Monetary

Highlights EM QE programs will ensure that EM local currency bond yields will drop further. However, the impact of these EM QE programs on EM currencies is ambiguous. Continue receiving long-term swap rates in a number of EM economies. QE programs globally constitute public debt monetization. A stronger money supply does not in itself constitute a sufficient reason to expect a rise in inflation rates. However, DM and EM QE programs could fuel financial market manias. Feature Chart I-1Broad Money Is Booming In DM And Accelerating In EM Broad Money Is Booming In DM And Accelerating In EM Broad Money Is Booming In DM And Accelerating In EM In this report we discuss the various quantitative easing programs (QEs) that have begun to surface in emerging economies. This is a new phenomenon that will likely mark a major precedent for EM central banks. Over time, these programs will likely become more prominent tools in EM. Understanding these unorthodox monetary policy easing measures in EM and DM is of paramount importance to investors. We use a Q&A format to discuss and elaborate on this topic. Question: What has forced the authorities to launch QE programs in EM and what forms have they taken? Answer: QE programs in developing countries are in their infancy. Several governments launched them in haste in the month of March in response to the recession and panic selloff that was occurring across global financial markets. These programs will be shaped by different forces and take different forms over time. Generally, QE programs are implemented in order to: (1) halt the abrupt deleveraging among local commercial banks amid the COVID-19 crisis (2) ensure credit continues to flow to the real economy (companies and households) (3) bring down long-term interest rates and prevent large government borrowings from crowding out the private sector. In addition to slashing policy rates, many EM central banks (CBs) are implementing one or more of the following initiatives to achieve these objectives: I.  Providing unlimited liquidity to commercial banks through various facilities II.  Buying government bonds III. Conducting direct purchases of local currency corporate bonds and, in some cases, mortgage-backed securities IV. Direct lending to non-banks such as mutual funds and enterprises V. Expanding the range of public and private sector securities that can be used as collateral when lending to banks The second, third and fourth types of operations can be considered forms of QE to the extent that they fall beyond the scope of customary CB operations. The latest QEs qualify as public debt monetization. This is also true for the QEs in advanced economies. Table I-1 provides information about various central bank policies across mainstream EM countries. Details are still limited regarding the technicalities, quantity and timelines of some of these measures. Table I-1Quantitative Easing Policies Annouced By Emerging Economies Understanding QE Programs In EM And DM Understanding QE Programs In EM And DM Question: Do these QEs represent a public debt and fiscal deficit monetization? Answer: Yes, monetary and fiscal policies are being coordinated and these QEs qualify as public debt monetization. This is also true for the QEs in advanced economies. These QE policies have been designed to ensure that the cost of government borrowing does not rise amid the surge in public sector borrowing requirements. Especially at a time when foreign investors were abandoning EM financial markets. Governments have deployed large fiscal stimulus packages to offset the devastating economic impact of COVID-19 induced shutdowns. Coupled with a collapse in fiscal revenues, this has resulted in a widening of fiscal deficits and large borrowing requirements. Chart I-2EM QEs Are Intended To Drive Down Local Bond Yields EM QEs Are Intended To Drive Down Local Bond Yields EM QEs Are Intended To Drive Down Local Bond Yields EM local currency government bond yields spiked in March (Chart I-2). This prompted CBs in many EMs to announce government bond purchasing programs in order to bring down government bond yields. Government bond yields influence other interest rates such as those for consumer and business loans. Higher borrowing costs amid a deep recession would have been lethal for corporate and household debtors. Additionally, it would have materially damaged public debt dynamics. To bring down government bond yields and ensure that policy rate cuts translate into lower borrowing costs across the entire yield curve, CBs have begun purchasing government bonds in the following developing countries: Brazil, South Africa, Poland, Colombia, India, Malaysia, Indonesia, Thailand and Korea. Government bond yields in many EMs have declined since mid-March (Chart I-2). That could be at least partially attributed to EM CBs’ QE programs. CB purchases of government bonds in either primary or secondary markets, qualify as public debt monetization. Question: How are QEs different from conventional CB operations and what makes them so unique as to warrant investor attention? Answer: There are three things that distinguish these QE initiatives from traditional CB operations: First, CBs do not typically lend to non-banks. They do not lend to or purchase credit instruments issued by non-banks. Hence, by purchasing corporate bonds and issuing loans to non-banks, CBs have entered into unchartered territory. This is also true for the Federal Reserve and CBs in other advanced economies. Second, by buying government bonds CBs are conducting an outright monetization of public debts and fiscal deficits. This is true for central banks in both EM and DM. Outside QEs, monetary authorities typically set the short-term interest rate and provide enough liquidity to the banking system to keep short-term interbank rates on par with policy rates. Chart I-3Fed’s Ownership Of Treasurys Fed's Ownership Of Treasurys Fed's Ownership Of Treasurys Prior to the launch of QE programs, CB operations with long-term government bonds were limited in scope and often technical in nature. For example, the Fed’s ownership of US Treasury securities rose by only 40% from $550 billion in 2002 to $775 billion in 2006. By comparison, it has doubled from $2 trillion to $4 trillion since September 2019 (Chart I-3). When CBs buy government bonds en masse, as they are currently doing in many countries, we are no longer talking about open market operations, but rather the monetization of public debt. Third, by launching QEs, CBs affect long-term interest rates. When financial markets are malfunctioning, which results in unjustifiably elevated long-term interest rates and cost of capital, QEs become essential to ensure the monetary policy transmission channel is operating effectively.  Nevertheless, as we have seen in the cases of the ECB and Bank of Japan, the use of QEs can become addictive. Once CBs have deployed QEs, they have a hard time abandoning them. When the financial systems and markets get accustomed to zero or negative nominal interest rates and to a constant overflow of CB liquidity, the termination of QEs will be disruptive and painful. Consequently, there is a risk that both DM and EM CBs will end up overdoing it with QEs - suppress long-term interest rates too much, for too long and for no justifiable reason. This will in turn lead to misallocations of capital, asset bubbles and other distortions in financial markets and real economies. If the velocity of money recovers to its pre-pandemic levels amid the massive expansion of money supply, inflation will rise even if real output returns to its potential pace. Question: Is it fair to say that QEs lead only to an increase in commercial banks’ excess reserves at the CB, and that they have no real impact on the money supply? In other words, if commercial banks do not lend, is it true that the money supply will not expand and, thereby, QEs will never lead to higher rates of inflation?  Answer: Not really. QEs have a much more nuanced impact on the money supply. Moreover, the relationship between the money supply and the inflation rate is not straightforward. We will consider several examples, dissecting the impact of QEs on both excess reserves (ER) and the money supply. But first, let us recall that the broad money supply is the sum of both the cash in circulation and all types of deposits in commercial banks, including demand, time and savings deposits. Commercial banks’ ER at CBs are not included in either the narrow or broad definitions of money supply. Case 1: When a central bank purchases securities from or lends to a bank, ER rise although no deposit is created, so the money supply does not change.  Case 2: When a central bank purchases securities from or lends money to non-banks, this transaction creates both an ER and a new deposit in commercial banks, meaning that the money supply does increase. Case 3: When a commercial bank buys securities from or lends to non-banks, ER do not change while a new deposit is created “out of thin air”, so that the money supply rises. Conversely, when a bank sells a security to a non-bank, or a non-bank repays a loan, the money supply (i.e. the amount of deposits in the banking system) shrinks. To sum up, QEs lead to a larger money supply when CBs purchase assets from or lend to non-banks. When CBs purchase assets from banks, no new money (deposits) are created. Importantly, the money supply also expands when commercial banks buy securities from or lend to non-banks. Chart I-4A and I-4B reveal that QEs in the US, the UK, Japan and the euro area, over the past 10 or so, years have created a lot of ER but little money supply. Chart I-4AExcess Reserves Have Expanded More Than Broad Money In US, Japan… Excess Reserves Have Expanded More Than Broad Money In US, Japan... Excess Reserves Have Expanded More Than Broad Money In US, Japan... Chart I-4B… Euro Area And UK ... Euro Area And UK ... Euro Area And UK   In China, the broad money supply has been exploding since 2009. The commercial banks have, on their own, generated an enormous increase in the money supply “out of thin air”, by making loans to and buying securities from non-banks, even though there has been much less ER creation from the PBoC (Chart I-5). The top panel of Chart I-6 illustrates the remarkable evolution of broad money supply in China versus the US, the euro area and Japan. In the chart, broad money supply in these four economies is plotted along the same scale, since January 2009, when QEs began in DM and the credit boom commenced in China. Even though ERs have expanded much more in the US, the euro area and Japan (Chart I-6, bottom panel), broad money growth in China outstripped all other economies by a large margin (Chart I-6, top panel). Chart I-5Excess Reserves Have Expanded Less Than Broad Money In China Excess Reserves Have Expanded Less Than Broad Money In China Excess Reserves Have Expanded Less Than Broad Money In China Chart I-6Broad Money And Excess Reserves: China Versus DM Broad Money And Excess Reserves: China Versus DM Broad Money And Excess Reserves: China Versus DM     As we discussed in our previous reports on money, credit and savings, money supply growth is not at all contingent on savings in an economy. Rather, outside of QEs money in all countries is primarily created by the commercial banks when they lend to or purchase assets from non-banks. Still, the nature of QE is now changing in the US. Chart I-7 reveals that the broad money supply is booming faster than it ever has, since World War II. As the Fed lends directly to businesses and purchases corporate bonds that are largely held by non-banks, the money supply will explode in the US, alongside a surge in ER. Chart I-7US Money Growth: The Sky Is The Limit US Money Growth: The Sky Is The Limit US Money Growth: The Sky Is The Limit Chart I-8April Datapoints Suggest Notable EM Money Growth Acceleration April Datapoints Suggest Notable EM Money Growth Acceleration April Datapoints Suggest Notable EM Money Growth Acceleration Similar trends will occur in EM and other DM (Chart I-8): as their CBs buy securities from non-banks, they will simultaneously create both ER and new deposits at commercial banks (money supply). Question: Does this potential explosion in money supply globally – and in the US in particular – imply that there is an imminent risk of an inflation outbreak in the real economy? Answer: A stronger money supply does not in itself constitute a sufficient reason to expect a rise in inflation rates. Inflation (rising prices of goods and services) also depends on the velocity of money and the productive capacity of an economy. Nominal GDP = Velocity of Money x Money Supply In turn, Nominal GDP = Output Volume x Prices Hence, Output Volume x Prices = Velocity of Money x Money Supply Finally, Prices = (Velocity of Money x Money Supply) / Output Volume. Therefore, inflation is contingent not only on the money supply but also on the velocity of money and the output volume. The money supply will continue surging in the US and will boom in the rest of the world as other CBs also deploy QEs (Chart I-7 and I-8). However, the surge in money supply has so far been offset by a lower velocity of money (Chart I-9Aand I-9B). The velocity of money reflects the willingness of consumers and businesses to spend their money. Chart I-9AVelocity Of Money Dropped In March Velocity Of Money Dropped In March Velocity Of Money Dropped In March Chart I-9BVelocity Of Money Dropped In March Velocity Of Money Dropped In March Velocity Of Money Dropped In March If the velocity of money recovers to its pre-pandemic levels amid the massive expansion of money supply, inflation will rise. In a nutshell, money growth will be booming worldwide due to QEs but the velocity of money, or the willingness to spend, will be the critical factor in determining inflation dynamics in the months and years to come. Question: Will the current excessive creation of money leak into asset prices and produce asset bubbles? Answer: It could. As we discussed in our January report titled, A Primer On Liquidity, an abundant money supply is conducive to higher asset prices and bubbles, but it is not a sufficient condition. Investors should be willing to allocate money to financial assets in order for the latter to appreciate. For example, since the beginning of this year, global risk assets have gone through an enormous roller-coaster ride. Through mid-February, risk assets were buoyant and the oft-cited rationale for the rally was plentiful liquidity. Then, from mid-February on through late March, we witnessed historic liquidity crunches across all financial markets, including US Treasurys. It is crucial to note that neither ER in the global banking system, nor global narrow and broad money slowed down during that period (Chart I-1 on page 1 and Charts I-4A and I-4B on page 6). Investors were simply liquidating financial assets and raising their cash level. Since late March, risk assets have been rallying as investors have felt more comfortable taking on more risk. Overall, whether ballooning money supply flows into financial assets or not is contingent on the willingness of all types of investors to deploy their deposits into financial markets. Just as price inflation in the real economy is dependent on the willingness of consumers and businesses to spend their money on goods and services, financial asset price appreciation is contingent on the animal spirit of all investors and their inclination to take on more risk. Whether ballooning money supply flows into financial assets or not is contingent on the willingness of all types of investors to deploy their deposits into financial markets. Question: How does the stock of US dollars (the broad money supply) compare with the value of US-denominated securities available to investors? Has the Fed’s purchases of securities not shrunk the amount of publicly-traded securities available to investors? Answer: Yes, indeed, they have. One of the distortions that the Fed’s and other CBs' QEs created has been the shrinkage of publicly-traded bonds and stocks. This has certainly lifted asset prices to levels they would have otherwise not reached. Chart I-10 plots the ratio of the US broad money supply-to-the market value of all US dollar-denominated securities. The US broad money supply represents all US dollars in the world – in cash and in electronic bank deposits. The denominator is the market capitalization of US denominated stocks and all types of bonds held by non-bank investors. It is calculated as the sum of the following: US equity market capitalization (the Wilshire 5000); the market cap values of all US-dollar bonds, including government, corporate, mortgage-backed securities, asset-backed securities and commercial mortgage backed securities (the Bloomberg Barclays US Aggregate Index); and the market cap value of US dollar-denominated bonds issued by EM governments and corporations; minus the Fed’s and US commercial banks’ holdings of all types of securities. Chart I-10The US: Broad Money Supply Relative To Equity And Bond Market Capitalization The US: Broad Money Supply Relative To Equity And Bond Market Capitalization The US: Broad Money Supply Relative To Equity And Bond Market Capitalization The higher this ratio, the more US dollar deposits, or liquidity, is available per one dollar of market value of outstanding securities – excluding those held by the Fed and US commercial banks. Based on the past 25 years, this ratio is somewhat elevated meaning that liquidity is relatively abundant. However, as argued above, animal spirits among investors are as important in driving financial asset prices as the amount of money supply. Question: What will happen to exchange rates in general, and to EM currencies in particular, given that almost every country in the world is expanding its money supply, simultaneously? Answer: There is no stable correlation between the relative money supply of two individual economies and their bi-lateral exchange rate. In addition, this is the first time that QEs are being deployed in both DM and EM countries at the same time. Therefore, there is no easy and straightforward answer to this question. Chart I-11EM Currencies: A Bounce Or Beginning Of A Cyclical Rally? EM Currencies: A Bounce Or Beginning Of A Cyclical Rally? EM Currencies: A Bounce Or Beginning Of A Cyclical Rally? We recommend using the following framework to think about EM exchange rates versus the US dollar, at the moment: 1. EM currencies in aggregate will continue to be driven by global growth, as they have been historically. Chart I-11 illustrates that the EM ex-China currency index correlates with industrial commodity prices. The basis for this correlation is that they are both driven by the global business cycle. So far, the advance in both EM exchange rates and industrial commodities has been tame. It is still not clear if this is merely a rebound from very oversold levels or rather the beginning of a cyclical rally. 2. The rampant expansion of US money supply will eventually lead to the greenback’s depreciation. However, for the US dollar to depreciate against EM currencies, the following two conditions should be satisfied: US imports should expand, meaning that the US should send dollars to the rest of the world by buying goods and services. This has not yet happened though, as domestic demand in America has plunged and any demand recovery in the next three to six months will be tame and muted. US investors should channel US dollars to EM to purchase EM financial assets. 3. From an individual EM perspective, there are several scenarios to consider: If a country’s QE: materially boosts its real growth, its currency will rally in spite of ongoing domestic QE; fails to meaningfully boost growth, its exchange rate will weaken; produces a rapid rise in inflation, its currency will depreciate; is used to finance unsustainable public debt dynamics, its currency will depreciate. As we have written in the recent reports, this could very well be the case in Brazil and South Africa. Investment Conclusions We expect EM local yields to fall further. For absolute-return investors we continue to recommend receiving swap rates in Korea, China, India, Malaysia, Russia, Colombia and Mexico. Our country allocation for EM local currency bond portfolios is always presented at the end of our reports on page 15. We continue shorting a basket of the following EM currencies versus the US dollar: BRL, CLP, ZAR, PHP, IDR and KRW. However, if the strength in EM currencies persists in the near term, we will close our short positions. Continue underweighting EM equities and credit within global equity and credit portfolios, respectively. Within the EM credit space, favor sovereign to corporate credit. On that issue, please refer to our April 22, Special Report on EM foreign currency debt. For dedicated EM equity managers, we recommend overweighting Korea, Thailand, Vietnam, Russia, central Europe, Mexico and Peru. Our underweights are Indonesia, India, the Philippines, the UAE, South Africa and Brazil. Please refer to our Open Position Table on page 14. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

What Can 1918/1919 Teach Us About COVID-19?    “Those who cannot remember the past are condemned to repeat it” George Santayana – 1905   Chart 1Coronavirus: As Contagious But Not As Deadly As Spanish Flu Lessons From The Spanish Flu Lessons From The Spanish Flu Today’s economy is very different to that of 100 years ago. Many countries then were in the middle of World War I (which ended in November 1918). The characteristics of the Spanish Flu which struck the world in 1918 and 1919 were also different to this year’s pandemic. COVID-19 is almost as contagious as the Spanish Flu, but it is much less deadly (Chart 1). Healthcare systems and treatments today are far more advanced than those of a century ago: many people who caught Spanish flu died of complications caused by bacterial pneumonia, given the absence of antibiotics. Influenza viruses tend to mutate rapidly: the influenza virus in 1918 first mutated to become far more virulent in its second wave, and then to become much milder. Coronaviruses have a “proofreading” capacity and mutate less easily.1  Nevertheless, an analysis of the pandemic of 100 years ago provides a number of insights into the current crisis, particularly now that policymakers are easing social-distancing rules to help the economy, even at the risk of more cases and deaths. Among the lessons of 1918-1919: Non-pharmaceutical interventions (NPIs) do lower mortality rates. The speed at which NPIs are implemented and the period of implementation are as important as the number of measures taken. Removing or relaxing measures too early can lead to a renewed rise in mortality rates. It is hard to compare current fiscal and monetary policies to those taken during the 1918 pandemic, since policy in both areas was already easy before the pandemic as a result of the world war. However, a severe pandemic would certainly call for a wartime-like fiscal and monetary response. The economy was negatively impacted by the pandemic in 1918-19 but, despite the shock to industrial activity and employment, the economy subsequently rebounded quickly, in a V-shaped recovery. Introduction Predicting how the economy will react to the COVID-19 pandemic is hard. Governments and policymakers face multiple uncertainties: How effective are different containment measures? Will cases and deaths rebound quickly if lockdown measures are eased? When will the coronavirus disappear? When will a vaccine be ready? With an event unprecedented in the experience of anyone alive today, perhaps there are some lessons to be learned from history. For this Special Report, we attempt to draw some parallels between the current situation and the 1918-19 Spanish flu. We focus on the different containment efforts implemented, the role that fiscal and monetary policies played, the impact on markets and the economy, and whether history can throw any light on how the COVID-19 crisis might pan out. The 1918 Spanish Flu Chart 2The Spanish Flu Hit The World In Three Waves The Spanish Flu Hit The World In Three Waves The Spanish Flu Hit The World In Three Waves The 1918 influenza pandemic was the most lethal in modern history. Soldiers returning from World War I helped spread the pandemic across the globe. The first recorded case is believed to have been in an army camp in Kansas. While there is no official count, researchers estimate that about 500 million people contracted the virus globally, with a mortality rate of between 5% and 10%. The pandemic occurred over three waves in 1918 and 1919 – the first in the spring of 1918, the second (and most deadly) in the fall of 1918, and the third in spring 1919 (Chart 2). In the US alone, official data estimate that around 500,000 deaths (or over 25% of all deaths) in 1918 and 1919 were caused by pneumonia and influenza.2 The pandemic moved swiftly to Europe and reached Asia by mid-1918, but became more lethal only towards the end of the year (Map 1).3 Map 1The Spread Of Influenza Through Europe Lessons From The Spanish Flu Lessons From The Spanish Flu Initially, scientists were puzzled by the origin of the influenza and its biology. It was not until a decade later, in the early 1930s, that Richard Shope isolated the particular influenza virus from infected pigs, confirming that a virus caused the Spanish Flu, not a bacterium as most had thought. Many of those who caught this strain of influenza died as a result of their lungs filling with fluid in a severe form of pneumonia. In reporting death rates, then, it is considered best practice to include deaths from both influenza and pneumonia. The first wave had almost all the hallmarks of a seasonal flu, albeit of a highly contagious strain. Symptoms were similar and mortality rates were only slightly higher than a normal influenza. The first wave went largely unnoticed given that deaths from pneumonia were common then. US public health reports show that the disease received little attention until it reappeared in a more severe form in Boston in September 1918.4  Most countries did not begin investigating and reporting cases until the second wave was underway (Chart 3). Chart 3Most Countries Began Reporting Only When The Second Wave Hit Lessons From The Spanish Flu Lessons From The Spanish Flu This second wave – which was more lethal because the virus had mutated – had a unique characteristic. Unlike the typical influenza mortality curve – which is usually “U” shaped, affecting mainly the very young and elderly – the 1918 influenza strain had a “W”-shaped mortality curve – impacting young adults as well as old people (Chart 4). This pattern was evident in all three waves, but most pronounced during the second wave. The reason for this was that the infection caused by the influenza became hyperactive, producing a “cytokine storm” – when mediators secreted from the immune system result in severe inflammation.5 Simply put, as the virus became virulent, the body’s immune system overworked to fight it. Younger people, with strong immune systems, suffered most from this phenomenon. Chart 4A Unique Characteristic: Impacting Younger Adults Lessons From The Spanish Flu Lessons From The Spanish Flu By the summer of 1919, the pandemic was over, since those who had been infected had either died or recovered, therefore developing immunity. The lack of records makes it difficult to assess if “herd immunity” was achieved. However, some historical accounts and research – particularly for army groups in the US and the UK – suggest that those exposed to the disease in the first mild wave were not affected during the second more severe wave.6 The failure to define the causative pathogen at the time made development of a vaccine impossible. Nevertheless, some treatments and remedies showed modest success. These varied from using a serum – obtained from people who had recovered, who therefore had antibodies against the disease – to simple symptomatic drugs and various oils and herbs. The Effectiveness Of Non-Pharmaceutical Interventions (NPIs) What we today call “social distancing” showed positive effects during the 1918-19 pandemic. These included measures very similar to those applied today: school closures, isolation and quarantines, bans on some sorts of public gatherings, and more. However, there were few travel bans.  The number of passengers carried during the months of the pandemic did noticeably decline though (Chart 5). Chart 5Travel Slowed...Just Not Enough Travel Slowed...Just Not Enough Travel Slowed...Just Not Enough Table 1, based on research by Hatchett, Mecher and Lipsitch, breaks down NPIs by type for 17 major US cities. Most cities implemented a wide range of interventions. But it was not only the type of NPIs implemented that made a difference, but also the speed and length of implementation. Table 1Measures Applied Then Are Very Similar To Those Applied Today Lessons From The Spanish Flu Lessons From The Spanish Flu Further research by Markel, Lipman and Navarro based on 43 US cities shows that the median number of days between the first reported influenza case and the first NPI implementation was over two weeks. The median period during which various NPIs were implemented was about six weeks (Table 2). Table 2NPIs Were Implemented Only For Short Periods Lessons From The Spanish Flu Lessons From The Spanish Flu Markel, Lipman and Navarro's findings show that a rapid public-health response was an important factor in reducing the mortality rate by slowing the rate of infection, what we now refer to as “flattening the curve.” There were major differences in cities’ policies: both the speed at which they implement NPIs, and the length of the implementation period. Chart 6 shows that: Cities that acted quickly to implement NPIs slowed the rate of infections and deaths (Chart 6, panel 1) Cities that acted quickly had lower mortality rates from influenza and pneumonia (Chart 6, panel 2) Cities that implemented NPIs for longer periods had fewer deaths (Chart 6, panel 3) Chart 7 quantifies the number of NPIs taken, the time it took to implement the measures, and the length of NPIs to gauge policy strictness. Cities with stricter enforcement had lower death rates than those with laxer measures. Chart 6Fast Response And Longer Implementation Led To Fewer Deaths... Lessons From The Spanish Flu Lessons From The Spanish Flu Chart 7...So Did Policy Strictness Lessons From The Spanish Flu Lessons From The Spanish Flu For example, Kansas City, less than a week after its first reported case, had implemented quarantine and isolation measures. By the second week, schools, churches, and other entertainment facilities closed. Schools reopened a month later (in early November) but quickly shut again until early January 1919.  