Monetary

Highlights Yesterday we published a Special Report titled EM: Foreign Currency Debt Strains. We are upgrading our stance on EM local currency bonds from negative to neutral. Before upgrading to a bullish stance, we would first need to upgrade our stance on EM currencies. We recommend receiving long-term swap rates in Russia, Mexico, Colombia, China and India. EM central banks’ swap lines with the Fed could be used to fend off short-term speculative attacks on EM currencies. Nevertheless, they cannot prevent EM exchange rates from depreciation when fundamental pressures warrant weaker EM currencies. For the rampant expansion of US money supply to produce a lasting greenback depreciation, US dollars should be recycled abroad. This is not yet occurring. Domestic Bonds: A New Normal Chart I-1Performance Of EM Domestic Bonds In The Last Decade Performance Of EM Domestic Bonds In The Last Decade Performance Of EM Domestic Bonds In The Last Decade In recent years, our strategy has favored the US dollar and, by extension, US Treasurys over EM domestic bonds. Chart I-1 demonstrates that the EM GBI local currency bond total return index in US dollar terms is at the same level as it was in 2011, and has massively underperformed 5-year US Treasurys. We are now upgrading our stance on EM local currency bonds from negative to neutral. Consistently, we recommend investors seek longer duration in EM domestic bonds while remaining cautious on the majority of EM currencies. Before upgrading to a bullish stance on EM local bonds, we would first need to upgrade our stance on EM currencies. Still, long-term investors who can tolerate volatility should begin accumulating EM local bonds on any further currency weakness. Our upgrade is based on the following reasons: First, there has been a fundamental shift in EM central banks’ policies. In past global downturns, many EM central banks hiked interest rates to defend their currencies. Presently, they are cutting rates aggressively despite large currency depreciation. This is the right policy action to fight the epic deflationary shock that EM economies are presently facing. There has been a fundamental shift in EM central banks’ policies. They are cutting rates aggressively despite large currency depreciation. Historically, EM local bond yields were often negatively correlated with exchange rates (Chart I-2, top panel). Similarly, when EM currencies began plunging two months ago, EM local bond yields initially spiked. However, following the brief spike, bond yields have begun dropping, even though EM currencies have not rallied (Chart I-2, bottom panel). This represents a new normal, which we discussed in detail in our October 24 report. Overall, even if EM currencies continue to depreciate, EM domestic bond yields will drop as they price in lower EM policy rates. Second, the monetary policy transmission mechanism in many EMs was broken before the COVID-19 outbreak. Even though central banks in many developing countries were reducing their policy rates before the pandemic, commercial banks’ corresponding lending rates were not dropping much (Chart I-3, top panel). Chart II-2EM Local Bond Yields And EM Currencies EM Local Bond Yields And EM Currencies EM Local Bond Yields And EM Currencies Chart I-3EM ex-China: Monetary Transmission Has Been Impaired EM ex-China: Monetary Transmission Has Been Impaired EM ex-China: Monetary Transmission Has Been Impaired   Further, core inflation rates were at all time lows and prime lending rates in real terms were extremely high (Chart I-3, middle panels). Consequently, bank loan growth was slowing preceding the pandemic (Chart I-3, bottom panel). The reason was banks’ poor financial health. Saddled with a lot of NPLs, banks had been seeking wide interest rate margins to generate profit and recapitalize themselves. With the outburst of the pandemic and the sudden stop in domestic and global economic activity, EM banks’ willingness to lend has all but evaporated. Chart I-4 reveals EM ex-China bank stocks have plunged, despite considerable monetary policy easing in EM, which historically was bullish for bank share prices. This upholds the fact that the monetary policy transmission mechanism in EM is broken. Mounting bad loans due to the pandemic will only reinforce these dynamics. Swap lines with the Fed cannot prevent EM exchange rates from depreciation when fundamental pressures – global and domestic recessions – warrant weaker EM currencies. In brief, EM lower policy rates will not be transmitted to lower borrowing costs for companies and households anytime soon. Loan growth and domestic demand will remain in an air pocket for some time.    Consequently, EM policy rates will have to drop much lower to have a meaningful impact on growth. Third, there is value in EM local yields. The yield differential between EM GBI local currency bonds and 5-year US Treasurys shot up back to 500 basis points, the upper end of its historical range (Chart I-5). Chart I-4EM ex-China: Bank Stocks Plunged Despite Rate Cuts EM ex-China: Bank Stocks Plunged Despite Rate Cuts EM ex-China: Bank Stocks Plunged Despite Rate Cuts Chart I-5The EM Vs. US Yield Differential Is Attractive The EM Vs. US Yield Differential Is Attractive The EM Vs. US Yield Differential Is Attractive   Bottom Line: Odds favor further declines in EM local currency bond yields. Fixed-income investors should augment their duration exposure. We express this view by recommending receiving swap rates in the following markets: Russia, Mexico, Colombia, India and China. This is in addition to our existing receiver positions in Korean and Malaysian swap rates. For more detail, please refer to the Investment Recommendations section on page 8. Nevertheless, absolute-return investors should be cognizant of further EM currency depreciation. EM Currencies: At Mercy Of Global Growth Chart I-6EM Currencies Correlate With Commodities Prices EM Currencies Correlate With Commodities Prices EM Currencies Correlate With Commodities Prices The key driver of EM currencies has been and remains global growth. The latter will remain very depressed for some time, warranting patience before turning bullish on EM exchange rates. We have long argued that EM exchange rates are driven not by US interest rates but by global growth. Industrial metals prices offer a reasonable pulse on global growth. Chart I-6 illustrates their tight correlation with EM currencies. Even though the S&P 500 has rebounded sharply in recent weeks, there are no signs of a meaningful improvement in industrial metals prices. Various raw materials prices in China are also sliding (Chart I-7). In a separate section below we lay out the case as to why there is more downside in iron ore and steel as well as coal prices in China. Finally, the ADXY – the emerging Asia currency index against the US dollar – has broken down below its 2008, 2016 and 2018-19 lows (Chart I-8). This is a very bearish technical profile, suggesting more downside ahead. This fits with our fundamental assessment that a recovery in global economic activity is not yet imminent. Chart I-7China: Commodities Prices Are Sliding China: Commodities Prices Are Sliding China: Commodities Prices Are Sliding Chart I-8A Breakdown In Emerging Asian Currencies A Breakdown In Emerging Asian Currencies A Breakdown In Emerging Asian Currencies   What About The Fed’s Swap Lines? A pertinent question is whether EM central banks’ foreign currency reserves and the Federal Reserve’s swap lines with several of its EM counterparts are sufficient to prop up EM currencies prior to a pickup in global growth. The short answer is as follows: These swap lines will likely limit the downside but cannot preclude further depreciation. With the exception of Turkey and South Africa, virtually all mainstream EM banks have large foreign currency reserves. On top of this, several of them – Brazil, Mexico, South Korea and Singapore– have recently obtained access to Fed swap lines. Their own foreign exchange reserves and the swap lines with the Fed give them an option to defend their currencies from depreciation if they choose to do so. However, selling US dollars by EM central banks is not without cost. When central banks sell their FX reserves or dollars obtained from the Fed via swap lines, they withdraw local currency liquidity from the system. As a result, banking system liquidity shrinks, pushing up interbank rates. This is equivalent to hiking interest rates. The Fed’s outright money printing is the sole reason to buy EM risk assets and currencies at the moment. Yet, EM fundamentals – namely, its growth outlook – remain downbeat. Hence, the cost of defending the exchange rate by using FX reserves is both liquidity and credit tightening. In such a case, the currency could stabilize but the economy will take a beating. Since the currency depreciation was itself due to economic weakness, such a policy will in and of itself be self-defeating. The basis is that escalating domestic economic weakness will re-assert its dampening effect on the currency. Of course, EM central banks can offset such tightening by injecting new liquidity. However, this could also backfire and lead to renewed currency depreciation. Bottom Line: EM central banks’ swap lines with the Fed are primarily intended to instill confidence among investors in financial markets. They could be used to fend off short-term speculative attacks on EM currencies. Nevertheless, they cannot prevent EM exchange rates from depreciation when fundamental pressures – global and domestic recessions – warrant weaker EM currencies. What About The Fed’s Money Printing? Chart I-9The Fed Is Aggressively Printing Money The Fed Is Aggressively Printing Money The Fed Is Aggressively Printing Money The Fed is printing money and monetising not only public debt but also substantial amounts of private debt. This will ultimately be very bearish for the US dollar. Chart I-9 illustrates that the Fed is printing money much more aggressively than during its quantitative easing (QE) policies post 2008. The key difference between the Fed’s liquidity provisions now and during its previous QEs is as follows: When the Fed purchases securities from or lends to commercial banks, it creates new reserves (banking system liquidity) but it does not create money supply. Banks’ reserves at the Fed are not a part of broad money supply. This was generally the case during previous QEs when the Fed was buying bonds mostly – but not exclusively – from banks, therefore increasing reserves without raising money supply by much. When the Fed lends to or purchases securities from non-banks, it creates both excess reserves for the banking system and money supply (deposits at banks) out of thin air. The fact that US money supply (M2) growth is now much stronger than during the 2010s QEs suggests the recent surge in US money supply is due to the Fed’s asset purchases from and lending to non-banks, which creates money/deposits outright.  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: 1. US imports should expand, reviving global growth, i.e., the US should send dollars to the rest of the world by buying goods and services. This is not yet happening as domestic demand in America has plunged and any demand recovery in the next three to six months will be tame and muted. 