ex-China, Korea and Taiwan are rather grim. If the S&P 500 relapses for whatever reason, there is little chance EM risk assets will avoid selling off. Bottom Line: Risks are abundant and fundamentals (profits, valuations, geopolitical risks, the ongoing pandemic) do not justify higher share prices. However, if a FOMO-driven rush into stocks persists, financial markets will continue ignoring fundamentals. Investment Strategy: Momentum Is Now King When retail investors invest aggressively and central banks buy assets en masse, it is not the time for fundamental analysis. Indeed, momentum becomes king. Investors should adjust their strategy based on momentum in global stocks and the broad trade-weighted US dollar in the coming weeks. Our composite momentum indicator for global share prices has risen to zero from extremely oversold levels (Chart I-14). Chart I-14Global Share Prices Are At A Critical Juncture Global Share Prices Are At A Critical Juncture Global Share Prices Are At A Critical Juncture If global and EM share prices break meaningfully above their 200-day moving averages and the US dollar breaks materially below its 200-day moving average (see Chart I-1 on page 1), our advice will be for investors to chase the rally. Even if DM and EM share prices break out, the odds are that EM stocks will continue underperforming DM ones. Hence, we continue to underweight EM in a global equity portfolio. The basis is that North Asian equity markets (China, Korea and Taiwan) are at risk of a heightened geopolitical confrontation between the US and China, as per our discussion above. Meanwhile, the remainder of EM is struggling with the pandemic. Hence, EM will continue to underperform, even if global share prices rise a lot. The current equity mania resembles the one in China’s A-share market in 2014-‘15 in two aspects: (1) it is driven by retail investors and (2) it is occurring amid very underwhelming corporate profits. That said, if global stocks and commodities prices break out and the greenback breaks down, we will close our remaining short positions in EM currencies and upgrade our stance on EM fixed-income markets from neutral to bullish. We have been receiving rates in Mexico, Colombia, Russia, India, China, Korea, Pakistan, Ukraine and Egypt, but have been reluctant to take on currency risk. Also, we upgraded our stance on EM credit markets to neutral on June 4. We will likely upgrade EM local currency bonds and EM credit markets further to “buy” if the above-mentioned breakouts transpire. Upgrade Chinese, Downgrade Korean Stocks Chart I-15DRAM And Korean Tech Stocks DRAM And Korean Tech Stocks DRAM And Korean Tech Stocks We are moving China from neutral to overweight and downgrading Korea from overweight to neutral relative to the EM equity benchmark. Regarding Korean equities, the risks are as follows: First, rising threats of North Korea testing a strategic weapon is negative for South Korea’s equities and currency. Second, DRAM prices and volumes are dropping. Chart I-15 shows that the DRAM revenue proxy is falling, a bad omen for Korean tech stocks that derive a lot of operating profits from DRAM sales.  Finally, the Korean bourse is heavy in old-economy stocks, which will experience a slow recovery in their profits from very low levels amid the enduring global trade downturn.  The reasons to upgrade Chinese investable stocks relative to the EM equity benchmark include: As we discussed above, the medium-term growth outlook for China is mildly positive due to the credit and fiscal stimulus Beijing has unleashed. The outlook for domestic demand is worse in many other developing economies. The credit and money bubble in China will inflate further and will pose a major challenge in the years ahead. That said, another round of major credit/money expansion will likely stabilize the system in the medium term. If the FOMO-driven mania continues, FAANG stocks will likely outperform, which will spread to similar stocks around the world. The Chinese investable index includes Alibaba, Tencent and other new economy stocks that will likely outperform the EM benchmark. If global markets correct and EM currencies drop, the Chinese RMB will appreciate relative to most EM exchange rates. This will help China’s equity performance relative to other EM bourses. Finally, if US-China tensions escalate and EM markets sell off, Chinese authorities will support share prices by deploying the national team and other government proxies to buy Chinese stocks. This will help the broad universe of Chinese stocks to outperform the EM benchmark. Chart I-16Long Chinese Investable / Short Korean Equities Long Chinese Investable / Short Korean Equities Long Chinese Investable / Short Korean Equities Bottom Line: We are upgrading Chinese stocks from neutral to overweight and downgrading the Korean bourse from overweight to neutral within an EM equity portfolio. Market-neutral investors should consider the following trade: long Chinese / short Korean equities (Chart I-16).   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   1     Please see the following articles: Coronavirus spawns new generation of Japanese stock pickers Stuck at Home, More Filipinos Try Luck at Stock Investing   Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights High-Yield: Our analysis of current junk spread levels relative to likely economic outcomes leaves us inclined to maintain our current recommended positioning: Overweight Ba-rated bonds, underweight bonds rated B & below. Fed/Treasuries: There is no urgency for the Fed to provide more explicit forward rate guidance. The market has already taken on board the expectation that the funds rate will stay pinned at zero at least through the end of 2022. Investors should keep portfolio duration near benchmark but add tactical overlay positions: long TIPS versus nominal Treasuries, and steepeners along both the nominal and real yield curves. Securitizations: We recommend that investors continue to overweight Aaa-rated consumer ABS and CMBS, as both sectors offer attractive spreads and benefit from TALF. Despite the lack of Fed support, adding some non-Aaa consumer ABS exposure also makes sense. Investors should continue to avoid Agency MBS, where value has improved but prepayment risk remains high. Feature In case it wasn’t already obvious that the Fed will continue to act as a tailwind behind risky asset prices, Chair Powell made it abundantly clear at last week’s FOMC press conference. When asked about the risk of bubbles in financial markets, Powell’s response was to focus on the millions of unemployed workers and imply that it would be a dereliction of the Fed’s duties if it were to hold back on monetary stimulus because it thought asset prices were too high. Ironically, this strong statement of market support came the day before the S&P 500 fell 6% in a single session. Nonetheless, with the Fed providing such aggressive forward guidance on top of direct intervention in certain segments of the fixed income market, it behooves us to consider whether our recommended portfolio allocation is insufficiently aggressive. The Strong Performance Of Low-Rated Junk Chart 1Lower-Rated Junk Bonds Playing Catch-Up Lower-Rated Junk Bonds Playing Catch-Up Lower-Rated Junk Bonds Playing Catch-Up Within the high-yield corporate bond market we have been advising an overweight allocation to Ba-rated bonds but an underweight allocation to bonds rated B and below. The reasoning is that Ba-rated bonds are largely eligible for the Fed’s emergency lending facilities while lower-rated junk bonds are mostly left out in the cold.1 This positioning worked well throughout April and the first half of May, but lower-rated junk bonds have started to play catch-up during the past month (Chart 1). High-Yield Index Fundamentals To get a sense of whether we should extend our overweight recommendation to the B and below credit tiers, let’s first perform a valuation exercise on the entire high-yield index. In this exercise we consider current spread levels relative to likely economic outcomes. We set aside any impact from direct Fed intervention for the time being. Our analysis revolves around the High-Yield Default-Adjusted Spread (Chart 2). This valuation measure takes the junk index spread and subtracts default losses realized during the subsequent 12 month period. The spread’s historical average is around 250 bps, but it has occasionally dipped below zero during periods when default losses swamp the compensation offered by the index. Chart 2High-Yield Index Assessment: Default-Adjusted Spread High-Yield Index Assessment: Default-Adjusted Spread High-Yield Index Assessment: Default-Adjusted Spread The Default-Adjusted Spread also lines up very closely with 12-month excess returns (Chart 2, panel 2). A simple linear regression model of 12-month excess returns versus the Default-Adjusted Spread gives an R2 of 53% and tells us that the threshold between positive and negative excess returns is a Default-Adjusted Spread of 187 bps. That is, if the Default-Adjusted Spread is above 187 bps we should expect high-yield to outperform Treasuries, if it is below 187 bps we should expect high-yield to underperform. With that in mind, we can apply some quick figures to the current context. The High-Yield index option-adjusted spread is 611 bps. If we assume a default rate of 10% and recovery rate of 25% for the next 12 months, we get expected default losses of 750 bps and a Default-Adjusted Spread of -139 bps. We should expect Treasuries to outperform junk bonds in that scenario. Ba-rated bonds are largely eligible for the Fed’s emergency lending facilities while lower-rated junk bonds are mostly left out in the cold. We can also perform the same sort of analysis in reverse. If we target a Default-Adjusted Spread of 187 bps – the spread that is consistent with high-yield performing in line with Treasuries – and we also assume a recovery rate of 25%, then the current index spread gives us an implied 12-month default rate of 5.7% (Chart 2, bottom panel). That is, we should expect high-yield to outperform Treasuries during the next 12 months if the default rate comes in below 5.7%, and underperform if it is above 5.7%. There are a couple assumptions used in the above analysis that require clarification. First, we relied on a simple linear regression model to get the result that a Default-Adjusted Spread of 187 bps is consistent with junk bonds breaking even with Treasuries. This is not an entirely accurate depiction of the historical record. Table 1 shows a more complete picture of the historical linkage between the Default-Adjusted Spread and 12-month high-yield excess returns. Here, we see that junk bonds have actually outperformed duration-matched Treasuries 81% of the time when the Default-Adjusted Spread is between 150 bps and 200 bps, and 72% of the time when it is between 100 bps and 150 bps. Relative junk bond losses only become more likely than gains when the Default-Adjusted Spread is below 100 bps. Table 1The Default-Adjusted Spread & High-Yield Excess Returns No Holding Back No Holding Back Second, we assumed a 25% recovery rate when we calculated our implied default rate of 5.7%. This is low compared to the historical average, but we would argue that a low recovery rate assumption is appropriate in the current environment. We analyzed the main economic drivers of default and recovery rates in a recent Special Report and found that the recovery rate observed during an economic downturn is primarily driven by corporate balance sheet leverage heading into that downturn.2 Corporate balance sheets were carrying a lot of debt heading into the current recession, meaning that we should expect a lower-than-normal recovery rate. In fact, the current trailing 12-month recovery rate is 22%, below our assumed level. Table 2 shows what the Default-Adjusted Spread will be for the next 12 months under different default and recovery rate assumptions. We think that 25% is a reasonable recovery rate assumption and expect that the default rate will be somewhere between 9% and 12% during the next 12 months. At present, Moody’s baseline 12-month default rate forecast is 11.6%. Table 2Default-Adjusted Spread (BPs) Given Different Assumptions For Default And Recovery Rates No Holding Back No Holding Back Clearly, junk spreads do not offer adequate compensation for default losses in the economic environment we anticipate. This logic also extends to the individual B and Caa/C credit tiers when we look at them in isolation. A