While we do not have definitive dates on when each NPI was lifted, some sort of protective measures in Kansas City were in place for almost 170 days. By contrast, Philadelphia, one of the cities hardest hit by Spanish Flu, took more than a month to implement any measures. Its tardiness meant that it reached a peak mortality rate much more quickly: in 13 days compared to 31 days for Kansas City. Even after the first reported case, the Liberty Loans Parade was still held on September 28, 1918 – with the knowledge that hundreds of thousands of spectators might be vulnerable to infection.7,8 It was not until a few days later that institutions were closed and a ban on public gatherings was imposed. Many other cities also held a Liberty Loans Parade, including Pittsburgh and Washington DC, but Philadelphia’s was the deadliest. Studies also show that relaxing interventions too early could be as damaging as implementing them too late. St. Louis, for example, was quick to lift restrictions and suffered particularly badly in the second wave as a result. It later reinstated NPIs up until end of February 1919. Other cities that eased restrictions too early (San Francisco and Minneapolis, for example) also suffered from a second swift, albeit milder, increase in weekly excess death rates from pneumonia and influenza (Chart 8). Chart 8Relaxing Lockdown Measures Too Early Can Lead To A Second Rise In Deaths... Lessons From The Spanish Flu Lessons From The Spanish Flu Chart 9...And So Can Highly Effective Measures Lessons From The Spanish Flu Lessons From The Spanish Flu Of course, NPIs cannot be implemented indefinitely. A recent research paper by Bootsma and Ferguson raises the point that suppressing a pandemic may not be the best strategy because it just leaves some people susceptible to infection later. They argue that highly effective social distancing measures, which allow a susceptible pool of people to reintegrate into society when the measures are lifted, are likely to lead to a resurgence in infections and fatalities in a second peak (Chart 9).9 They suggest an optimal level of control measures to reduce R (the infection rate) to a value that makes a significant portion of the population immune once measures are lifted.   The Impact Of The Spanish Flu On The Economy And Markets How did the Spanish Flu pandemic affect the economy? Many pandemic researchers ignore the official recession identified by the NBER during the months of the pandemic (between August 1918 and March 1919).10 The reason is that most of the evidence indicates that the economic effects of the 1918-19 pandemic were short-term and relatively mild.11 Disentangling drivers of the economy is, indeed, tricky given that WW1 ended in November 1918. However, it is easy to underestimate the negative impact of the pandemic since the war had such a big impact on the economy, as well as investor and public sentiment. Various research papers support the fact that, while the pandemic did indeed have an adverse effect on the economy, NPIs did not just depress mortality rates, but also sped the post-pandemic economic recovery.12 Research by Correia, Sergio, and Luck showed that the areas most severely affected by the pandemic saw a sharp and persistent decline in real economic activity, whereas cities that intervened earlier and more aggressively, experienced a relative increase in economic activity post the pandemic.13 Their findings are based on the increase in manufacturing employment after the pandemic compared to before it (1919 versus 1914). However, note that the rise of manufacturing payrolls in 1919 was high everywhere given the return of soldiers post-WWI. The researchers also note that those cities hardest hit by the pandemic also saw a negative impact on manufacturing activity, the stock of durable goods, and bank assets. Because Spanish flu disproportionately killed younger adults, many families lost their breadwinner. In economic terms, this implies both a negative supply shock and negative demand shock. If fewer employees are available to produce a certain good, supply will fall. The same reduction in employment also implies reduced income and therefore lower purchasing power. Both cases will result in a decrease in output. However, the change in prices depends on the decline of supply relative to demand. In 1918-19, the impact was disinflationary: demand declined by more than supply, and both spending and consumer prices fell during the pandemic (Chart 10). Chart 10Short-Term Price Impact Was Disinflationary Short-Term Price Impact Was Disinflationary Short-Term Price Impact Was Disinflationary US factory employment fell by over 8% between March 1918 and March 1919 – the period from the beginning of the first wave until the end of the second wave. It is important to note, however, that few businesses went bankrupt during the pandemic years (Chart 11). Additionally, the November 1918 Federal Reserve Bulletin highlighted that many cities, including New York, Kansas City, and Richmond, experienced a shortage of labor due to the influenza.14  Factory employment in New York fell by over 10% during this period.  Chart 11Loss Of Middle-Aged Adults = Loss Of Breadwinners Loss Of Middle-Aged Adults = Loss Of Breadwinners Loss Of Middle-Aged Adults = Loss Of Breadwinners The link between the labor shortages and the decline in industrial production is unclear. Industrial activity in the US peaked just before the second wave, contracting by over 20% during the second wave (Chart 12). Various industries reported disruptions: automobile production fell by 67%, anthracite coal production and shipments fell by around 45%, and railroad freight revenues declined by over seven billion ton-miles (Chart 12, panels 2, 3 & 4). However, some of this decline is attributed to falling defense production after the war. Chart 12Activity Slowed, But Rebounded Quickly Activity Slowed, But Rebounded Quickly Activity Slowed, But Rebounded Quickly Chart 13The War Had A Bigger Impact On The Stock Market Than The Pandemic The War Had A Bigger Impact On The Stock Market Than The Pandemic The War Had A Bigger Impact On The Stock Market Than The Pandemic The equity market moved in a broad range in 1915-1919 and fell sharply only ahead of the 1920 recession (Chart 13). Seemingly, stock market participants were more focused on the war than the pandemic. The lack of reporting of the pandemic could have contributed to this: newspapers were encouraged to avoid carrying bad news for reasons of patriotism and did not widely cover the pandemic until late 1918.15   Chart 14Monetary Policy Was Easy...Even Before The Pandemic Started Monetary Policy Was Easy...Even Before The Pandemic Started Monetary Policy Was Easy...Even Before The Pandemic Started The Federal Reserve played an active role in funding the government’s spending on the war, and so monetary policy was very easy during the pandemic – but for other reasons. The Fed used its position as a lender to the banking system to facilitate war bond sales.16 Interest rates were cut in 1914 and 1915 even before the US entered the war. The US economy had been in recession between January 1913 and December 1914. Policy rates remained low throughout 1916 and 1917 and slightly rose in 1918 and 1919. It was not until 1920 that Federal Reserve Bank System tightened policy rapidly to choke off inflation, which accelerated to over 20% in mid-1920 – rising inflation being a common post-war phenomenon (Chart 14). The Lessons Of 1918-19 For The Coronavirus Pandemic Non-pharmaceutical interventions should continue to be implemented until a vaccine, effective therapeutic drugs, or mass testing is available. Relaxing measures prematurely is as damaging as a tardy reaction to the pandemic. Reacting quickly and imposing multiple measures for longer periods not only reduces mortality rates, but also improves economic outcomes post-crisis. The economy suffers in the short-term: supply and demand shocks lead to lower output. The demand shock however is larger leading to lower prices and disinflationary pressures, at least during and immediately after the pandemic.   Amr Hanafy Senior Analyst amrh@bcaresearch.com Footnotes 1  Please see the Q&A with immunologist and Nobel laureate Professor Peter Doherty, published by BCA Research April 1st 2020: BCA Research Special Report, “Questions On The Coronavirus: An Expert Answers,” available at bcaresearch.com 2 Please see “Leading Cause of Death, 1990-1998,” CDC Centers for Disease Control and Prevention. 3 Please see Ansart S, Pelat C, Boelle PY, Carrat F, Flahault A, Valleron AJ, “Mortality burden of the 1918-1919 influenza pandemic in Europe,” NCBI. 4 Please see Public Health Report, vol. 34, No. 38, Sept. 19, 1919. 5 Please see Qiang Liu, Yuan-hong Zhou, Zhan-qiu Yang Cell Mol Immunol. 2016 Jan; 13(1): 3–10. 6 Please see Shope, R. (1958) Public Health Rep. 73, 165–178. 7 The Liberty Loans Parade was intended to promote the sale of government bonds to pay for World War One. 8 Please see Hatchett RJ, Mecher CE, Lipsitch M (2007) "Public health interventions and epidemic intensity during the 1918 influenza pandemic,"PNAS 104: 7582–7587. 9 Please see Bootsma M, Ferguson N, “The Effect Of Public Health Measures On The 1918 Influenza Pandemic In U.S. Cities,” PNAS (2007). 10Please see https://www.nber.org/cycles.html 11Please see https://www.stlouisfed.org/~/media/files/pdfs/community-development/research-reports/pandemic_flu_report.pdf 12Please see https://libertystreeteconomics.newyorkfed.org/2020/03/fight-the-pandemic-save-the-economy-lessons-from-the-1918-flu.html. 13Please see Correia, Sergio and Luck, Stephan and Verner, Emil, Pandemics Depress the Economy, Public Health Interventions Do Not: Evidence from the 1918 Flu (March 30, 2020). Available at SSRN: https://ssrn.com/abstract=3561560 or http://dx.doi.org/10.2139/ssrn.3561560. 14Please see Board of Governors of the Federal Reserve System (U.S.), 1935- and Federal Reserve Board, 1914-1935. "November 1918," Federal Reserve Bulletin (November 1918). 15Please see https://newrepublic.com/article/157094/americas-newspapers-covered-pandemic. 16Please see https://www.federalreservehistory.org/essays/feds_role_during_wwi.

Highlights Fed/BoE NIRP: It is too soon for either the Fed or Bank of England to consider a move to a negative interest rate policy (NIRP), even with US and UK money markets flirting with pricing in that outcome. Lessons from “NIRP 1.0”: In the countries that did go to negative rates in 2014-16 (Japan, Switzerland, the euro area, Sweden and Denmark), there existed some combination of weak economies, near-0% inflation, anemic credit growth or unwanted currency appreciation. Negative rates were needed to help fight those trends by driving down longer-term bond yields. NIRP 2.0?: Among the major countries without negative rate policies in effect (the US, UK, Canada and Australia), there is no evidence that longer-term borrowing rates need to fall further to boost credit growth, even in the midst of deep recessions. However, additional strength of the stubbornly resilient US dollar could be the deflationary shock that eventually forces the Fed into NIRP. Feature Chart 1NIRP 2.0 Would Trigger A Surge Of Negative Yielding Bonds NIRP 2.0 Would Trigger A Surge Of Negative Yielding Bonds NIRP 2.0 Would Trigger A Surge Of Negative Yielding Bonds Within a 20-month window in 2014-16, the central banks of Japan, Sweden, the euro area, Switzerland and Denmark all cut policy interest rates to below 0% - where they remain to this day. Fast forward to 2020, in the midst of a global pandemic and deep worldwide recession that has already forced major developed market central banks to cut rates close to 0%, there is now increased speculation that the negative interest rate policy (NIRP) club might soon get a few new members. The Federal Reserve has been front and center in that group. Fed funds futures contracts had recently priced in slightly negative rates in 2021, despite Fed Chair Jerome Powell repeatedly saying that a sub-0% funds rate was not in the Fed’s plans. The Bank of England (BoE) has also seen markets inch toward pricing in negative rates, although BoE officials have been more open to the idea of negative rates as a viable policy choice. Even the Reserve Bank of New Zealand has suggested that negative rates may be needed there soon. An expansion of the list of countries that have moved to negative rates, beyond the “NIRP 1.0” group of 2014-16, has the potential to drive down global bond yields even further. Already, there is $11 trillion of negative yielding debt within the Bloomberg Barclays Global Aggregate index, representing 20% of the total (Chart 1) If there is a shift to negative rates in the potential “NIRP 2.0” group of major developed economies with policy rates now near 0% – a list that includes the US, the UK, Canada and Australia – then the amount of negative yielding debt worldwide will soar to new highs. An expansion of the list of countries that have moved to negative rates, beyond the “NIRP 1.0” group of 2014-16, has the potential to drive down global bond yields even further. In this report, we take a look at the conditions that led the NIRP 1.0 countries to shift to negative rates in the middle of the last decade, to see if any similarities exist in non-NIRP countries today. We conclude that the conditions are not yet in place for a shift to sub-0% policy rates in the US, the UK, Canada or Australia – all countries where central banks still have other policy tools available to provide stimulus before resorting to negative rates. How Negative Interest Rates Can “Work” To Revive Growth Broadly speaking, central banks around the world have had difficulty meeting their inflation targets since the 2008 Global Financial Crisis. The main reason for this has been sub-par economic growth, much of which is structural due to aging demographics and weak productivity. Since central bankers must stick to their legislated inflation targeting mandates, they are forced to cut rates when economic growth and inflation are too low. If real economic growth remains weak for structural reasons, then central banks can enter into a cycle of continually cutting rates all the way to zero, or even below zero, in order to try and prevent low inflation from becoming entrenched into longer-term inflation expectations. If growth and inflation continue to languish even after policy rates have reached 0%, then other tools must be used to ease monetary conditions to try and stimulate economies. These typically involve driving down longer-term borrowing rates (bond yields) through dovish forward guidance on future monetary policy, bond purchases through quantitative easing (QE) and, if those don’t work, moving to negative policy interest rates. A nice summary indicator to identify this intertwined dynamic of real economic growth and inflation is to look at the trend growth rate of nominal GDP. Chart 2 shows the policy interest rates three-year annualized trend of nominal GDP growth for the NIRP 1.0 countries, dating back to before the 2008 crisis. Japan stands out as the weakest of the group, with trend nominal growth contracting during and after the 2009 recession, while struggling to reach even +2% since then. The euro area, Sweden and Switzerland all enjoyed +5% nominal growth prior to 2008, before a plunge to the 1-2% range during and after the recession. After that, the three countries had varying degrees of economic success. Between 2016 and 2019, Sweden saw trend nominal growth between 4-5%, while the euro area struggled to achieve even +3% nominal growth and Switzerland maintained a Japan-like pace. Chart 2Fewer Tools Left For NIRP 1.0 Countries To Boost Growth Fewer Tools Left For NIRP 1.0 Countries To Boost Growth Fewer Tools Left For NIRP 1.0 Countries To Boost Growth Chart 3NIRP 2.0 Candidates Can Still Expand QE First NIRP 2.0 Candidates Can Still Expand QE First NIRP 2.0 Candidates Can Still Expand QE First The European Central Bank (ECB), Swiss National Bank (SNB), the Bank of Japan (BoJ) and Sweden’s Riksbank all cut policy rates aggressively in 2008/09, helping spur a recovery in nominal growth. The central banks had to keep rates lower for longer because of structurally weak growth, leaving far less capacity to ease aggressively in response to the growth downturn a few years later. Eventually, the ECB, SNB, BoJ and Riksbank all went to negative rates between June 2014 and February 2016. The BoJ and SNB, facing persistent headwinds from strengthening currencies, also resorted to aggressive balance sheet expansion to provide additional monetary stimulus – trends that have continued to this day, with both central banks having balance sheets equal to around 120% of GDP. The experience of these four NIRP 1.0 countries showed that the move to negative rates was a process that began in the 2008 financial crisis. Central banks there were unable to raise rates much, if at all, after the recession, leaving little ammunition to fight the varying growth slowdowns suffered between 2012 and 2016. Eventually, rates had to be cut below 0% which, combined with QE, helped generate lower bond yields, weaker currencies and, eventually, a pickup in growth and inflation. Looking at the NIRP 2.0 candidate countries, nominal GDP growth has also struggled since the financial crisis, unable to stay much above 3-4% in the US, Canada and the UK. Only Australia has seen trend growth reach peaks closer to 5-6% (Chart 3). The Fed, BoE, Reserve Bank of Australia (RBA) and Bank of Canada (BoC) all also cut rates aggressively in 2008/09, with the Fed and BoE doing QE buying of domestic bonds. Rates were left at low levels after the crisis in the US and UK, with only the RBA and, to a lesser extent, the BoC hiking rates after the recession ended. When growth slowed again in these countries during the 2014-16 period, the RBA and BoC did lower policy rates, but negative rates were avoided by all four central banks. Today, nominal growth rates have collapsed because of the COVID-19 lockdowns that have shuttered much of the world economy. Central banks that have had any remaining capacity to cut policy rates back to 0% have done so, yet this recession has already become so deep that additional declines in rates may be necessary to stabilize unemployment and inflation. The experience of the NIRP 1.0 countries shows that negative rates can also be effective in boosting growth – especially in countries suffering unwanted currency strength. One way to see the problem that monetary policymakers are now facing is by looking at Taylor Rule estimates of appropriate interest rate levels (Charts 4 and 5). Given the rapid surge in global unemployment rates to levels that, in some cases, have not been seen since the Great Depression (Chart 6), alongside decelerating inflation, Taylor Rule implied policy rates are now deeply negative in the US (-5.6%), Canada (-2.9%) and euro area (-1.7%).1 Taylor Rules show that moderately negative rates are also needed in Sweden (-0.5%), Switzerland (-0.2%) and Japan (-0.2%). Only in Australia (+1.3%) and the UK (+0.3%) is the Taylor Rule indicating that negative rates are not currently required. Chart 4Taylor Rule Says More Rate Cuts Needed Here … Taylor Rule Says More Rate Cuts Needed Here ... Taylor Rule Says More Rate Cuts Needed Here ... Chart 5… But Rates Are Appropriate Here ... But Rates Are Appropriate Here ... But Rates Are Appropriate Here Chart 6The Main Reason Why Taylor Rule Implied Policy Rates Have Plunged The Main Reason Why Taylor Rule Implied Policy Rates Have Plunged The Main Reason Why Taylor Rule Implied Policy Rates Have Plunged Among the potential NIRP 2.0 candidates, the negative rate option has been avoided and aggressive QE balance sheet expansion has been pursued by all of them – including the BoC and RBA who avoided asset purchase programs in 2008/09. Balance sheet expansion can be an adequate substitute for policy interest rate cuts by helping drive down longer-term bond yields and borrowing rates, which helps spur credit demand and, eventually, economic growth. Yet the experience of the NIRP 1.0 countries shows that negative rates can also be effective in boosting growth – especially in countries suffering unwanted currency strength. How negative rates worked for the NIRP 1.0 countries For the ECB (Chart 7), BoJ (Chart 8), Riksbank (Chart 9) and SNB, the path from negative policy rates in 2014-16 to, eventually, faster economic growth and inflation followed a similar process: Chart 7The Euro Area's Negative Rates Experience The Euro Area's Negative Rates Experience The Euro Area's Negative Rates Experience Chart 8Japan's Negative Rates Experience Japan's Negative Rates Experience Japan's Negative Rates Experience Chart 9Sweden's Negative Rates Experience Sweden's Negative Rates Experience Sweden's Negative Rates Experience Moving to negative policy rates resulted in a sharp decline in nominal government bond yields The fall in yields helped trigger currency depreciation Nominal yields fell faster than inflation expectations, allowing real bond yields to turn negative Credit growth eventually began to pick up in response to the decline in real borrowing costs Inflation bottomed out and started to move higher. In Japan, the euro area and Sweden, this process played out fairly rapidly with credit growth and inflation bottoming within 6-12 months of the move to negative rates. Only in Switzerland (Chart 10), where the SNB gave up on currency intervention in January 2015, was the process delayed, as the surge in the currency triggered a move into deeper deflation and higher real bond yields. It took a little more than a year for the deflationary impact of the franc’s surge to fade, allowing real bond yields to decline and credit growth and inflation to bottom out and recover. The implication is clear – negative rates are good for real assets, but troublesome for banks.  Of course, we are talking about the pure economic effect of negative rates as a monetary policy tool. There are side effects of having negative nominal interest rates and deeply negative real bond yields, like surging asset values (especially for real assets like housing). Bank profitability is also negatively impacted by the sharp fall in longer-term bond yields that hurts net interest margins, even with higher lending volumes and reduced non-performing loans. Chart 10Switzerland's Negative Rates Experience Switzerland's Negative Rates Experience Switzerland's Negative Rates Experience Chart 11Negative Rates Are Good For Real Assets Negative Rates Are Good For Real Assets Negative Rates Are Good For Real Assets This can be seen in Charts 11 & 12, which compare the performance of real house prices and bank equities (relative to the domestic equity market) in the years leading up to, and following, the move to negative rates in 2014-16 for the NIRP 1.0 countries. The implication is clear – negative rates are good for real assets, but troublesome for banks. Chart 12Negative Rates Are Bad For Bank Stocks Negative Rates Are Bad For Bank Stocks Negative Rates Are Bad For Bank Stocks Nonetheless, the experience of the NIRP 1.0 countries suggests that the potential NIRP 2.0 countries could see similar benefits on growth and inflation – but not before other policy options are exhausted first. Bottom Line: In the countries that did go to negative rates in 2014-16 (Japan, Switzerland, the euro area, Sweden and Denmark), there existed some combination of weak economies, near-0% inflation, anemic credit growth or unwanted currency appreciation. Negative rates were needed to help fight those trends by driving down longer-term bond yields and helping spur credit growth and, eventually, some inflation. Depreciating currencies had a big role to play in generating those outcomes. Negative Rates Are Not Necessary (Yet) In The NIRP 2.0 Countries As discussed earlier, the sharp surge in unemployment because of the COVID-19 global recession means that negative interest rates may now be “appropriate” in the US and Canada, based on Taylor Rules. Negative rates are not needed in the UK and Australia, however, although policy rates need to stay very low in both countries. A similar divergence can be seen in inflation. Headline CPI inflation rates were already under severe downward pressure from the recent collapse in oil prices. The surge in spare economic capacity opened up by the current recession can only exacerbate the disinflation trend. However, the drop in inflation has been more acute in the US and Canada relative to the UK and Australia, suggesting a greater need for the Fed and BoC to be even more stimulative than the BoE or RBA (Chart 13). A renewed breakout of the currency to new cyclical highs could be the deflationary signal that triggers the Fed into an even more aggressive policy response. There is one area where the Fed stands alone in this group. The relentless strength of the US dollar, even as the Fed’s rate cuts have taken much of the attractive carry out of the greenback, hurts US export competitiveness in a demand-deficient recessionary global economy. The strong dollar also acts as a dampening influence on US inflation. A renewed breakout of the currency to new cyclical highs could be the deflationary signal that triggers the Fed into an even more aggressive policy response (Chart 14). This would mirror the experience of the NIRP 1.0 countries prior to the move to negative rates, where unwanted currency strength crippled both economic growth and inflation. Chart 13The Threat Of Deflation Could Trigger NIRP The Threat Of Deflation Could Trigger NIRP The Threat Of Deflation Could Trigger NIRP Chart 14Could More USD Strength Drag The Fed Into NIRP? Could More USD Strength Drag The Fed Into NIRP? Could More USD Strength Drag The Fed Into NIRP? For now, the Fed has many other policy options open before negative rates would be seriously considered. The reach of its QE programs could be expanded even further, even including equity purchases. The existing bond QE could be combined with a specific yield target (i.e. yield curve control) for shorter-maturity US Treasuries, helping anchor US yields at low levels for longer. Summing it all up, we do not see the need for any of the NIRP 2.0 candidates to move to negative rates anytime soon. The need for such extreme policies is not yet necessary, though, both in the US and the other NIRP 2.0 candidate countries. Bank lending is expanding at a double-digit pace in the US, and still at a decent 5-7% pace in the UK, Canada and Australia, even in the midst of a sharp recession (Chart 15). This may only be due to the numerous loan guarantees provided by governments as part of fiscal stimulus responses, or it may be related to companies running down credit lines to maintain liquidity. The experience of the NIRP 1.0 countries, though, suggests that credit growth must be far weaker than this to require negative policy rates to push down longer-term borrowing costs. Chart 15These Already Look Very "NIRP-ish" These Already Look Very "NIRP-ish" These Already Look Very "NIRP-ish" Chart 16Too Soon For Global NIRP, Maintain Neutral Global Duration Exposure Too Soon For Global NIRP, Maintain Neutral Global Duration Exposure Too Soon For Global NIRP, Maintain Neutral Global Duration Exposure Summing it all up, we do not see the need for any of the NIRP 2.0 candidates to move to negative rates anytime soon. In terms of investment implications, we continue to recommend an overall neutral stance on global duration exposure, as we see little immediate impetus for yields to move lower because of reduced expectations of future interest rates or inflation (Chart 16). We will continue to watch currency levels and credit growth as a sign that policymakers may need to shift their tone in the coming months. Bottom Line: Among the major countries without negative rate policies in effect (the US, UK, Canada and Australia), there is no evidence that longer-term borrowing rates need to fall further to boost credit growth, even in the midst of deep recessions. However, additional strength of the stubbornly resilient US dollar could be the deflationary shock that eventually forces the Fed into NIRP.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Negative Rates: Coming Soon To A Bond Market Near You? Negative Rates: Coming Soon To A Bond Market Near You? Footnotes 1 Our specification of the Taylor Rule uses unemployment rates relative to full employment (NAIRU) levels as the measure of spare capacity in the economies. For the neutral real interest rate, we use the New York Fed’s estimate of r-star for the US, Canada, the euro area and the UK; while using the OECD’s estimate of potential GDP growth as the neutral real rate measure for countries where we have no r-star estimate (Japan, Sweden, Switzerland and Australia).