2. US investors should channel US dollars to EM to purchase EM financial assets. In recent weeks, foreign flows have been returning to EM due to the considerable improvement in EM asset valuations. However, the sustainability of these capital flows into EM remains questionable. The main reasons are two-fold: (A) there is huge uncertainty on how efficiently EM countries will be able handle the economic and health repercussions of the pandemic; and (B) global growth remains weak and, as we discussed above, it has historically been the main driver of EM risk assets and currencies.  Bottom Line: The Fed’s outright money printing is the sole reason to buy EM risk assets and currencies at the moment. Yet, EM fundamentals – namely, its growth outlook – remain downbeat. Overall, we recommend investors to stay put on EM risk assets and currencies in the near-term. Investment Recommendations Chart I-10China: Bet On Lower Long-Term Yields China: Bet On Lower Long-Term Yields China: Bet On Lower Long-Term Yields We have been recommending receiving rates in a few markets such as Korea and Malaysia. Now, we are widening this universe to include Russia, Mexico, Colombia, China, and India. In China, the long end of the yield curve offers value (Chart I-10, top panel). The People’s Bank of China has brought down short rates dramatically but the long end has so far lagged (Chart I-10, bottom panel). We recommend investors receive 10-year swap rates. Fixed-income investors could also bet on yield curve flattening. The recovery in China will be tame and the PBoC will keep interest rates lower for longer. Consequently, long-dated swap rates will gravitate toward short rates.  We are closing three fixed-income trades: In Mexico, we are booking profits on our trade of receiving 2-year / paying 10-year swap rates – a bet on a steeper yield curve. This position has generated a 152 basis-point gain since its initiation on April 12, 2018. In Colombia, our bet on yield curve flattening has produced a loss of 28 basis points since January 17, 2019. We are closing it. In Chile, we are closing our long 3-year bonds / short 3-year inflation-linked bonds position. This trade has returned 2.0% since we recommended it on October 3, 2019. For dedicated EM domestic bond portfolios, our overweights are Russia, Mexico, Peru, Colombia, Korea, Malaysia, Thailand, India, China, Pakistan and Ukraine. Our underweights are South Africa, Turkey, Brazil, Indonesia and the Philippines. The remaining markets warrant a neutral allocation. Regarding EM currencies, we continue to recommend shorting a basket of the following currencies versus the US dollar: BRL, CLP, ZAR, IDR, PHP and KRW. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Chinese Steel, Iron Ore And Coal Markets: Heading South Chart II-1Steel, Iron Ore And Coal Prices: More Downside Ahead? Steel, Iron Ore And Coal Prices: More Downside Ahead? Steel, Iron Ore And Coal Prices: More Downside Ahead? Odds are that iron ore, steel and coal prices will all continue heading south (Chart II-1). Lower prices will harm both Chinese and global producers of these commodities. Steel And Iron Ore The oversupplied conditions in the Chinese steel market will become even more aggravated over the next three to six months. First, Chinese output of steel products has not contracted even though demand plunged in the first three months of the year, creating oversupply. Despite falling steel prices and the demand breakdown resulting from the COVID-19 outbreak, Chinese crude steel output still grew at 1.5% and its steel products output only declined 0.6% between January and March from a year ago (Chart II-2). Chart II-2Steel Products Output In China: Still No Contraction Steel Products Output In China: Still No Contraction Steel Products Output In China: Still No Contraction The profit margin of Chinese steel producers has compressed but not enough to herald a sizable cut in mainland steel production. Despite oversupply, Chinese steel producers are reluctant to curtail output to prevent layoffs. This year, there will be 62 million tons of new steel production capacity while 82 million tons of obsolete capacity will be shut down. As the capacity-utilization rate (CUR) of the new advanced production capacity will be much higher than the CUR on those soon-to-be-removed capacities in previous years, this will help lift steel output.   Second, Chinese steel demand has plummeted, and any revival will be mild and gradual over the next three to six months. Construction accounts for about 55% of Chinese steel demand, with about 35% coming from the property market and 20% from infrastructure. Additionally, the automobile industry contributes about 10% of demand. All three sectors are currently in deep contraction (Chart II-3). Looking ahead, we expect that the demand for steel from property construction and automobile production will revive only gradually. Overall, it will continue contracting on a year-on-year basis, albeit at a diminishing rate than now. While we projected a 6-8% rise in Chinese infrastructure investment for this year, most of that will be back-loaded to the second half of the year. In addition, modest and gradual steel demand increases from this source will not be able to offset the loss of demand from the property and automobile sectors. The oversupplied conditions in the Chinese steel market will become even more aggravated over the next three to six months. Reflecting the disparity between weak demand and resilient supply, steel inventories in the hands of producers and traders are surging, which also warrants much lower prices (Chart II-4).   Chart II-3Deep Contraction In Steel Demand From Major Users Deep Contraction In Steel Demand From Major Users Deep Contraction In Steel Demand From Major Users Chart II-4Significant Build-Up In Steel Inventories Significant Build-Up In Steel Inventories Significant Build-Up In Steel Inventories   Chart II-5Chinese Iron Ore Imports Will Likely Decline In 2020 Chinese Iron Ore Imports Will Likely Decline In 2020 Chinese Iron Ore Imports Will Likely Decline In 2020 Regarding iron ore, mushrooming steel inventories in China and lower steel prices will eventually lead to steel output cutbacks in the country. This will be compounded by shrinking steel production outside of China, dampening global demand for iron ore. Besides, in China, scrap steel prices have fallen more sharply than iron ore prices have. This makes the use of scrap steel more appealing than iron ore in steel production. Chinese iron ore imports will likely drop this year (Chart II-5). Finally, the global output of iron ore is likely to increase in 2020. The top three producers (Vale, Rio Tinto and BHP) have all set their 2020 guidelines above their 2019 production levels. This will further weigh on iron ore prices. Coal Although Chinese coal prices will also face downward pressure, we believe that the downside will be much less than that for steel and iron ore prices. Coal prices have already declined nearly 27% from their 2019 peak. They recently declined below 500 RMB per ton – the lower end of a range that the government generally tries to maintain. Prices had not dropped below this level since September 2016. In the near term, prices could go down by another 5-10%, given that record-high domestic coal production and imports have overwhelmed the market (Chart II-6). Coal prices have already declined nearly 27% from their 2019 peak. They recently declined below 500 RMB per ton – the lower end of a range that the government generally tries to maintain. However, there are emerging supportive forces. China Coal Transport & Distribution Association (CCTD), the nation’s leading industry group, on April 18, called on the industry to slash production (of both thermal and coking coal) in May by 10%. It also proposed that the government should restrict imports. The CCTD stated that about 42% of the producers are losing money at current coal prices. The government had demanded producers make similar cuts for a much longer time duration in 2016, which pushed coal to sky-high prices.  The outlook for a revival in the consumption of electricity and, thereby, in the demand for coal is more certain than it is for steel and iron ore. About 60% of Chinese coal is used to generate thermal power. Finally, odds are rising that the government will temporarily impose restrictions on coal imports as it did last December – when coal imports to China fell by 70% as a result. Investment Implications Companies and countries producing these commodities will be hurt by the reduction of Chinese purchases. These include, but are not limited to, producers in Indonesia, Australia, Brazil and South Africa. Iron ore and coal make up 10% of total exports in Brazil, 6% in South Africa, 18% in Indonesia and 32% in Australia. Investors should avoid global steel and mining stocks (Chart II-7). Chart II-6Chinese Coal Output And Imports Are At Record Highs Chinese Coal Output And Imports Are At Record Highs Chinese Coal Output And Imports Are At Record Highs Chart II-7Avoid Global Steel And Mining Stocks For Now Avoid Global Steel And Mining Stocks For Now Avoid Global Steel And Mining Stocks For Now   We continue to recommend shorting BRL, ZAR and IDR versus the US dollar. Ellen JingYuan He Associate Vice President ellenj@bcaresearch.com     Footnotes   Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Dear Client, Please join me and my fellow BCA Strategists Caroline Miller and Arthur Budaghyan for a live webcast tomorrow, Friday, April 24 at 8:00 AM EDT (1:00 PM BST, 2:00 PM CEST, 8:00 PM HKT) where we will discuss the outlook for developed and emerging market equities over the immediate (0-3 month) and cyclical (12 month) horizon. In lieu of our regular report next week, we will be sending you a Special Report from my colleague Jonathan LaBerge. Jonathan will discuss the global fiscal response to the COVID-19 pandemic, and will provide some perspective on whether the response will be enough to prevent an "L-shaped" economic outcome. I hope you find the report insightful. Best regards, Peter Berezin, Chief Global Strategist Highlights Theoretically, the pandemic could raise the long-term fair value of equities – as proxied by the present value of future cash flows – if it causes the discount rate to fall by more than enough to offset the decline in corporate earnings. While such a seemingly bizarre outcome is not our base case, it cannot be easily dismissed, especially since the evidence suggests that real long-term interest rates have fallen a lot more since the start of the pandemic than have earnings estimates. We consider a number of challenges to this claim, including: current earnings estimates are too optimistic; long-term interest rates are being distorted by QE and other factors; and the equity risk premium will be higher in a post-pandemic world. While all these counterarguments have merit, none of them are airtight. Even if the pandemic ultimately boosts stock prices, the path to new highs will be a bumpy one. In the near term, a slew of bad economic data could cause another bout of market turbulence. Nevertheless, over a 12-month horizon, investors should continue to overweight equities relative to cash and bonds. The plunge in front-end oil futures this week was a timely reminder of the extent to which the pandemic has suppressed crude demand. Oil prices should bounce back later this year as global growth recovers, the dollar weakens, and more oil supply is taken offline. A Counterintuitive Scenario Chart 1EPS Growth Scenarios