Focus On B-Rated & Below Junk Bonds Charts 3A and 3B show the historical linkage between Default-Adjusted Spreads and excess returns for those specific credit tiers, with forecasts plugged in for “mild”, “moderate” and “severe” default scenarios. All three scenarios use a recovery rate of 25%. The assumed default rate is 6% in the “mild” scenario, 9% in the “moderate” scenario and 12% in the “severe” scenario. Default-adjusted compensation is unattractive in all three cases. Chart 3AB-Rated Default-Adjusted Spread No Holding Back No Holding Back Chart 3BCaa/C-Rated Default-Adjusted Spread No Holding Back No Holding Back Bottom Line: Our analysis of current junk spread levels relative to likely economic outcomes leaves us inclined to maintain our current recommended positioning: Overweight Ba-rated bonds, underweight bonds rated B & below. The Fed’s support for the Ba credit tier will significantly limit default losses for those bonds, making current spread levels attractive. However, absent Fed intervention, junk spreads are already far too tight. Investors should avoid bonds rated B & below where issuers generally don’t benefit from the Fed’s emergency programs. No Rush For More Explicit Forward Guidance In addition to Chair Powell’s strong statement of support for risky assets, last week’s FOMC meeting brought us the committee’s updated interest rate projections. With only two exceptions, those projections revealed that all Fed policymakers expect to keep the fed funds rate at its current level at least until the end of 2022. There had been some expectation that the Fed might provide more explicit forward guidance for the funds rate. Something along the lines of the “Evans Rule” that was used during the last zero-lower-bound episode. For example, the Fed could pledge to not increase rates until the unemployment rate is below some specified threshold or inflation is above some specified threshold. Fed policymakers expect to keep the fed funds rate at its current level at least until the end of 2022. This sort of forward guidance would be useful if the Fed needed to convince markets about its commitment to keeping rates pinned near zero, but the market has already internalized that message. Notice in Chart 4 that expectations priced into the overnight index swap curve show no rate hikes through the end of 2022. The same goes for the median estimate from the New York Fed’s April 2020 Survey of Market Participants. Chart 4Fed Policymakers And Market Participants Agree: No Hikes Until 2023 Fed Policymakers And Market Participants Agree: No Hikes Until 2023 Fed Policymakers And Market Participants Agree: No Hikes Until 2023 More explicit forward rate guidance will likely be required in the future, when the market starts to price-in the eventual return of rate hikes. But for the time being, the Fed will probably be content to stay the course. Treasury Positioning The combination of the Fed’s strong commitment to zero interest rates and the risks to the 6-12 month economic outlook that we detailed in last week’s report make us inclined to maintain our recommended “At Benchmark” portfolio duration stance.3 However, we also recognize that yields are more likely to rise than fall in the coming months as the US economy re-opens and the economic data trend higher. For this reason, we advise holding several tactical overlay trades that will profit from rising bond yields: overweight TIPS versus nominal Treasuries, duration-neutral nominal curve steepeners, real yield curve steepeners. On TIPS, May’s CPI report showed a third consecutive month-over-month decline but the drop was far less severe than what was seen in March and April (Chart 5). This is a preliminary indication that we could already be passed the trough in inflation. The fact that trimmed mean CPI has not followed the core measure lower during the past few months is further evidence that inflation may not fall much more from its current level (Chart 5, bottom panel). If inflation has indeed bottomed, then our recommendation to favor TIPS over nominal Treasuries looks very good. We calculate that the current 1-year TIPS breakeven inflation rate is 0.1%, slightly below trailing 12-month headline CPI inflation (Chart 5, panel 2). Along the nominal Treasury curve, we continue to recommend favoring the 5-year bullet over a duration-matched 2/10 barbell. This position will profit from continued 2/10 yield curve steepening (Chart 6). We also recommend steepeners along the real yield curve. The real 2/10 slope has already steepened a lot (Chart 6, bottom panel), but has more room to run given that the 2-year cost of inflation compensation remains well below the 10-year cost (Chart 6, panel 3). Chart 5Is The Trough In Inflation Already##br## Behind Us? Is The Trough In Inflation Already Behind Us? Is The Trough In Inflation Already Behind Us? Chart 6Keep Steepeners Along Both The Nominal And Real Yield Curves Keep Steepeners Along Both The Nominal And Real Yield Curves Keep Steepeners Along Both The Nominal And Real Yield Curves Bottom Line: There is no urgency for the Fed to provide more explicit forward rate guidance. The market has already taken on board the expectation that the funds rate will stay pinned at zero at least through the end of 2022. Investors should keep portfolio duration near benchmark but add tactical overlay positions: long TIPS versus nominal Treasuries, and steepeners along both the nominal and real yield curves. Securitized Products Update Take Some Non-Aaa Risk In Consumer ABS, But Not In CMBS Since the Fed rolled out its emergency lending facilities in late-March, our spread product strategy has been to favor sectors that offer attractive spreads and that benefit from Fed support. This has meant owning Aaa-rated consumer ABS and CMBS, which are eligible for the Fed’s Term Asset-Backed Securities Loan Facility (TALF), and avoiding non-Aaa securitizations, which don’t qualify for Fed support. How has this worked out? Aaa-rated ABS and CMBS have both performed well since spreads peaked on March 23 (Chart 7). Within ABS, Aaa issues have beaten Treasuries by 390 bps since March 23 compared to 290 bps for non-Aaa securities. In CMBS, non-Aaa securities have lagged, losing 470 bps versus Treasuries since March 23 compared to gains of 810 bps for Aaa CMBS. As Chart 7 makes plain, no segments of either market have regained all of the ground that was lost during March’s blow-up. Chart 7Opportunities In Non-Aaa Consumer ABS, But Not In CMBS Opportunities In Non-Aaa Consumer ABS, But Not In CMBS Opportunities In Non-Aaa Consumer ABS, But Not In CMBS Going forward, we think it is wise to re-consider our strategy when it comes to consumer ABS. Specifically, we think investors should dip into non-Aaa ABS where we see potential for strong returns, even in the absence of Fed support. The reason for our optimism is that consumer credit losses will probably turn out to be significantly lower than many had feared in March. During the past two months, we learned that federal government stimulus actually caused real personal income to rise by 9% since February. Also, consumers have generally been able to keep up with their debt payments.4  According to data from TransUnion, the percentage of credit card and mortgage loans that are more than 30 days past due actually declined in April compared to March. For auto loans it only increased by 7 bps (Table 3). Further, the data show that households paid off significantly more of their credit card balances than usual in April, presumably because they received an influx of cash from the government but had fewer spending opportunities due to the quarantine. Table 3No Spike In Consumer Credit Delinquencies No Holding Back No Holding Back There remains a risk that Congress will delay passing further stimulus measures to keep consumers flush during the next few months. But we think enough stimulus will be delivered to prevent a significant default spike in credit cards and auto loans. Investors should add some exposure to non-Aaa consumer ABS. CMBS is a different story. The commercial real estate market is particularly challenged by the current environment. The office and retail sectors in particular were already facing structural headwinds from remote working and online shopping, respectively. The pandemic has accelerated the adoption of those trends. Not surprisingly, May’s CMBS delinquency rate saw its largest jump since 2017 and more delinquencies are certainly on the way (Chart 8). Chart 8Challenging Environment For CMBS Challenging Environment For CMBS Challenging Environment For CMBS Investors should continue to avoid non-Aaa CMBS. Continue To Avoid Agency MBS We have been advising an underweight allocation to Agency MBS because, even though the securities benefit from support through the Fed’s direct MBS purchases, value has been insufficiently attractive. That is starting to change. Agency MBS spreads widened considerably during the past month and are now very close to Aa-rated corporate bond spreads. They are also greater than Agency CMBS and Aaa ABS spreads (Chart 9). However, despite improving valuations, we remain concerned about risks in the MBS sector. Notice in the top 2 panels of Chart 9 that the MBS option-adjusted spread (OAS) has returned to 2012 levels, but the nominal spread (which is not adjusted for expected prepayment losses) remains quite low. This means that the prepayment loss assumption embedded in the current index OAS is much lower than it was in 2012. Is this reasonable? We estimate that 63% of the conventional 30-year MBS index is eligible for refinancing. In part, yes it is. Even with mortgage rates at all-time lows, we estimate that 63% of the conventional 30-year MBS index is eligible for refinancing. This is lower than what was seen in 2012 (Chart 10). However, we would also argue that mortgage rates have room to fall further Chart 9Agency MBS Spreads Have Widened Agency MBS Spreads Have Widened Agency MBS Spreads Have Widened Chart 10Prepayment Risk Is Elevated Prepayment Risk Is Elevated Prepayment Risk Is Elevated Despite having fallen to all-time lows, this year’s decline in the 30-year mortgage rate has been much smaller than what was seen in Treasury or MBS yields (Chart 10, bottom 3 panels). The 30-year mortgage rate could drop by another 50 bps and it would only restore typical primary and secondary mortgage spread levels. We estimate that a further 50 bps drop in the mortgage rate would increase the refinanceable share of the MBS index from 63% to 74% (horizontal dashed line in the second panel of Chart 10). This is below 2012 levels, but still leads us to the conclusion that the current index OAS understates the risk of prepayment losses. In summary, the Agency MBS OAS is starting to look more attractive but we are concerned that it embeds an overly optimistic prepayment loss assumption. Investors should maintain underweight allocations to Agency MBS. Bottom Line: We recommend that investors continue to overweight Aaa-rated consumer ABS and CMBS, as both sectors offer attractive spreads and benefit from TALF. Despite the lack of Fed support, adding some non-Aaa consumer ABS exposure also makes sense. Investors should continue to avoid Agency MBS, where value has improved but prepayment risk remains high. Appendix A: Buy What The Fed Is Buying The Fed rolled out a number of aggressive lending facilities on March 23. These facilities focused on different specific sectors of the US bond market. The fact that the Fed has decided to support some parts of the market and not others has caused some traditional bond market correlations to break down. It has also led us to adopt of a strategy of “Buy What The Fed Is Buying”. That is, we favor those sectors that offer attractive spreads and that benefit from Fed support. The below Table tracks the performance of different bond sectors since the March 23 announcement. We will use this to monitor bond market correlations and evaluate our strategy’s success. Table 4Performance Since March 23 Announcement Of Emergency Fed Facilities No Holding Back No Holding Back Footnotes 1 For more details on the Fed’s emergency lending facilities please see US Investment Strategy/US Bond Strategy Special Report, “Alphabet Soup: A Summary Of The Fed’s Anti-Virus Measures”, dated April 14, 2020, available at usbs.bcaresearch.com 2 Please see US Bond Strategy/Global Fixed Income Strategy Special Report, “Trading The US Corporate Bond Market In A Time Of Crisis”, dated March 31, 2020, available at