Highlights COVID-19 & The Economy: Australia is now in its first recession in 30 years, thanks to lockdown measures to contain the spread of COVID-19. Yet the nation’s rates of infection and death from the virus are relatively low, which should allow for a faster reopening of the domestic economy. Policy Responses: The RBA has taken extraordinary measures to cushion the blow from the lockdowns, like cutting policy rates to near-0% and capping shorter maturity bond yields through quantitative easing. The Australian government has also been aggressive in providing fiscal stimulus. These measures give the economy a better chance of seeing a “v”-shaped recovery as the lockdown restrictions are eased. Fixed Income Strategy: Downgrade Australian government bonds to neutral within global fixed income portfolios: the RBA has little room to cut rates, inflation expectations are too low and the structural convergence to global yields is largely complete. Favor inflation-linked bonds and investment grade corporate debt over government debt, as both now offer better value. Feature Chart 1The Australian Bond Yield Convergence Story Is Over The Australian Bond Yield Convergence Story Is Over The Australian Bond Yield Convergence Story Is Over Australia has a well-deserved reputation as a wonderful place to live, regularly sitting near the top of annual “world’s most livable countries” lists. A big reason for that is the stability of the economy, which has famously not suffered a recession since 1991. The COVID-19 pandemic has changed that happy economic story, with Australia now in the midst of a deep recession. Yet even during this uncertain time, Australia is living up to its reputation as a livable country, with one of the lowest rates of COVID-19 infection among the major economies. This potentially sets up Australia as an economy that can recover from the pandemic – and the growth-crushing measures used to contain its spread - more quickly than harder-hit countries like the US and Italy. For global fixed income investors, Australia has also been a very pleasant place to spend some time. The local bond market has enjoyed a stellar bull run since the 2008 Global Financial Crisis, with policy rates and yields converging to much lower global levels (Chart 1). We have steadfastly maintained a structural overweight recommendation on Australian government bonds since December 2017. Over that time, the benchmark yield on the Bloomberg Barclays Australia government bond index declined -168bps, delivering a total return of +17.6% (in local currency terms). That soundly outperformed the global government benchmark index by 5.7 percentage points (in USD-hedged terms). However, just like the nation’s recession-free streak, Australia’s status as a secular bond outperformer is coming to an end. Just like the nation’s recession-free streak, Australia’s status as a secular bond outperformer is coming to an end. In this Special Report, we take a closer look at the Australian economy and fixed income landscape after the shock of the global pandemic. Our main conclusion is that most of the juice has been squeezed out of the Australian government bond yield global convergence trade. There are, however, some interesting opportunities still available in other parts of the Australian fixed income universe, like corporates and inflation-linked bonds. Yes, Recessions Can Actually Happen In Australia Chart 2A V-Shaped Recovery Is Widely Expected A V-Shaped Recovery Is Widely Expected A V-Shaped Recovery Is Widely Expected During the record streak of recession-free growth in Australia, the annual growth of real GDP has never dipped below 1.1%. The fact that a recession was avoided in 2009, given the degree of the shock from the Global Financial Crisis, is a testament to the balance within the Australian economy; consumer spending is 55% of GDP, business investment is 12%, government spending is 24% and exports are 25%. This stands out in contrast to more imbalanced economies like the US (where consumer spending is 70% of GDP) and Germany (where exports are 47% of GDP). Yet the unique nature of the COVID-19 pandemic, which has forced shutdowns across the entire economy, has nullified that advantage for Australia. There is no part of the economy that can avoid a major slowdown to help prevent a full-blown recession in 2020. Yet while expectations have adjusted to this new short-term reality, there appears to be a broad consensus that this Australian recession will be a short-lived “V” rather than an extended “U”. That can be seen in the forecasts of the Bloomberg Consensus survey and the Reserve Bank of Australia (RBA), both of which are calling for a year-over-year decline in real GDP growth of at least -7% in Q2/2020. That will represent the low point of the recession, with growth expected to steadily recover over the subsequent year, with annual real GDP growth reaching +7% by the second quarter of 2021 (Chart 2). The Westpac-Melbourne Institute consumer sentiment index suffered the single greatest monthly decline in the 47-year history of the series in April. Yet there was only a modest decline in the longer-run expectations component of that survey, which remains above recent cyclical lows (bottom panel) This is a message consistent with the RBA and Bloomberg consensus forecasts, where economic resiliency is expected. One reason for that relative optimism among Australian consumers is that COVID-19 has not hit the country as hard as other nations. A recent survey of Australian consumers conducted by McKinsey in April showed that 65% of respondents named “the Australian economy” as their biggest COVID-19 related concern. At the same time, only 33% of those surveyed cited “not being able to make ends meet” as their main worry related to the virus (Chart 3). Other responses to the survey showed a similar divide, with greater concern shown for the state of the overall Australian nation compared to worries about one’s own economic or health outlook. Chart 3Australians Worrying More About The Nation Than Their Own Situation Australia: All Good Streaks Must Come To An End Australia: All Good Streaks Must Come To An End For an economy that has not seen a recession in over a generation, a relative lack of concern over one’s own financial health – even in a global pandemic that has paralyzed the world economy – may not be that surprising. Another reason for that relative optimism is that Australia has, so far, escaped relatively unscathed from the spread of COVID-19 compared to other nations. Australia has, so far, escaped relatively unscathed from the spread of COVID-19 compared to other nations. The number of new daily COVID-19 cases is now only 1 per million people, according to the Johns Hopkins University data on the virus. This is down from the peak of 20 per million people reached on March 28, and substantially below the numbers seen in countries more severely struck by the virus like the US and Italy (Chart 4). Australia has also seen a relatively low fatality rate from the virus, with only 1.4% of confirmed cases resulting in deaths (Chart 5). Chart 4The COVID-19 Wave Has Crested Down Under The COVID-19 Wave Has Crested Down Under The COVID-19 Wave Has Crested Down Under Chart 5Australia Has Weathered The Pandemic Much Better Than Others Australia: All Good Streaks Must Come To An End Australia: All Good Streaks Must Come To An End Given these low rates of infection and death, it is likely that Australia will be able to reopen its economy faster than other nations. The Australian government has already announced an easing of the COVID-19 lockdown measures, which will include the opening of restaurants (with limited seating) and schools (on a staggered schedule). There is even talk of creating a “trans-Tasman travel bubble” with neighboring New Zealand, which has similarly low rates of COVID-19 infection. Yet even when Australians can begin resuming a more “normal” life, the backdrop for consumer spending will be constrained by relatively low income growth and high consumer debt levels (Chart 6). Real consumer spending has struggled to grow faster than 2-3% over the past decade and, with household debt now up to a staggering 190% of disposable income, a faster pace of spending is unlikely even as the economy reopens. Chart 6Weak Consumer Fundamentals Weak Consumer Fundamentals Weak Consumer Fundamentals Chart 7Australian Businesses Are Retrenching Australian Businesses Are Retrenching Australian Businesses Are Retrenching Among the other parts of the Australian economy, the near-term outlook is gloomy, but there are potential areas where the damage to growth could be more limited. Capital Spending Business fixed investment has been flat in real terms over the past year. With corporate profit growth already slowing rapidly and likely to contract because of the recession, firms will look to cut back on capital spending to preserve cash, leading to a bigger drag on overall growth from investment (Chart 7). According to the latest National Australia Bank business survey conducted in March, confidence has collapsed to lower levels than seen during the Global Financial Crisis, while capital spending and employment expectations have also declined sharply – trends that had already started before the COVID-19 breakout. Chart 8No Rebound In Housing No Rebound In Housing No Rebound In Housing Housing The housing market has long been a source of both strength and vulnerability for the Australian economy. While the days of double-digit growth in house prices are in the past, thanks to greater restrictions on banks for mortgage lending and worsening affordability, Australian housing was showing signs of life before the COVID-19 outbreak. National house prices were up +2.8% on a year-over-year basis in Q4/2019, while building approvals were stabilizing (Chart 8). That nascent housing rebound was choked off by the virus, with the Westpac-Melbourne Institute “good time to buy a home” survey plunging 30 points in April to the lowest level since February 2008. While the RBA’s interest rate cuts over the past decade have helped lower borrowing costs in Australia, the gap between the RBA cash rate and variable mortgage rates has been steadily widening (bottom panel). This suggests a worsening transmission from monetary policy into the most interest-sensitive parts of the economy like housing. Australian banks have been more stringent on mortgage lending standards over the past couple of years, which likely explains some of the widening gap between the RBA cash rate and mortgage rates. However, Australian banks have also seen an increase in their funding costs over that same period, both for onshore measures like the Bank Bill Swap Rate and offshore indicators like cross-currency basis swaps (Chart 9). Those funding costs have plunged in recent weeks, in response to the RBA’s aggressive monetary policy easing measures to help mitigate the hit to growth from COVID-19. The US Federal Reserve’s decision to activate a $60 billion currency swap line with the RBA back in March also helped reduce offshore funding costs for Australian banks. It is possible that the easing of funding costs could make banks more willing to make consumer and mortgage loans in the coming months, at lower interest rates, as the lockdown restrictions ease. This could help improve the transmission from easy RBA monetary policy to economic activity. Exports Demand for Australian exports was already starting to soften in the first few months of 2020. The year-over-year growth in total exports fell to 9.7% in March from a peak of 18.7% in July 2019. Exports to China, Australia’s largest trade partner, have held up better than non-Chinese exports (Chart 10). This was largely due to increased Chinese demand for Australian iron ore earlier in the year. Chart 9Bank Funding Pressures Have Diminished Bank Funding Pressures Have Diminished Bank Funding Pressures Have Diminished Iron ore prices have been declining more recently, but remain surprisingly elevated given the sharp contraction in global economic activity since March. This may be a sign that China’s reawakening from its own COVID-19 lockdowns, combined with more monetary and fiscal stimulus measures from Chinese policymakers, is putting a floor under the demand for Australian exports to China. Chart 10Australian Exports Will Not Rebound Anytime Soon Australian Exports Will Not Rebound Anytime Soon Australian Exports Will Not Rebound Anytime Soon Summing it all up, a major near-term economic contraction in Australia is unavoidable, but a relatively quick rebound could happen as domestic quarantine measures are lifted – especially given the significant amount of monetary and fiscal stimulus put in place by the RBA and the Australian government. Bottom Line: Australia is now in its first recession in 30 years, thanks to lockdown measures to contain the spread of COVID-19. Yet the nation’s rates of infection and death from the virus are relatively low, which should allow for a faster reopening of the domestic economy. A Powerful Policy Response To The Recession Almost every government and central bank in the world has introduced fiscal stimulus or monetary easing measures in response to the COVID-19 economic downturn. Australia’s policymakers have been particularly aggressive, both on the monetary and (especially) fiscal side. Monetary Policy The RBA has announced a variety of measures since late March to ease financial conditions and provide more liquidity to the economy, including: cutting the cash rate by 50bps to 0.25% the introduction of quantitative easing for the first time, buying government bonds in enough quantity in secondary markets to keep the yield on 3-year Australian government debt around 0.25% introducing a Term Funding Facility for the banking system under which authorized deposit-taking institutions can get funding from the RBA for three years at a rate of 0.25%, with additional funding available to increase lending to small and medium-sized businesses an increase in the amount and maturity of daily reverse repurchase (repo) operations, to support liquidity in the financial system setting up the currency swap line with the US Fed, providing US dollar liquidity to market participants in Australia. The RBA’s decisions on cutting the cash rate the 0.25%, and capping 3-year bond yields at the same level, sent a strong message to the markets that monetary policy must be highly accommodative until the threat of COVID-19 has passed. Fixed income markets have taken notice, with the yield on the benchmark 10-year Australian government bond falling from 1.30% just before the RBA announced the easing measures on March 19th to a low of 0.68% on April 1st. The yield has since rebounded to 0.95%, but this remains well below the level prevailing before the RBA eased. Those low interest rates have also helped to keep monetary conditions easy by dampening the attractiveness, and value, of the Australian dollar. The currency has historically been driven by three factors – interest rate differentials, commodity prices and global investor risk-aversion. With the RBA’s relentless rate cuts over the past decade, capped off by the measures introduced two months ago, the dominant factor on the currency has become interest rate differentials between Australia and other countries (Chart 11). The Aussie dollar has enjoyed a bounce as global equity markets have rebounded since the collapse in March, but remains well below levels implied by the RBA Commodity Price Index. The implication is that the upside in the currency will be capped by the RBA’s interest rate stance, which has taken all the formerly attractive carry out of the Aussie dollar. The RBA will need to maintain an accommodative stance for some time, as inflation – and inflation expectations – are likely to remain well below the central bank’s 2-3% target range. The RBA will need to maintain an accommodative stance for some time, as inflation – and inflation expectations – are likely to remain well below the central bank’s 2-3% target range. The new baseline forecast by the RBA calls for the Australian unemployment rate to double from 5.2% in Q1/2020 to 10% in Q2/2020, before drifting back down to 8.5% by Q2/2021 (Chart 12). The central bank sees the jobless rate returning to 6.5% in Q2/2022, but that will still not be enough to push headline or core CPI inflation back above 2% (middle panel). Chart 11Interest Rates Are The Main Driver Of The AUD Now Interest Rates Are The Main Driver Of The AUD Now Interest Rates Are The Main Driver Of The AUD Now Chart 12Inflation Is Dormant Down Under Inflation Is Dormant Down Under Inflation Is Dormant Down Under Inflation expectations have discounted a similar outcome. The Union Officials’ and Market Economists’ surveys of 2-year-ahead inflation expectations are both now under 2%. Market-based measures like the 2-year CPI swap rate are even more pessimistic, priced at a mere 0.12%! The recent plunge in oil prices is clearly playing a role in that extreme CPI swap pricing, but until there is some recover in market-based inflation expectations, the RBA will be unable to move away from its current emergency policy easing measures. Fiscal Policy The Australian government has been very aggressive in its economic support measures, including1: a so-called “JobKeeper Payment” to allow businesses to cover employee wages direct income support payments to individuals and households allowing temporary withdrawals from superannuation (retirement savings) plans direct financial support to businesses to “boost cash flow” temporary changes to bankruptcy laws to make it more difficult for creditors to demand payment increased financial incentives for new investment providing loan guarantees to small and medium-sized businesses temporarily easily regulatory standards (like capital ratios) for Australian banks, to free up more funds for lending The size of these combined measures is estimated to be 12.5% of GDP, according to calculations from the IMF (Chart 13). This puts Australia in the upper tier of G20 countries in terms of the size of the total government support measures, according to an analysis of fiscal policy responses to COVID-19 from our colleagues at BCA Research Global Investment Strategy.2 When looking at purely the fiscal policy response through tax changes and direct spending, and removing liquidity support and loan guarantees that may not be fully utilized, the Australian government’s stimulus response is 10.6% of GDP - the largest in the G20 (Chart 14). Chart 13Australian Policymakers Have Responded Aggressively To COVID-19 Australia: All Good Streaks Must Come To An End Australia: All Good Streaks Must Come To An End Chart 14Australia’s Planned Deficit Increase Is The Largest In The G20 Australia: All Good Streaks Must Come To An End Australia: All Good Streaks Must Come To An End Chart 15Australia Has The Fiscal Space To Be Aggressive Australia Has The Fiscal Space To Be Aggressive Australia Has The Fiscal Space To Be Aggressive The Australian government can deliver such a large response because it has the fiscal space to do it, with a debt/GDP ratio that was only 41.9% prior to the COVID-19 outbreak (Chart 15). This compares favorably to other countries that have delivered major stimulus packages but from a starting point of much higher levels of government debt. The Australian government can deliver such a large response because it has the fiscal space to do it. We do not see any downgrade risk for Australia’s sovereign AAA credit rating from the fiscal stimulus measures, despite the recent decision by S&P to put the nation on negative outlook. Australia will still have one of the lowest government debt/GDP ratios among the G20, even after adding in the expected increases in deficits for all the countries in 2020 (Chart 16). Chart 16Australia’s AAA Credit Rating Is Safe Australia: All Good Streaks Must Come To An End Australia: All Good Streaks Must Come To An End Net-net, the monetary and fiscal stimulus measures undertaken by Australian policymakers appear large enough to offset the immediate hit to the economy from the COVID-19 recession. This has important investment implications for Australian bond markets. The monetary and fiscal stimulus measures undertaken by Australian policymakers appear large enough to offset the immediate hit to the economy from the COVID-19 recession. Bottom Line: The RBA has taken extraordinary measures to cushion the blow from the lockdowns, like cutting policy rates to near-0% and capping shorter maturity bond yields through quantitative easing. The Australian government has also been aggressive in providing fiscal stimulus. These measures give the economy a better chance of seeing a “v”-shaped recovery as the lockdown restrictions are eased. Investment Conclusions We started this report by discussing the consistent outperformance of Australian government bonds versus other developed market debt over the past decade. After going through a careful analysis of the economy, inflation, monetary policy and fiscal policy, we now view the period of Australian bond outperformance as essentially complete. This leads us to make the following investment conclusions on a strategic (6-12 months) investment horizon. Duration: We recommend only a neutral duration stance for dedicated Australian fixed income portfolios; the RBA has little room to cut policy rates further; inflation expectations are too low; the nation is poised to rapidly emerge from COVID-19 lockdowns; and fiscal stimulus will be more than enough to offset the hit to domestic incomes from the recession. Country Allocation: Within global bond portfolios, we recommend downgrading Australia to neutral from overweight. The multi-year interest rate convergence story is largely complete, both in terms of central bank policy rates and longer-term bond yields. Our most reliable indicator for the future relative performance of Australian government bonds versus the global benchmark – the ratio of the OECD’s leading economic indicator for Australia to the overall OECD leading indicator – is increasing because of a greater decline in the non-Australian measure (Chart 17, second panel). This fits with the idea of the relative economic growth story turning into a headwind for Australian bonds after being a tailwind for the past few years. Within global bond portfolios, we recommend downgrading Australia to neutral from overweight.  Yield Curve: We recommend positioning for a steeper Australian government bond yield curve. The RBA is anchoring the short-end of the curve as part of its quantitative easing program, leaving the slope of the curve to be driven more by longer-term inflation expectations that are too depressed (third panel). Inflation-linked Bonds: We recommend overweighting Australian inflation-linked bonds versus nominal government debt. As we discussed in a recent report, breakevens on Australian inflation-linked bonds are far too low on our fair value models, which include the sharp decline in global oil prices (fourth panel).3 Chart 17Move To Neutral Duration Exposure In Australia, While Favoring Inflation-Linked Bonds Move To Neutral Duration Exposure In Australia, While Favoring Inflation-Linked Bonds Move To Neutral Duration Exposure In Australia, While Favoring Inflation-Linked Bonds Chart 18Australian Corporate Bonds Look More Attractive Now Australian Corporate Bonds Look More Attractive Now Australian Corporate Bonds Look More Attractive Now   Corporate Credit: We recommend going overweight Australian investment grade corporate debt versus government bonds. The recent spread widening has restored some value - especially when compared to the more modest increase seen in credit default spreads - while Australian equity market volatility, which correlates with spreads, has peaked (Chart 18). Also, the RBA has just announced that they will now accept investment grade corporates as collateral for its domestic repo market operations, which should increase the demand for corporates on the margin.4   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 The full details of the Australian government economic response to COVID-19 can be found here: https://treasury.gov.au/sites/default/files/2020-03/Overview-Economic_Response_to_the_Coronavirus_2.pdf 2 Please see BCA Research Global Investment Strategy Special Report, “The Global COVID-19 Fiscal Response: Is It Enough?”, dated April 30, 2020, available at gis.bcaresearch.com. 3 Please see BCA Research Global Fixed Income Strategy Weekly Report, "Global Inflation Expectations Are Now Too Low", dated April 28, 2020, available at gfis.bcaresearch.com. 4https://www.rba.gov.au/mkt-operations/announcements/broadening-eligibility-of-corporate-debt-securities.html Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Australia: All Good Streaks Must Come To An End Australia: All Good Streaks Must Come To An End

The Fed Is Your Friend The Fed Is Your Friend The Fed’s unorthodox monetary policy will likely continue to underpin equity prices in the coming 9-12 months. Specifically, according to Leo Krippner’s shadow short rates (SSR) estimate, the shadow fed funds rate is now negative, which is tailwind for the SPX (SSR shown inverted, top panel). Falling interest rates are a boon to equities via a rising price-to-earnings multiple (SSR shown inverted, bottom panel). Also, while the Fed would never admit to it, it is trying to devalue the US dollar and reflate the global economy, which will indirectly boost S&P 500 revenues. As a reminder, 40% of SPX sales are internationally sourced and thus a falling greenback is a welcoming sign for S&P 500 turnover (middle panel). Bottom Line: We remain constructive on the prospects of the broad equity market on a cyclical time horizon. Please refer to this Monday’s Weekly Report for more details.