Could The Pandemic Lead To Higher Stock Prices? Could The Pandemic Lead To Higher Stock Prices? Could the pandemic end up raising the long-term fair value of equities – as proxied by the present value of future cash flows – compared with a scenario in which the virus never emerged? Such an outcome sounds far-fetched but could occur if the pandemic causes the discount rate to fall by more than enough to offset the decline in corporate earnings. How likely is such an outcome? To get a sense of the answer, let us consider a simple example where, prior to the pandemic, cash flows to shareholders were expected to grow by 2% per annum, the risk-free interest rate was 2%, and the equity risk premium was 5% (implying a discount rate of 7%). Let us suppose that the pandemic temporarily reduces corporate profits by 60% in 2020, 40% in 2021, and 20% in 2022 relative to the aforementioned baseline, with earnings returning to trend beyond then (Chart 1, Scenario 1). All things equal, an earnings shock of this magnitude would reduce the present value of corporate profits by 5.4%. For the present value to return to its original level, the discount rate would have to fall by 27 bps. How does this example square with reality? While it is impossible to know what would have happened in the absence of the pandemic, we can observe that S&P 500 EPS estimates have so far fallen by 22% for 2020 and 11% for both 2021 and 2022 since the start of the year. Meanwhile, the 30-year TIPS yield – a proxy for long-term real interest rates – has fallen by 75 bps, and is down 138 bps since the beginning of 2019. Based on this comparison, one can conclude that the decline in rate expectations has been large enough to offset the drop in projected earnings. Four Counterarguments The discussion above makes a number of assumptions that could easily be challenged. Let us consider four counterarguments to the claim that the pandemic has increased the long-term fair value of equities. As we shall see, while all four counterarguments are valid, none of them are bulletproof. Bottom-up earnings estimates are too optimistic. As estimates come down, so will stock prices. Calculations of long-term risk-free rates are being distorted by QE and other factors. If a more cautious mindset results in a lower risk-free rate, it should also result in a higher equity risk premium (ERP). A higher ERP would push up the discount rate, reducing the fair value of the stock market. The pandemic could lead to a variety of investor-negative outcomes, including further deglobalization, higher corporate taxes, and the loss of policy maneuverability during the next downturn. Let us examine all four of these counterarguments in turn. 1.   Are Earnings Estimates Too Optimistic? BCA’s US equity strategists expect S&P 500 companies to generate $104 in EPS this year and $162 in 2021. A simple weighted-average of these estimates implies a forward 12-month EPS of $123, compared with the current consensus of $140. Could the pandemic end up raising the long-term fair value of equities? Granted, consensus estimates for any given calendar year usually start high and drift lower over time, reflecting the overoptimistic bias of bottom-up analysts (Chart 2). Nevertheless, the gap between where consensus is today and where we think it will end up is large enough that further negative revisions could still weigh on stocks. As evidence, note that stock prices tend to move in the same direction as earnings revisions and 12-month ahead earnings estimates (Chart 3). Chart 2Are Earnings Estimates Too Optimistic? Could The Pandemic Lead To Higher Stock Prices? Could The Pandemic Lead To Higher Stock Prices? Chart 3Negative Earnings Revisions Will Weigh On Stocks In The Near Term Negative Earnings Revisions Will Weigh On Stocks In The Near Term Negative Earnings Revisions Will Weigh On Stocks In The Near Term The discussion above suggests that stocks could face some downward pressure in the near term, reflecting the tendency for investors to myopically focus on earnings over the next 12 months. This does not, however, negate the possibility that the pandemic could raise the long-term present value of future cash flows. After all, even the earnings projections from our equity strategists are much more benign than those in the stylized example of a 60%, 40%, and 20% decline in EPS for the next three years. In fact, to get something that fully offsets the decline in real yields since the start of the year requires a scenario that not only assumes a 60%, 40%, and 20% drop in earnings, but also assumes that profits remain 10% lower forever relative to the baseline (Chart 1, Scenario 2). 2.    Are Estimates Of Long-Term Risk-Free Rates Distorted To The Downside? Chart 4Rate Expectations Have Come Down Rate Expectations Have Come Down Rate Expectations Have Come Down So far, we have argued that earnings are unlikely to fall by enough over the next few years to counteract the steep drop in long-term interest rates. But, perhaps the problem is not with the earnings projections? Perhaps the problem is with the estimates of the long-term risk-free rate? Conceptually, long-term government bond yields should incorporate the market’s expectation of how short-term interest rates will evolve over the life of the bond plus a “term premium.” The inelegantly named term premium is a catch-all, unobservable variable that captures everything that affects bond yields other than changes in rate expectations. Term premia have fallen in global bond markets since the start of the year, partly because central banks have ramped up bond buying programs with the express intent of pushing down long-term yields. Nevertheless, rate expectations have also come down, as can be gleaned from forward contracts linked to expected overnight rates (Chart 4). This suggests that expectations of lower rates have played an important role in explaining the decline in bond yields. In any case, it is not clear why one should control for the term premium in calculating discount rates. If the idea is to compare bonds with stocks, then one should look at bond yields directly, rather than trying to ascertain what yields would hypothetically be in the absence of various distortions – especially if these distortions are unlikely to go away anytime soon. You can’t eat hypothetical profits. 3.    Projecting The Equity Risk Premium If overly optimistic earnings estimates and a distorted risk-free rate cannot fully counteract the claim that the pandemic has raised the long-term fair value of equities, what about the third driver of present value calculations: the equity risk premium (ERP)? While the ERP cannot be observed directly, it is possible to infer it by looking at the difference between the long-term earnings yield and the real bond yield. Under some simplifying assumptions, the earnings yield provides a good estimate of the long-term real total return to holding stocks.1 To the extent that the earnings yield has risen this year, while the risk-free rate has fallen, one can infer that the equity risk premium has gone up. However, there is no money in observing today’s equity risk premium; the money is in projecting it. The equity risk premium can shift a lot over the course of the business cycle. This is why the stock-to-bond ratio moves so closely with, say, the ISM manufacturing index (Chart 5). Chart 5Stock-To-Bond Ratio And Economic Growth Go Hand-In-Hand Stock-To-Bond Ratio And Economic Growth Go Hand-In-Hand Stock-To-Bond Ratio And Economic Growth Go Hand-In-Hand Like many financial market variables, the ERP has tended to be mean reverting. Today, the ERP is above its long-term average both in the US and the rest of the world, which suggests that it may decline over time (Chart 6). If that were to happen, stocks would almost certainly outperform bonds. Chart 6Favor Equities Over Bonds Over A 12-Month Horizon Favor Equities Over Bonds Over A 12-Month Horizon Favor Equities Over Bonds Over A 12-Month Horizon Yet, in an environment where caution reigns supreme, might the ERP stay elevated? After all, if risk-free bond yields remain low because people are more reluctant to spend, wouldn’t that mean that investors will continue to demand an additional premium to holding stocks? Perhaps, but this assumes that bonds will retain their safe-haven characteristics. There are two reasons to think that these characteristics may fray in a post-pandemic world. First, with policy rates now close to zero in most markets, there is a limit to how much further bond yields can decline. This means that bond prices will not rise much even if the recession lasts much longer than expected  (Table 1). Table 1Bonds Won't Provide Much Of A Hedge Even In A Severe Recession Scenario Could The Pandemic Lead To Higher Stock Prices? Could The Pandemic Lead To Higher Stock Prices? Second, looking further out, highly indebted governments may try to dissuade central banks from raising rates even once unemployment has fallen back to normal levels. This could lead to higher inflation, imperiling bond investors. While such an outcome would not necessarily be good for stocks, equities will be more insulated than bonds because nominal profits tend to rise more quickly in an environment of higher inflation. As such, one could plausibly argue that the equity risk premium should not be any higher, and conceivably should be lower, in a post-pandemic world. 4.     Unintended Consequences Chart 7Global Trade Was Already Stalling Global Trade Was Already Stalling Global Trade Was Already Stalling While it is too early to say with any confidence what the long-term effects of the pandemic will be, it is certainly possible that they will be momentous. Globalization had already stalled before the eruption of the Sino-US trade war (Chart 7). It could go into reverse if trade tensions remain elevated and countries increasingly focus on ensuring that they have enough domestic capacity to produce various essential goods. Support for pro-business, laissez-faire policies could also wane further. Prior to the pandemic, BCA’s geopolitical team gave President Trump a 55% chance of being re-elected. Now, with the economy in shambles, they only give him a 35% chance. If the Democrats take control of the White House and both Houses of Congress, Trump’s corporate tax cuts are sure to be watered down if not fully reversed. The pandemic could also limit the ability of policymakers to respond to the next downturn. Interest rates cannot be cut further and high debt levels may limit fiscal maneuverability, especially for countries that do not have access to their own printing press. To be sure, there could be some silver linings. Many lessons have been learned over the past few months. If another pandemic were to occur, we will be better prepared. Meanwhile, gratuitous business travel will be curtailed now that people have grown more comfortable with videoconferencing. And just like the space race inspired a generation of scientists and engineers, the pandemic could motivate more young people to pursue a career in medical research. Investment Conclusions While not our base case, we would subjectively assign a 25% probability to an outcome where the pandemic ends up raising the long-term present value of corporate cash flows by pushing down the discount rate by more than enough to offset the near-term drop in profits. Chart 8Don't Rush Into Growth Stocks Just Yet, As Value Stocks Are Still Cheap Don't Rush Into Growth Stocks Just Yet, As Value Stocks Are Still Cheap Don't Rush Into Growth Stocks Just Yet, As Value Stocks Are Still Cheap Even if the pandemic leaves stocks lower than they otherwise would have been, the current equity risk premium is high enough to warrant overweighting global equities over bonds on a 12-month horizon. Of course, stocks are unlikely to sail smoothly to new highs on the back of lower interest rates alone. As we discussed last week in a reported entitled “Still Stuck in The Tree,” it will be difficult to dismantle ongoing lockdown measures until a mass-testing regime is put in place, something that is still at least a few months away at best.2 With the data on the economy and corporate earnings set to disappoint in the near term, stocks could give up some of their recent gains. Thus, while we are still bullish on equities on a long-term horizon, we are more cautious on a short-term, 3-month horizon.  