usbs.bcaresearch.com 3 Please see US Bond Strategy Weekly Report, “Assessing Healthcare & Pharma Bonds In A Pandemic”, dated June 9, 2020, available at usbs.bcaresearch.com 4 For more details on the outlook for the US consumer please see US Investment Strategy Weekly Report, “So Far, So Good (How Markets Learned To Stop Worrying And Love Washington, DC)”, dated June 8, 2020, available at usis.bcaresearch.com   Ryan Swift US Bond Strategist rswift@bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Equities hit an air pocket last week after making another recovery high: Investors seemed to reassess the economy’s direction following official forecasts that ranged from sober to grim. “Whatever we can, and for as long as it takes”: The FOMC’s outlook may have dampened investors’ mood now, but it contained the promise of an extended period of easy policy. Further fiscal help is on the way: The White House supports additional spending and some new Republican proposals offered a hint of what the next phase of fiscal relief might look like. Bank stocks quailed at the prospect of lower rates: The SIFI banks sold off sharply as investors feared that falling rates and a flatter yield curve would crimp net interest margins. We are undeterred from our bullish stance on the group. Feature Coming into last week, the gap between the effervescence of the stock market and the gloom of the pandemic-stricken economy was Topic A for investors and the financial media. We have interpreted the gap as a vote of confidence for policymakers. The Fed and Congress have thrown nearly everything they have at shielding the economy from the virus’ depredations and investors have concluded that they’ll succeed, bidding equities higher and corporate bond spreads tighter (Chart 1). Chart 1Spreads Are Back To The Middle Of Their Post-GFC Range ... Spreads Are Back To The Middle Of Their Post-GFC Range ... Spreads Are Back To The Middle Of Their Post-GFC Range ... Through last Monday, the benchmark Bloomberg Barclays Investment Grade and High Yield Corporate Bond Indexes had generated total returns of 17% and 24%, respectively, since their March 20-23 lows, while the S&P 500 was up 45% peak-to-trough on a total return basis. Equities’ torrid run had the S&P in the black year-to-date and within just 5% of its mid-February peak (Chart 2). Given that the economic projections have only worsened since late March, and the virus toll has been worse than the consensus expected, policy has had to shoulder the entire load. Chart 2... And Equities Made It All The Way Back To Their 2019 Close ... And Equities Made It All The Way Back To Their 2019 Close ... And Equities Made It All The Way Back To Their 2019 Close In the monetary sphere, the Fed swiftly cut the fed funds rate to zero, purchased Treasuries and agency MBS at a faster rate than it did during the global financial crisis, revived several GFC initiatives and announced it would lend money directly to investment-grade-rated corporations1 for the first time. The medley of measures quickly gained traction. Though the new issuance market initially seized up upon the arrival of the pandemic, record amounts of corporate bonds were issued in both March and April. All-out stimulus efforts from Congress and the Fed have produced a remarkable market turnaround. From the fiscal side, Congress passed several measures to speed aid to vulnerable parts of the economy, crowned by the CARES Act. As we detailed last week,2 its expansion of state unemployment insurance benefits has made two-thirds of the unemployed eligible to earn more than they did at their jobs. Bolstering unemployment insurance and sending direct $1,200 payments to nearly two-thirds of taxpayers has allowed households to service their debt and pay their rent, preventing wider contagion. Although several fiscal hawks cited May’s way-better-than-expected employment situation report as evidence that Congress can relax its fiscal efforts, we expect that another phase of assistance will follow by the end of July. The potential vulnerability in financial markets stems from the prevailing certainty that policymakers have already won. But things could still go wrong, as highlighted by last week’s bracing economic projections from the OECD and the Fed. US financial markets are generally unaware of the OECD’s semi-annual outlooks, but this one’s probability assessments were striking: it sees a 50-50 chance that an infection second wave will require new lockdowns before the end of the year. The Fed Has The Economy’s Back … Chart 3Take All This ZIRP And Call Me In 2023 The Fed, Congress And The Yield Curve The Fed, Congress And The Yield Curve “At the Federal Reserve, we are strongly committed to using our tools to do whatever we can, and for as long as it takes, to provide some relief and stability, to ensure that the recovery will be as strong as possible, and to limit lasting damage to the economy.” As Chair Powell stated at the beginning of his prepared remarks, whatever it takes was the theme of last week’s FOMC meeting press conference. He made it very clear that the Fed intends to err to the side of providing too much accommodation as it confronts the highly uncertain environment. Asked how long the Fed would stick with zero interest rates if the economy surprises to the upside, he said, “we’re not even thinking about thinking about raising rates.” The first Summary of Economic Projections (SEP) since December validated his statement. Every voter projected that the fed funds rate will remain at its current near-zero level for all of 2020 and 2021, and only two voters foresaw rate hikes in 2022 (Chart 3). After Powell described the new round of QE purchases as a necessary measure to support the smooth functioning of financial markets and ensure credit access, a reporter asked if they were still needed, given how market disruptions have dissipated amidst the recovery rally. He replied that the FOMC did not want to take anything for granted and risk prematurely withdrawing its support. As he said in his prepared remarks, “We will continue to use [our emergency lending] powers forcefully, proactively, and aggressively until we are confident that we are solidly on the road to recovery.” The Fed is not even thinking about thinking about raising rates. Powell’s pledges to keep applying the Fed’s full range of tools to support the economy went to the heart of our rationale for overweighting equities over the cyclical timeframe: the Fed will maintain hyper-accommodative policy settings even after they’re no longer necessary. Every rose has its thorn, however, and the Fed would not be on an emergency footing if conditions weren’t dire. Though Powell and the committee expect a recovery to take hold over the next two quarters, the median SEP participant expects the unemployment rate to exceed 9% at the end of this year and does not see GDP returning to its 2019 level until the second half of 2022. The glum projections dampened investors’ enthusiasm and halted equities’ upward march. … And Congress Eventually Will, Too In testimony before a Senate committee on Wednesday, Treasury Secretary Mnuchin touted the budding recovery but made it clear that the administration wants additional stimulus measures. “I definitely think we are going to need … to put more money into the economy,” he said. He expressed a preference for programs that get people back to work and voiced concern that the first round of enhanced unemployment benefits may encourage people to stay out of work, but left the door open to some form of extension. He also indicated that the administration would consider another round of direct payments to taxpayers. Unemployment benefits well in excess of median wages may not be extended beyond July 31st but Republican senators and representatives have begun to put forth appealing alternative proposals like a temporary $450 weekly bonus or an additional two weeks of the existing $600 supplement for those returning to work. The bottom line is that events are validating our geopolitical strategists’ view that another fiscal stimulus package is inevitable. Senate holdouts caught between the House’s and the White House’s desire for more aid will be unable to thwart another round. Banks And The Yield Curve Just a week ago, when the animal spirits sap was rising and a range of indicators suggested that growth may be bottoming, the 10-year Treasury yield surged 26 basis points (bps) in six sessions, from 0.65% to 0.91%, and the 2s/10s segment of the curve steepened by 20 bps. Bank stocks surged, and the SIFIs gained an average of 22% (Table 1). Then the 10-year yield reversed field, tumbling 25 bps in just three sessions from Tuesday to Thursday, and the curve flattened by 23 bps. The SIFI rally evaporated across the three midweek sessions, and the group fell 18% to end the nine-day round trip 30 bps from where it began. Table 1Back So Soon? The Fed, Congress And The Yield Curve The Fed, Congress And The Yield Curve The violent back and forth reinforced the conventional wisdom that banks are joined at the hip with long yields and the slope of the curve. If the 10-year doesn’t go anywhere, the thinking goes, and the curve doesn’t steepen, bank stocks can’t make any significant headway. We beg to differ. The link from the curve to bank earnings runs through net interest margin (NIM), the difference between the banks’ weighted-average lending yield and cost of funds. It makes perfect sense that NIM would expand and contract as the yield curve steepens and flattens, and it did into the early nineties. But by then banks had learned the lesson of the savings and loan debacle – borrowing short and lending long can be fatal if inflation and/or the Fed drive short rates much higher – and they became fastidious about matching the duration of their assets and liabilities. In the new duration-matched regime, NIM has become insensitive to the slope of the curve (Chart 4). With the NIM link broken, the yield curve has no influence on bank earnings (Chart 5). There is no doubt that banks regularly trade with long yields, but any link with the yield curve is easily severed (Chart 6) by earnings surprises. If the policy outlook doesn’t change between now and mid-July, we expect the SIFI banks will get a boost from smaller than expected loan-loss reserve builds. Taking our cue from the way monetary and fiscal largess will hold down defaults, we reiterate our overweight on the SIFI banks. Chart 4There's No Empirical Relationship Between Bank NIM And The Yield Curve, ... There's No Empirical Relationship Between Bank NIM And The Yield Curve, ... There's No Empirical Relationship Between Bank NIM And The Yield Curve, ... Chart 5... Or Bank Net Income And The Yield Curve ... Or Bank Net Income And The Yield Curve ... Or Bank Net Income And The Yield Curve Chart 6Bank Stocks' Relative Performance Is Not A Function Of The Yield Curve Bank Stocks' Relative Performance Is Not A Function Of The Yield Curve Bank Stocks' Relative Performance Is Not A Function Of The Yield Curve Investment Implications A client asked us last week how investors who have built up cash holdings over the last few months should approach re-entering the equity market. Patiently, we replied, in line with the qualms we’ve had about the magnitude and speed of the rally from the March lows. We are only neutral equities over the tactical 0-to-3-month horizon because the S&P 500’s forward P/E multiple is elevated (Chart 7) and investors don’t seem to be assigning a high enough probability to the possibility that the virus, Congress, or geopolitics could create a bump in the road. We are still looking for a double-digit correction. Our SIFI banks thesis doesn't require a steeper curve or higher long yields; it'll work as long as loan-loss reserve builds fall short of investors' fears. Chart 7Stocks Are Expensive Stocks Are Expensive Stocks Are Expensive Table 2Downside Insurance Is Awfully Expensive The Fed, Congress And The Yield Curve The Fed, Congress And The Yield Curve We suggested that the client get 15-20% of the desired allocation deployed that day (Thursday, fortuitously) and parcel the rest out at lower limits all the way down to 2,875 (10% below the recent peak around 3,200) or some lower target like 2,700 or 2,800. With the revival in the VIX, we also suggested considering writing out-of-the-money put options on the SPY ETF. As of Thursday’s close, an investor could be compensated handsomely for agreeing to get hit down another 6.7% (280) or 10% (270) any time between now and the third Friday of July (Table 2). Writing puts is a way to get paid to wait to deploy capital, and with the VIX in the 40s, an investor can earn 20-30% annualized on the notional amount of capital s/he is committing by writing the option.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 Corporations downgraded to junk ("fallen angels") after the lending facility was announced subsequently became eligible to participate. 2 Please see the June 8, 2020 US Investment Strategy Weekly Report, "So Far, So Good (How Markets Learned To Stop Worrying And Love Washington, DC)", available at usis.bcaresearch.com.