Highlights Treasuries: Despite surging issuance, long-dated Treasury yields will move only slightly higher this year, driven by a modest recovery in global demand. There is also a risk that a second wave of COVID infections will send yields to new lows. We recommend keeping portfolio duration close to benchmark while hedging the risk of higher yields by entering duration-neutral curve steepeners. Negative Rates: The Fed will not cut rates into negative territory any time soon. Investors who are able to do so should go short fed funds futures contracts that are priced for negative rates. EM Sovereigns: US bond investors should avoid USD-denominated EM sovereign debt and focus instead on US corporate credit rated Ba and higher. Of the EM countries with large USD bond markets, Mexican debt looks most attractive on a risk/reward basis. Don’t Expect A Taper Tantrum The big announcement in bond markets last week was the Treasury department detailing its plans for note and bond issuance in the second and third quarters. Of course, with the CARES act injecting $2.8 trillion into the economy, investors were already prepared for a big step up in issuance.1 But the numbers are striking nonetheless, particularly at the long-end of the curve. Overall note and bond issuance will reach $910 billion in Q3, roughly equal to the 2010 peak as a percent of GDP (Chart 1). Issuance beyond the 10-year point of the curve (i.e. the 30-year bond and new 20-year bond) will far exceed its financial crisis highpoint (bottom panel). Many bond investors are understandably worried that surging issuance will put significant upward pressure on yields in the coming months. Long-maturity Treasury yields jumped after the Treasury’s announcement on Wednesday before reversing all of that bounce the following day. But despite the mild market reaction, many bond investors are understandably worried that surging issuance will put significant upward pressure on yields in the coming months, especially with the Fed paring its pace of Treasury purchases (Chart 2). Chart 1Gross Treasury Issuance Gross Treasury Issuance Gross Treasury Issuance Chart 2Fed Buying Fewer Treasuries Fed Buying Fewer Treasuries Fed Buying Fewer Treasuries Our base case outlook is that Treasury yields will be marginally higher by the end of the year, and the yield curve will be steeper.2 However, we do not foresee a Taper Tantrum-style bond market rout. Treasury supply will continue to expand in the months ahead. But on the flipside, the Fed’s forward rate guidance will remain very dovish. If investors believe that short-dated interest rates will stay pinned near zero for a long time, fear of significant losses will remain low and Treasury demand will keep pace with supply, even at the long-end of the curve. Chart 3No Taper Tantrum In 2020 No Taper Tantrum In 2020 No Taper Tantrum In 2020 Yes, the Fed has scaled back its pace of Treasury purchases during the past few weeks, removing a significant source of demand from the market. However, it has also given no indication that it intends to lighten up on monetary stimulus broadly speaking. Based on the Fed’s dovish posture, we can be sure that if surging issuance leads to undesirably high term premiums at the long-end of the Treasury curve, the Fed will quickly ramp purchases back up to squash them. In general, our view is that all dramatic bond sell-offs are caused by the market suddenly pricing in a much more hawkish Fed reaction function. This can be driven by surprisingly strong economic growth and inflation, or by investors collectively changing their assessments of how the Fed will react. In this regard, the 2013 Taper Tantrum is an interesting case study. The Treasury curve bear-steepened dramatically in 2013 after Fed Chair Ben Bernanke laid out the Fed’s plan for winding down asset purchases. But this is not a simple story of bond yields rising because the market reacted to less demand in the form of Fed purchases. Rather, yields rose so much because Bernanke signaled to investors that the overall stance of monetary policy was much less accommodative than they had previously thought. Notice that gold fell sharply during this period (Chart 3), not because of less direct demand for Treasuries but because a more hawkish Fed meant less long-run inflation risk. The dynamic is illustrated very clearly by the CRB Raw Industrials / Gold ratio (Chart 3, bottom panel). The ratio is highly correlated with long-dated Treasury yields, meaning that for yields to shoot higher we need to see either a surge in global demand (i.e. CRB commodity prices) or a hawkish shift in the Fed’s reaction function (i.e. a drop in the gold price). If, as we expect, global demand improves only modestly this year and the Fed remains steadfastly dovish, upside in both the CRB/Gold ratio and long-maturity Treasury yields will be limited. Bottom Line: Despite surging issuance, long-dated Treasury yields will move only slightly higher this year, driven by a modest recovery in global demand. There is also a risk that a second wave of COVID infections will send yields to new lows. We recommend keeping portfolio duration close to benchmark while hedging the risk of higher yields by entering duration-neutral curve steepeners. Don’t Bet On Negative Rates Table 1Fed Funds Futures The Treasury Market Amid Surging Supply The Treasury Market Amid Surging Supply The massive amount of new issuance was not the only exciting development in fixed income markets last week. Short-dated yields also started to price-in the possibility of negative interest rates in the US! Table 1 shows the price of different fed funds futures contracts (as of Monday morning) and what funds rate those prices imply for each contract’s maturity month. We also show the return you would earn by taking an unlevered short position in each contract and holding to maturity, assuming that the actual fed funds rate remains unchanged. We assume that the fed funds rate will stay at its current level (0.05%) because the Fed has made it very clear that a negative policy rate is not an option that will be considered. As evidence, we present some excerpts from recent Fed communications. Fed Chair Jerome Powell from his March 15 press conference:3 So, as I’ve noted on several occasions, really, the Committee – as you know, we did a year-plus-long study of our tools and strategies and communications. And we, really, at the end of that, and also when we started out, we view forward guidance and asset purchases – asset purchases and also different variations and combinations of those tools as the basic elements of our toolkit once the federal funds rate reaches the effective lower bound – so, really, forward guidance, asset purchases, and combinations of those. You know, we looked at negative policy rates during the Global Financial Crisis, we monitored their use in other jurisdictions, we continue to do so, but we do not see negative policy rates as likely to be an appropriate policy response here in the United States. The Fed staff’s assessment of negative interest rates from the October 2019 FOMC minutes:4 The briefing also discussed negative interest rates, a policy option implemented by several foreign central banks. The staff noted that although the evidence so far suggested that this tool had provided accommodation in jurisdictions where it had been employed, there were also indications of possible adverse side effects. Moreover, differences between the US financial system and the financial systems of those jurisdictions suggested that the foreign experience may not provide a useful guide in assessing whether negative interest rates would be effective in the United States. FOMC participants’ assessment of negative interest rates from the October 2019 minutes:5 All participants judged that negative interest rates currently did not appear to be an attractive monetary policy tool in the United States. Participants commented that there was limited scope to bring the policy rate into negative territory, that the evidence on the beneficial effects of negative interest rates abroad was mixed, and that it was unclear what effects negative interest rates might have on the willingness of financial intermediaries to lend and on the spending plans of households and businesses. Participants noted that negative interest rates would entail risks of introducing significant complexity or distortions to the financial system. In particular, some participants cautioned that the financial system in the United States is considerably different from those in countries that implemented negative interest rate policies, and that negative rates could have more significant adverse effects on market functioning and financial stability here than abroad. Notwithstanding these considerations, participants did not rule out the possibility that circumstances could arise in which it might be appropriate to reassess the potential role of negative interest rates as a policy tool. It is always possible that the Fed’s view of negative interest rates will change in the future. However, this won’t happen any time soon. The Fed still has other zero-lower-bound policy options it can deploy before it gets desperate enough to re-consider negative rates. The Fed still has other zero-lower-bound policy options it can deploy before it gets desperate enough to re-consider negative rates. For example, one logical next step would be to bring back the Evans Rule. That is, specify economic targets (related to unemployment and inflation) that must be met before the Fed will consider lifting rates. If that sort of forward guidance is deemed insufficient, the Fed could adopt a plan recently advocated by Governor Lael Brainard and start to cap short-maturity bond yields.6 If it wants more stimulus after that it could gradually move further out the curve, capping bond yields for longer and longer maturities. According to the FOMC minutes, this sort of Yield Curve Control policy had more support among participants at the October 2019 FOMC meeting than did negative interest rates:7 A few participants saw benefits to capping longer-term interest rates that more directly influence household and business spending. In addition, capping longer-maturity interest rates using balance sheet tools, if judged as credible by market participants, might require a smaller amount of asset purchases to provide a similar amount of accommodation as a quantity-based program purchasing longer-maturity securities. However, many participants raised concerns about capping long-term rates. Some of those participants noted that uncertainty regarding the neutral federal funds rate and regarding the effects of rate ceiling policies on future interest rates and inflation made it difficult to determine the appropriate level of the rate ceiling or when that ceiling should be removed; that maintaining a rate ceiling could result in an elevated level of the Federal Reserve’s balance sheet or significant volatility in its size or maturity composition; or that managing longer-term interest rates might be seen as interacting with the federal debt management process. By contrast, a majority of participants saw greater benefits in using balance sheet tools to cap shorter-term interest rates and reinforce forward guidance about the near-term path of the policy rate. Bottom Line: The Fed will not cut rates into negative territory any time soon. Investors who are able to do so should go short fed funds futures contracts that are priced for negative rates. For example, a short position in the June 2021 fed funds futures contract will earn an unlevered 6.5 bps if the fed funds rate remains unchanged and the position is held to maturity. No Buying Opportunity Yet In EM Sovereigns When assessing the outlook for the US dollar denominated sovereign debt of emerging markets we consider two main factors: Valuation, relative to both US Treasuries and US corporate credit. The outlook for EM currencies versus the dollar. Ideally, we want to move into EM sovereign debt when spreads look attractive relative to the domestic investment alternatives and when EM currencies are on the cusp of rallying versus the dollar. Valuation At first blush, value looks like it has improved considerably for EM sovereigns. The average spread on the Bloomberg Barclays EM Sovereign index is 167 bps wider than it was at the beginning of the year and the spread differential with the duration-matched Ba-rated US corporate bond index is elevated compared to the recent past (Chart 4). However, widening has been driven by a select few distressed countries (e.g. Ecuador, Argentina and Lebanon). When we strip those out and look only at the investment grade EM sovereign index (Chart 4, panels 3 & 4), the average spread looks relatively tight compared to a duration-matched position in Baa-rated US corporate credit. Chart 4Only A Few EMs Look Cheap Only A few EMs Look Cheap Only A few EMs Look Cheap Because country-specific trends often exert undue influence on the overall index, we find it helpful to look at value on a country-by-country basis. Chart 5A shows the average option-adjusted spread for major countries included in the Bloomberg Barclays EM Sovereign index. This chart makes no adjustments for credit rating or duration, and as such we see the lower-rated nations (Turkey, South Africa, Brazil) offering the widest spreads. Chart 5B shows each country’s spread relative to a duration and credit rating matched position in US corporate credit. Viewed this way, the most attractive opportunities lie in Mexico, Saudi Arabia, UAE, Colombia, Qatar and South Africa. Chart 5AUSD-Denominated EM Sovereign Debt By Country: Spread Versus Treasuries The Treasury Market Amid Surging Supply The Treasury Market Amid Surging Supply Chart 5BUSD-Denominated EM Sovereign Debt By Country: Spread Versus US Credit The Treasury Market Amid Surging Supply The Treasury Market Amid Surging Supply Currency Outlook Chart 6EM Currencies Are Linked To Global Growth EM Currencies Are Linked To Global Growth EM Currencies Are Linked To Global Growth Currency is important for EM sovereign spreads because a stronger local currency literally makes US dollars cheaper for the EM nation to acquire. This, in turn, makes its USD-denominated debt easier to service, leading to tighter spreads. Chart 6 shows that EM Sovereign excess returns versus US Treasuries closely track EM currency performance. We also observe a strong link between EM currencies and high-frequency global growth indicators like the CRB Raw Industrials commodity price index (Chart 6, bottom panel). Based on this, we would only expect EM currencies to strengthen when global demand starts to pick up. Further, as our Emerging Market strategists wrote in a recent report, EM central banks are behaving differently during this recession than they have in past downturns.8 In the past, EMs would often run relatively tight monetary policies in order to fend off currency depreciation in the hopes of preventing capital outflows. This time, EM central banks are cutting rates aggressively, allowing their currencies to depreciate but supporting domestic demand. This is bearish for EM currencies and sovereign spreads in the near-term, but will probably lead to stronger economic recovery down the road. At the country level, we assess how vulnerable each country’s currency is to further depreciation by looking at its ratio of exports to foreign debt obligations.9 This ratio is a measure of US dollars coming in over a 12-month period relative to 12-month US dollar debt obligations. It has a relatively tight correlation with the dollar-denominated sovereign spread (Chart 7A). Low-rated countries, like Turkey and South Africa, have relatively low export coverage of foreign debt obligations, while Russia and South Korea have relatively strong debt coverage. Combining Valuation & Currency Outlook Chart 7B shows the same measure of currency vulnerability on the horizontal axis, but shows EM spreads relative to duration and credit rating matched US corporate credit on the vertical axis. Here, we see that Russia offers poor valuation, but a relatively safe currency. Meanwhile, Colombia offers an attractive spread but has a poor currency outlook. In this chart, Mexico stands out as the most attractive on a risk/reward basis. Chart 7AEM Sovereign Spread Versus Currency Vulnerability The Treasury Market Amid Surging Supply The Treasury Market Amid Surging Supply Chart 7BEM Sovereign Spread Over US Credit Versus Currency Vulnerability The Treasury Market Amid Surging Supply The Treasury Market Amid Surging Supply You will notice that the three Middle Eastern countries that stood out as having attractive spreads in Chart 5B are not shown in Charts 7A and 7B. This is because some data are unavailable, and also because those countries operate with currency pegs. Despite attractive spreads in those countries, we would not advise long-run positions in the USD-denominated sovereign debt of Saudi Arabia, Qatar or UAE. As our EM strategists wrote in a recent Special Report, if oil prices remain structurally low in the coming years (~$40 range), pressure will grow for Saudi Arabia to break its currency peg and allow some depreciation.10  The same holds true for Qatar and UAE. A bet on those countries’ sovereign spreads today amounts to a bet on higher oil prices. Despite attractive spreads, we would not advise long-run positions in the USD-denominated sovereign debt of Saudi Arabia, Qatar or UAE. Bottom Line: US bond investors should avoid USD-denominated EM sovereign debt and focus instead on US corporate credit rated Ba and higher. Of the EM countries with large USD bond markets, Mexican debt looks most attractive on a risk/reward basis. Appendix: 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 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. Right now, that means we are overweight corporate bonds rated Ba and higher, Aaa-rated Agency and non-agency CMBS, Aaa-rated consumer ABS and municipal bonds. We are underweight residential mortgage-backed securities and corporate bonds rated B and lower. The below Table tracks the performance of these different bond sectors since the Fed’s March 23 announcement. We will use this Table to monitor bond market correlations and evaluate our strategy's success. Table 2Performance Since March 23 Announcement Of Emergency Fed Facilities The Treasury Market Amid Surging Supply The Treasury Market Amid Surging Supply   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes  1 For more details on the size and potential efficacy of the CARES act please see Bank Credit Analyst Special Report, “The Global COVID-19 Fiscal Response: Is It Enough?”, dated April 30, 2020, available at bca.bcaresearch.com 2 Please see US Bond Strategy Portfolio Allocation Summary, “The Policy-Driven Bond Market”, dated May 5, 2020, available at usbs.bcaresearch.com 3 https://www.federalreserve.gov/mediacenter/files/FOMCpresconf20200315.pdf 4  https://www.federalreserve.gov/monetarypolicy/files/fomcminutes20191030.pdf 5 https://www.federalreserve.gov/monetarypolicy/files/fomcminutes20191030.pdf 6 https://www.federalreserve.gov/newsevents/speech/brainard20191126a.htm 7 https://www.federalreserve.gov/monetarypolicy/files/fomcminutes20191030.pdf 8 Please see Emerging Markets Strategy Weekly Report, “EM Domestic Bonds And Currencies”, dated April 23, 2020, available at ems.bcaresearch.com 9 For more information on this ratio please see Emerging Markets Strategy Special Report, “EM: Foreign Currency Debt Strains”, dated April 22, 2020, available at ems.bcaresearch.com 10 Please see Emerging Markets Strategy Special Report, “Saudi Riyal Devaluation: Not Imminent But Necessary”, dated May 7, 2020, available at ems.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights ECB: The ECB disappointed markets last week who expected an increase in the size of its asset purchase schemes given the recent increase of Italian bond yields. For now, the central bank remains focused on preventing a European credit crunch through increased use of bank funding measures like TLTROs – although a renewed selloff in BTPs would likely change the minds of the “Italy hawks” on the ECB Governing Council. Euro Area High-Yield: Valuations for euro area junk bonds improved somewhat during the COVID-19 selloff, but spreads do not offer much protection from the coming surge in default losses. Remain underweight euro area high-yield corporates in global fixed income portfolios. Feature Chart 1Will Growth Trump Liquidity For Euro Area Junk Bonds? Will Growth Trump Liquidity For Euro Area Junk Bonds? Will Growth Trump Liquidity For Euro Area Junk Bonds? Over the past week, investors heard from the three major developed market central banks – the Federal Reserve, the European Central Bank (ECB) and the Bank of Japan (BoJ). The Fed and BoJ did little to seriously impact financial markets, offering only strengthened forward guidance on already hyper-easy policy settings along with some expansion of existing asset purchase programs (involving municipal bonds for the Fed, JGBs and Japanese corporate bonds for the BoJ). The ECB was the most interesting of the three, because of what was NOT done – namely, an increase in the amount of asset purchases – and what it implies about the policy debate within the central bank on how to deal with Italy. The hit to the euro area economy from the COVID-19 lockdowns has been sharp and brutal, pushing the entire region quickly into deep recession (Chart 1). Given such a severe hit to growth, and with policy interest rates already at zero (or even negative), the only avenue for the ECB to deliver more stimulus is through expanding its balance sheet through asset purchases and liquidity provision to banks. This makes the ECB’s next moves on its balance sheet critical for determining the future path of European risk assets like equities and high-yield corporate bonds – the latter of which we discuss later in this report. A Cautious Next Step From The ECB Chart 2An Unprecedented Economic Collapse An Unprecedented Economic Collapse An Unprecedented Economic Collapse The need for the ECB to do something at last week’s monetary policy meeting was obvious. Real GDP for the entire region is estimated to have contracted -3.8% on a year-over-year basis in the first quarter of the year. At the country level, large declines occurred in France (-5.8%), Italy (-4.7%) and Spain (-5.2%) that were far greater than seen during the 2009 recession. The decline was broad-based across industries as well, with the European Commission’s (EC) business confidence indices collapsing in April for manufacturing, services, retail and construction (Chart 2). The bottom has also fallen out on the EC price expectations indices, suggesting that outright deflation across the euro area is just around the corner. The ECB last week provided what were called “alternative scenarios” for the impact of COVID-19 on euro area growth. We presume these are meant to be an alternative to the most recent set of ECB economic projections that were published in March that now look wildly optimistic given the COVID-19 lockdowns. The revised scenarios now call for a real GDP contraction in 2020 of anywhere from -5% to -12%, with only a partial recovery of those losses in 2021.1 The central bank also provided an estimate of the output loss by industry from COVID-19 related lockdowns (Table 1) – a staggering -60% for retail, transportation, accommodation and food services and -40% for manufacturing and construction. Table 1The Lockdown Has Been Painful For Europe The ECB Will Do Whatever It Takes … Eventually The ECB Will Do Whatever It Takes … Eventually Against this horrendous growth and inflation backdrop, with forecasts being slashed, the expectation was that the ECB would ramp up the size of its bond buying programs to try and ease financial conditions further. That would help cushion the growth downturn and attempt to put a floor under collapsing inflation expectations (Chart 3). Yet at last week’s monetary policy meeting, the ECB announced the following: No changes in policy interest rates No increase in the size of the Asset Purchase Program (APP) from the existing €120bn or Pandemic Emergency Purchase Program (PEPP) from the existing €750bn For existing targeted long-term refinancing operations (TLTROs) between June 2020 and June 2021, interest rates were lowered by -25bps A new long-term refinancing operation for euro area banks was introduced called the Pandemic Emergency Long Term Refinancing Operation (PELTRO), which would offer liquidity to euro area banks on a monthly basis until December, at an interest rate of -0.25%. The increased use of LTROs was an easier way for the ECB Governing Council to avoid a potential credit crunch if euro area banks become more risk averse. The ECB clearly wants to take no chances on banks reining in loan activity. The latest ECB Bank Lending Survey, released just two days before last week’s policy meeting, showed a modest tightening of standards for bank loans to businesses in the first quarter of 2020. This was most visible in Germany and Italy, with France actually showing a slight decline in the net percentage of banks tightening lending standards (Chart 4). The survey also showed that euro area banks expected a significant net easing of lending standards in response to the loan guarantees and liquidity support measures announced by European governments to mitigate the impact of COVID-19 lockdowns. Chart 3Expanding The Balance Sheet Is The Only Tool The ECB Has Left Expanding The Balance Sheet Is The Only Tool The ECB Has Left Expanding The Balance Sheet Is The Only Tool The ECB Has Left Chart 4The ECB Wants To Avoid A Credit Crunch The ECB Wants To Avoid A Credit Crunch The ECB Wants To Avoid A Credit Crunch With bank lending growth across the entire euro area having already increased to 4.9% on a year-over-year basis in March, the fastest pace in two years, the ECB clearly wants to take no chances on banks reining in loan activity - even if those loans are merely for stressed companies tapping existing credit lines, or taking advantage of government loan guarantees to minimize layoffs in a deep recession. Another surge in Italian bond yields in the next few months would likely trigger an increase in the size of the PEPP. However, there was likely an additional reason why the ECB chose the LTRO route over ramping up asset purchases – internal political divisions over Italy. Chart 5Italian Financial Stability Remains Critical For The ECB Italian Financial Stability Remains Critical For The ECB Italian Financial Stability Remains Critical For The ECB There remain some on the ECB Governing Council that do not wish to keep buying more BTPs, thus giving Italy a blank check to run even larger budget deficits. The unique nature of the COVID-19 outbreak has somewhat loosened those biases against the highly indebted countries of southern Europe, as evidenced by the inclusion of Greek bonds in the PEPP shopping list. Yet there are still many within the ECB, and within the governments of the “hard money” countries of the euro area, who would prefer to see Italy get monetary support for greater deficit spending through ECB vehicles with conditionality like Outright Monetary Transactions (OMT). Given these internal divisions over Italy, an increase in the size of the existing asset purchase schemes will only take place if there is a major increase in Italian risk premiums