Drilling further down, the decline in long-term rates this year is likely to create winners and losers across all asset classes. Some of the winners and losers are fairly straightforward to identify. For instance, growth stocks, whose market value hinges on anticipated cash flows that may not be realized until far into the future, gain relatively more from lower rates than value stocks. Banks, which are overrepresented in value indices, have suffered from the flattening of yield curves and lower rates in general. That said, given that value stocks currently trade at a multi-decade discount to growth stocks, we would not recommend that clients chase growth stocks at this juncture (Chart 8). Other winners and losers from lower rates may be less readily discernible. For example, consider the US dollar. The greenback benefited over the past few years from the fact that US rates were higher than those abroad. That rate differential has narrowed significantly recently as the Fed brought interest rates down to zero (Chart 9). Yet, the dollar has managed to remain well bid thanks to safe-haven flows into the Treasury market. Looking out, if the Fed succeeds in easing dollar funding pressures, as we expect will be the case, the dollar will weaken. Chart 9Rate Differentials Are No Longer A Tailwind For The US Dollar Rate Differentials Are No Longer A Tailwind For The US Dollar Rate Differentials Are No Longer A Tailwind For The US Dollar The plunge in near-term oil futures this week was a reminder of the extent to which the pandemic has suppressed crude demand. Transportation accounts for over half of global oil usage. Going forward, the combination of a weaker dollar, increased supply discipline, and a rebound in global growth in the second half of this year will help lift oil prices (Chart 10). Our energy analysts see WTI and Brent returning to $38/bbl and $42/bbl, respectively, by the end of the year following the drumming they received this week (Chart 11).3 Chart 10Commodity Prices Usually Rise When The Dollar Weakens Commodity Prices Usually Rise When The Dollar Weakens Commodity Prices Usually Rise When The Dollar Weakens Chart 11Oil Prices Expected To Recover Oil Prices Expected To Recover Oil Prices Expected To Recover Oil prices tend to be strongly correlated with inflation expectations (Chart 12). As inflation expectations rise, real rates could fall further, giving an additional boost to equity valuations.   Chart 12Inflation Expectations And Oil Prices Tend To Move Closely Together Inflation Expectations And Oil Prices Tend To Move Closely Together Inflation Expectations And Oil Prices Tend To Move Closely Together Peter Berezin Chief Global Strategist peterb@bcaresearch.com   Footnotes 1  For a more in-depth discussion on this, please see Global Investment Strategy Special Report, “TINA To The Rescue,” dated August 23, 2019. 2  Please see Global Investment Strategy Weekly Report, “Still Stuck In The Tree,” dated April 16, 2020. 3  Please see Commodity & Energy Strategy Weekly Report, “USD Strength Restrains Commodity Recovery,” dated April 23, 2020; Special Alert, “WTI In Free Fall,” dated April 20, 2020; and Weekly Report, “US Storage Tightens, Pushing WTI Lower,” dated April 16, 2020. Global Investment Strategy View Matrix Could The Pandemic Lead To Higher Stock Prices? Could The Pandemic Lead To Higher Stock Prices? Current MacroQuant Model Scores Could The Pandemic Lead To Higher Stock Prices? Could The Pandemic Lead To Higher Stock Prices?

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

Highlights With interest rates near zero around the world, balance sheet policy will become an important driver for currencies. Should the global economy need another dose of monetary stimulus, yield curve control (YCC) and direct financing of governments will increasingly be the policy tool of choice. This will lead to more bloated central bank balance sheets. The dollar will initially rally, as it did in 2008, since the conditions needed for even more central bank stimulus is a deeper than perceived contraction in global growth. Once the dust settles, the global economy will be awash with liquidity, which will light a fire under procyclical currencies, akin to 2009. An important barometer will be the velocity of money. We continue to recommend a barbell strategy for now – a basket of the cheapest currencies together with some save havens. Shorting EUR/JPY is a good insurance policy. Feature Quantitative easing affects the economy and currency markets through three major channels: By lowering interbank spreads and boosting commercial bank excess reserves, the credit channel is widened. Purchases of securities along the yield curve also lowers long-term borrowing costs for economic agents. Central bank purchases of government securities crowds out private concerns. As these funds are redirected out the risk curve, this loosens financial conditions. This is the portfolio balance effect.  Part of the flows from portfolio rebalancing leave the country, especially if interest rates are too low for bond investors. This lowers the exchange rate, boosting imported inflation, which further lowers domestic real rates. During isolated crises, the QE exchange rate channel works like a charm. Chart I-1 shows that for most of the post-2008 period when the euro area was engulfed in a crisis, the EUR/USD exchange rate oscillated with the relative balance sheet impulse1 between the Federal Reserve and the European Central Bank. The story in Japan was similar after the Fukushima crisis in 2011 and the subsequent adoption of Abenomics. In short, the more aggressive a central bank is with quantitative easing, the bigger the impact on currency markets. Chart I-1QE And EUR/USD QE And EUR/USD QE And EUR/USD The dollar seems to be following this narrative. Ever since hitting a March 19 high near 103, the DXY index has been in a broad-based consolidation phase, currently trading around 100. Swap lines are running full throttle as foreign central banks have tapped into the Fed’s liquidity provisions (Chart I-2). Despite this, our contention is that the dollar could still retest its recent highs before ultimately cresting. Chart I-2Improving Liquidity Improving Liquidity Improving Liquidity When V Is Collapsing Everywhere Currencies move on relative fundamentals. So, if one country is in a crisis and precipitously drops interest rates, then its currency should collapse relative to its trading partners. However, when interest rates are collectively plummeting around the world, they lose their relative anchor for currencies. In such times, correlations shift to 1, volatility spikes and valuations are thrown out the window (Chart I-3). As a reserve currency, the dollar benefits. When interest rates are collectively plummeting around the world, they lose their relative anchor for currencies. Many countries have announced QE in one form or another, and their balance sheets are set to explode higher, led by the Fed (Chart I-4). But akin to 2008, the dollar can still tick higher as markets remain in the belly of a liquidity trap. In these situations, technical indicators can help. But more often than not, it is usually instructive to sit back and gauge the signal from the velocity of money (or V), especially after interest rates have collapsed to zero. Chart I-3Life At Zero Life At Zero Life At Zero Chart I-4The QE Club The QE Club The QE Club V can be summarized by Irving Fisher’s classical equation MV=PQ, where P is the price level in the economy, Q is output, and M is the money supply. In other words, V=PQ/M. A few observations are clear from the equation: If output or PQ is collapsing, then the only way the authorities can stabilize demand is by driving up the money supply. It is an open debate as to whether V is stable or not. Over the last decade or so, V has been collapsing (Chart I-5). Meanwhile, the fact there has been no correlation between prices and money supply suggests that V may have a life of its own. Finally, as the collapse in V accelerates, there is a window in which policymakers can be behind the curve. In this window, zero rates and QE could still be insufficient to stem the decline in output.  Chart I-5A Collapse Of V Everywhere A Collapse Of V Everywhere A Collapse Of V Everywhere It becomes clear that observing V can provide valuable information for the economy and currency markets. A rising V means that central bank liquidity injections are being turned over into real economic activity, either through rising prices, output or a combination of the two. In a sense, a turnaround in V is a signal that the precautionary demand for money is falling. This is usually synonymous with higher interest rates. Chart I-6Watch The Yield Curve Watch The Yield Curve Watch The Yield Curve In a general sense, V can be viewed as the interest rate required by the underlying economy (the neutral rate), since it is measured using economic variables. Once economic agents start to increase the turnover of money in the system as activity improves, it is an endogenous sign that the economy has escaped a liquidity trap and can handle higher rates. Over the longer term, exchange rates should fluctuate along with the ebb and flow of V, or the relative neutral rate of interest between two countries. Herein lies the problem. The velocity of money is observed ex-post, meaning it is not very useful as a forecasting tool. We already know from the drop in interest rates that the velocity of money is collapsing everywhere. Therefore, how can one gauge for tentative signs of a reversal? One method is to look at financial variables. The yield curve is one example. Whenever the fed funds target rate falls below the neutral rate of interest in the US, the yield curve usually steepens (Chart I-6). A steepening yield curve usually signifies borrowing costs are well below the structural growth rate of the economy. As such, banks do well in this environment. Another barometer, and our favorite, is the ratio of industrial commodities to financial ones, or more precisely, the gold-to-silver ratio. A steepening yield curve usually signifies borrowing costs are well below the structural growth rate of the economy.  