Highlights Historically, when global growth picks up, the yen weakens. But this is less likely in an environment where global yields remain anchored at low levels. Meanwhile, there is rising risk that consumption in Japan will remain muted. This will limit any pickup in domestic inflation. A modest rise in real rates will lead to a self-reinforcing upward spiral for the yen. That said, cheap yen valuations will buffet Japanese exports. Go short USD/JPY with an initial target of 100. Feature Chart I-1Higher Volatility, Higher Yen An Update On The Yen An Update On The Yen The powerful bounce in global markets since the March lows is at risk of a bigger technical correction. As we enter the volatile summer months, it may only require a small shift in market sentiment to trigger this reversal. The yen has tended to strengthen when market volatility rises (Chart I-1). Should this happen, it will provide the necessary catalyst for established long yen positions. On the other hand, if risk sentiment stays ebullient, the yen will surely weaken on its crosses but can still strengthen vis-à-vis the dollar. This places short USD/JPY bets in an enviable “heads I win, tails I do not lose too much” position. Growth And Monetary Policy Like most other economies, Japan entered a recession in the first quarter of this year, with GDP contracting at a 2.2% annualized pace. For the private sector, this is the worst growth rate since the Fukushima crisis in 2011. This is particularly significant, since the structural growth rate of the economy has fallen below interest rates. Going back to Japan’s lost decades, where private sector GDP growth averaged well below nominal rates (due to the zero bound), it is particularly imperative that Japan exits this liquidity trap in fast order (Chart I-2). A strong yen back then, on the back of deficient domestic demand, led to a self-fulfilling deflationary spiral. Chart I-2The Story Of Japan In One Chart The Story Of Japan In One Chart The Story Of Japan In One Chart The Bank of Japan began to acknowledge this problem with the end of the Heisei era1  last year. For example, with the BoJ owning almost 50% of outstanding JGBs, the supply side puts a serious limitation on how much more stimulus the BoJ can provide. The yen has become extremely sensitive to shifts in the relative balance sheets between the Federal Reserve and the BoJ. If the BoJ continues to purchase securities at the current pace, then the rate of expansion in its balance sheet will severely lag behind the Fed, and could trigger a knee-jerk rally in the yen (Chart I-3). Chart I-3The Yen And QE The Yen And QE The Yen And QE Inflation And The 2% Target The US is a much more closed economy than Japan, and has not been able to maintain a 2% inflation rate since the Global Financial Crisis. This makes the BoJ’s target of 2% a pipe dream for any timeline in the near future. There are three key variables the authorities pay attention to for inflation: Core CPI, the GDP deflator and the output gap. All three indicators point towards deflationary pressures, with the recent slowdown in the global economy exacerbating the trend. In fact, since the financial crisis, prices in Japan have only been able to really rise during a tax hike (Chart I-4). Always forgotten is that the overarching theme for prices in Japan is a rapidly falling (and ageing) population, leading to deficient demand. The overarching theme for prices in Japan is a rapidly falling (and ageing) population, leading to deficient demand. More importantly, almost 50% of the Japanese consumption basket is in tradeable goods, meaning domestic inflation is as much driven by the influence of the BoJ as it is by globalization. Even for domestically-driven prices, an ageing demographic that has a strong preference for falling prices is a powerful conflicting force. For example, over the years, a strong voting lobby has been able to advocate for lower telecom prices, which makes it difficult for the BoJ to re-anchor inflation expectations upward (Chart I-5). Chart I-4Japan CPI At A Glance Japan CPI At A Glance Japan CPI At A Glance Chart I-5Strong Deflationary Pressures In Japan Strong Deflationary Pressures In Japan Strong Deflationary Pressures In Japan Meanwhile, the BoJ understands that it needs domestic banks to expand the credit intermediation process if any inflation is to take hold. Unfortunately, the yield curve control strategy and negative interest rates have been anathema for Japanese net interest margins and share prices (Chart I-6). This puts the BoJ in a precarious balance between trying to stimulate the economy further and biting the hand that will feed a pickup in inflation. Chart I-6Point Of No Return For Japanese Banks? Point Of No Return For Japanese Banks? Point Of No Return For Japanese Banks? Japanese Consumption And Fiscal Policy The consumption tax hike last year delivered a severe punch to aggregate demand in Japan. COVID-19 has dealt a fatal blow. In prior episodes of the tax hikes, it took around three to four quarters for growth to eventually bottom. This suggests that a protracted slowdown in Japanese consumption is a fait accompli (Chart I-7). Foreign and domestic machinery orders are slowing, employment growth has gone from over 2% to free fall and the availability of jobs relative to applicants has reversed a decade-long rising trend. The Abe government has passed an additional 117 trillion yen of fiscal stimulus. With overall fiscal announcements near 40% of GDP, could this fully plug the spending gap? Not quite. The consumption tax hike last year delivered a severe punch to aggregate demand in Japan.  First, as is usually the case with Japanese stimulus announcements, the timeframe is uncertain for when the funds will be deployed. It could be one year or ten years. Chart I-7A V-Shaped Recovery Might Stall A V-Shaped Recovery Might Stall A V-Shaped Recovery Might Stall Chart I-8More Jobs, More Savings More Jobs, More Savings More Jobs, More Savings Second, Japanese consumption has been quite weak for some time. Despite relatively robust economic conditions since the Fukushima disaster, Japanese consumption has trended downward. The reason is that government spending triggered a rise in private savings, because of expectations of higher taxes. In other words, the savings ratio for workers has surged. If consumers were not willing to spend prior to COVID-19 due to Ricardian equivalence,2  they are unlikely to do so with much higher fiscal deficits (Chart I-8). Some of the government’s outlays will certainly go a long way to boosting aggregate demand, since the fiscal multiplier tends to be much larger in a liquidity trap. This will especially be the case for increased social security spending such as child education, construction activity or the move towards promoting cashless transactions (with a tax rebate). However, there are important near-term offsets. In particular, the postponement of the Olympics will continue to be a drag on Japanese construction activity, and the labor (and income) dividend from immigration has practically vanished. The important tourism industry that faced sudden death will only recover slowly. This suggests a much more protracted recovery in many nuggets of Japanese activity. The Yen As A Safe Haven Real interest rates are already higher in Japan, well before any of the above factors began to meaningfully generate a deflationary impulse. As such, the starting point for yen long positions is already favorable (Chart I-9). Real interest rates are already higher in Japan, well before any of the above factors began to meaningfully generate a deflationary impulse. With global growth bottoming, a continued rise in global equity markets is a key risk to our scenario. However, if inflows into Japan accelerate on cheap equity valuations, the propensity of investors to hedge these purchases will be much less today, given how cheap the yen has become. This is especially important since in an era of rising budget deficits, balance of payments dynamics can resurface as the key driver of currencies. This suggests the negative yen/Nikkei correlation will continue to weaken, as has been the case in recent quarters. Chart I-9Real Rates And The Yen Real Rates And The Yen Real Rates And The Yen Chart I-10USD/JPY And DXY Are Positively Correlated USD/JPY And DXY Are Positively Correlated USD/JPY And DXY Are Positively Correlated As a low-beta currency, our contention is that the yen will surely weaken on its crosses, but could strengthen versus the dollar. The yen rises versus the dollar not only during recessions, but during most episodes of broad dollar weakness (Chart I-10). This places short USD/JPY trades in an envious “heads I win, tails I do not lose too much” position.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 The Heisei era refers to the period of Japanese history corresponding to the reign of Emperor Akihito from 8 January 8th, 1989 until his abdication on April 30th, 2019. 2 Ricardian equivalence suggests in simple terms that public sector dissaving will encourage private sector savings. Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 Recent data in the US have been robust: Nonfarm payrolls increased by 2.5 million in May after declining by a record 20.7 million in April. This was better than expectations of an 8 million job loss. The unemployment rate fell from 14.7% to 13.3%. The NFIB business optimism index increased from 90.9 to 94.4 in May. Headline consumer price inflation fell from 0.3% to 0.1% year-on-year in May. Core inflation fell from 1.4% to 1.2%. Initial jobless claims increased by 1542K for the week ended June 5th. The DXY index fell by 1.3% this week. On Wednesday, the Fed left interest rates unchanged, with a signal that rates might not be increased before the end of 2022. The Fed also stated that it will maintain the current pace of Treasuries and mortgage-backed securities purchases, at minimum. Report Links: DXY: False Breakdown Or Cyclical Bear Market? - June 5, 2020 Cycles And The US Dollar - May 15, 2020 Capitulation? - April 3, 2020 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Recent data in the euro area have been improving: The Sentix investor confidence index improved from -41.8 to -24.8 in June. Employment increased by 0.4% year-on-year in Q1. GDP contracted by 3.1% year-on-year in Q1. The euro appreciated by 1.2% against the US dollar this week. At an online seminar held this week, Isabel Schnabel, member of the executive board of the ECB, noted that "evidence is increasingly pointing towards a protracted impact of the crisis on both demand and supply conditions in the euro area and beyond" and that the current PEPP remains appropriate in de aling with the global recession. Report Links: On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 On Money Velocity, EUR/USD And Silver - October 11, 2019 Japanese Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data in Japan have been negative: The coincident index fell from 88.8 to 81.5 in April. The leading economic index also decreased from 85.1 to 76.2. The current account surplus shrank from ¥1971 billion to ¥262.7 billion in April. Annualized GDP fell by 2.2% year-on-year in Q1. Machine tool orders plunged by 52.8% year-on-year in May, following a 48.3% decrease the previous month. The Japanese yen appreciated by 2.6% against the US dollar this week. According to a Bloomberg survey, the majority of economists believe that the BoJ has done enough to cushion the economy, and expect the BoJ to leave current monetary policy unchanged next week. We continue to recommend the yen as a safe-haven hedge, especially given a possible second wave of COVID-19. Report Links: The Near-Term Bull Case For The Dollar - February 28, 2020 Building A Protector Currency Portfolio - February 7, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data in the UK have been positive: Halifax house prices increased by 2.6% year-on-year in May. Retail sales surged by 7.9% year-on-year in May, up from 5.7% the previous month. GfK consumer confidence was little changed at -36 in May. The British pound rose by 1% against the US dollar this week. On Wednesday, BoE governor Andrew Bailey noted that easing lockdown restrictions has been fueling a recovery in the UK, which could be faster than previously anticipated. Our long GBP/USD and short EUR/GBP positions are 4% and 0.2% in the money, respectively. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 A Few Trade Ideas - Sept. 27, 2019 United Kingdom: Cyclical Slowdown Or Structural Malaise? - Sept. 20, 2019 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Recent data in Australia have been mixed: The NAB business confidence index increased from -45 to -20 in May. The business conditions index also ticked up from -34 to -24. The Westpac consumer confidence index increased from 88.1 to 93.7 in June. Home loans declined by 4.8% month-on-month in April, down from a 0.3% increase the previous month. That said, expectations were for a fall of 10%. AUD/USD was flat this week. While the RBA has other options in its policy toolkit to combat the global recession, negative interest rates is still on the table and hasn't been totally ruled out. We remain positive on the Australian dollar both against the US dollar and the New Zealand dollar due to cheap valuations and increasing Chinese stimulus. Report Links: On AUD And CNY - January 17, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 A Contrarian View On The Australian Dollar - May 24, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 Recent data in New Zealand have been mixed: Manufacturing sales declined by 1.7% quarter-on-quarter in Q1, down from a 2.8% increase the previous quarter. ANZ business confidence increased from -41.8 to -33 in June. The activity outlook index also ticked up from -38.7 to -29.1. The New Zealand dollar appreciated by 0.8% against the US dollar this week. RBNZ's Deputy Governor Geoff Bascand said that house prices in New Zealand could fall by 9-10% or even worse. Besides disrupting exports and imports for a trade-reliant country like New Zealand, the global health crisis is also likely to further reduce immigration to New Zealand, curbing housing demand. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Place A Limit Sell On DXY At 100 - November 15, 2019 USD/CNY And Market Turbulence - August 9, 2019 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Recent data in Canada have been positive: The unemployment rate ticked up from 13% to 13.7% in May, versus expectations of a rise to 15%, but this was due to a  rise in the participation rate from 59.8% to 61.4%. Average hourly wages increased by 10% year-on-year in May. Net employment increased by 289.6K, up from a 1994K job loss the previous month. Housing starts increased by 193.5K in May, up from 166.5K the previous month.  The Canadian dollar fell by 0.2% against the US dollar this week. The labor market has seen some recovery in May with the gradual easing of COVID-19 restrictions and re-opening of the economy. Employment rebounded and absences from work dropped. Notably, Quebec accounts for nearly 80% of overall employment gains in May. Report Links: More On Competitive Devaluations, The CAD And The SEK - May 1, 2020 A New Paradigm For Petrocurrencies - April 10, 2020 The Loonie: Upside Versus The Dollar, But Downside At The Crosses Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 There was scant data out of Switzerland this week: FX reserves increased from CHF 801 billion to CHF 816 billion in May.  The unemployment rate increased from 3.1% to 3.4% in May, lower than the expected 3.7%. The Swiss franc appreciated by 2.3% against the US dollar this week, reflecting a flight back to safety amid concerns over political risks and a second wave of COVID-19. While the euro has been strong recently and EUR/CHF touched 1.09, the franc has lost most of those gains. We are lifting our limit buy on EUR/CHF to 1.055 on expectations we are in a run-of-the-mill correction.  Report Links: On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 Portfolio Tweaks Before The Chinese New Year - January 24, 2020 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Recent data in Norway have been mixed: Manufacturing output shrank by 1.6% month-on-month in April.  PPI fell by 17.5% year-on-year in May. Headline consumer prices increased by 1.3% year-on-year in May, up from 0.8% the previous month. Core inflation also increased from 2.8% to 3% in May. The Norwegian krone fell by 1.5% against the US dollar this week. The recent OPEC meeting over the weekend concluded that all members agreed to the extension to curb oil production. We believe that oil prices will continue to recover, and recommend to stay long the Norwegian krone. Report Links: A New Paradigm For Petrocurrencies - April 10, 2020 Building A Protector Currency Portfolio - February 7, 2020 On Oil, Growth And The Dollar - January 10, 2020 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Recent data in Sweden have been mixed: Household consumption plunged by 10% year-on-year in April. The current account surplus increased from SEK 43.2 billion to SEK 80.6 billion in Q1. Headline consumer prices recovered from a 0.4% year-on-year decline to flat in May. The Swedish krona increased by 0.6% against the US dollar this week. Sweden is benefitting economically from a less stringent Covid-19 agenda. With very cheap valuations, we remain short EUR/SEK and USD/SEK. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019 Balance Of Payments Across The G10 - February 15, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Please note that yesterday we published Special Report on Egypt recommending buying domestic bonds while hedging currency risk. Today we are enclosing analysis on Hungary, Poland and Colombia. I will present our latest thoughts on the global macro outlook and implications for EM during today’s webcast at 10 am EST. You can access the webcast by clicking here. Yours sincerely, Arthur Budaghyan Hungary Versus Poland: Mind The Reversal Conditions are set for the Hungarian forint to outperform the Polish zloty over the coming months. We recommend going long the HUF against the PLN. Hungarian opposition parties criticized the government about the considerable depreciation in the forint. As a result, we suspect that political pressure from Prime Minister Viktor Orban led monetary authorities to alter their stance since April. Critically, the main architect of super-dovish monetary policy Marton Nagy resigned from the board of the central bank on May 28. In line with tighter liquidity, interbank rates have risen above the policy rate. This is marginally positive for the forint. The Hungarian central bank (NBH) tweaked its monetary policy in April after the currency had plunged to new lows against the euro, underperforming its Central European counterparts. The NBH widened its policy rate corridor by hiking the upper interest band to 1.85% and keeping the policy rate at 0.90%. The wider interest rate corridor makes it more costly for commercial banks to borrow reserves from the central bank. Hence, such liquidity tightening is positive for the forint. For years, Hungary was pursuing a super-easy monetary policy and consumer price inflation rose to 4% (Chart I-1). With the NBH keeping interest rates close to zero, real rates have plunged well into negative territory (Chart I-2, top panel). Chart I-1Hungary: Inflation Could Pause For Now Hungary: Inflation Could Pause For Now Hungary: Inflation Could Pause For Now Chart I-2Hungary Vs. Poland: Real Rates Reversal Is Coming Hungary Vs. Poland: Real Rates Reversal Is Coming Hungary Vs. Poland: Real Rates Reversal Is Coming     In brief, the central bank has been behind the inflation curve. As a result, the forint has been depreciating against both the euro and its central European peers. In such a situation, the key to reversal in the exchange rate trend would be the monetary authority’s readiness to raise real interest rates. The NBH has made a small step in this direction. Going forward, the central bank will be restrained in its quantitative easing (QE) program and will not augment it any further. So far, QE uptake has been slow: around half out of the available HUF 1,500 billion has been tapped by commercial banks and corporates. Importantly, the NBH announced its intention to sterilize its government and corporate bond purchases. Already, the commercial banks excess reserves at the central bank have fallen to zero, which suggests that liquidity is no longer abundant in the banking system (Chart I-3). In line with tighter liquidity, interbank rates have risen above the policy rate. This is marginally positive for the forint. Hungarian authorities have become more cognizant of the economic and financial risks associated with their ultra-accommodative policies. For instance, they initiated a clampdown on real estate speculation, which is leading to dwindling real estate prices. This will lead to a decline in overall inflation expectations and, thereby, lift expected real interest rates. The open nature of Hungary’s economy – whereby exports of goods and services constitute 85% of GDP - makes it much more sensitive to pan-European tourism and manufacturing cycles. With the collapse in its manufacturing and tourism revenues, wage growth in Hungary is bound to decelerate rapidly (Chart I-4). Chart I-3Hungary: Central Bank Has Drained Liquidity Hungary: Central Bank Has Drained Liquidity Hungary: Central Bank Has Drained Liquidity Chart I-4Economic Growth: Hungary Is More Vulnerable Than Poland Economic Growth: Hungary Is More Vulnerable Than Poland Economic Growth: Hungary Is More Vulnerable Than Poland   Rapidly deteriorating wage and employment dynamics reduces the odds of an inflation breakout anytime soon. This will cool down inflation and, thereby, increase real rates on the margin. The central bank in Poland will stay super accommodative while the National Bank of Hungary will be a bit less aggressive. Bottom Line: Although this monetary policy adjustment does not entail the end of easy policy in Hungary, generally, it does signal restraint on the part of monetary authorities resulting from a much reduced tolerance for currency depreciation. This creates conditions for the forint to outperform. Poland In the meantime, Polish monetary authorities have switched into an ultra-accommodative mode. Recent policy announcements by the National Bank of Poland (NBP) represent the most dramatic example of policy easing in Central Europe. Such a policy stance in Poland will produce lower real rates than in Hungary, which is negative for the Polish zloty against the forint. The NBP is set to finance the majority of a new 11% of GDP fiscal spending program enacted by the government amid the COVID-19 lockdowns. This amounts to de-facto public debt and fiscal deficit monetization. The latter will not be sterilized unlike in Hungary and will therefore lead to an excess liquidity overflow in the banking system. The Polish central bank has cut interest rates by 140 bps to 10 bps since March. Pushing nominal rates down close to zero has produced more negative real policy rates than in Hungary (Chart I-2, top panel on page 2). Also, Polish prime lending rates in real terms have fallen below those in Hungary (Chart I-2, bottom panel). Chances are that inflation in Poland will also prove to be stickier than in Hungary due to the minimum wage raise at the beginning of the year and very aggressive fiscal and monetary stimulus since the pandemics has erupted (Chart I-5). Critically, the Polish economy is much less open than Hungary’s, and it is therefore less vulnerable to the collapse of pan-European manufacturing and tourism. This will ensure better employment and wage conditions in Poland. All in all, Poland’s final demand outperformance, versus Hungary, will contribute to a higher rate of inflation there. Bottom Line: The central bank in Poland will stay super accommodative while the National Bank of Hungary will be a bit less aggressive. This is producing a U-turn in both countries’ nominal and relative real interest rates, which heralds a reversal in the HUF / PLN cross rate (Chart I-6). Chart I-5Polish Inflation Will Be Sticker Than In Hungary Polish Inflation Will Be Sticker Than In Hungary Polish Inflation Will Be Sticker Than In Hungary Chart I-6Go Long HUF / Short PLN Go Long HUF / Short PLN Go Long HUF / Short PLN   Investment Strategy For Central Europe A new trade: go long the HUF versus the PLN. Take a 3% profit on the short HUF and PLN / long CZK trade. Close the short IDR / long PLN trade with a 20% loss. Downgrade central European bourses (Polish, Czech and Hungarian) from an overweight to a neutral allocation within the EM equity benchmark. Lower for longer European interest rates disfavor bank stocks that dominate central European bourses. Andrija Vesic Associate Editor andrijav@bcaresearch.com Colombia: Continue Betting On Lower Rates Colombia has been badly hit by two shocks: the precipitous fall in oil prices and the strict quarantine measures to constrain the spread of the COVID-19 outbreak. An underwhelming fiscal stimulus in response to the lockdowns will further weigh on private demand. An underwhelming fiscal stimulus in response to the lockdowns will further weigh on private demand. We have been recommending receiving 10-year swap rates in Colombia since April 23rd and this strategy remains unchanged: While oil prices seem to have rebounded sharply, they will remain structurally low (Chart II-1). The Emerging Markets Strategy team's view is that oil prices will average $40 per barrel this year and next.1 After the recent rally, chances of further upside in crude prices are limited. Chart II-1A Long-Term Perspective On Oil Prices A Long-Term Perspective On Oil Prices A Long-Term Perspective On Oil Prices Table II-1Colombia’s Fiscal Package Is The Lowest In The Region Hungary Versus Poland; Colombia Hungary Versus Poland; Colombia Colombia's high sensitivity to oil prices is particularly visible via its current account balance. Indeed, Colombia’s net crude exports cover as much as 50% of the current account deficit, such that low oil prices severely affect the currency and produce a negative income shock for the economy. Fiscal policy remains unreasonably tight, especially in the face of the global pandemic. The government’s fiscal response plan amounts to only a meagre 1.5% of GDP. This is low not only compared to advanced economies but also to the rest of Latin America (Table II-1). Moreover, President Duque’s administration has been running the tightest fiscal budget in almost a decade, with the primary fiscal balance reaching 1% of GDP before the pandemic. The country’s COVID-19 response has been fast and effective. Colombia has managed to achieve the lowest amount of infections and deaths among major economies in Latin America (Chart II-2). Chart II-2COVID-19 Casualties Across Latin America COVID-19 Casualties Across Latin America COVID-19 Casualties Across Latin America Duque’s administration has taken a pragmatic approach to handling the pandemic by enforcing strict lockdowns and banning international and inter-municipal travel since late March, only three days after the country’s first casualty. Further, the nationwide confinement measures have been extended until July 1st, with particularly stringent rules applying to major cities. These have helped the country avoid a nation-wide health crisis, but they will engender prolonged economic pain. Regarding monetary stimulus, the central bank (Banrep) has cut interest rates by 150 basis points since March of this year. It also embarked on the first and largest QE program in the region. Banrep has committed to purchase 12 trillion pesos worth of government and corporate securities (amounting to a whopping 8% of GDP). Consumer price inflation is falling across various core measures and will drop below the low end of Banrep’s target range (Chart II-3). This will push the central bank to continue cutting rates. Despite the monetary easing, nominal lending rates are still restrictive. Real lending rates (deflated by core CPI) remain elevated at 7% (Chart II-4). Chart II-3Colombia: Inflation Will Fall Below Target Colombia: Inflation Will Fall Below Target Colombia: Inflation Will Fall Below Target Chart II-4Colombia: Real Lending Rates Are Still High Colombia: Real Lending Rates Are Still High Colombia: Real Lending Rates Are Still High Chart II-5The Colombian Economy Was Already Under Pressure The Colombian Economy Was Already Under Pressure The Colombian Economy Was Already Under Pressure Importantly, there has not been an appropriate amount of credit support and debt waving programs for SMEs, as there has been in many other countries. Given that SMEs employ a large share of the workforce, and that household spending accounts for about 70% of GDP, consumer spending and overall economic growth will contract substantially and be slow to recover. Employment rates had already been contracting, and wage growth downshifting, before the pandemic started (Chart II-5). Household income is now certainly in decline as major cities are in full lockdown and economic activity is frozen. Investment Recommendations Even though we are structurally positive on the country due to its orthodox macroeconomic policies, positive structural reforms, and low levels of debt among both households and companies, we maintain a neutral allocation on Colombian stocks within an EM equity portfolio. This bourse is dominated by banks and energy stocks. The lack of both fiscal support and bank loan guarantees amid the recession means that banks will carry the burden of ultimate losses. They will suffer materially due to loan restructuring and defaults. For fixed income investors, we reiterate our call to receive 10-year swap rates and recommend overweighting local currency government bonds versus the EM domestic bond benchmark. The yield curve is steep and real bond yields are elevated (Chart II-6). Hence, long-term interest rates offer great value. Additional monetary easing, including quantitative easing, will suppress yields much further. Chart II-6A Great Opportunity In Colombian Rates A Great Opportunity In Colombian Rates A Great Opportunity In Colombian Rates Chart II-7The COP Has Depreciated Considerably The COP Has Depreciated Considerably The COP Has Depreciated Considerably   We are upgrading Colombia sovereign credit from neutral to overweight within an EM credit portfolio. General public debt (including the central and state governments) stands at 59% of GDP. Conservative fiscal policy and the central bank’s large purchases of local bonds will allow the government to finance itself locally. Presently, 40% of public debt is foreign currency and 60% local currency denominated. As a result, sovereign credit will outperform the EM credit benchmark. In terms of the currency, we recommend investors to be cautious for now. Even though the peso is cheap (Chart II-7), another relapse in oil prices or a potential flare up in social protests could cause further downfall in the currency. Juan Egaña Research Associate juane@bcaresearch.com   1 This differs from the view of BCA’s Commodities and Energy Strategy service. We believe structural forces such as the lasting decline in air travel and commuting will impede a recovery in oil demand while, at the same time, US shale production will rise again considerably if crude prices rise and remain well above $40   Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights The economic and health crises since Q1 2020 have accelerated the breakdown in the US-China relationship. Although the US is in a much weaker economic position this year than in 2019, President Trump may have fewer political constraints to an escalation in the trade war. President Xi Jinping is fueling provocations with the US, adding instability and unpredictability to the geopolitical equation. The Phase One trade deal may be collapsing. We recommend a defensive stance on Chinese risk assets and the RMB during the summer. Feature The outbreak of COVID-19 this year has sparked the worst economic contraction in China and the US in decades. Economic calamities and social unrest should have tied the hands of leaders in both countries. However, as our Geopolitical Strategist Matt Gertken reminds us, this is an atypical election year in the US and some constraints that previously deterred both sides from taking aggressive actions may be diminishing.1 We agree that the economic and health crises have likely accelerated the possibility of a breakdown in the relationship between the US and China. The risk will likely reach a new height in the summer, when pressure on Trump’s election campaign intensifies leading up to the vote in November. While there is a growing bipartisan hawkish view on China in Washington, China is also playing a part in fanning the flames. The USD/CNY exchange rate will be extremely volatile during this episode of heightened geopolitical turbulence. We continue to hold a long USD-CNH position, with the expectation that the RMB will likely weaken further in the summer. Trump Facing Fewer Constraints Whether Trump’s chances of reelection increase through a strong recovery in the US stock market and economy, or decrease through an economic recession and/or weak public support, either scenario could remove constraints preventing Trump from confronting China.     Trump’s current priority may be to secure a recovery in the equity market and improve his polling, which will require economic improvement. Ironically, the US stock market has been on fire despite the battered real economy. The S&P 500 Index has gone up by 44% since its trough on March 23, nearly erasing its losses for the year. The higher the market rises, the more Trump may believe that the market can sustain a shock even if he resorts to imposing tariffs on Chinese export goods - particularly if his approval rating does not rise along with the market. The market’s reaction in 2018 and 2019 provides a good example of how the US financial markets shrugged off any negative impact from a trade war between the US and China (Chart 1). If the pandemic prevents the US economy from fully reopening and/or recovering in the summer, then an equity market correction could send a negative signal about Trump’s reelection prospects. In this case, Trump may not be as enslaved by financial constraints as he would have been if the economy was in an expansionary state.  A falling approval rating, coupled with domestic social unrest, would make Trump a “lame duck” President (Chart 2).  Therefore, he may try to divert attention away from the economy and adopt an aggressive foreign and trade policy. China is already perceived negatively by a majority of American voters and certain political communities, thus there could be a political upside for Trump to escalate his confrontation with China. Chart 1US Stocks Kept Reaching New Highs In 2019 Despite An Ongoing Trade War US Stocks Kept Reaching New Highs In 2019 Despite An Ongoing Trade War US Stocks Kept Reaching New Highs In 2019 Despite An Ongoing Trade War Chart 2Trump’s Polling Drops Below Average Watch Out For A Second Wave (Of US-China Frictions) Watch Out For A Second Wave (Of US-China Frictions) All bets are off if Trump’s approval rating continues to trend downwards, regardless of whether the US equity market continues to rally and/or if the US economy is mired in recession. Our Geopolitical Strategy illustrates the scenarios as follows (Diagram 1). If Trump’s approval rating is high and the market is up, then Trump is “winning” and the only risk of a tariff hike would come from overconfidence or Chinese provocation. If his approval is up but the market falls, then he may become more inclined to use tariffs. If his approval rating is low but the market is up, then he has ammunition to get tougher on China. If his approval and the market are collapsing, then he is a “lame duck president” and all bets are off. Combined, these scenarios imply there is a 59% probability that Trump refrains from large tariffs, and a 41% chance that he reverts to large tariffs. Diagram 1Odds President Trump Will Hike Tariffs On China Before US Election Watch Out For A Second Wave (Of US-China Frictions) Watch Out For A Second Wave (Of US-China Frictions) Bottom Line: All bets are off if Trump’s approval rating continues to trend downwards, regardless of whether the US equity market continues to rally and/or if the US economy is mired in recession. Both scenarios would remove financial and economic constraints that Trump faced in 2019. If Trump's polling is weak, he may spend financial ammunition to shore up his “America First” credentials.      