that threatens the financial stability of the entire euro area. On that front, risk indicators like the BTP-Bund spread and credit default spreads on Italian banks have risen over the past month, but remain well below the stressed levels witnessed during the Global Financial Crisis and the European Debt Crisis (Chart 5). Additionally, Italian bank stocks have actually been outperforming their euro area peers since early 2019, while the Italy-Germany spread curve is not inverted (2-year spreads higher than 10yr spreads) as occurred in 2011 when investors feared Italy would crash out of the euro. With Italian government yields still at relatively low and manageable levels, even as the highly-indebted Italian government has stated that its budget deficit will surge to -10% of GDP to provide stimulus to a virus-ravaged economy, there is no pressure on the ECB to increase the size of the PEPP that was just announced less than two months ago. Yet even with all the internal divisions, another surge in Italian bond yields in the next few months would likely trigger an increase in the size of the PEPP to prevent a broader tightening of euro area financial conditions. For this reason, we continue to recommend a strategic (6-12 months) overweight stance on Italian government bonds within global fixed income portfolios. Bottom Line: The ECB disappointed markets last week who expected an increase in the size of its asset purchase schemes given the recent increase of Italian bond yields. For now, the central bank remains focused on preventing a European credit crunch through increased use of bank funding measures like TLTROs – although a renewed selloff in BTPs would likely change the minds of the “Italy hawks” on the ECB Governing Council. A Quick Look At Euro Area High-Yield Valuation We recently upgraded our recommended investment stance on euro area investment grade corporate bonds to neutral.2 This shift was based on the ECB increasing the amount of its corporate bond purchases as part of its COVID-19 monetary easing measures, coming after the Fed announced its own new programs to buy US investment grade corporates. With the major central banks providing direct support to higher quality corporates, the left side of the return distribution for those bonds eligible for these purchase programs has effectively been reduced. This warrants a higher weighting for those bonds in investor portfolios. For high-yield corporates, the story is more nuanced. Both the Fed and ECB have announced that investment grade bonds purchased in their bond buying programs, which are then subsequently downgraded to below investment grade, can stay on the balance sheet of those programs. This makes Ba-rated junk bonds – the highest credit tier below investment grade – a relatively more attractive bet within the overall high-yield universe, both in the US and Europe. Although the lack of a direct central bank bid still makes high-yield corporates a riskier bet in a recessionary environment where default losses will surely increase. This means rather than just “buying what the central banks are buying”, we must rely on more traditional metrics to determine if high-yield bonds offer value. To evaluate the attractiveness of euro area high-yield corporates, we use three different approaches that use relative value to other credit markets, or more intrinsic value based on potential credit losses. Relative spreads vs. euro area investment grade One way to assess the value of euro area high-yield is to compare its credit spread to that of higher-rated euro area investment grade corporate bonds. Since movements in both spreads are highly correlated, as they both benefit from accelerating euro area economic growth (and vice versa), any change in spreads between the two could represent a relative value opportunity. Currently, the option-adjusted spread (OAS) of the euro area high-yield benchmark index (635bps) is 449bps over that of the investment grade index (186bps), using Bloomberg Barclays index data (Chart 6). While this is a relatively wide spread differential for the years since the 2008 financial crisis, it is not a particularly large gap during a recession that is likely to be deeper than the 2009 downturn. The same argument holds when looking at the ratio of the euro area high-yield OAS to the investment grade OAS, which is only at average levels for the post crisis period (3rd panel). 12-month breakeven spreads One of our favorite credit valuation tools is the 12-month breakeven spread, which measures the amount of spread widening over a one-year horizon that would make the total return of a corporate bond equal to that of a duration-matched government bond. We apply that calculation to data for an entire spread product sector, like investment grade or high-yield, to determine a breakeven spread for that sector. We then look at the percentile ranks of the breakeven spread versus its own history to determine if that particular fixed income sector looks relatively attractive. Rather than just “buying what the central banks are buying”, we must rely on more traditional metrics to determine if high-yield bonds offer value. On that basis, euro area high-yield corporates, across all credit tiers, offer somewhat attractive spreads, with 12-month breakevens in the upper half of the historical distribution (Chart 7). US high-yield, by comparison, offers far more attractive spreads with 12-month breakevens in the upper quartile of their historical distribution across all credit tiers. Only the riskiest Caa-rated bonds are in the top 25% of the distribution in the euro area (Chart 8). Chart 6In The Euro Area, HY Is Not That Cheap Versus IG In The Euro Area, HY Is Not That Cheap Versus IG In The Euro Area, HY Is Not That Cheap Versus IG Chart 712-Month Breakeven Spreads For Euro Area HY Are Now More Attractive ... 12-Month Breakeven Spreads For Euro Area HY Are Now More Attractive ... 12-Month Breakeven Spreads For Euro Area HY Are Now More Attractive ... Chart 8… But Not Versus US High-Yield The ECB Will Do Whatever It Takes … Eventually The ECB Will Do Whatever It Takes … Eventually The overall attractiveness of US high-yield versus euro area equivalents can also be seen when comparing the benchmark index yields in common currency terms. For the overall indices, euro area junk bond yields, hedged into USD dollars, offer a yield of 7.8%, virtually equal to the 8.0% yield in the US (Chart 9), although more material differences do exist within credit tiers. Chart 9A Comparison Of Junk Bond Yields In The Euro Area & The US The ECB Will Do Whatever It Takes … Eventually The ECB Will Do Whatever It Takes … Eventually Default-adjusted spreads The other metric that we use to assess the value of high-yield corporate bonds is default-adjusted spreads. This measure takes the high-yield index OAS and subtracts credit losses to determine an “excess” spread. We look at the current default-adjusted spread versus its long-run average to determine if high-yield spreads offer an attractive valuation cushion relative to expected credit losses. To determine the credit losses, we need the default rate, and the recovery rate given default, for the overall high-yield market. For defaults, we will use the output of our euro area default rate model (Chart 10). The model uses four variables: lending standards for businesses from the ECB bank lending survey, high-yield ratings downgrades as a share of all rating actions, euro area real GDP growth, and the median debt-to-equity ratio for a sample of issuers in the euro area high-yield space. All the variables are advanced such that the model produces a one-year-ahead forecast of expected high-yield defaults.3 Our high-yield model is projecting that the euro area default rate will climb to 11% by the end of 2020, before declining to 8% mid-2021 as the euro area economy recovers from the 2020 recession. For the euro recovery rate, we are using a range based on the historical experience during recessions (30%) and recoveries (45%). Using our default rate model projection, and that range of recovery rates, we can produce a range of euro area default-adjusted spreads. Euro area high-yield spreads do not offer much of a spread cushion to absorb expected default losses over the next year. Thus, euro area junk bonds are expensive. In Chart 11, we show the history of the euro area default adjusted spread. We have added the long run average (358bps) and the +/1 standard deviation of the spread. Spreads at or lower than -1 standard deviation are considered expensive (i.e. the high-yield index spread is too low relative to credit losses), and vice versa. The shaded box in the bottom right corner of the chart represents our forecasted default-adjusted spread for the next year. Chart 10Our Model Says The Euro Area Default Rate Will Surpass 10% Our Model Says The Euro Area Default Rate Will Surpass 10% Our Model Says The Euro Area Default Rate Will Surpass 10% Chart 11Euro Area HY Default-Adjusted Spreads Do Not Offer Compelling Value Euro Area HY Default-Adjusted Spreads Do Not Offer Compelling Value Euro Area HY Default-Adjusted Spreads Do Not Offer Compelling Value Chart 12An Aggressive Overweight Stance On Risk Assets Is Still Not Warranted An Aggressive Overweight Stance On Risk Assets Is Still Not Warranted An Aggressive Overweight Stance On Risk Assets Is Still Not Warranted Our projected spread range over the next twelve months is 218bps to -112bps, well below the long-run average and at the low end of the historical distribution. We conclude from this analysis that current euro area high-yield spreads do not offer much of a spread cushion to absorb expected default losses over the next year. Thus, euro area junk bonds are expensive. Given the lack of a compelling valuation argument under all our metrics, we are leaving our recommended investment stance on euro area high-yield bonds at underweight. We continue to focus our recommended global spread product allocations on overweights in markets where there is direct and explicit support from policymaker purchase programs: US investment grade bonds with maturity of less than five years, US Ba-rated high-yield bonds, and UK investment grade corporates. This selectively overweight investment stance on global credit is warranted from a risk management perspective, as well. Our “Pro-Risk Checklist” of indicators that would lead us to recommend a more aggressive stance on risk assets in general, and spread product in particular, is still flashing a cautious message (Chart 12). The US dollar continues to strengthen (exacerbating global deflation and dollar funding pressures); the VIX index of US equity volatility has fallen below our threshold of 40, but not by much; and the number of new global (ex-China) COVID-19 cases is showing mixed results, falling in the US and Italy but increasing elsewhere. Bottom Line: Valuations for euro area junk bonds improved somewhat during the COVID-19 selloff, but spreads do not offer much protection from the coming surge in default losses. Remain underweight euro area high-yield corporates in global fixed income portfolios.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 The alternative ECB growth forecasts can be found here: https://www.ecb.europa.eu/pub/economic-bulletin/focus/2020/html/ecb.ebbox202003_01~767f86ae95.en.html 2 Please see BCA Research Global Fixed Income Strategy Weekly Report, "Buy What The Central Banks Are Buying", dated April 14, 2020, available at gfis.bcaresearch.com. 3 For real GDP growth, we use Bloomberg consensus forecasts for the next four quarters in the model. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index The ECB Will Do Whatever It Takes … Eventually The ECB Will Do Whatever It Takes … Eventually Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights The air is thick with denunciations of the Fed’s new round of aggressive interventions … : In financial circles, it’s beginning to sound like the winter of 2008-9 all over again, as respected thought leaders with enviable track records decry bailouts. … but we are firmly resolved to keep judgments about what central banks ought to do out of our analysis of the market impacts of their actions: “Dogmatic” is about the worst thing one BCA researcher can call another. The Fed’s expanded lending remit may simply be the logical evolution of the Debt Supercycle: The Debt Supercycle may have reached its natural limit, but policy makers won’t surrender such a cherished tool without a fight. Capitalism isn’t entirely dead, and the Fed isn’t the Coast Guard or the Forest Service: The new approach is meant to protect society, not individuals who get themselves into idiosyncratic trouble. Feature We will be holding a webcast next Monday, May 11th at 10:00 a.m. Eastern time in lieu of publishing a Weekly Report. Please join us with your questions to make it a fully interactive event. We will resume our regular publication schedule on the 18th. Here we go again. A potentially catastrophic recession has arrived, and the Fed has embarked on a series of unprecedented actions to try to shield the economy from it. Its goal is to stave off hysteresis, whereby a cyclical downturn, left unchecked, gives rise to a structural albatross that weighs on long-run growth. Just how much a central bank ought to interpose itself between the economy and its participants can be a matter of fierce debate, as it was in November 2010, when 23 members of the broader economic community, including three elite investors and a handful of respected economists, signed an open letter to Ben Bernanke, urging him to abandon QE2 (Box 1). Box 1 A Central Bank Can’t Win Open Letter to Ben Bernanke November 15, 2010 We believe the Federal Reserve’s large-scale asset purchase plan (so-called “quantitative easing”) should be reconsidered and discontinued. We do not believe such a plan is necessary or advisable under current circumstances. The planned asset purchases risk currency debasement and inflation, and we do not think they will achieve the Fed’s objective of promoting employment. We subscribe to your statement in the Washington Post on November 4 that “the Federal Reserve cannot solve all the economy’s problems on its own.” In this case, we think improvements in tax, spending and regulatory policies must take precedence in a national growth program, not further monetary stimulus. We disagree with the view that inflation needs to be pushed higher, and worry that another round of asset purchases, with interest rates still near zero over a year into the recovery, will distort financial markets and greatly complicate future Fed efforts to normalize monetary policy. The Fed’s purchase program has also met broad opposition from other central banks and we share their concerns that quantitative easing by the Fed is neither warranted nor helpful in addressing either US or global economic problems.1 Dire forecasts about the effects of the Fed's unconven-tional GFC interventions have not come to pass and have since been emulated by other major central banks. No one bats a thousand when predicting the future, but the authors of the letter could not have been further off the mark when they warned about currency debasement and inflation. Monetary policy has not yet been normalized in the way anyone would have defined it at the time, but other central banks have overcome their aversion to QE, pursuing it as avidly as the Fed (Chart 1). One should also note that some of the author-investors were not disinterested observers. QE signaled an extended period of easy monetary conditions that was likely to narrow distinctions among individual companies, undermining stock-picking processes that had produced outperformance against a conventional monetary policy backdrop. Chart 1What Was Once Unthinkable Has Become Routine What Was Once Unthinkable Has Become Routine What Was Once Unthinkable Has Become Routine Moral Hazard Inflation and the dollar are well down the list in the latest round of denunciations, which are principally occupied with moral hazard. In his outlook last week, Guggenheim Investments’ CIO Scott Minerd warned that the Fed’s purchases of corporate debt establish a new precedent that will have a persistent half-life, if QE is any guide. By socializing credit risk, he asserts, the purchases mark the end of US free-market capitalism as we have always known it. Two weeks before, Howard Marks argued that capitalist principles are being undermined by the Fed’s programs, if not entirely overthrown: Most of us believe in the free-market system as the best allocator of resources. Now it seems the government is happy to step in and take the place of private actors. We have a buyer and lender of last resort, cushioning pain but taking over the role of the free market. When people get the feeling that the government will protect them from unpleasant financial consequences of their actions, it’s called “moral hazard.” There’s an old saying … to the effect that “capitalism without bankruptcy is like Catholicism without hell.” It appeals to me strongly. Markets work best when participants have a healthy fear of loss. It shouldn’t be the role of the Fed or the government to eradicate it. We have never been enamored of the concept of the Fed put because we don’t think it is terribly relevant for any individual investment decision maker, and relying on it could be hazardous to one’s health. First, the Fed put is absolutely not an at-the-money put, or even a put with a strike price that is only slightly out of the money. It doesn’t do an investor much good if the Fed doesn’t ride to the rescue until his/her position is 30% underwater. Second, the Fed doesn’t care if any individual entity fails. It only acts to protect the overall financial system and the broad economy. An individual entity that gets into trouble cannot count on the Fed to throw it a lifeline. The Fed is not the Coast Guard or the Forest Service, which will go to great lengths to rescue a foolhardy or unskilled pilot or hiker who gets in over his or her head in rough weather. It cares only about the collective, and the only way an individual entity can count on receiving aid is if everyone else runs into trouble at the same time. That collective insurance policy may promote some operational risk-taking at the margin, but we wouldn’t want to rely on it. How could an overleveraged company possibly know that a critical mass of other companies will get into trouble at the same time? The Fed put doesn’t apply to the first entity to fail, or to entities in industries that are not seen as critical. It could surely encourage investors to lend to entities of dubious quality, but timing is everything there, too. The less-than-pristine borrower will have to hold on long enough to be somewhere in the middle of the pack of failing entities to qualify for a life preserver. The Trouble With The Austrians We lean to the view that moral hazard, as promoted by Fed policies, is largely in the eye of the beholder. The ability to perceive moral hazard seems to be related to one’s propensity for moral indignation. Austrian School devotees (Box 2) regularly have that propensity in spades. Box 2 An Austrian’s Lonely Lot The Austrian School of Economics most saliently parts company with neoclassical economics in its adamant opposition to government intervention and its fraught relationship with credit. Instead of intervening to counter business cycles, Austrians would prefer to let busts run their course so as to cleanse the economy of the excesses embedded in booms. They occupy the Mellonian, purge-the-rottenness-out-of-the-system end of the continuum in opposition to the Debt Supercycle’s unconditional forgiveness. Austrians regard banking and credit with some measure of suspicion, as Austrian Business Cycle Theory holds that artificially low interest rates are the raw material of destabilizing booms. Encouraged by central bankers seeking to steer an economy out of recession with a bare minimum of discomfort, borrowers take on debt to invest in projects that may not be able to pay their own way were it not for intervention. Once rates rise after policy accommodation fades, the economy slows and the extent of the malinvestment is revealed. The Debt Supercycle prescribes more of the hair of the dog to alleviate the suffering from malinvestment. The debt overhang is thereby never eliminated; it instead continues to silt up, requiring larger and larger interventions. Unchecked, the degree of intervention required to keep the plates spinning will eventually exceed capacity. Austrians despise the existence of such an arrangement, but it is so thoroughly entrenched in the reigning orthodoxy that an investor who becomes emotionally invested in opposing it is at risk of serially tilting at windmills. There is nothing wrong with the Austrian School per se. We rather like its outsider status, and actively seek heterodox inputs and perspectives so as to stay out of the ruts of the well-worn consensus path. Even its pessimistic bent has its uses; investors are surely exposed to enough cheerleading. Its prescriptions are so bracing, however, that a little goes a long way and real-world users should handle them with care. A popular pair of You Tube videos of actors portraying Keynes and Hayek dueling via raps about their respective ideologies (Keynes: I want to steer markets/Hayek: I want them set free!) provide an entertaining example of the Austrian-inspired investor’s dilemma. Keynes, drink after drink in hand, is the exuberant life of the party, while the sallow Hayek stares into the bottom of his glass, unable to capture any other partygoers’ attention. The simple conceit animating the video – Keynesianism is fun; Austrians are dour scolds – resonates deeply with elected officials, even if they never studied Economics. Voters love free drinks, but hate being told to eat their vegetables. There are no atheists in foxholes, and there are no Austrians in crises. When push comes to shove, government officials will do what they can to alleviate economic pain. The Austrian School, therefore, is a poor guide to the path that policy is likely to take. It also has the problematic effect of introducing an element of moral judgment into what should be a purely objective sphere. Investors should maintain a laser-like focus on what is most likely to happen and strive to suppress extraneous notions about what should happen. The Debt Supercycle’s Second Act Chart 3The End Of An Era? The End Of An Era? The End Of An Era? Call us jaded, but after 20-plus years in the business, the Austrians, with their fusty rectitude and gold-standard nostalgia, have come to seem like utopians. We prefer to borrow a page from public choice theory, and assume that elected and appointed officials respond to incentives just as surely as individuals outside of government. Legislators will pull fiscal levers to keep the party going and extend their own tenures, while the Fed will do its utmost to preserve its discretion to steer the economy as it sees fit. From that perspective, the Fed’s pull-out-all-the-stops approach to protecting markets and the economy simply looks like a logical evolution of the Debt Supercycle (Box 3). Now that a decade of zero and near-zero rates has failed to stimulate private sector borrowing (Chart 3), our colleague Martin Barnes has written that the Debt Supercycle is played out. Changing consumer preferences (Chart 4) and regulatory measures reining in banks’ lending capacity have impeded the credit channel, sharply degrading the Fed’s conventional policy arsenal. Central bankers want to remain in the thick of the action as much as any other bureaucrats, and it follows that the Fed has expanded its remit with unconventional measures that maintain its relevance. Chart 4Consumer Preferences Have Changed Since The GFC Consumer Preferences Have Changed Since The GFC Consumer Preferences Have Changed Since The GFC Box 3 The Debt Supercycle Longtime BCA clients are familiar with the Debt Supercycle concept, which holds that postwar Fed stimulus provoked successive waves of household and corporate borrowing to reflate the economy following recessions. Managing the economy with countercyclical fiscal and monetary policy has helped make recessions less frequent and less severe than they had been under the laissez faire prewar approach (Chart 2). Chart 2Intervention Has Helped Tame Cyclical Oscillations Intervention Has Helped Tame Cyclical Oscillations Intervention Has Helped Tame Cyclical Oscillations The only rub was that serial interventions to promote a quickening in the flow of new credit left the economy with an ever-increasing stock of debt. The prewar recessions were vicious, but bank and business failures allowed for frequent balance sheet resets that purged the economy of its boom excesses. The Debt Supercycle effectively sacrificed modest increments of structural stability for cyclical stability. Structural instability rose in step with the stock of debt, driving up the potential long-run cost of cyclical slumps, making the preservation of the Debt Supercycle increasingly imperative. Investment Implications We do not think investors should adjust to the new central banking orthodoxy by loading their portfolios with risk to embrace the Fed put. That put only applies to markets collectively, and cannot be seen as insurance for any single economic entity or asset portfolio. It would also be a mistake to renounce risk, however, by refusing to participate in a rigged game that violates Austrian principles. Investors should simply recognize that the new monetary orthodoxy calls for central banks to throw the kitchen sink at major economic threats. That suggests that shorts or underweights in risk assets based on macro vulnerabilities should be covered or closed without delay once a preset downside target has been reached. It seems that investors had 2009 in mind when they dove back into risk assets upon the Fed’s March 23rd announcement of its mix of revised and brand-new lending facilities and the March 27th passage of the CARES Act.2 No one wants to miss a big policy-induced bounce. Buy what the Fed is buying, and don't stress over it. Investors should buy what the Fed’s buying while its purchase programs and lending facilities are operating. That subset includes agency CMBS, AAA-rated CMBS, AAA-rated ABS, investment grade corporate debt and newly fallen angels in the BB-rated tier. Though they’ve already had a hearty bounce, agency mortgage REITs offer an equity vehicle for playing the Fed-purchase theme, as do the SIFI banks, which are the biggest indirect beneficiary of reduced default rates. We expect Guggenheim’s admonition that the Fed’s support of corporate borrowers will have a long half-life will prove to be accurate. As our Chief Global Fixed Income strategist put it at last week’s meeting to review long-term virus impacts, “Everyone on this call may be retired before a central banker ever utters the word ‘taper’ again.” That may not be the backdrop this free-markets devotee would choose, but it’s the backdrop all of us will have for the foreseeable future, and we’re determined to make the most of it.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1https://www.hoover.org/research/open-letter-ben-bernanke. Accessed April 28, 2020. 2 Please see the April 14, 2020 US Investment Strategy/US Bond Strategy Special Report, "Alphabet Soup: A Summary of the Fed’s Anti-Virus Measures," available at www.bcaresearch.com.