Bottom Line: With interest rates near zero in the developed world, proxies for the velocity of money become important in gauging when we exit the belly of the liquidity trap. Gold Versus Silver Chart I-7Watch The Gold/Silver Ratio Watch The Gold/Silver Ratio Watch The Gold/Silver Ratio The gold/silver ratio (GSR) provides important information on the battleground between easing financial conditions and a pick-up in economic (or manufacturing) activity. The GSR tends to rally ahead of an economic slowdown, but then peaks when growth is still weak but financial conditions are easy enough to lift the economy out of a liquidity trap. Of course, a key assumption is that the global economy fends off a deeper recession, which would otherwise sustain a high and rising GSR. Just like gold, silver benefits from low interest rates, plentiful liquidity, and the incentive for fiat money debasement. However, today, silver has much more industrial uses than gold, allowing it to sniff out any shift in the economic landscape. Silver fabrication demand benefits from new industries such as solar and a flourishing “cloud” orbit that are capturing the new manufacturing landscape. As a result, the dollar tends to be positively correlated with the gold/silver ratio (Chart I-7). The gold/silver ratio has been a good confirming indicator on when to rebuy procyclical currencies. The gold/silver ratio (GSR) broke above major overhead resistance at 100 just as the dollar liquidity crunch was intensifying and is now showing tentative signs of a reversal. The history of these reversals is that they tend to be powerful but extremely volatile. More importantly, the ratio has been a good confirming indicator on when to rebuy procyclical currencies (Chart I-8). Given that the ratio is close to its highest level in 120 years, the odds are that the forces of mean reversion will continue to push it lower. A break in the ratio below 100 will be a positive development (Chart I-9). Chart I-8Tentative Signs Of Improvement Tentative Signs Of Improvement Tentative Signs Of Improvement Chart I-9Watch The 100 Level Watch The 100 Level Watch The 100 Level The ratio of the velocity of money between the US and China has tended to track both the gold/silver ratio and the dollar closely. Given the epicenter of the crisis was China, a falling GSR will also signify Beijing has been successful in rekindling animal spirits, as the economy reopens for business. Bottom Line: A falling GSR will be consistent with a peak in the dollar and upside for pro-cyclical currencies. Housekeeping We continue to recommend a barbell strategy for now – a basket of the cheapest currencies together with some save havens. Investors can seek such protection by selling EUR/JPY. EUR/JPY should continue to sell off in the short term. First, the yen tends to do well when volatility is high, as is the case now. Second, given that Japan is closer to the Asean economies who were first hit with Covid-19, it will probably see activity recover a little faster relative to the West. In addition, real rates are higher in Japan relative to Europe. Lastly, consistent with our thesis above, place a sell-stop on GSR at 100.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1  Given that GDP is a flow concept, and central bank balance sheets are a stock concept, the impulse is calculated as follows: 1) Take the 12-month change in the balance sheet, to convert it to a flow. 2) Show the 12-month change of this flow as a % of GDP to gauge the impulse of stimulus.  Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 Recent data in the US have been negative: Headline inflation fell sharply from 2.3% to 1.5% year-on-year in March. Core inflation dropped by 0.3% to 2.1%. Export and import prices both contracted by 3.6% and 4.1% year-on-year, respectively in March. NY Empire State manufacturing index plunged from -21.5 to -78.2 in April. Retail sales slumped by 8.7% month-on-month in March, down from -0.4% the previous month. Initial jobless claims increased by 5,245K last week, above the expectations of 5,105K. The DXY index increased by 0.3% this week on the back of safe-haven demand. The break above the psychological overhead resistance at 100 means we can begin to see a flurry of buy orders, as traders move to hedge positions. The Fed’s Beige Book reported sharp contraction in Q1, which should carry on into Q2.  Leisure, hospitality and retail were the hardest-hit industries. Report Links: Capitulation? - April 3, 2020 The Dollar Funding Crisis - March 19, 2020 Are Competitive Devaluations Next? - March 6, 2020 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Recent data in the euro area have been negative: March consumer prices were released across the euro area: the headline inflation rate was stable at 1.3% year-on-year in Germany and 0.1% in Italy. It increased from 0.7% to 0.8% in France while falling from 0.1% to 0 in Spain. Industrial production contracted by 1.9% year-on-year in February. The euro fell by 0.5% against the US dollar this week. As the anti-dollar and a global growth barometer, trends in the euro will primarily be dictated by what happens to the greenback. The IMF April 2020 World Economic Outlook forecasted global output to contract by 3% in 2020. Moreover, it predicted the Euro area to be hit the hardest, with output shrinking by 7.5% this year, in comparison to 5.9% in the US, 6.5% in the UK, and 5.2% in Japan. Report Links: On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 On Money Velocity, EUR/USD And Silver - October 11, 2019 Japanese Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data in Japan have been negative: Machine tool orders kept contracting by 41% year-on-year in March, worse than the 30% decline in February. Money supply (M2) increased by 3.3% year-on-year in March, up from 3% the previous month. The Japanese yen rose by 1% against the US dollar this week. The BoJ Governor Haruhiko Kuroda said that the central bank will not hesitate to further ease monetary policy depending on COVID-19 developments. Possible solutions to support corporate funding include more purchases of corporate bonds and commercial paper, as well as easing collateral standards. More importantly, the government unveiled a 108 trillion yen fiscal package, amounting to 20% of GDP. Report Links: The Near-Term Bull Case For The Dollar - February 28, 2020 Building A Protector Currency Portfolio - February 7, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data in the UK have been negative: Retail sales contracted by 3.5% year-on-year in March. The British pound has been flat against the US dollar this week. The BoE’s Credit Conditions Survey showed growing concerns from banks about the outlook during the COVID-19 health crisis. The BoE said that “Overall availability of credit to the corporate sector was unchanged for all business sizes in Q1, but was expected to increase for all business sizes in Q2.” British banks now expect to lend more to businesses in the next three months, more so than to the household sector. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 A Few Trade Ideas - Sept. 27, 2019 United Kingdom: Cyclical Slowdown Or Structural Malaise? - Sept. 20, 2019 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Recent data in Australia have been negative: NAB business confidence crashed from -2 to -66 in March. Business conditions also dropped from 2 to -21. Westpac consumer confidence plunged from -3.8 to -17.7 in April. The unemployment rate inched up from 5.1% to 5.2% in March, lower than the expected 5.5%. 6K jobs were created in March, down from 26K the previous month, while well above the consensus of 40K job loss. However, the Australian Bureau of Statistics pointed out that the monthly data mostly only covers the first two weeks of March. AUD/USD fell by 0.6% this week. With Australian GDP now forecasted to shrink by 7% in Q2, and another 1% in Q3, the Australian economy is destined for its first recession in three decades. Prime Minister Scott Morrison has pledged A$130 billion subsidy for employers to prevent further layoffs. Report Links: On AUD And CNY - January 17, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 A Contrarian View On The Australian Dollar - May 24, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 Recent data in New Zealand have been negative: Visitor arrivals declined by 11% year-on-year in February, down from an increase of 3% the previous month. This trend will likely worsen in March. House prices increased by 0.7% month-on-month in March, down from the last reading of 3.1%. The New Zealand dollar fell by 2% against the US dollar this week. On Thursday, the RBNZ Governor Adrian Orr said that the New Zealand financial institutions were strong and in a position to be part of the solution, while acknowledging that the soaring unemployment and high mortgage debts could pose a big challenge to the economy. Moreover, he said that the current central bank interventions to mitigate COVID-19 damage are just the beginning, and that negative interest rates are not off-the-table. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Place A Limit Sell On DXY At 100 - November 15, 2019 USD/CNY And Market Turbulence - August 9, 2019 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Recent data in Canada have been negative: Existing home sales slumped 14.3% month-on-month in March, down from 5.9% the prior month. Bloomberg Nanos confidence kept falling to 38.7 from 42.7 for the week ended April 10. The Canadian dollar kept falling by 1.2% against the US dollar this week. On Wednesday, the BoC kept interest rates steady at 0.25%, after having lowered it by 150 bps over the past three weeks. Moreover, the BoC has announced additional measures to weather the crisis, including new purchases of provincial bonds by up to C$50 billion and corporate bonds by up to C$10 billion. The Bank has also enhanced its term repo facility to permit funding for up to 24 months. Report Links: A New Paradigm For Petrocurrencies - April 10, 2020 The Loonie: Upside Versus The Dollar, But Downside At The Crosses Updating Our Balance Of Payments Monitor - November 29, 2019 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Recent data in Switzerland have been mixed: Total sight deposits increased to CHF 634 billion for the week ended April 10, up from the previous reading of CHF 627 billion. Producer prices fell by 2.7% year-on-year in March, lower than the expected -2.5%. The Swiss franc fell by 0.3% against the US dollar this week, amid broad US dollar strength. While USD/CHF remains under parity, investors seeking cover from US dollar strength did not find shelter in the franc. Switzerland’s Federal Council has offered emergency loans to almost 80,000 small businesses, far more than other European countries. The most recent IMF World Economic Outlook is now forecasting the Swiss GDP to slump 6% in 2020, followed by a rebound of 3.8% next year. This compares favorably with the slated euro area contraction of 7.5% this year. Report Links: On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 Portfolio Tweaks Before The Chinese New Year - January 24, 2020 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Recent data in Norway have been negative: The trade surplus tumbled to NOK 2.5 billion in March from NOK 18.5 billion the same month last year. After having rebounded by 15% from its March lows, the Norwegian krone fell again by 3% against the US dollar this week, making it the worst-performing G10 currency. The trading pattern of the Norwegian krone in recent weeks has mirrored that of emerging market currencies, warranting intervention by the central bank. OPEC has agreed over the weekend to cut production by 9.7 million barrels per day in May and June, which represents approximately 10% of global supply. Despite the production cut, oil prices slipped this week over growing COVID-19 demand fears and supply concerns.  