Adding China To The Geopolitical Instability Equation China itself may be an independent source of geopolitical instability and unpredictability. While President Xi Jinping does not have any electoral constraints, he needs to restore the confidence of Chinese people in the wake of the worst public health crisis and economic performance in decades. Like Trump, the pandemic gives President Xi an incentive to distract his populace from domestic crises by adopting hawkish foreign policies.  This hawkish approach was demonstrated when a new Hong Kong SAR national security law was proposed and approved at this year’s National People’s Congress (NPC). The new law would give Beijing greater direct control over Hong Kong, in contravention of its promise of 50 years of substantial autonomy enshrined in the Sino-British Joint Declaration of 1984.  China’s foreign policy tone recently shifted to a more combative one. This “wolf warrior diplomacy" has gained popularity among Chinese diplomats.2 During a news conference at this year’s NPC, China’s Foreign Minister Wang Yi defended the “wolf warrior diplomacy” by stating that the country will stand firm in defending its national interest and combating “smears.”  Chart 3Chinese Imports Of American Goods Are Falling Far Short Of The Target Set By The Trade Deal Chinese Imports Of American Goods Are Falling Far Short Of The Target Set By The Trade Deal Chinese Imports Of American Goods Are Falling Far Short Of The Target Set By The Trade Deal The response from the Trump administration has been lukewarm. While Secretary of State Mike Pompeo will strip Hong Kong of its autonomous status, President Trump is taking limited sanctions on mainland China and eschewing more drastic punitive measures. China may see the timid response as a sign that Trump is reluctant to take action on China and tip the bilateral relationship into an outright confrontation. This perception is, in itself, a risk that may lead to more provocation on both sides. Lastly, the Phase One trade deal is tenuous. US Trade Representative Robert Lighthizer last week stated that "China has done a pretty good job" at meeting its trade-deal quotas,3 but we have long argued China was never going to honor the commitment to its full extent.4 The latest data shows that Chinese purchases of American exports in the first four months of 2020, from manufacturing goods to agricultural produce and energy, have fallen far short of the huge expansion agreed in the deal (Chart 3). The recent depreciation in the RMB may be another sign that China is abandoning the Phase One trade deal.5 Weakness in economic fundamentals and renewed tensions between the US and China may have contributed to the RMB’s recent depreciation. However, the decline was reinforced by the PBoC’s move to set the CNY/USD fixing rate to its lowest point since 2008 (Chart 4). Given that the RMB has become an anchor for emerging market currencies, a rapid drop in the RMB would lead to selloffs in emerging Asian and Latin American currencies and, in turn, would strengthen the USD (Chart 5). The Trump administration may see a swift RMB depreciation as China is deliberately violating the Phase One trade deal, which will prompt Trump to seek retaliatory actions against China. Chinese purchases of American goods in the first four months of 2020 have fallen far short of the Phase One trade agreement. Chart 4Is The PBoC Sending A Warning Signal To Trump? Is The PBoC Sending A Warning Signal To Trump? Is The PBoC Sending A Warning Signal To Trump? Chart 5The RMB Has Been The Anchor Currency In EM The RMB Has Been The Anchor Currency In EM The RMB Has Been The Anchor Currency In EM Bottom Line: While China is prioritizing its own economic recovery, its foreign policy stance has decisively swung to a more combative one. Additionally, the Phase One trade deal is on the verge of collapsing.  Investment Conclusions The USD/CNY exchange rate will likely be extremely volatile in the next quarter amid heightened geopolitical turbulence, with more downside risks to the RMB. As such, we continue to recommend that investors hedge their RMB exposure in Chinese stocks by holding a long USD-CNH position. We remain neutral on Chinese stocks in relative terms in view of the non-trivial, near-term vulnerability of risk assets. As in 2019, investable stocks are particularly exposed to an escalation in the US-China conflict (Chart 6). Chart 6Large Divergence In Onshore Versus Offshore Stock Performance During The Trade War Large Divergence In Onshore Versus Offshore Stock Performance During The Trade War Large Divergence In Onshore Versus Offshore Stock Performance During The Trade War Chart 7Stocks In Some Domestic Demand-Oriented Sectors Are Still Relatively Safe Bets Stocks In Some Domestic Demand-Oriented Sectors Are Still Relatively Safe Bets Stocks In Some Domestic Demand-Oriented Sectors Are Still Relatively Safe Bets Price corrections in both China’s onshore and offshore aggregate equity markets are likely to occur during the summer. Nevertheless, cyclical plays that closely track Chinese stimulus are relatively safe bets, especially for China’s domestic investors and in absolute terms (Chart 7).   Jing Sima China Strategist jings@bcaresearch.com   Footnotes 1Please see Geopolitical Strategy Weekly Report "Spheres Of Influence (GeoRisk Update)," dated May 29, 2020, available at gps.bcaresearch.com 2South China Morning Post, “Chinese Foreign Minister Wang Yi defends ‘wolf warrior’ diplomats for standing up to ‘smears’”, May 24, 2020 3Bloomberg, “Lighthizer Says He Feels ‘Very Good’ About Phase One China Deal”, June 4, 2020 4Please see China Investment Strategy Weekly Report "Managing Expectations," dated January 22, 2020, available at cis.bcaresearch.com 5The Phase One trade deal prohibits both the US and China from manipulating exchange rates to devalue their currencies for competitive purposes. Cyclical Investment Stance Equity Sector Recommendations

Highlights Egypt’s balance of payments have deteriorated materially due to both the crash in oil prices and the global pandemic. The country’s foreign funding requirements in 2020 are high and the currency is under depreciation pressures. Unless domestic interest rates are brought considerably lower, the nation’s public debt is on an unsustainable trajectory. Hence, Egypt needs to reduce local interest rates substantially and rapidly. And in so doing, the central bank cannot control or defend the exchange rate. The latter is set to depreciate. Investors should buy Egyptian local currency bonds while hedging their currency exposure. Feature The Central Bank of Egypt (CBE) is depleting its foreign exchange (FX) reserves to defend the currency (Chart I-1). As the CBE’s foreign exchange reserves diminish, so will its ability to support the currency. As such, the Egyptian pound will likely depreciate in the next 6-9 months. Interestingly, despite being a net importer of energy, many of Egypt’s critical macro parameters are positively correlated with oil prices (Chart I-2). Egypt is in fact deeply integrated in the Gulf oil-economy network via trade and capital flows. In other words, Egypt is a veiled play on oil. Chart I-1The CBE Has Been Defending The Currency The CBE Has Been Defending The Currency The CBE Has Been Defending The Currency Chart I-2Egypt: A Veiled Play On Oil Egypt: A Veiled Play On Oil Egypt: A Veiled Play On Oil   Although oil prices have rallied sharply recently, the Emerging Markets Strategy team believes upside is limited and that oil prices will average about $40 over the next three years.1  In addition, local interest rates that are persistently above 10% are disastrous for both Egypt’s domestic demand and public debt sustainability. Egypt’s current account balance strongly correlates with oil prices because of the strong interlinkages that exist between Egypt and the oil-exporting Gulf countries. To preclude a vicious cycle in both the economy and public debt, the CBE should reduce interest rates materially and rapidly. Therefore, higher interest rates cannot be used to defend the exchange rate. Balance Of Payments Strains Egypt’s balance of payments (BoP) dynamics have deteriorated and the probability of a currency devaluation has risen: Current Account: The current account deficit – which stood at $9 billion and 3% of the GDP as of December 2019 – is widening significantly due to the plunge in oil prices this year (Chart I-2, top panel). Egypt’s current account balance strongly correlates with oil prices because of the strong interlinkages that exist between Egypt and the oil-exporting Gulf countries. The latter have been hard hit by the twin shocks of the coronavirus pandemic and the oil crash. First, Egypt’s $27 billion in annual remittances are drying up (Chart I-2, bottom panel). The majority of these transmittals come from Egyptian workers working in Gulf countries. Second, Egypt’s tourism industry – which brings in $13 billion in annual revenues or 4% of GDP – has collapsed due to the pandemic. Tourist arrivals from Middle Eastern countries – which makeup 20% of total tourist arrivals into Egypt – will diminish substantially due to both the pandemic and the negative income shock that the Gulf economies have experienced (Chart I-3). Third, Egyptian exports are in freefall (Chart I-4, top panel). Not only is this due to the freeze in global trade, but also because the country’s exports to the oil-leveraged Arab economies have taken a massive hit. The latter make up 25% of Egypt’s total goods shipments. Chart I-3Egypt: Tourism Is Linked To Oil Prices Egypt: Tourism Is Linked To Oil Prices Egypt: Tourism Is Linked To Oil Prices Chart I-4Exports Revenues Swing With Oil Prices Exports Revenues Swing With Oil Prices Exports Revenues Swing With Oil Prices   Furthermore, since 2019 Egypt has been increasingly exporting natural gas. The collapse in gas prices has probably already wiped out a large of chunk its natural gas export revenues (Chart I-5). Chart 6 exhibits the structure of Egypt’s exports of goods and services. Energy, tourism and transportation constituted 67% of total exports in 2019. Chart I-5Gas Export Revenues Are At Risk Gas Export Revenues Are At Risk Gas Export Revenues Are At Risk Chart I-6Egypt: Structure Of Goods & Services Exports Egypt: A Veiled Oil Play Egypt: A Veiled Oil Play Chart I-7Exports Are Shrinking Amid Resilient Imports Exports Are Shrinking Amid Resilient Imports Exports Are Shrinking Amid Resilient Imports Finally, while export revenues have plunged, imports remain resilient (Chart I-7). Critically, 26% of Egypt’s imports are composed of essential and basic items such as consumer non-durable goods, wheat and maize. Consumption of these staples and goods are less sensitive to business cycle oscillations. Therefore, the nation’s current account deficit has ballooned. A wider current account deficit needs to be funded by foreign inflows. With foreign investors reluctant to provide funds, the CBE has lately been financing BoP by depleting its foreign exchange reserves (Chart I-1, on page 1). Foreign Funding Requirements: Not only is Egypt facing a massively deteriorating current account deficit, but the country also carries large foreign funding debt obligations (FDO). FDOs are the sum of debt expiring in the next 12 months, and interest as well as amortization payments over the next 12 months. FDOs due in 2020 were $24 billion.2 In turn, Egypt’s total foreign funding requirements (FFR) – which is the sum of FDOs and the country’s current account deficit – has risen to $33 billion.3 Importantly, this FFR amount is based on the current account for 2019 and, thereby, does not take Egypt’s deteriorating current account deficit into consideration – as discussed above. Meanwhile, the central bank has net FX reserves of only $8 billion.4 If the monetary authorities continue to fund FFR of $33 billion in 2020 to prevent the pound from depreciating, the CBE will soon run out of its net FX reserves. Overall, Chart I-8 compares Egypt to the rest of the EM universe: with respect to (1) exports-to-FDO on the x-axis and (2) foreign exchange reserves-to-FFR on the y-axis. Based on these two measurements, Egypt is among the most vulnerable EM countries in terms of the balance of payments as it has the lowest FX reserves-to-FFR ratio and a low export-to-FDO ratio as well. Chart I-8Egypt Is One Of The Most Exposed EM Countries To Currency Depreciation Egypt: A Veiled Oil Play Egypt: A Veiled Oil Play Chart I-9FDI Inflows Are Set To Diminish FDI Inflows Are Set To Diminish FDI Inflows Are Set To Diminish Foreign Funding of Private Sector: Egypt will struggle to attract private-sector foreign inflows to meet its large