Highlights The global economy will contract at its fastest pace since the early 1930s, but will not slump into a depression. Easy monetary conditions, an extremely expansive fiscal policy, and solid bank and household balance sheets are crucial to the economic outlook. Risk assets remain attractive. The dollar and bonds will soon move from bull to bear markets. The credit market offers some attractive opportunities. Stocks are vulnerable to short-term profit-taking, but the cyclical outlook remains bright. Favor energy and consumer discretionary equities. Feature What a difference a month makes. US and global equities have rallied by 31.4% and 28.3% from their March lows, respectively. Last month we recommended investors shift the weighting of their portfolios to stocks over bonds. April’s dramatic turnaround has not altered our positive view of equities on a 12- to 24-month basis, especially relative to government bonds. However, the probability of near-term profit taking is significant. The spectacular dislocation in the oil market also has grabbed headlines. This was a capitulation event. Hence, assets linked to oil are now cyclically attractive, even if they remain volatile in the coming weeks. It is time to buy energy equities, especially firms with solid balance sheets and proven dividend records. Under the IMF’s base case, the resulting output loss will total $9 trillion. Finally, the Federal Reserve’s large liquidity injections have dulled the dollar’s strength. While the USD still has some upside risk in the near term, investors should continue to transfer capital into foreign currencies. A weaker dollar will be the catalyst to lift Treasury yields and will contribute to the outperformance of energy stocks. Dismal Growth Versus Vigorous Policy Responses Chart I-1Consumer Spending Is In Freefall Consumer Spending Is In Freefall Consumer Spending Is In Freefall The economic lockdowns and the collapse in consumer confidence continue to take their toll on the US and global economies (Chart I-1). The eventual end of the shelter-at-home orders and the progressive re-opening of the economy will halt this trend. The rapid monetary and fiscal easing worldwide will allow growth to recover smartly in the second half of the year, but only after authorities loosen extreme social distancing measures. The Economy Is In Freefall… First-quarter US growth is already as weak as it was at the depth of the recession that followed the Great Financial Crisis. The second quarter will be even more anemic. Our Live-Trackers for both the US and global economies either continue to collapse or have flat-lined at rock-bottom levels (Chart I-2). US industrial production is falling at a 21% quarterly annualized rate and the weakness in the PMI manufacturing survey warns that the worst is yet to come. In March, retail sales contracted by 8.7% compared with February, which was the poorest reading on record, and year-on-year comparisons will only deteriorate further. Annual GDP growth could fall below -11% next quarter with both the industrial and consumer sectors in shock, according to the New York Fed Weekly Economic Index (Chart I-3). Chart I-2No Hope From The Live Trackers May 2020 May 2020 Chart I-3Real GDP Growth Is Melting Real GDP Growth Is Melting Real GDP Growth Is Melting The IMF expects the recession to eclipse the post GFC-slump, in both advanced and emerging economies. Its most recent World Economic Outlook describes base-case 2020 growth of -5.9%, -7.5%, and -1.0% in the US, Eurozone and emerging markets, respectively. This compares with -2.5%, -4.5% and 2.8% each in 2009. If a second wave of infections forces renewed lockdowns in the fall, then 2020 growth could be 5.12% and 4.49% lower than baseline in developed markets and emerging markets, respectively. Under the IMF’s base case, the resulting output loss will total $9 trillion in the coming 3 years (Chart I-4). Chart I-4An Enormous Output Gap Is Forming May 2020 May 2020 Chart I-5Disinflation Build-Up Disinflation Build-Up Disinflation Build-Up An output gap of the magnitude depicted by the IMF will dampen inflation for the next 12 to 24 months. In addition to the shortfall in aggregate demand, imploding economic confidence and the lag effect of the Fed’s monetary tightening in 2018 will pull down the velocity of money even further. This combination will reduce US inflation to 1.5% or lower (Chart I-5, top panel). The Price Paid component of both the Philly Fed and Empire State Manufacturing Surveys already captures this impact. The return of producer price deflation in China guarantees that weak US import prices will add to domestic deflationary pressures (Chart I-5 third panel). The recent strength in the dollar will only amplify imported deflation (Chart I-5, bottom panel). A deflationary shock is an immediate problem for businesses and creates a huge risk for household incomes because it exacerbates the already violent contraction in aggregate demand. In the coming months, the weakest nominal GDP growth since the Great Depression will depress profits. BCA Research’s US Equity Strategy team expects S&P 500 operating earnings per share to drop from $162 in 2019 to no further than $104 in 2020.1 The profits of small businesses will suffer even more. Cash flow shortfalls will also cause corporate defaults to spike because many firms will not be able to service their debt (Chart I-6). Currently, 86% of the job losses since the onset of the COVID-19 crisis are temporary. However, if corporate bankruptcies spike too fast and too high, then these job losses will become permanent and household incomes will not recover quickly. A sharp but brief recession would turn into a long depression. Chart I-6Defaults Can Only Rise Defaults Can Only Rise Defaults Can Only Rise …But The Liquidity Crisis Will Not Morph Into A Solvency Crisis… In response to the aggregate demand shock caused by COVID-19, global central banks are supporting lending. These policies are an essential ingredient to flatten the default curve and minimize the permanent hit to employment and household income. The US Fed is acting as the central banker to the world. The US Fed is acting as the central banker to the world. Its new quantitative easing program has already added $1.36 trillion in excess reserves this quarter. Moreover, the Fed’s decision to loosen supplementary liquidity ratios and capital adequacy ratios allows the interbank and offshore markets to normalize. Meanwhile, the Fed’s swap lines with global central banks have surged by $432 billion since the crisis began. Its FIMA facility also permits central banks to pledge Treasurys as collateral to receive US dollars. These two programs let global central banks provide dollar funding to the private sector outside the US. Chart I-7Easing Liquidity Stress Easing Liquidity Stress Easing Liquidity Stress The Fed is also supporting the credit market directly. The $250 billion Secondary Market Corporate Facility, the $500 billion Primary Market Corporate Facility and the $600 billion Main Street New Loan and Expanded Loan Facilities, all mean that firms with a credit rating above Baa or a debt-to-EBITDA ratio below 4x can still get funding. Together with the $100 billion Term-Asset-backed Securities Loan Facility, these measures will prevent a liquidity crisis from morphing into a solvency crisis in which healthier borrowers cannot roll over their debt. Such a crisis would magnify the inevitable increase in defaults manyfold.  The market is already reflecting the impact of the Fed’s programs. Corporate spreads for credit tiers affected by the Fed’s support are narrowing (Chart I-7). Spreads reflective of liquidity conditions, such as the FRA-OIS gap, the Commercial paper-OIS spread and cross-currency basis-swap spreads, have also begun to normalize. The narrowing of bank CDS spreads demonstrates that unlike the GFC, the current crisis does not threaten the viability of major commercial banks (Chart I-7, bottom panel). Other central banks are doing their share. The Bank of Canada is buying provincial debt to ensure that the authorities directly tasked with managing the pandemic have the ability to do so. The European Central Bank has enacted a QE program of at least EUR1.1 trillion and enlarged the TLTRO facility while decreasing its interest rate, which cheapens the cost of financing for commercial banks. Moreover, the ECB has also eased liquidity and capital adequacy ratios for commercial banks. Last week, it announced that it would also accept junk bonds as collateral, as long as these bonds were rated as investment grade prior to April 7, 2020. …And Governments Are Pulling Levers… Chart I-8Record Fiscal Easing May 2020 May 2020 Governments, too, are ensuring that private-sector default rates do not spike uncontrollably and doom the economy to a repeat of the 1930s. Policymakers in the G-10 and China have announced larger stimulus packages than the programs implemented in the wake of the GFC (Chart I-8). The US’s programs already total $2.89 trillion or 13% of 2020 GDP. Germany is abandoning fiscal discipline and has declared stimulus measures totaling 12% of GDP. Italy’s package is more modest at 3% of GDP. Even powerhouse China is not taking chances. In addition to a larger fiscal package than in 2008, the reserve requirement ratio stands at 9.5%, the lowest level in 13 years, and the People’s Bank of China cut the rate of interest on excess reserves by 37 basis points to 0.35% (Chart I-9). The last cut to the IOER was in November 2008 and was of 27 basis points. This interest rate easing preceded a CNY4 trillion increase in the stock of credit, which played a major role in the global recovery that began in 2009. Hence, the recent IOER reduction, in light of the decline in loan prime rates and MLF rates, suggests that China is getting ready to boost its economy by as much as in 2008. Chart I-9China Is Pressing On The Gas Pedal China Is Pressing On The Gas Pedal China Is Pressing On The Gas Pedal Among the advanced economies, loan guarantees supplement growing deficits. So far, this protection totals at least $1.3 trillion. While guarantees do not directly boost the income and spending of the private sector, they address the risk of an uncontrolled spike in defaults. Therefore, they minimize the odds that rocketing temporary layoffs will morph into permanent unemployment. Section II, written by BCA’s Jonathan Laberge, addresses the question of fiscal policy and whether the packages announced so far are large enough to fill the hole created by COVID-19. While a deep recession is unavoidable, governments will provide more stimulus if activity does not soon stabilize. … While Banks And Household Balance Sheets Compare Favorably To 2008 Banks and the household sector, the largest agent in the private sector, entered 2020 on stronger footing than prior to the GFC. Otherwise, all the fiscal and monetary easing in the world would do little to support the global economy. If banks were as weak as when they entered the GFC, then monetary stimulus would have remained trapped in the banking system in the form of excess reserves. Both in the US and in the euro area, banks now possess higher capital adequacy ratios than in 2008 (Chart I-10). Moreover, as BCA Research’s US Investment Strategy service has demonstrated, the large cash holdings and low loan-to-deposit ratio of the US banking system reinforces its strength (Chart I-11).2  Thus, banks are unlikely to tighten credit standards for as long as they did after the GFC. Broad money expansion should outpace the post-GFC experience, as the surge in US M2 growth to a post-war record of 16% indicates. Chart I-10Banks Have More Capital Than In 2008… May 2020 May 2020 Chart I-11...And Have More Cash And Secure Funding ...And Have More Cash And Secure Funding ...And Have More Cash And Secure Funding     Consumers are also in better shape than in 2008. Last December, US household debt stood at 99.7% of disposable income compared with a peak of 136% in 2008. More importantly, financial obligations represented only 15.1% of disposable income, a near-record low. Limited financial obligations suggest that consumer bankruptcies should remain manageable as long as governments help households weather the current period of temporary unemployment (Chart I-12). Meanwhile, household indebtedness in Spain and Ireland has collapsed from 137% to 94% and from 183% to 85% of disposable income, respectively. Italy, despite its structural economic weakness, always sported a low private-sector debt load. A precautionary rise in the savings rate is unavoidable, but it will not match the magnitude of the increase that followed the GFC. The economy will recover quicker than it did following the GFC. The deep recession engulfing the world should not evolve into a prolonged depression because banks and household balance sheets are in a better state than in 2008. While the recovery will be chaotic, the velocity of money will not remain as depressed for as long as it stayed after 2008, which will allow nominal GDP to recover faster than after the GFC. Banks and households will be quicker to lend and borrow from each other than they were after the GFC. Consequently, the collapse in the consumption of durable goods (e.g. cars) has created pent-up demand, but not a permanent downshift in the demand curve (Chart I-13). Chart I-12Robust Household Finances Robust Household Finances Robust Household Finances Chart I-13Households' Pent-Up Demand Households' Pent-Up Demand Households' Pent-Up Demand   Bottom Line: The global economy is on track to suffer its worst contraction since the 1930s. However, the combination of aggressive monetary and fiscal stimulus will prevent a rising wave of defaults from swelling to a crippling tsunami that permanently curtails household income. Given that banks and households have stronger balance sheets than in 2008, when governments ease lockdowns, the economy will recover quicker than it did following the GFC. The evolution of any second wave of infection is the crucial risk to this view. The IMF’s forecast indicates that growth will suffer substantial downside relative to its baseline scenario if the second wave is strong and forces renewed lockdowns. In this scenario, the current package of stimulus must be augmented to avoid a depression-like outcome. A big problem for forecasters, is that we do not have a good sense of how the second wave of infections will evolve. Moreover, the ability to test the population and engage in contact tracing will determine how aggressive lockdowns will be. Therefore, we currently have very little visibility to handicap the odds of each path. Investment Implications Low inflation for the next 18 months will allow monetary conditions to stay extremely accommodative. Growth will recover in the second half of 2020, so the window to own risk assets remains fully open as long as we can avoid a second wave of complete lockdowns. The Dollar’s Last Hurrah The US dollar has become dangerously expensive. According to a simple model, the dollar trades at a premium to its purchasing-parity equilibrium against major currencies, which is comparable to 1985 or 2002 when it attained its most recent cyclical tops (Chart I-14). The dollar may not trade as richly against our Behavioral Effective Exchange Rate model, but this fair value estimate has rolled over (Chart I-14, bottom panel). A peak in global policy uncertainty may be the key to timing the start of the dollar’s decline. Policy will prompt downside risk created by the dollar’s overvaluation. The US twin deficit, which is the sum of the fiscal and current account deficits, is set to explode because Washington will expand the fiscal gap by 15~20% of GDP while the private sector will not increase its savings rate at the same pace. If US real interest rates are high and rising, then foreign investors will snap up US liabilities and finance the twin deficit. If real rates are low and falling, then foreigners will demand a much cheapened dollar (which would embed higher long-term expected returns) to buy US liabilities (Chart I-15). Chart I-14The Dollar Is Pricey The Dollar Is Pricey The Dollar Is Pricey Chart I-15Bulging Twin Deficits Are A Worry Bulging Twin Deficits Are A Worry Bulging Twin Deficits Are A Worry   Real interest rates probably will not climb, hence the twin deficit will become an insurmountable burden for the dollar. The Fed has not hit its symmetric 2% inflation target since the GFC and will not do so in the next one to two years. As a result, the Fed will not lift nominal interest rates until inflation expectations, currently at 1.14%, return to the 2.3% to 2.5% zone consistent with investors believing that the Fed is achieving its mandate. Thus, real interest rates will decline, which will drag down the USD. Relative money supply trends also point to a weaker dollar in the coming 12 months (Chart I-16). The Fed is easing policy more aggressively than other central banks and US banks are better capitalized than European or Japanese ones. Therefore, US money supply growth should continue to outpace foreign money supply. The inevitable slippage of dollars out of the US economy, especially if the current account deficit widens, will boost the supply of dollars globally relative to other currencies. Without any real interest rate advantage, the USD will lose value against other currencies. China’s policy easing is also negative for the dollar. China’s large-scale stimulus will allow the global industrial cycle to recover smartly in the second half of 2020, especially if the increase in pent-up demand fuels realized demand in the fall. The US economy’s closed nature and low exposure to both trade and manufacturing will weigh on US internal rates of return relative to the rest of the world, and invite outflows (Chart I-17). This selling will accentuate downward pressure created by the aforementioned balance of payments and policy dynamics.  Chart I-16Money Supply Trends Will Hurt The Dollar Money Supply Trends Will Hurt The Dollar Money Supply Trends Will Hurt The Dollar Chart I-17The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency   The dollar is also vulnerable from a technical perspective. A record share of currencies is more than one-standard deviation oversold against the USD (Chart I-18). According to the Institute of International Finance (IIF), outflows from EM economies have already eclipsed their 2008 records, and the underperformance of DM assets suggests that portfolio managers have aggressively abandoned non-USD assets. These developments imply that investors who wanted to move money back into the US have already done so. Chart I-18The Dollar Is Becoming Overbought The Dollar Is Becoming Overbought The Dollar Is Becoming Overbought Chart I-19The Dollar Is A Momentum Currency May 2020 May 2020 Investors should move funds out of the dollar, but not aggressively. The outlook for the dollar in the next year or two is poor, but the USD’s most important tailwind is intact: the global economy will recover, but for the time being, it remains in freefall. Moreover, among the G-10 currencies, the dollar responds most positively to the momentum factor (Chart I-19), which remains another tailwind. The greenback will remain volatile in the coming weeks. EM currencies offer a particularly tricky dilemma. They have cheapened to levels where historically they offer very compelling long-term returns (Chart I-20). However, EM firms have large amounts of dollar-denominated debt. The fall in EM FX and collapse in domestic cash flows will likely cause some large-scale bankruptcies. If a large, famous EM company defaults, then the headline risk would probably trigger a broad-based selling of EM currencies. For now, our Emerging Market Strategy service recommends that, within the EM FX space, investors favor the currencies with the lowest funding needs, such as the RUB, KRW and THB.3 Chart I-20EM FX Is Decisively Cheap EM FX Is Decisively Cheap EM FX Is Decisively Cheap For tactical investors, a peak in global policy uncertainty may be the key to timing the start of the dollar’s decline (Chart I-21). This implies that if a second wave of infections force severe lockdowns, the dollar rally may not be done. Chart I-21Uncertainty Must Recede For The Dollar To Weaken Uncertainty Must Recede For The Dollar To Weaken Uncertainty Must Recede For The Dollar To Weaken Fixed Income Government bonds have not yet depreciated and the exact timing of a price decline remains uncertain. However, Treasurys and Bunds offer an increasingly poor cyclical risk-reward ratio. Bond valuations continue to deteriorate. Our time-tested BCA Bond Valuation model shows that G-10 bonds, in general, and US Treasurys, in particular, are at their most expensive levels since December 2008 and March 1985, two periods that preceded major increases in yields (Chart I-22). Buy inflation-protected securities at the expense of nominal bonds. Liquidity conditions also represent a threat for safe-haven bonds. The wave of liquidity unleashed by global central banks is meeting record fiscal thrust. Thus, not only is the supply of government bonds increasing, but a larger proportion of the money injected by central banks will actually make its way into the real economy than after 2008. Record-low yields are vulnerable because the increase in the global money supply should prevent nominal GDP growth from slumping permanently as in the 1930s and after the GFC. Additionally, the sharp escalation in liquid assets on the balance sheets of commercial banks also creates an additional risk for bond prices (Chart I-23). Chart I-22Bonds Are Furiously Expensive Bonds Are Furiously Expensive Bonds Are Furiously Expensive Chart I-23Liquidity Injections Point To Higher Yields Liquidity Injections Point To Higher Yields Liquidity Injections Point To Higher Yields   QE also threatens government fixed income. After the GFC, real interest rates fell because investors understood that US short rates would remain at zero for a long time. Yet, 10-year Treasury yields rose sharply in 2009 as inflation breakevens increased more than the decline in TIPS yields. This pattern repeated itself following each QE wave (Chart I-24). In essence, if the Fed provides enough liquidity to allow markets to function well, then the chance of cyclical deflation decreases, which warrants higher inflation expectations. A lower dollar will be fundamental to the rise in inflation breakeven and yields. A soft dollar will confirm that the Fed is providing enough liquidity to satiate dollar demand and it will favor risk-taking around the world. Moreover, it will boost commodity prices and help realize inflation increases down the line. Chart I-24QE Lifts Breakevens And Yields QE Lifts Breakevens And Yields QE Lifts Breakevens And Yields Technical considerations also point to the end of the bond bull market, at least for the next 12 to 18 months. Investors remain bullish toward bonds, which is a contrarian signal. Our Composite Momentum Indicator has reached levels last achieved at the end of 2008, which suggested at that time that bond-buying was long in the tooth. Chart I-25Inflation Will Drive US/German Spreads Inflation Will Drive US/German Spreads Inflation Will Drive US/German Spreads In this context, investors with a cyclical investment horizon should consider bringing duration below benchmark. In the short term, this position still carries significant risks because the outlook for yields depends on the dollar. Another dollar spike caused by renewed lockdowns would also pin yields near current levels for longer. A lower-risk version of this bet would be to buy inflation-protected securities at the expense of nominal bonds, a position recommended by our US Bond Strategy service.4  Investors should be careful when betting that US yields will further converge toward German ones. The 10-year yield spread between US Treasurys and German Bunds has quickly narrowed, falling by 170 basis points from a high of 279 basis points in November 2018. Despite this sharp contraction, the spread remains elevated by historical standards. So far, the declining yield gap reflects the fall in policy rates in the US relative to Europe. Given that both the Fed and the ECB are at the lower bounds of their policy rates, short-rate differentials are unlikely to compress further. Instead, inflation differentials between the US and Europe must decline (Chart I-25). The inflation gap between the US and Europe probably will not narrow significantly this year. The IMF forecasts that Europe’s economy will underperform the US. Therefore, slack in Europe will expand faster than in the US. Moreover, monetary and fiscal support in the US is more aggressive than in Europe. Consequently, a weaker dollar, which will increase US inflation expectations relative to Europe, will put upward pressure on the US/German 10-year spread. However, if the European fiscal policy response starts to match the size of the US stimulus, then the spread between the US and Germany would narrow further. Ample liquidity also continues to underpin equity prices. Finally, for credit investors, our US Bond Strategy service recommends buying securities with abnormally large spreads and which the various Fed programs target. These include agency CMBS, consumer ABS, municipal bonds, and corporates rated Ba and above.5 Equities Chart I-26Investors Are Not Exuberant About Stocks Investors Are Not Exuberant About Stocks Investors Are Not Exuberant About Stocks Despite some short-term risks, we continue to favor equities on a 12- to 18-month investment horizon in an environment where a second wave of lockdowns can be avoided. Stock valuations have deteriorated, but they remain broadly attractive (see page 2 of Section III). While multiples are not particularly cheap, the equity risk premium remains very high. Alternatively, the expected growth rate of long-term earnings embedded in stock prices continues to hover at the bottom of its post-war distribution (Chart I-26). In other words, stocks are attractive because bond yields are low. Ample liquidity also continues to underpin equity prices. Our US Financial Liquidity Index points to rising S&P 500 returns in the coming months (Chart I-27). The Fed’s surging liquidity injections, which foreign central banks are mimicking, will only accentuate this backdrop. Moreover, in times of crisis, inflation expectations correlate positively with stock prices because “bad deflation” represents an existential threat to profitability.6 QE lifts inflation expectations, therefore, its bearish impact on bond prices should not translate into a fall in stock prices. Chart I-27Ample Liquidity For The S&P 500 Ample Liquidity For The S&P 500 Ample Liquidity For The S&P 500 Chart I-28Valuation And Monetary Condition Offset COVID-19 Valuation And Monetary Condition Offset COVID-19 Valuation And Monetary Condition Offset COVID-19 The combined valuation and liquidity backdrop are accommodative enough for stocks to persevere higher, despite the immense economic shock generated by COVID-19. The readings of our BCA Valuation and Monetary Indicator are even more accommodative for stocks than they were in Q1 2009, which marked the beginning of a 340% bull market (Chart I-28). Moreover, trend growth may have been less negatively affected by COVID-19 than it was by the GFC. Consequently, our US Equity Strategy service uses the historical pattern of profit rebounds subsequent to recessions to anticipate 2021 S&P 500 earnings per share of $162.1 Technicals remain supportive for stocks on a cyclical basis. Sentiment and momentum continue to be depressed, which could explain the resilience of stocks. Indeed, our Composite Momentum Indicator based on both the 13-week rate of change of the S&P 500 and traders’ sentiment lingers at the bottom of its historical distribution (Chart I-29). Moreover, the percentage of stocks above their 30-week moving average or at 52-week highs suggests that the average stock is still oversold (Chart I-30). Chart I-29Cyclical Momentum Is Not A Risk Yet Cyclical Momentum Is Not A Risk Yet Cyclical Momentum Is Not A Risk Yet Chart I-30The Median Stock Remains Oversold The Median Stock Remains Oversold The Median Stock Remains Oversold The problem for equity indices is that some sectors, such as tech, are very overbought on a near-term basis, which could invite profit-taking among the names that account for a disproportionate share of the index. If these sectors correct meaningfully, then the whole index would fall even if the median stocks barely vacillate. Nonetheless, all the forces listed in Section I suggest that the correction will not develop into a new down leg for the market. Energy stocks offer an attractive opportunity for investors, a view shared by our US Equity Strategy colleagues.1 The energy sector trades at its largest discount to the broad market on record and a weaker dollar normally lifts its relative performance (Chart I-31). Moreover, energy stocks have modestly outperformed the market since its March 23 bottom, despite the abyss into which oil prices tumbled. A pair trade is also available to investors. Healthcare and tech stocks have rallied in parabolic fashion relative to energy stocks. Oil may have capitulated on April 20 when the WTI May contract hit $-40/bbl. Storage capacity is essentially maxed out, but the Kingdom of Saudi Arabia is set to restrict production from 12.3 million b/d to 8.5 million b/d, which will contribute generously to the 10 million bpd cut agreed by OPEC+. Countries such as Canada are also curtailing output, a move repeated among many oil producers. US shale firms, which have become marginal producers of oil, are also paring down their production. Shale producers are not done cutting, judging by both the decline in horizontal rig counts and WTI trading below most marginal costs (Chart I-32). The oil market will move away from its surplus position when the global economy restarts. Chart I-31An Opportunity In Energy An Opportunity In Energy An Opportunity In Energy Chart I-32Shale Production Will Fall Much Further Shale Production Will Fall Much Further Shale Production Will Fall Much Further   The slope of the oil curve confirms that the outlook for energy stocks is improving. On April 20, Brent and WTI hit their deepest contango on record, a development accentuated by the reflexive relationship between major oil ETFs and the price of the commodity itself. The structure of those ETFs was amended on April 21st, allowing a break in this reflexive relationship. The oil curve is again steepening, which after such a large contango often results in higher crude prices (Chart I-33). Meanwhile, net earnings revisions for the energy sector have become very depressed. Relative to the broad market, revisions are also weak but turning up. In this context, rising oil prices can easily lift energy stocks relative to the broad market. Chart I-33A Decreasing Contango Would Boost Oil Stocks A Decreasing Contango Would Boost Oil Stocks A Decreasing Contango Would Boost Oil Stocks Chart I-34Parabolic Moves Are Rarely Durable Parabolic Moves Are Rarely Durable Parabolic Moves Are Rarely Durable   A pair trade is also available to investors. Healthcare and tech stocks have rallied in parabolic fashion relative to energy stocks (Chart I-34). We constructed a global sector ranking based on the bottom-up valuation scores from BCA Research’s Equity Trading Strategy service. Based on this metric, energy stocks are attractively valued, while tech and healthcare are not (Chart I-35). A rebound in oil prices should prompt some portfolio rebalancing in favor of the energy sector.   