Report Links: A New Paradigm For Petrocurrencies - April 10, 2020 Building A Protector Currency Portfolio - February 7, 2020 On Oil, Growth And The Dollar - January 10, 2020 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Recent data in Sweden have been negative: Headline inflation declined from 1% to 0.6% year-on-year in March, while in line with expectations, this is the lowest inflation rate since May 2016. The Swedish krona fell by 0.8% against the US dollar this week. Sweden’s COVID-19 death toll just passed 1000 this week. While its fatality rate is still well below that in Italy and the UK, it’s much higher than its Scandinavian neighbors, which adds more criticism surrounding Sweden’s decision to ignore the lockdown measures imposed elsewhere. Prime Minister Stefan Lofven has said that stricter measures may be needed going forward, which will pose more threat to the economy. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019 Balance Of Payments Across The G10 - February 15, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Feature In this report, we determine which South and Southeast Asian countries are better equipped to endure the COVID-19 pandemic. Answers to this question combined with our macro fundamental analysis lead us to recommend which countries to favor or avoid. We assess several factors in regard to the COVID-19 shock: (1) the healthcare capacity in each country, (2) the COVID-19 containment measures that have been implemented, and (3) the magnitude of fiscal and monetary stimulus packages that have been announced. We conclude that EM equity investors should keep an overweight position in Thai equities and a neutral one in the Malaysian stock market. Indian, Indonesian and Philippine stock markets, on the other hand, warrant an underweight stance. Healthcare System Capacity The COVID-19 virus can cause individuals with underlying medical conditions and already in poor health, as well as those above a certain age, to become seriously ill when infected. These patients will require the kind of special medical attention  – such as ventilation – that is only provided in a hospital’s intensive care unit (ICU). A country that currently lacks sufficient ICU capacity relative to the number of patients requiring it, risks overburdening the health care system. This would be a social catastrophe. A country that currently lacks sufficient ICU capacity relative to the number of patients requiring it, risks over¬burdening the health care system. Therefore, a key measure of the current coronavirus crisis is the relation between a population’s risk of developing critical illness from COVID-19 infections and a country’s intensive care unit (ICU) availability. We assess the risk of COVID-19 infections developing into critical illnesses in ASEAN countries and in India by gauging (1) the prevalence of diabetes in the population and (2) the share in population of people above the age of 60. Chart I-1 and Chart I-2 illustrate these factors separately. Chart I-1ASEAN & India: Population With Diabetes COVID-19 Battle: Assessing ASEAN And Indian Capabilities COVID-19 Battle: Assessing ASEAN And Indian Capabilities Chart I-2Population Above 60 Years Old COVID-19 Battle: Assessing ASEAN And Indian Capabilities COVID-19 Battle: Assessing ASEAN And Indian Capabilities In addition, we combine these two risk variables to calculate the risk of critical illness. This measure is shown in Chart I-3. The measure shows that the population of both Malaysia and Thailand carry the highest risk of developing critical illnesses from COVID-19, owing to Malaysia’s high prevalence of diabetes and to Thailand’s rapidly aging population. Meanwhile, that risk is somewhat lower in India and dramatically lower in both the Philippines and Indonesia.  The next thing to look at is each country’s ICU capacity. Chart I-4 shows the number of ICU beds available per 100,000 people. Thailand has the highest number and Malaysia the second highest. On the other hand, India, Indonesia and the Philippines all have lower rates of ICU capacity. Chart i-3The Risk Of Critical Illness From COVID-19 COVID-19 Battle: Assessing ASEAN And Indian Capabilities COVID-19 Battle: Assessing ASEAN And Indian Capabilities Chart I-4Intensive Care Unit (ICU) Capacity COVID-19 Battle: Assessing ASEAN And Indian Capabilities COVID-19 Battle: Assessing ASEAN And Indian Capabilities Finally, we compare the risk of critical illness in each country to its available ICU capacity. Chart I-5 shows a scatter plot between these two variables. The risk of critical illness is shown on the Y-axis and the availability of ICU beds per 100,000 people is plotted on the X-axis. Thailand and Malaysia both have the highest risk of critical illness but also a large number of available ICU beds. India, Indonesia and the Philippines have lower average risk of critical illness but also far fewer ICU bed availabilities. Chart I-5The Risk Of Critical Illness Versus ICU Capacity COVID-19 Battle: Assessing ASEAN And Indian Capabilities COVID-19 Battle: Assessing ASEAN And Indian Capabilities It is also important to note that Malaysia has the highest relative number of medical doctors per 10,000 people in the region (15 versus an average of 8). Furthermore, both Malaysia and Thailand appear to be performing many more COVID-19 tests. That in turn should help slow the spread of the virus and avoid overwhelming health care systems of Malaysia and Thailand. Bottom Line: Thailand and Malaysia have decent healthcare care capabilities relative to the threat of critical illness among their populations. India, Indonesia and the Philippines, on the other hand, seem relatively unprepared to weather this outbreak. Containment Response The magnitude and effectiveness of social distancing measures implemented is a critical means of protecting a country’s health care system. Indeed, the sooner such measures are put into place, the earlier the threat of the pandemic is likely to subside. This will then allow a country to normalize its economic activities sooner.  It appears that the Philippines and India have enacted the most stringent social distancing measures. Both announced complete lockdowns and called in their respective national armies to intervene. Malaysia has also announced extremely inhibitive measures and their enforcement has been quite successful. In Thailand, while the authorities have not imposed a complete lockdown, they have placed curfews and checkpoints that are subject to extension. Thai authorities have also warned that more restrictive measures could be imposed if residents do not comply. Indonesia, on the other hand, has been much softer on enforcement and is reluctant to introduce additional measures due to its economic concerns. Malaysia and Thailand emerge as the most likely to win the battle against COVID-19 in the region. Remarkably, the effectiveness of the measures can be quantitatively assessed via Google’s COVID-19 mobility tool and TomTom’s traffic congestion data. The average of all Google’s mobility variables, as of April 5, has declined most significantly in the Philippines, Malaysia, and India, relative to baseline values (Chart I-6).1 Likewise, TomTom’s traffic congestion data for the major cities in these same countries’ shows a similar decline during average peak hours over the first two weeks of April 2020, relative to the same period in 2019 (Chart I-7). Chart I-6How Effective Are Social Distancing Measures? COVID-19 Battle: Assessing ASEAN And Indian Capabilities COVID-19 Battle: Assessing ASEAN And Indian Capabilities Chart I-7Decline In Traffic From ##br##A Year Ago COVID-19 Battle: Assessing ASEAN And Indian Capabilities COVID-19 Battle: Assessing ASEAN And Indian Capabilities Bottom Line: The Philippines, India, and Malaysia have imposed the most effective and successful social distancing measures. This is then followed by Thailand. Indonesia on the other hand has not been as effective in this aspect. Fiscal And Monetary Stimulus Table I-1Stimulus Packages So Far Announced COVID-19 Battle: Assessing ASEAN And Indian Capabilities COVID-19 Battle: Assessing ASEAN And Indian Capabilities The magnitude of the stimulus plans announced by each country is also important. Once the pandemic subsides and social distancing measures are relaxed, countries with a larger stimulus package in place should experience a faster economic recovery. Table I-1 shows the size of the overall stimulus packages announced so far. Malaysia and Thailand have the largest overall stimulus packages to the tune of 16% and 14% of GDP, respectively. India, Indonesia and the Philippines fall well short of these levels. Regarding monetary policy, central banks in all these countries have been cutting policy rates and injecting local currency liquidity. However, some of the programs announced by some of the central banks stand out: The Bank Of Thailand will inject 400 billion baht ($13 billion or 2% of GDP) into the corporate bond market. The central bank is also allocating 500 billion baht ($15 billion or 3% of GDP) of soft loans to small-and mid-sized companies.2 The central bank of the Philippines will be purchasing 300 billion pesos worth of government bonds ($6 billion or 1.6% of GDP) under a 3- to 6-month repurchase agreement to aid government efforts in countering the pandemic. Bank Indonesia may also begin buying government bonds (recovery/pandemic bonds) directly from the primary market. Details are not yet clear but the Indonesian government plans to issue $27 billion worth of these bonds and the central bank might emerge as the largest buyer. Similarly, the Reserve Bank of India has been injecting liquidity and purchasing government bonds for some time now. For instance, it announced a 1 trillion rupees injection in February – or $13 billion – via the long-term repo operation channel. It is now infusing an additional 1 trillion rupees through the same channel. It will also continue purchasing government bonds and securities to keep liquidity aflush and suppress market interest rates. Crucially, Governor Shaktikanta Das indicated that the RBI might even be forced to purchase government bonds directly from the primary market and that all options – including non-conventional ones – are on the table. Bottom Line: Both Thailand and Malaysia have so far announced larger overall stimulus packages than Indonesia, the Philippines and India have. This combined with their better health care capacities, suggests that the Thai and Malaysian economies will recover more quickly than they will in India, Indonesia and the Philippines. Conclusions Having considered risk of critical illness, the ICU availability and general medical capacities, the effectiveness of social distancing measures, and the stimulus packages each country has announced, Malaysia and Thailand emerge as the most likely to win the battle against COVID-19 in the region. Despite their elevated risk of critical illness, both countries have decent healthcare system capacities. Additionally, Malaysia has put in place very effective social distancing measures. Meanwhile, Thailand is placing curfews and monitoring developments very closely. Finally, both countries have enacted massive stimulus packages that will aid in the recovery of their economies later this year.  