FFR amid this adverse regional economic environment and the likely renewed relapse in oil prices in the months ahead. FDI inflows are set to drop (Chart I-9). The oil & gas sector has been the largest recipient of FDI inflows recently (around 55% in 2019 according to the central bank). The crash in both crude oil and natural gas prices will therefore ensure that FDIs into this sector will dry up. Besides, overall FDI inflows emanating from Gulf countries are poised to shrink substantially.5 Chart I-10The Egyptian Pound Is Once Again Expensive The Egyptian Pound Is Once Again Expensive The Egyptian Pound Is Once Again Expensive Foreign Funding of Government: With FDI inflows diminishing, the Egyptian government has once again been forced to approach the IMF for assistance. The country managed to secure $8 billion in assistance from the IMF ($2.8 billion in May and $5.2 in June). This has ameliorated international investor confidence in Egypt. Indeed, the country raised $5 billion by issuing US dollar-denominated sovereign bonds in May. Egypt is now seeking another $4 billion from other international lenders. Crucially, assuming Egypt manages to get the $4 billion loan, which would allow it to raise a total of $17 billion, Egypt would still be short on foreign funding to finance its $33 billion in FFR. Therefore, the currency will come under pressure of devaluation. As we argue below, the nation’s public debt sustainability is in jeopardy unless local currency interest rates are brought down substantially. This can only happen if the currency is allowed to depreciate. Consistently, foreign investors might be unwilling to lend to Egypt until interest rates are pushed lower and the country’s public debt trajectory is placed back on a sustainable path. Finally, the Egyptian pound has once again become expensive according to the real effective exchange rate (REER) which is based on both consumer and producer prices (Chart I-10). Bottom Line: Egypt is facing sharply slowing foreign inflows due to both the crash in oil prices and the global pandemic. This is occurring amid increased FFRs. Meanwhile, the CBE’s net FX reserves are insufficient to defend the exchange rate. Public Debt Sustainability The BoP strains discussed above are forcing the CBE to keep interest rates high to prevent the currency from depreciating. Yet the country’s public debt is on a dangerous path due to elevated interest rates. In turn, without currency devaluation that ultimately allows local interest rates to drop dramatically, the sustainability of Egypt’s public debt will worsen considerably. The BoP strains discussed above are forcing the CBE to keep interest rates high to prevent the currency from depreciating. Yet the country’s public debt is on a dangerous path due to elevated interest rates. To start, Egypt’s public debt stands at 97% of GDP – local currency and foreign currency debt account for 79% and 18% of GDP respectively (Chart I-11, top panel). Chart I-12 illustrates that interest payments on public debt is already using up 60% of government revenue and stands at 10% of GDP. Chart I-11Egypt: Public Debt Profile Egypt: Public Debt Profile Egypt: Public Debt Profile Chart I-12The Government's Interest Payments Are Unsustainable The Government's Interest Payments Are Unsustainable The Government's Interest Payments Are Unsustainable   Therefore, if the CBE keeps interest rates at the current level, then the government will continue to pay high interest on its debt. Generally, two conditions need to be met to ensure public debt sustainability in any country (i.e., to ensure that the public debt-to-GDP ratio does not to surge). Nominal GDP growth needs to be higher than government borrowing costs. The government needs to run persistently large primary fiscal surpluses. Chart I-13Egypt: Nominal GDP Growth And Government Borrowing Costs Egypt: Nominal GDP Growth And Government Borrowing Costs Egypt: Nominal GDP Growth And Government Borrowing Costs Regarding the first condition, nominal GDP growth was already dangerously close to the level of Egypt’s government borrowing costs even before the pandemic hit Egypt (Chart I-13). With the pandemic, both domestic demand and exports have plunged. Consequently, nominal GDP is likely close to zero while local currency borrowing costs are above 10%. So long as nominal GDP growth remains below borrowing costs, the public debt sustainability will continue to deteriorate. As to the second condition, Egypt only started running primary fiscal surpluses in 2018 as it implemented extremely tight fiscal policy by cutting non-interest expenditures (Chart I-14). However, that was only possible because economic growth was then strong. As growth has slumped, government revenue is most likely shrinking. Chart I-14Egypt Only Recently Started Running A Primary Fiscal Surplus Egypt Only Recently Started Running A Primary Fiscal Surplus Egypt Only Recently Started Running A Primary Fiscal Surplus Tightening fiscal policy amid the economic downturn will be ruinous. Cutting non-interest expenditures further will depress the already weak economy, drying up both nominal GDP and government revenues even more. This will bring about a vicious economic cycle. Needless to say, the latter option is politically unviable. The most feasible option to ensure sustainability of public debt dynamics is to bring down domestic interest rates considerably. Lower local interest rates will reduce interest expenditures on its domestic debt and will either narrow overall fiscal deficit or free up space for the government to spend elsewhere, boosting much needed economic growth. Meanwhile lower interest rates will boost demand for credit and revive private-sector domestic demand. Provided Egypt’s public debt has a short maturity profile, lower interest rates will reasonably quickly feed into lower interest payments for the government. This means that lower interest rates could reasonably quickly feed to lower interest payments for the government. Importantly, there is a trade-off between the exchange rates and interest rates. Lowering interest rates entail currency depreciation. According to the impossible trinity theory, a central bank facing an open capital needs to choose between controlling interest rates or the exchange rate, it cannot control both simultaneously. As such, if the Central Bank of Egypt opts to bring down local interest rates, while keeping the capital account reasonably open, it needs to tolerate a weaker currency amid its ongoing BoP strains. Bottom Line: Public debt dynamics are treading on a dangerous path. Egypt needs to bring down local interest rates down substantially and rapidly. And in so doing, the CBE cannot control and defend the exchange rate. Devaluation Is Needed All in all, the Egyptian authorities are facing a tight tradeoff: (1) either they continue to defend the currency at the expense of depressing the economy and worsening public debt dynamic, or (2) they tolerate a one-off currency devaluation which would allow the monetary authorities reduce interest rates aggressively. The latter will help stimulate economic growth and make public debt sustainable. Specifically, if the Central Bank of Egypt opts for defending the currency from depreciation, it will need to tolerate much higher interest rates for a long period of time. The CBE would essentially need to deplete whatever little net FX reserves it currently has to fund BoP deficits. This would simultaneously shrink local banking system liquidity, pushing domestic interbank rates higher.  All in all, the Egyptian authorities are facing a tight tradeoff: (1) either they continue to defend the currency at the expense of depressing the economy and worsening public debt dynamic, or (2) they tolerate a one-off currency devaluation which would allow the monetary authorities reduce interest rates aggressively. Worryingly, not only would high interest rates devastate the already shaky Egyptian economy, but higher domestic interest rates carry major ramifications for Egypt’s public debt sustainability as discussed earlier. A one-off currency devaluation is painful and carries some political risks yet, it is still the least worst choice for Egypt from a longer-term perspective. Although inflation will spike due to pass-through from currency devaluation, it will be a transitory one-off increase (Chart I-15). Besides, the pertinent risk to the Egyptian economy currently is low inflation and high real interest rates (Chart I-16). Chart I-15Egypt: Currency-Induced Inflation Is A One-Off Egypt: Currency-Induced Inflation Is A One-Off Egypt: Currency-Induced Inflation Is A One-Off Chart I-16Egypt: Real Interest Rates Are High Egypt: Real Interest Rates Are High Egypt: Real Interest Rates Are High     In turn, currency depreciation will ultimately provide the CBE with scope to reduce its policy rate which will help stimulate the ailing economy as well as make public debt trajectory more sustainable. Finally, odds are high that Egyptian authorities might choose to devalue the currency sooner rather than later. The basis for this is that the government’s foreign public debt is still relatively small at 18% of the GDP and 19% of the total government debt (Chart I-11, on page 8). Further, the majority (70%) of Egypt’s foreign public debt remains linked to international and bilateral government loans making it easier to renegotiate their terms than in the case of publicly traded sovereign US dollar bonds (Chart I-11, bottom panel). This means that currency depreciation will not materially deteriorate the government’s debt servicing ability. Furthermore, Egypt has experience managing and tolerating currency depreciation. The currency depreciated against the US dollar by 50% in 2016 and before that by 12% in 2013. Bottom Line: The Central Bank of Egypt will not hike interest rates or sell its foreign currency reserves for too long to defend the pound. Odds are high that it will allow the currency to depreciate and will cut interest rates materially. Investment Recommendations Chart I-17Egyptian Pound In The Forward Market Egyptian Pound In The Forward Market Egyptian Pound In The Forward Market Investors should buy Egyptian 3-year local currency bonds while hedging their currency exposure. The basis is that low inflation and a depressed economy in Egypt will lead the CBE to cut rates by several hundred basis points over the next 12 months while allowing currency to depreciate. Forward markets are pricing 5% depreciation in the EGP in the next 6 months and 10% in the next 12 months (Chart I-17). We would assign a higher probability of depreciation.   For now, EM credit portfolios should have a neutral allocation on Egyptian sovereign credit. While another potential drop in oil prices and the currency devaluation could push sovereign spreads wider (Chart I-18), eventually large rate cuts by the CBE will make public debt dynamics more sustainable. Absolute return investors should wait for devaluation to go long on Egypt’s US dollar sovereign bonds. Chart I-18Remain Neutral On Egypt's Sovereign Credit Remain Neutral On Egypt's Sovereign Credit Remain Neutral On Egypt's Sovereign Credit Chart I-19Remain Neutral On Egyptian Equities Remain Neutral On Egyptian Equities Remain Neutral On Egyptian Equities   Equity investors should keep a neutral allocation on Egyptian stocks with an EM equity portfolio (Chart I-19). Lower interest rates ahead will eventually boost this stock market. Ayman Kawtharani Editor/Strategist ayman@bcaresearch.com      1 This is the view of BCA’s Emerging Markets Strategy service and it differs from the view of BCA’s Commodities and Energy Strategy service. 2 We exclude the Central Bank’s foreign liabilities due in 2020 as they are mostly deposits at the Central Bank of Egypt owed to Gulf countries. It is highly likely that Gulf lenders will agree to extend these deposits given the difficulties Egypt is experiencing. 3 Excluding the Central Bank’s foreign liabilities due in the next 12 months. Please refer to above footnote. 4 The amount of net foreign exchange reserves currently at the Central Bank – i.e. excluding the Bank’s foreign liabilities– are now low at $8 billion. 5 Gulf Co-operation Countries (GCC) are in no position to provide much financial assistance due to the pandemic and oil crash as they are under severe financial strain themselves. Also, GCC countries run strict currency pegs and need to preserve their dwindling foreign exchange reserves to defend their currency pegs to the US dollar.