Chart I-35A Bottom-Up Ranking For Sectors Valuations May 2020 May 2020 Finally, our US Equity Sector Strategy service also recommends investors overweight consumer discretionary stocks. This sector will benefit because robust household balance sheets will allow consumers to take advantage of low interest rates when the global economy recovers.7 Mathieu Savary Vice President The Bank Credit Analyst April 30, 2020 Next Report: May 28, 2020   II. The Global COVID-19 Fiscal Response: Is It Enough? In this Special Report we explore in detail the fiscal response amongst advanced economies, with the goal of judging whether the response is large enough to prevent an “L-shaped” recession. The crisis remains in its early days and new information about the size and character of the response, as well as the magnitude of the economic shock, continues to emerge on a near-daily basis. As such, our conclusions may change over the coming weeks in line with incoming data. Even when narrowly-defined, the announced (or likely) fiscal response of the US, China, and Germany is quite large and appears to be adequate to prevent the direct and indirect effects of the lockdowns from causing an “L-shaped” event. This is not the case, however, in other euro area economies (France, Italy, and Spain), or in emerging markets. Our analysis also suggests that the global fiscal response will need to increase if the global economy faces a W-shaped shock caused by another round of aggressive containment measures later this year. This underscores the importance of ensuring that the “Great Lockdown” succeeds at reducing the spread of the disease to a point that does not necessitate widespread renewed restrictions on economic activity. The global economic expansion that began in 2009 has come to an abrupt end due to the COVID-19 pandemic. Aggressive containment measures necessary to control the spread of the disease and prevent the collapse in health care systems around the world have caused a large and sudden stop in global economic activity, which has prompted unprecedented responses from governments around the world. In this Special Report we explore in detail the fiscal response amongst advanced economies, with the goal of judging whether the response is large enough to prevent an “L-shaped” recession (characterized by a very prolonged return to trend growth). The crisis remains in its early days and new information about the size and character of the response, as well as the magnitude of the economic shock, continues to emerge on a near-daily basis. As such, our conclusions may change over the coming weeks in line with incoming data. But for now, we (tentatively) conclude that the fiscal response appears to be adequate to prevent the direct and indirect effects of the lockdowns from causing an “L-shaped” event. However, there are two important caveats. First, while Germany has provided among the strongest fiscal responses globally, measures in France, Italy, and Spain are still lacking and must be stepped up. Second, the announced fiscal measures will not be sufficient if the global economy faces a W-shaped shock caused by another round of aggressive containment measures later this year – more will have to be done. For policymakers, this underscores the importance of ensuring that the “Great Lockdown” succeeds at reducing the spread of the disease to a point that does not necessitate widespread renewed restrictions on economic activity. In this regard, the gradual re-opening of several US states by early-May, while positive for economic activity in the short-run, is a non-trivial risk to the US and global economic outlooks over the coming 6-12 months. This risk must be closely watched by investors. The Global Fiscal Response: Comparing Across Countries And Across Measures The flurry of policy announcements from national governments over the past six weeks has led to a great degree of confusion about the size and disposition of the global COVID-19 fiscal response. Our analysis is based heavily on the IMF’s tracking of these measures, albeit with a few adjustments. We also rely on analysis from Bruegel, a prominent European macroeconomic think-tank, as well as our own Geopolitical Strategy team and a variety of news reports. Chart II-1 presents the IMF’s estimate of the total fiscal response to the crisis across major countries, as of April 23rd, broken down into “above-the-line” and “below-the-line” measures. Above-the-line measures are those that directly impact government budget balances (direct fiscal spending and revenue measures, usually tax deferrals), whereas below-the-line measures typically involve balance sheet measures to backstop businesses through capital injections and loan guarantees. Chart II-1The Global Fiscal Response Is Huge When Including All Measures May 2020 May 2020 Chart II-1 makes it clear that the fiscal response of advanced economies is enormous when including both above- and below-the-line measures. By this metric, the response of most developed economies is on the order of 10% of GDP, and well above 30% in the case of Italy and Germany. However, using the sum of above- and below-the-line measures to gauge the fiscal response of any country may not be the ideal approach, given that below-the-line measures are contingent either on the triggering of certain conditions or on the provision of credit to households and firms from the financial system. Below-the-line measures also likely increase the liability position of the private sector, thus raising the odds of negative second-round effects. Instead, Chart II-2 compares the countries shown in Chart 1 based only on the IMF’s estimate of above-the-line measures, and with a 4% downward adjustment to Japan’s reported spending to account for previously announced measures.8 The chart shows that countries fall into roughly three categories in terms of the magnitude of their above-the-line response: in excess of 4% of GDP (Australia, the US, Japan, Canada, and Germany), 2-3% (the UK, Brazil, and China), and sub-2% (all other countries shown in the chart, including Spain, Italy, and France). Chart II-2The Picture Changes When Excluding Below-The-Line Measures May 2020 May 2020 Analysis by Bruegel provides somewhat different estimates of the global COVID-19 fiscal response for select European countries as well as the US (Table II-1). Bruegel breaks down discretionary fiscal measures that have been announced into three categories: those involving an immediate fiscal impulse (new spending and foregone revenues), those related to deferred payments, and other liquidity provisions and guarantees. Bruegel distinguishes between the first and second categories because of their differing impact on government budget balances. Deferrals improve the liquidity positions of individuals and companies but do not cancel their obligations, meaning that they result only in a temporary deterioration in budget balances. Table II-1The Type Of Fiscal Response Varies Significantly Across Countries May 2020 May 2020 Table II-1 highlights that Bruegel’s estimates of the sum of above- and below-the-line measures are similar to the IMF’s estimates for the US, the UK, and Spain, but are smaller for Italy and larger for France and Germany (particularly the latter). These differences underscore the extreme uncertainty facing investors, who have to contend not only with varying estimates of the magnitude of government policies but also a torrent of news concerning the evolution of the pandemic itself. Chart II-3 presents our best current estimate of the above-the-line fiscal response of several countries (the measure we deem to be most likely to result in an immediate fiscal impulse), by excluding loans, guarantees, and non-specified revenue deferrals to the best of our ability.9 Chart II-3 is based on a combination of data from the IMF, Bruegel analysis, and BCA estimates and news analysis. Chart II-3When Narrowly Defined, Several Countries Are Responding Forcefully, But Many Countries Are Not May 2020 May 2020 Overall, investors can draw the following conclusions from Charts II-1 – II-3 and Table II-1: When measured as the total of above- and below-the-line measures, nearly all large developed market countries have responded with sizeable measures. Emerging market economies are the clear laggards. Excluding below-the-line measures and using our approach, Australia, the US, China, Germany, Japan, and Canada appear to be spending the most relative to the size of their economies. While Japan’s “headline” fiscal number was inflated by including previously-announced spending, it is still decently-sized after adjustment. Outside of Germany, the rest of Europe appears to be providing a middling or poor above-the-line fiscal response. The UK appears to be providing between 4-5% of GDP as a fiscal impulse, whereas the fiscal response in Italy, Spain, and France looks more like that of emerging markets than of advanced economies. Measuring The Stimulus Against The Shock Despite the substantial amount of new information over the past six weeks concerning the evolution of the pandemic and the attendant policy response, it remains extremely difficult to judge what the balance between shock and stimulus will be and what that means for the profile of growth. Nonetheless, below we present a framework that investors can use to approach the question, and that can be updated as new information emerges concerning the impact of the shutdowns and the extent of the response. Our approach involves analyzing four specific questions: What is the size of the initial shock? What are the likely second-round effects on growth? What is the likely multiplier on fiscal spending? Will the composition of fiscal spending alter its effectiveness? The Size Of The Initial Shock Chart II-4 presents the OECD’s estimates of the initial impact of partial or complete shutdowns on economic activity in several countries. The OECD first used a sectoral approach to estimating the impact on activity while lockdowns are in effect, assuming a 100% shutdown for manufacturing of transportation equipment and other personal services, a 50% decline in activity for construction and professional services, and a 75% decline for retail trade, wholesale trade, hotels, restaurants, and air travel. Chart II-4 illustrates the total impact of this approach for key developed and emerging economies. Chart II-4Annual GDP Will Be 1.5%-2.5% Lower For Each Month Lockdowns Are In Effect May 2020 May 2020 The OECD’s approach provides a credible estimate of the impact of aggressive containment policies, and implies that annual real GDP is likely to be 1.5-2.5% lower for major countries for each month that lockdown policies are in effect. This implies that output in major economies is likely to fall 3.5% - 6% for the year from the initial shock alone, assuming an aggressive 10-week lockdown followed by a complete return to normal. Estimating Potential Second Round Effects Chart II-5 presents projections from the Bank for International Settlements on the spillover and spillback potential of a 5% initial shock to the level of global GDP from the COVID-19 pandemic (equivalent to a 20% impact on an annualized basis). Chart II-5Additional Lockdown Events Are A Greater Risk Than First Wave After-Effects May 2020 May 2020 The chart shows that the cumulative impact of the initial shock rises to 7-8% by the end of this year for the US, euro area, and emerging markets, and 6% for other advanced economies. These estimates account for both domestic second round effects of the initial shock, as well as the reverberating impact of the shock on global trade. Chart II-5 also shows the devastating effect that a second wave of COVID-19 emerging in the second half of the year would have after including spillover and spillback effects, assuming that only partial lockdowns would be required. In this scenario, the level of GDP would be 10-12% lower at the end of the year depending on the region, suggesting that investors should be more concerned about the possibility of additional lockdown events than they should be about the after-effects of the first wave of infections (more on this below). Will Fiscal Multipliers Be High Or Low? When examining the academic literature on fiscal multipliers, the first impression is that multipliers are likely to be extremely large in the current environment. Tables II-2 and II-3 present a range of academic multiplier estimates aggregated by the IMF, categorized by the stage of the business cycle and whether the zero lower bound is in effect. Table II-2Fiscal Multipliers Are Much Larger During Recessions Than Expansions May 2020 May 2020 Table II-3Models Suggest The Multiplier Is Quite High At The Zero Lower Bound May 2020 May 2020 The tables tell a clear story: multipliers are typically meaningfully larger during recessions than during expansions, and extremely large when the zero lower bound (ZLB) is in effect. However, there are at least two reasons to expect that the fiscal multiplier during this crisis will not be as large as Tables II-2 and II-3 suggest. First, it is obviously the case that the multiplier will be low while full or even partial lockdowns are in effect, as consumers will not have the ability to fully act in response to stimulative measures. This will be partially offset by a burst of spending once lockdowns are removed, but the empirical multiplier estimates during recessions shown in Table II-2 have not been measured during a period when constraints to spending have been in effect, and we suspect that this will have at least somewhat of a dampening effect on the efficacy of fiscal spending relative to previous recessions (even once regulations concerning store closures are removed). Second, Table II-3 likely overestimates the multiplier at the ZLB. These estimates have been based on models rather than empirical analysis, and appear to be in reference to the prevention of large subsequent declines in output following an initial shock. The modeled finding of a large multiplier at the ZLB occurs because increased deficit spending will not lead to higher policy rates in a scenario where the neutral rate has fallen below zero. But it seems difficult to believe that the fiscal multiplier during ZLB episodes, defined as the impact of fiscal spending on the path of output relative to the initial shock (not relative to a counterfactual additional shock), is larger than the highest empirical estimates of the multiplier during recessions. The only circumstance in which we can envision this being the case is an environment where long-term bond yields are capped and remain at zero, alongside short-term interest rates, as the economy improves. The IMF has provided a simple rule of thumb approach to estimating the fiscal multiplier for a given country. The IMF’s approach involves first estimating the multiplier under normal circumstances based on a series of key structural characteristics that have been shown to influence the economy’s response to fiscal shocks. Then, the “normal” multiplier is adjusted higher or lower depending on the stage of the business cycle, and whether monetary policy is constrained by the ZLB. For the US, the IMF’s approach suggests that a multiplier range of 1.1 – 1.6 is reasonable, assuming the highest cyclical adjustment but no ZLB adjustment (see Box II-1 for a description of the calculation). Given the unprecedented nature of this crisis, we are inclined to use the low end of this range (1.1) as a conservative assumption when judging whether fiscal responses to the crisis are sufficient. For investors, this means that governments should be aiming, at a minimum, for fiscal packages that are roughly 90% of the size of the expected shock of their economies, using our US fiscal multiplier assumption as a guide. Box II-1 The “Bucket” Approach To Estimating Fiscal Multipliers The IMF “bucket” approach to estimating fiscal multiplier involves determining the multiplier that is likely to apply to a given country during “normal” circumstances, based on a set of structural characteristics associated with larger multipliers. This “normal” multiplier is then adjusted based on the following formula: M = MNT * (1+Cycle) * (1+Mon) Where M is the final multiplier estimate, MNT is the “normal times” multiplier derived from structural characteristics, Cycle is the cyclical factor ranging from −0.4 to +0.6, and Mon is the monetary policy stance factor ranging from 0 to 0.3. The Cycle factor is higher the more a country’s output gap is negative, and the Mon factor is higher the closer the economy is to the zero lower bound. Table II-B1 applies the IMF’s approach to the US, using the same structural score as the IMF presented in the note that described the approach. The table highlights that the approach suggests a US fiscal multiplier range of 1.1 – 1.6 given the maximum cycle adjustment proscribed by the rule, which we feel is reasonable given the unprecedented rise in US unemployment. We make no adjustment to the range for the zero lower bound. Table II-B1A Multiplier Estimate Of 1.1 – 1.6 Seems Reasonable For The US May 2020 May 2020 The Composition Of The Response: Helping Or Hurting? The last of our four questions deals with the issue of composition and whether the form of a country’s fiscal response is likely to alter its effectiveness. We implicitly addressed the first element of composition, whether measures are above-the-line or below-the-line, by comparing Charts II-1 - II-3 on pages 28-31. Our view is that above-the-line measures are far more important than below-the-line measures, as the former provides direct income and liquidity support. Below-the-line measures are also important, as they are likely to help reduce business failure and household bankruptcies. The fiscal multiplier on these measures has to be above zero, but it is likely to be much lower than that of an above-the-line response. The second element of composition concerns the appropriate distribution of aid among households, businesses, and local governments. On this particular question, it remains extremely challenging to analyze the issue on a global basis, owing to a frequent lack of an explicit breakdown of fiscal measures by recipient. Chart II-6Much Of The US Fiscal Response Is Going To Households And Small Businesses May 2020 May 2020 For now, we limit our distributional analysis to the US, and hope to expand our approach to other countries in future research. Chart II-6 presents a breakdown of the US fiscal response by recipient, which informs the following observations. Households: Chart II-6 highlights that US households will receive approximately $600 billion as part of the CARES Act, roughly half of which will occur through direct payments (i.e. “stimulus checks”) and another 40% from expanded unemployment benefits. In cases where the federal household response has been criticized by members of the public as inadequate, it has often been compared to income support programs of other countries. The Canada Emergency Response Benefit (“CERB”) is a good example of a program that seems, at first blush, to be superior: it provides $2,000 CAD in direct payments to individuals for a 4 week period, for up to 16 weeks (i.e. a maximum of $8,000 CAD), which seems better than a $1,200 USD stimulus check. However, Table II-4 highlights that this comparison is mostly spurious. First, the CERB is not universal, in that it is only available to those who have stopped or will stop working due to COVID-19. At a projected cost of $35 billion CAD, the CERB program represents 1.5% of Canadian GDP. By comparison, $600 billion USD in overall household support represents 2.75% of US GDP; this number drops to 1.75% when only considering support to those who have lost their jobs, but this is still higher as a share of the economy than in Canada. Moreover, there is little question that Congress is prepared to pass more stimulus for additional weeks of required assistance. The discrepancy between the perception and reality of US household sector support appears to be rooted in the speed of payments. Speed is the one area where Canada’s household sector response appears to have legitimately outperformed the US; CERB payments are received by applicants within three business days for those registered for electronic payment, and in some cases they are received the following day. By contrast, it has taken some time for US States to start paying out the additional $600 USD per week in expanded unemployment benefits, but as of the middle of last week nearly all states had started making these payments. Table II-4US Household Relief Is Just As Generous As Seemingly Better Programs May 2020 May 2020 Firms: On April 16th the Small Business Administration announced that the Paycheck Protection Program (“PPP”) had expended its initial budget of $350 billion. While additional funds of $320 billion have subsequently been approved (plus $60 billion in small business emergency loans and grants), the run on PPP funds was, to some investors, an implicit sign that the CARES Act was inadequately structured. However, the fact that the initial funds ran out in mid-April simply reflects the reality that social distancing measures had been in place for 3-4 weeks by the time that the program began taking applications. Table II-5 highlights that $350 billion was large enough to replace nearly 90% of lost small business income for one month, assuming that overall small business revenue has fallen by 50% and that small businesses account for 44% of total GDP. The Table also shows that a combined total of $730 billion is enough to replace almost 80% of lost small business income for 10 weeks, given these assumptions. With loan forgiveness at least partially tied to small businesses retaining employees on payroll for an 8-week period, the PPP is also essentially an indirect form of household income support. Table II-5Help For Small Businesses Will Replace A Significant Amount Of Lost Income May 2020 May 2020 Chart II-7Persistent State & Local Austerity Must Be Avoided This Time Persistent State & Local Austerity Must Be Avoided This Time Persistent State & Local Austerity Must Be Avoided This Time State & Local Governments: The magnitude of support for state & local (S&L) governments appears to be the least-well designed element of the US fiscal response. The CARES Act provides for $170 billion in support to S&L, which at first blush seems large as it is approximately 25% of S&L current receipts in Q4 2019 (i.e. it stands to cover a 25% loss in revenue for one quarter). However, this does not account for the significant reported increase in S&L costs to combat the pandemic, nor does it provide S&L governments with any revenue certainty beyond June 30th when most of the assistance from CARES must be spent. Unlike households or firms, who also face significant uncertainty, nearly all US states are subject to balanced budget requirements, which prevent them from spending more than they collect in revenue. When faced even with projected revenue losses in the second half of this year and into 2021, states are likely to aggressively and immediately cut costs in order to avoid budgetary shortfalls. Chart II-7 highlights that S&L austerity was a significant element of the persistent drag on real GDP growth from overall government expenditure and investment in the first 3-4 years of the post-GFC economic expansion. A repeat of this episode would significantly raise the odds of an “L-type” recession (and thus should certainly be avoided). This is why Congress is moving to pass larger state and local aid. Our Geopolitical Strategy team argues that neither President Trump nor Senate Majority Leader Mitch McConnell will