Notably, Thailand and Malaysia have been running current account surpluses for a long period of time whereas India, Indonesia and the Philippines generally run current account deficits. This, in turn, will allow the former to implement much larger overall stimulus packages than the latter, without risking major currency depreciation. Despite strong and successful social distancing efforts, India and the Philippines are hampered by a weakness in their health care infrastructures. They also are unlikely to be able to provide a large enough stimulus without subjecting themselves to significant currency depreciation. Additionally, India also has an elevated critical illness risk. Finally, Indonesia is likely to emerge from the crisis in the weakest position. Its healthcare system capacity is weak, the social distancing measures it implemented are insufficient and its enforcement has been lax. Indonesia is likely to emerge from the crisis in the weakest position. The government has also been timid about enacting significant stimulus given that it runs a large current account deficit. Moreover, it is unwilling to tolerate any further large currency depreciation due to the elevated foreign currency debt that Indonesian companies and banks carry. The latter stands at  $124 billion in the form of both bonds and loans. Investment Strategy Chart I-8Thai Stock Prices Vs. Emerging Markets Thai Stock Prices Vs. Emerging Markets Thai Stock Prices Vs. Emerging Markets The following is our strategy recommendations for each country: Thailand: Our equity overweight stance on this bourse has been significantly challenged since early this year (Chart I-8). However, Thai stocks seem to be holding up at an important technical support level in relative terms.       Furthermore, as of December 2019, the ownership of the country’s local currency bonds was low at 17% (i.e. even before the global sell-off commenced). Further selling by foreigners should therefore be limited, which should reduce renewed depreciation pressures on the Thai currency. We recommend that respective EM portfolios keep an overweight position on Thai equities, sovereign US dollar and local currency bonds. Malaysia: On the one hand, Malaysian stocks have been underperforming EM benchmarks since 2014. Also, foreign ownership of Malaysian local currency bonds has declined from 34% in 2016 to 25% as of December 2019. This limits the possibility of future foreign selling. On the other hand, the economy was facing severe deflationary pressures even before the COVID-19 shock occurred. The latter will only reinforce these deflationary dynamics. Considering the positives and the negatives together, we recommend a neutral allocation to Malaysia within an EM equity portfolio. The Philippines:  Philippine stock prices relative to EM seem to have broken below a critical support level that will now act as resistance (Chart I-9). Moreover, local currency government bond yields have risen sharply (Chart I-10 and Chart I-11). This does not bode well for real estate and bank stocks that account for a very large market-cap chunk of the Philippine MSCI Index (46%). Critically, government expenditures were strong even before the COVID-19 pandemic occurred and it was only a matter of time before that contributed to higher imports. Now that exports are crashing - due to collapsing global demand - and imports are likely to remain high because of even higher government spending/fiscal stimulus, the current account deficit will widen substantially. This will cause the peso – which has been holding up so far – to depreciate significantly. Stay underweight on this bourse and local currency government bonds relative to their respective EM benchmarks. We also recommend keeping a short position on the Philippine peso versus the US dollar. Chart I-9Philippine Stock Prices Vs. Emerging Markets Philippine Stock Prices Vs. Emerging Markets Philippine Stock Prices Vs. Emerging Markets Chart I-10Philippine Yields In Absolute Terms... Philippine Yields In Absolute Terms... Philippine Yields In Absolute Terms... Chart I-11...And Relative To Their EM Peers ...And Relative To Their EM Peers ...And Relative To Their EM Peers India: We discussed India in detail in a recent report. We recommend an underweight position amid the pandemic. In previous years, private banks lent enormous amounts to consumers via mortgages and consumer loans/credit cards. Therefore, the performance of both sectors has been contingent on the health of the Indian consumer sector. However, the outlook for the Indian consumer has worsened dramatically because of the unprecedented income hit households will suffer from the lockdown. Moreover, social safety nets and health care capacities (as mentioned above) are very weak in India. Indonesia: We also discussed Indonesia in detail in a report published on April 2. In recent years, the Indonesian bourse benefited from lower US interest rates and ignored deteriorating domestic fundamentals and lower commodities prices. Global investors’ increased sensitivity to individual EM fundamentals amid this pandemic will only make Indonesia’s weakest spots – like its exposure to commodities and its anemic domestic demand – more apparent. With global growth being very weak, commodities prices will remain low – reinforcing currency depreciation and pushing corporate bond yields higher. Combined with relapsing domestic growth, the Indonesian bourse will likely continue underperforming. Bottom Line:  Within an EM equity portfolio, we are keeping an overweight position on the Thai stock market. We also recommend keeping Malaysian equities on neutral. Our equity underweights are India, Indonesia, and the Philippines. In terms of fixed income markets, we recommend overweighting Thai, Malaysian and Indian local currency bonds and US dollar sovereign bonds. We recommend underweighting Indonesian and Philippine local and US dollar sovereign bonds.   Ayman Kawtharani Editor/Strategist ayman@bcaresearch.com Footnotes 1 The baseline is the median value between January 3 and February 6. Our average calculation includes retail & recreation, grocery & pharmacy, parks, transit stations, and workplaces. It excludes the residential variable. 2 Note that this is part of the stimulus shown in Table 1.

Highlights Portfolio Strategy The Fed’s QE and ZIRP, the collapse in gasoline prices and extremely depressed breadth readings that are contrarily positive, all signal that it no longer pays to be bearish consumer discretionary stocks. A boost in demand for e-commerce, the high-growth profile of internet retailers along with neutral valuations and technicals, all compel us to trigger our upgrade alert and lift the S&P internet retail index to overweight. The rising gap between house price inflation and mortgage rates, the looming increase in residential investment’s contribution to GDP growth and firming industry operating metrics, all argue for an above benchmark allocation in the S&P home improvement retail index. Recent Changes Boost the S&P consumer discretionary sector to overweight today. Execute the upgrade alert and lift the S&P internet retail index to overweight today. Augment exposure to the S&P home improvement retail index to above benchmark today. Table 1 Fight Central Banks At Your Own Peril Fight Central Banks At Your Own Peril Feature The SPX oscillated violently last week, and a glimmer of good news on the coronavirus fight front, the Fed’s newly announced bazooka and a tick down in unemployment insurance claims all signaled that the bulls have the upper hand. We first showed the Google Trends’ worldwide searches for “coronavirus” series in our early-March Weekly Report,1 when stocks were unhinged and we were still bearish. Now, the most recent update of this indicator suggests that the recessionary lows are likely in for the SPX – this search term peaked a week prior to the overall stock market’s bottom (Google Trends shown inverted, Chart 1) – and we therefore reiterate our cyclically sanguine equity market view.2 Moreover, two weeks ago we highlighted that market internals were confirming the SPX recessionary lows.3 Not only did the SOX versus NDX and small caps versus large caps bottom in advance of the S&P 500, but also transports along with the Value Line Geometric and Arithmetic Indexes relative ratios all led the broad market’s trough.4 Chart 1Joined At The Hip Joined At The Hip Joined At The Hip Chart 2Dr. Copper... Fight Central Banks At Your Own Peril Fight Central Banks At Your Own Peril Importantly, Dr. Copper is also sending a bullish signal for the broad equity market. Economically sensitive copper tends to trough prior to the SPX especially in recessions. Copper collapsed below $2/lb recently leading the SPX by a few days (Chart 2). Similarly, in the recent late-2015/early-2016 manufacturing recession, the 2007/09 and 2001 recessions, copper sniffed out the bottom before the overall equity market troughed (Chart 3). Turning over to the macro backdrop, keep in mind that the Fed first cut rates this year on March 3, 2020, a mere nine trading days following the SPX peak when it fell just below the 10% correction mark. Then, on Sunday March 15, 2020 the Fed cut rates to zero, as the SPX had fallen another 10% into a bear market. Chart 3...Tends To Lead ...Tends To Lead ...Tends To Lead Just to put these moves into perspective, the last time the SPX fell roughly 20% from its peak was on Christmas Eve 2018, and it took the Fed seven months to cut interest rates. While a retest of the 2174 ES futures lows is possible, we would rather not fight the Fed. Instead, we continue to recommend investors deploy cyclically oriented capital in the broad equity market with a 9-12 month time horizon. Chart 4 shows that the Fed is on track to balloon its balance sheet over $11tn in the coming year, i.e. almost trebling it, and soaring to over 50% of GDP. Chart 4Follow The… Follow The… Follow The… Beyond the Fed’s QE5 liquidity injection and skyrocketing bank credit, in response to firms tapping existing credit lines, money seems to be growing on trees. M2 money supply growth spiked to 14.8% of late, the highest rate since WWII! This breakneck pace of M2 growth translates into $2tn created versus last year. In the past two weeks alone, M2 grew by $805bn. Deposits and money market funds’ assets are surging, driving the money supply to unprecedented levels. While we have sympathy to some investors’ view that very little of this money and credit will flow to the real economy, such flush liquidity is likely to spillover from the banking system. Asset prices will be the primary beneficiaries of that flood, albeit with a slight lag (Chart 5). Chart 5…Money Trail …Money Trail …Money Trail Meanwhile, we have heeded our research of how to prepare a portfolio from the SPX peak to the recessionary trough highlighted in the Special Report penned in May 2018, and we have been overweight health care and consumer staples (please refer to Table 5 in that Special Report).5 We are now building on the research from that report. Table 2 shows the (unweighted) average relative sector performance six, twelve and eighteen months out from the SPX recessionary troughs, using market cycles since the 1960s. Table 2Sector Winners From Recessionary Recoveries Fight Central Banks At Your Own Peril Fight Central Banks At Your Own Peril Early cyclicals financials and consumer