prevent the additional financial assistance that US states will require, despite their rhetoric about states going bankrupt.10 A near-term, temporary standoff may occur, but Washington will almost certainly act to provide at least additional short-term funding if state employment starts to fall due to budget pressure. So while we recognize that the state & local component of the US fiscal response is currently lacking, it does not seem likely to represent a serious threat to an eventual economic recovery in the US. Putting It All Together: Will It Be Enough? Chart II-8 reproduces Chart II-3 with an assumed fiscal multiplier of 1.1, and with shaded regions denoting the likely initial and total impact on GDP from aggressive containment measures (based on the OECD and BIS’ estimates). Based on our analysis of the US fiscal response, we make no adjustments for the composition of the measures beyond defining the fiscal response on a narrow basis (i.e. excluding loans, guarantees, and non-specified revenue deferrals). The chart highlights that the narrowly-defined fiscal response of three key economies driving global demand, the US, China, and Germany, is either at the upper end or above the total impact range. Thus, for now, we tentatively conclude that the fiscal response that has or will happen appears to be adequate to prevent the direct and indirect effects of the lockdowns from causing an “L-shaped” event, especially since Chart II-8 explicitly excludes below-the-line measures. However, there are two important caveats to this conclusion. First, Chart II-8 makes it clear that measures in France, Italy, and Spain are still lacking and must be stepped up. Italy and France have provided a substantial below-the-line response, but it is far from clear that a debt-based response or one that only temporarily improves access to cash for households and businesses will be enough to prevent a prolonged fallout from the sudden stop in economic activity and income. Chart II-8Several Important Countries Seem To Be Doing Enough, But More Is Needed In Europe Ex-Germany May 2020 May 2020 Second, our analysis suggests that the announced fiscal measures will not be sufficient if the global economy faces a W-shaped shock caused by another round of aggressive containment measures later this year or if these measures remain in place at half-strength for many months. This underscores how sensitive the adequacy of announced fiscal measures are to the amount of time economies remain under full or partial lockdown. As such, it is crucial for investors to have some sense of when advanced economies may be able to sustainably end aggressive containment measures. When Can The Lockdowns Sustainably End? Several countries and US states have already announced some reductions in their restrictions, but the question of how comprehensive these measures can be without risking a second period of prolonged stay-at-home orders looms large. Table II-6 presents two different methods of estimating sustainable lockdown end dates for several advanced economies. First, we use the “70-day rule” that appears to have succeeded in ending the outbreak in Wuhan, calculated from the first day that either school or work closures took effect in each country.11 Second, using a linear trend from the peak 5-day moving average of confirmed cases and fatalities, we calculate when confirmed cases and fatalities may reach zero. Table II-6By Re-Opening Soon, The US May Be Risking A Damaging Second Wave May 2020 May 2020 The table highlights that these methods generally prescribe a reopening date of May 31st or earlier, with a few exceptions. The UK’s confirmed case count and fatality trends are still too shallow to suggest an end of May re-opening, as is the case in Canada. In the case of Sweden, no projections can truly be made based on the 70-day rule because closures never formally occurred. But the most problematic point highlighted in Table II-6 is that US newly confirmed cases are only currently projected to fall to zero as of February 2021. Chart II-9 highlights that while new cases per capita in New York state are much higher than in the rest of the country, they are declining whereas they have yet to clearly peak elsewhere. Cross-country case comparisons can be problematic due to differences in testing, but with several US states having already begun the gradual re-opening process, this underscores that US policymakers may be allowing a dangerous rise in the odds of a secondary infection wave. Chart II-9No Clear Downtrend Yet Outside Of New York State May 2020 May 2020 Investment Conclusions Our core conclusion that an “L-shaped” global recession is likely to be avoided is generally bullish for equities on a 12-month horizon. However, uncertainty remains extremely elevated, and the recent rise in stock prices in the US (and globally) has been at least partially based on the expectation that lockdowns will sustainably end soon, which at least in the case of the US appears to be a premature conclusion given the current lack of large-scale virus testing capacity. As such, we are less optimistic towards risky assets tactically, and would recommend a neutral stance over a 0-3 month horizon. As noted above, our cross-country comparison of narrowly-defined fiscal measures suggested that euro area countries (excluding Germany) will likely have to do more in order to prevent a long period of below-trend growth. In the case of highly-indebted countries like Italy, this raises the additional question of whether a significantly increased debt-to-GDP ratio stemming from an aggressive fiscal impulse will cause another euro area sovereign debt crisis similar to what occurred from 2010-2014. Chart II-10Italy's Debt Sustainability Hurdle Is Lower Than It Used To Be Italy's Debt Sustainability Hurdle Is Lower Than It Used To Be Italy's Debt Sustainability Hurdle Is Lower Than It Used To Be Government debts are sustainable as long as interest rates remain below economic growth, and from this vantage point Italy should spend as much as needed in order to ensure that nominal growth remains above current long-term government bond yields. Chart II-10 highlights that, despite a widening spread versus German bunds, Italian 10-year yields are much lower today than they were during the worst of the euro area crisis, meaning that the debt sustainability hurdle is technically lower. However, we have also noted in previous reports that high-debt countries often face multiple government debt equilibria; if global investors become fearful that that high-debt countries may not be able to repay their obligations without defaulting or devaluing, then a self-fulfilling prophecy will occur via sharply higher interest rates (Chart II-11). Chart II-11Multiple Equilibria In Debt Markets Are Possible Without A Lender Of Last Resort May 2020 May 2020 Chart II-12Italy's Structural Budget Balance Has Improved Italy's Structural Budget Balance Has Improved Italy's Structural Budget Balance Has Improved For now, we view the risk of a renewed Italian debt crisis from significantly increased spending related to COVID-19 as minimal, and it is certainly lower than the status quo as the latter risks causing a sharp gap between nominal growth and bond yields like what occurred from 2010 – 2014. First, Chart II-12 highlights that Italy has succeeded in somewhat reducing its structural balance, which averaged -4% for many years prior to the euro area crisis. Assuming an adequate global response to the crisis and that economic recovery ensues, it is not clear why global bond investors would be concerned that Italian structural deficits would persistently widen. Second, the ECB is purchasing Italian government bonds as part of its new Pandemic Emergency Purchase Program, which will help cap the level of Italian yields. Chart II-13Italy's Debt Service Ratio Won't Go Up Much, If Yields Are Unchanged Italy's Debt Service Ratio Won't Go Up Much, If Yields Are Unchanged Italy's Debt Service Ratio Won't Go Up Much, If Yields Are Unchanged Third, Chart II-13 shows what will occur to Italy’s government debt service ratio (general government net interest payments as a percent of GDP) in a scenario where Italy’s gross debt to GDP rises a full 20 percentage points and the ratio of net interest payments to debt remains unchanged. The chart shows that while debt service will rise, it will still be lower than at any point prior to 2015. So not only should Italy spend significantly more to combat the severely damaging nature of the pandemic, we would expect that Italian spreads would fall, not rise, in such an outcome. Jonathan LaBerge, CFA Vice President Special Reports III. Indicators And Reference Charts Last month, we took a more positive stance on equities as both our valuation and monetary indicators had moved decisively into accommodative territory. While the global economy was set to weaken violently, the easing in our indicators suggested that stocks offered an adequate risk/reward ratio to take some risk. This judgment was correct. On a cyclical basis, the same factors that made us willing buyers of stocks remain broadly in place. Stocks are not as cheap as they were in late March, but monetary conditions have only eased further. Moreover, we are starting to get more clarity as to the re-opening of most Western economies because new reported cases of COVID-19 are peaking. Finally, the VIX has declined substantially but is nowhere near levels warning of an imminent risk to stocks and sentiment is still subdued. Tactically, equities are becoming somewhat overbought. However, this impression is mostly driven by the rebound in tech stocks and the strong performance posted by the healthcare sector. The median stock remains quite oversold. In this context, if the S&P 500 were to correct, we would not anticipate this correction to morph into a new down leg in the bear market that would result in new lows below the levels reached on March 23. For now, the most attractive strategy to take advantage of the supportive backdrop for stocks is to buy equities relative to bonds. In contrast to global bourses, government bonds are still massively overbought and trading at their largest premium to fair value since Q4 2008 and late 1985. Additionally, the vast sums of both monetary and fiscal stimulus injected in the economy should lift inflation expectations and thus, bond yields. Real yields will likely remain at very low levels for an extended period of time as short rates are unlikely to rise anytime soon. The yield curve is therefore slated to steepen further. The dollar has stabilized since we last published but it has not meaningfully depreciated. On the one hand, the threat of an exploding twin deficit and a Fed working hard to address the dollar shortage and keep real rates in negative territory are very bearish for the dollar. But on the other hand, free-falling global growth and spiking policy uncertainty are highly bullish for the Greenback. A stalemate was thus the most likely outcome. However, we are getting closer to a rebound in growth in Q3, which means that the balance of forces will become an increasingly potent headwind for the expensive dollar. Thus, it remains appropriate to use rallies in the dollar to offload this currency. Finally, commodities continue to linger near their lows, creating a mirror image to the dollar. They are still very oversold and sentiment has greatly deteriorated, except for gold. Thus, if as we expect, the dollar will soon begin to soften, then commodities will appreciate in tandem. The move in oil prices was particularly dramatic this month. The oil curve is in deep contango and oil producers from Saudi Arabia to the US shale patch have begun cutting output. Therefore, oil is set to rally meaningfully as the global economy re-opens for business. The large balance sheet expansion by the Fed and other global central banks will only fuel that fire. EQUITIES: Chart III-1US Equity Indicators US Equity Indicators US Equity Indicators Chart III-2Willingness To Pay For Risk Willingness To Pay For Risk Willingness To Pay For Risk Chart III-3US Equity Sentiment Indicators US Equity Sentiment Indicators US Equity Sentiment Indicators   Chart III-4Revealed Preference Indicator Revealed Preference Indicator Revealed Preference Indicator Chart III-5US Stock Market Valuation US Stock Market Valuation US Stock Market Valuation Chart III-6US Earnings US Earnings US Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance   FIXED INCOME: Chart III-9US Treasurys And Valuations US Treasurys And Valuations US Treasurys And Valuations Chart III-10Yield Curve Slopes Yield Curve Slopes Yield Curve Slopes Chart III-11Selected US Bond Yields Selected US Bond Yields Selected US Bond Yields Chart III-1210-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components Chart III-13US Corporate Bonds And Health Monitor US Corporate Bonds And Health Monitor US Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Global Bonds: Developed Markets Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets Global Bonds: Emerging Markets Global Bonds: Emerging Markets   CURRENCIES: Chart III-16US Dollar And PPP US Dollar And PPP US Dollar And PPP Chart III-17US Dollar And Indicator US Dollar And Indicator US Dollar And Indicator Chart III-18US Dollar Fundamentals US Dollar Fundamentals US Dollar Fundamentals Chart III-19Japanese Yen Technicals Japanese Yen Technicals Japanese Yen Technicals Chart III-20Euro Technicals Euro Technicals Euro Technicals Chart III-21Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart III-22Euro/Pound Technicals Euro/Pound Technicals Euro/Pound Technicals   COMMODITIES: Chart III-23Broad Commodity Indicators Broad Commodity Indicators Broad Commodity Indicators Chart III-24Commodity Prices Commodity Prices Commodity Prices Chart III-25Commodity Prices Commodity Prices Commodity Prices Chart III-26Commodity Sentiment Commodity Sentiment Commodity Sentiment Chart III-27Speculative Positioning Speculative Positioning Speculative Positioning   ECONOMY: Chart III-28US And Global Macro Backdrop US And Global Macro Backdrop US And Global Macro Backdrop Chart III-29US Macro Snapshot US Macro Snapshot US Macro Snapshot Chart III-30US Growth Outlook US Growth Outlook US Growth Outlook Chart III-31US Cyclical Spending US Cyclical Spending US Cyclical Spending Chart III-32US Labor Market US Labor Market US Labor Market Chart III-33US Consumption US Consumption US Consumption Chart III-34US Housing US Housing US Housing Chart III-35US Debt And Deleveraging US Debt And Deleveraging US Debt And Deleveraging   Chart III-36US Financial Conditions US Financial Conditions US Financial Conditions Chart III-37Global Economic Snapshot: Europe Global Economic Snapshot: Europe Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Global Economic Snapshot: China Global Economic Snapshot: China   Mathieu Savary Vice President The Bank Credit Analyst Footnotes 1  Please see US Equity Strategy Weekly Report "Gauging Fair Value," dated April 27, 2020, available at uses.bcaresearch.com 2  Please see US Investment Strategy Special Report "How Vulnerable Are US Banks? Part 1: A 50-Year Bottom-Up Case Study," dated March 30, 2020 and US Investment Strategy Special Report "How Vulnerable Are US Banks? Part 2: It’s Complicated," dated April 6, 2020 available at usis.bcaresearch.com 3 Please see Emerging Markets Strategy Weekly Report "EM Domestic Bonds And Currencies," dated April 23, 2020, available at ems.bcaresearch.com 4  Please see US Bond Strategy Weekly Report "Buying Opportunities & Worst-Case Scenarios," dated March 17, 2020 and US Bond Strategy Weekly Report "Life At The Zero Bound," dated March 24, 2020 available at usbs.bcaresearch.com 5  Please see US Bond Strategy Weekly Report "Is The Bottom Already In?" dated April 21, 2020 and 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 6 “Bad deflation” reflects poor demand, which constrains corporate pricing power. “Good deflation” reflects productivity growth. Good deflation?? does not automatically extend to declining real profits and it is not linked with falling stock prices. The Roaring Twenties are an example of when “good deflation” resulted in a surging stock market. 7  Please see US Equity Strategy Weekly Report "Fight Central Banks At Your Own Peril," dated April 14, 2020, available at uses.bcaresearch.com 8  Skeptical economists call Japan’s largest-ever stimulus package ‘puffed-up’, Keita Nakamura, The Japan Times, April 8, 2020. 9  Please note that Chart II-3 differs somewhat from a chart that has been frequently shown by our Geopolitical Strategy service. Both charts are accurate; they simply employ different definitions of the fiscal response to the pandemic. 10 Indeed, McConnell has already walked back his comments that states should consider bankruptcy. President Trump is constrained by the election, as are Senate Republicans, and the House Democrats control the purse strings. Hence more state and local funding is forthcoming. At best for the Republicans, there may be provisions to ensure it goes to the COVID-19 crisis rather than states’ unfunded pension obligations. See Geopolitical Strategy, “Drowning In Oil (GeoRisk Update),” April 24, 2020, www.bcaresearch.com. 11 School and work closure dates have been sources from the Oxford COVID-19 Government Response Tracker.

Highlights The six-month increase in European bank credit flows amounts to an underwhelming $70 billion, compared to a record high $660 billion in the US and $550 billion in China. Underweight European domestic cyclicals versus their peers in the US and China. Specifically, underweight euro area banks versus US banks. Overweight equities on a long-term (2 years plus) horizon. The mid-single digit return that equities are offering makes them attractive versus ultra-low yielding bonds. But remain neutral equities on a 1-year horizon, until it becomes clear that we can prevent a second wave of the pandemic. Fractal trade: long bitcoin cash, short ethereum. Feature Chart I-1Bank Credit 6-Month Flow Up $70 Bn ##br##In The Euro Area… Bank Credit 6-Month Flow Up $70 Bn In The Euro Area... Bank Credit 6-Month Flow Up $70 Bn In The Euro Area... Chart I-2…But Up $700 Bn ##br##In The US ...But Up $700 Bn In The US ...But Up $700 Bn In The US Governments and central banks are dishing out an alphabet soup of stimulus. The question is: how much is reaching those that need it? Our preferred approach to assessing monetary stimulus is to focus on the evolution of bank credit flows and bond yields over a six-month period. Bank Credit Flows Have Surged In The US And China, Not In Europe On our preferred assessment, Europe’s monetary stimulus is underwhelming compared with that in the US and China. The six-month increase in US bank credit flows, at $660 billion, is the highest in a decade and not far from the highest ever. In China, the equivalent six-month increase is $550 billion. But in the euro area, the six-month increase in bank credit flows amounts to an underwhelming $70 billion (Charts I-1 - Chart I-4). Chart I-3Bank Credit 6-Month Flow Up $550 Bn In China… Bank Credit 6-Month Flow Up $550 Bn In China... Bank Credit 6-Month Flow Up $550 Bn In China... Chart I-4...And Up ##br##Globally ...And Up Globally ...And Up Globally Admittedly, US firms are drawing on pre-arranged bank credit lines rather than taking out new loans. Furthermore, the link between bank credit flows and final demand might be compromised during the current economic shutdown. For example, if firms are borrowing to pay workers who are not producing any output, then the transmission of a credit flow acceleration to a GDP acceleration would be weakened. Europe’s monetary stimulus is underwhelming compared with that in the US and China. Nevertheless, some bank credit flows will still reach the real economy. And the US and China are creating more bank credit flows than Europe. Focus On The Deceleration Of The Bond Yield Turning to the bond yield, it is important to focus not on its level, and not on its decline. Instead, it is important to focus on its deceleration. The focus on the deceleration of the bond yield sounds counterintuitive, but it results from a fundamental accounting identity. The next two paragraphs may seem somewhat technical but read them carefully, as they are important for understanding the transmission of stimulus. GDP is a flow. It measures the flow of goods and services produced in a quarter. Hence, GDP receives a contribution from the flow of credit. The flow of credit, in turn, is established by the level of bond yields. When we talk about stimulating the economy, we mean boosting the GDP growth rate from, say, -1 percent to +1 percent, which is an acceleration of GDP. This acceleration in the GDP flow must come from an acceleration in the flow of credit. This acceleration in the flow of credit, in turn, must come from a deceleration of bond yields. In other words, the bond yield decline in the most recent period must be greater than the decline in the previous period. Banks tend to perform better after bond yields have decelerated. The good news is that in the US and China, bond yields have decelerated; the bad news is that in Europe, they have not. Over the past six months, the 10-year bond yield has decelerated by 40 bps in the US and by 65 bps in China. Yet in France, despite the coronavirus crisis, the 10-year bond yield has accelerated by 60 bps (Charts I-5 - Chart I-8).1 Chart I-5The Bond Yield Has Accelerated ##br##In The Euro Area... The Bond Yield Has Accelerated In The Euro Area... CHART B The Bond Yield Has Accelerated In The Euro Area... CHART B Chart I-6...Decelerated ##br##In The US... ...Decelerated In The US... ...Decelerated In The US... Chart I-7...Decelerated In China... ...Decelerated In China... ...Decelerated In China... Chart I-8...And Decelerated Globally ...And Decelerated Globally ...And Decelerated Globally European bond yields are struggling to decelerate because of their proximity to the lower bound to bond yields, at around -1 percent. The inability to decelerate the bond yield constrains the monetary stimulus that Europe can apply compared to the US and China, whose bond yields are much further from the lower bound constraint. Compared to Europe, the US and China have much stronger decelerations in their bond yields and much stronger accelerations in their bank credit flows. This suggests underweighting European domestic cyclicals versus their peers in the US and China. Specifically, banks tend to perform better after bond yields have decelerated; and they tend to perform worse after bond yields have accelerated. On this basis, underweight euro area banks versus US banks (Chart I-9). Chart I-9Banks Perform Better After Bond Yields Have Decelerated, Worse After Bond Yields Have Accelerated Banks Perform Better After Bond Yields Have Decelerated, Worse After Bond Yields Have Accelerated Banks Perform Better After Bond Yields Have Decelerated, Worse After Bond Yields Have Accelerated Long-Term Asset Allocation Is Straightforward, Shorter-Term Is Not The level of the bond yield, or of so-called ‘financial conditions’, does not drive the short-term oscillations in credit flows. To repeat, it is the acceleration and deceleration of the bond yield that matters. Yet when it comes to the long-term valuation of assets, the level of the bond yield does matter, and when the bond yield is ultra-low it matters enormously. An ultra-low bond yield justifies a much lower prospective return on competing long-duration assets, like equities. The reason is that when bond yields approach their lower bound, bond prices can no longer rise, they can only fall. This higher riskiness of bonds justifies an abnormally low (or zero) ‘risk premium’ on equities. In this world of ultra-low numbers – for both bond yields and equity risk premiums – the low to mid-single digit long-term return that equities are offering makes them attractive versus bonds (Chart I-10). Chart I-10Equities Are Offering Mid-Single Digit Long-Term Returns Equities Are Offering Mid-Single Digit Long-Term Returns Equities Are Offering Mid-Single Digit Long-Term Returns But this long-term valuation argument only works for those with long-term investment horizons. What does long-term mean? There is no clear dividing line, but we would define long-term as two years at the very minimum. For a one-year investment horizon, the much more important question is: what will happen to 12-month forward earnings (profits)?  In the stock market recessions of 2008-09 and 2015-16, the stock market reached its low just before forward earnings reached their low. Assuming the same holds true in 2020-21, we must establish whether forward earnings are close to their low or not. In 2008-09, world forward earnings collapsed by 45 percent. In the current recession, which is putatively worse, world forward earnings are down by less than 20 percent to date. To have already reached the cycle low in forward earnings with only half the decline of 2008, the current recession needs to be much shorter than the 2008-09 episode (Chart I-11 and Chart I-12). Chart I-11In The Global Financial Crisis, Forward Earnings Collapsed By 45 Percent In The Global Financial Crisis, Forward Earnings Collapsed By 45 Percent In The Global Financial Crisis, Forward Earnings Collapsed By 45 Percent Chart I-12In The Current Crisis, Forward Earnings Are Down 20 Percent. Is That Enough? In The Current Crisis, Forward Earnings Are Down 20 Percent. Is That Enough? In The Current Crisis, Forward Earnings Are Down 20 Percent. Is That Enough? Whether this turns out to be the case or not hinges on the pandemic and our response to it. A controlled easing of lockdowns will boost growth as more of the economy comes back to life. But too rapid an easing of lockdowns will unleash a second wave of the pandemic, requiring a second wave of economic shutdowns, a double dip recession and a new low in the stock market. Hence, if you have a long-term (2-year plus) investment horizon, the choice between equities and bonds is very straightforward: overweight equities. On this long-term horizon, German and Swedish equities are especially attractive versus negative-yielding bonds. On a 1-year investment horizon, the key question is: can we avoid a second wave of the pandemic? But if you have a 1-year investment horizon, the choice is less straightforward, because it hinges on whether we can avoid a second wave of the pandemic or not. Until it becomes clear that governments will not reopen economies too quickly, remain neutral equities on the 1-year horizon. Fractal Trading System* This week’s recommended trade is a pair-trade within the cryptocurrency asset-class. Long bitcoin cash / short ethereum. Set the profit target at 21 percent with a symmetrical stop-loss. The 12-month rolling win ratio now stands at 61 percent. Chart I-13Bitcoin Cash Vs. Ethereum Bitcoin Cash Vs. Ethereum Bitcoin Cash Vs. Ethereum When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated  December 11, 2014, available at eis.bcaresearch.com.   Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1 In the US, the 10-year bond yield has declined by 120 bps in the past six months compared with 80 bps in the preceding six months, which equals a deceleration of 40 bps; in China, the 10-year bond yield has declined by 73 bps in the past six months compared with 18 bps in the preceding six months, which equals a deceleration of 65 bps; but in France, the 10-year bond yield has increased by 12 bps in the past six months compared with a 48 bps decline in the preceding six months, which equals an acceleration of 60 bps. 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