discretionary along with tech are clear winners in all three periods we analyzed. This empirical evidence confirms the theoretical backdrop that early cyclicals are the first to sniff out a recovery during a recession. At the opposite end of the spectrum, defensive utilities, consumer staples and telecom services fare poorly in the three time frames we examined. Impressively, health care (we are overweight), which is the defensive sector with the largest market cap weight, manages to eke out modest relative gains. Charts 6 & 7 depict these time series profiles for the ten GICS1 sectors (we use telecom services instead of communication services due to lack of historical data). Chart 6Early Cyclicals Rise To The Occasion... Early Cyclicals Rise To The Occasion... Early Cyclicals Rise To The Occasion... Chart 7...But Defensives Lag ...But Defensives Lag ...But Defensives Lag We are already overweight financials, hence, this week we heed this empirical evidence and are upgrading the S&P consumer discretionary sector to overweight via executing the upgrade alert on the S&P internet retail index and also via augmenting the S&P home improvement retail (HIR) index to an above benchmark allocation. Boost Consumer Discretionary To Overweight… While we may be a bit early, we recommend investors augment exposure to the S&P consumer discretionary index to overweight, today. The Fed really cares about household net worth (HNW). It is a key pillar of consumer spending, which powers over 70% of the US economy. Greenspan in the late 1990s eloquently described this relationship between HNW and the economy. In Q1/2020 HNW will take a beating, but the Fed is making sure it recovers in Q2, and is doing everything in its power to keep the stock and residential real estate markets afloat (roughly 50% of HNW). Granted employment and income are also currently of paramount importance, and the Main Street Fed programs along with the massive fiscal easing package should partially cushion the blow from the looming surge in the unemployment rate. We are therefore comfortable with lifting consumer discretionary to an above benchmark allocation. Chart 8 highlights the inverse correlation between consumer discretionary relative performance and the fed funds rate dating back to the 1980s. Now that the Fed has returned to ZIRP and is on track to expand its balance sheet to over $11tn, the risk/reward tradeoff favors consumer discretionary stocks. Keep in mind household balance sheets have been repaired since the Great Recession with both debt/income and debt/GDP ratios plumbing multi-year lows as the GFC hit the consumer (and financial sector) hardest (bottom panel, Chart 8). Chart 8Buy Consumer Discretionary Stocks Buy Consumer Discretionary Stocks Buy Consumer Discretionary Stocks Our consumer drag indicator comprising interest rates and oil prices also signals that the path of least resistance for this early cyclical sector is higher (Chart 9). Not only will consumers eventually take advantage of ultra-low interest rates to buy big ticket items on credit, but also a wave of mortgage refinancing at lower rates translates into more cash in consumers’ wallets. Keep in mind that $20/bbl oil also saves US consumers money as retail gas at the pump has now plunged to $1.8/gallon from a recent high of $2.8/gallon. If we are correct and the US economy avoids a Great Depression/Recession, then the swift economic collapse will likely prove transitory as the authorities will have to slowly reopen the economy in early May, and the US consumer will come roaring back in the back half of the year. Finally, sentiment is bombed out toward consumer discretionary equities. Earnings breadth is as bad as it gets, technicals are washed out and a lot of damage has already been done to these interest rate-hypersensitive stocks (Chart 10). True, valuations are a bit extended, but were our thesis to pan out, these early cyclical stocks will grow into their expensive valuations. Chart 9Tailwinds Tailwinds Tailwinds Netting it all out, the Fed’s QE and ZIRP, the collapse in gasoline prices and extremely depressed breadth readings that are contrarily positive, all signal that it no longer pays to be bearish consumer discretionary stocks. Chart 10As Bad As It Gets As Bad As It Gets As Bad As It Gets Bottom Line: Boost the S&P consumer discretionary sector to overweight today from previously underweight, for a modest loss of 1.4% since inception. …Via Executing The Upgrade Alert On Internet Retail To Overweight… E-commerce has been garnering a rising market share of total retail sales uninterruptedly for over two decades. In fact, this juggernaut accelerates during recessions not only because overall retail sales level off, but also internet sales prove resilient during downturns. We are thus compelled to boost the bellwether S&P internet retail index to overweight by executing our upgrade alert to take advantage of the ongoing explosion of internet sales in the face of the coronavirus pandemic (Chart 11). AMZN dominates the internet retail space and by extension the broad consumer discretionary index, especially ever since the media complex migrated to the newly formed S&P communications services index in October 2018. Therefore, as AMZN goes so goes the rest of the consumer discretionary sector. Chart 11Market Share Gains As Far As The Eye Can See Market Share Gains As Far As The Eye Can See Market Share Gains As Far As The Eye Can See AMZN is a retail category killer and the “amazonification” of the economy is not something new as evidenced by the shopping mall evisceration and the dampening of retail sales price inflation. Nearly every segment AMZN has entered it has dominated. The Whole Foods acquisition has also positioned this internet retail behemoth to benefit from an online push for groceries. All of these forces were ongoing prior to the current recession. Now we deem they will accelerate and disproportionately benefit internet retailers at the expense of bricks and mortar retailers: the howling out of the latter is best evidenced by the recent double demotion of Macy’s from the big leagues to the S&P 600 small cap index. Related to the inevitable rise in demand for e-commerce owing to social distancing, growth is a highly sought after attribute that this index enjoys. Time and again we have stressed that when growth is scarce investors flock to industries that exemplify growth (Chart 12). AMZN’s cloud business, AWS, represents another aspect of significant growth, that will remain on an exponential trajectory as more and more businesses move to the SaaS model catalyzed by the current recession. While at first sight this index appears expensive, versus its own history it has worked off previously extreme valuation readings. In more detail, our relative Valuation Indicator has fallen from three standard deviations above the mean back to the historical average. Similarly, despite the recent run-up in prices, relative technicals are only back up to the neutral zone (Chart 13). Chart 12Seek Out Growth… Seek Out Growth… Seek Out Growth… Chart 13...At A Reasonable Price ...At A Reasonable Price ...At A Reasonable Price Adding it all up, a boost in demand for e-commerce, the high-growth profile of internet retailers along with neutral valuations and technicals, all compel us to trigger our upgrade alert and lift the S&P internet retail index to overweight. Bottom Line: Execute the upgrade alert and boost the S&P internet retail index to overweight, today. The ticker symbols for the stocks in this index are: BLBG: S5INRE - AMZN, BKNG, EBAY, EXPE. …And Upgrading Home Improvement Retailers To Overweight Home improvement retailers (HIR) were the first consumer discretionary stocks to sniff out the end of the Great Recession, troughing even prior to the China-sensitive materials and industrials equities (Chart 14). As such we believe these economically hyper-sensitive stocks will once again showcase their early cyclical status, and we recommend augmenting exposure to above benchmark. ZIRP along with the rising gap between house price inflation and mortgage refinancing rates are a tonic for home improvement retailers (fed funds rate shown inverted, Chart 14). While the residential real estate market will remain in the doldrums for a few months (we recently monetized impressive gains in our underweight stance in the S&P homebuilding index and lifted to neutral), mortgage holders that retain their jobs will be quick to benefit from lower refinancing rates, and boost their savings. Some of these savings will likely flow into home improvement activities courtesy of the recent quarantine rules. One big assumption is that these retailers remain open during the coronavirus induced lockdown. Chart 14Overweight Home Improvement Retailers… Overweight Home Improvement Retailers… Overweight Home Improvement Retailers… If our thesis pans out, then given the looming drubbing in Q2 GDP, residential investment/GDP should jump and provide a relative boost to the S&P HIR index (second panel, Chart 15). None of this positive news is priced in relative forward sales or profits that are flirting with the zero line (third panel, Chart 15). Importantly, relative valuations have dropped below par and are 30% below the historical mean, offering a compelling entry point for fresh capital with a 12-18 month time horizon (bottom panel, Chart 15). Turning over to industry operating metrics, there is a budding recovery in a number of the indicators we track. Chart 15...As A Play On A Relative Rise In Fixed Residential Investment ...As A Play On A Relative Rise In Fixed Residential Investment ...As A Play On A Relative Rise In Fixed Residential Investment Chart 16Firming Operating Metrics Firming Operating Metrics Firming Operating Metrics While it is not very visible in Chart 16, lumber prices have bounced from $275/tbf to over $338/tbf of late, signaling gains for industry relative profits. As a reminder, HIR make a set margin on lumber sales, thus earnings tend to move with the ebb and flow of lumber prices. Moreover, the Fed is resolute to keep the residential real estate market afloat, as we aforementioned, owing to the HNW effect and all these new and old Fed QE policies should underpin the US residential market and by extension lumber prices (Chart 16). Meanwhile, the HIR price deflator has made an effort to exit deflation recently and should also contribute to the sector’s profitability in the coming quarters (Chart 16). Tack on the V-shaped recovery in the HIR sales-to-inventories ratio, albeit from depressed levels, and factors are falling into place for an earnings-led rebound in relative share prices (Chart 16). In sum, the Fed’s ZIRP and QE5, the rising gap between house price inflation and mortgage rates, the looming increase in residential investment’s contribution to GDP growth and firming industry operating metrics, all argue for an above benchmark allocation in the S&P home improvement retail index. Bottom Line: Lift the S&P HIR index to overweight, today. The ticker symbols for the stocks in this index are: BLBG: S5HOMI – HD, LOW.   Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com   Footnotes 1     Please see BCA US Equity Strategy Weekly Report, “From "Stairway To Heaven" To "Highway To Hell"?” dated March 2, 2020, available at uses.bcaresearch.com. 2     Please see BCA US Equity Strategy Weekly Report, ““The Darkest Hour Is Just Before The Dawn”” dated March 23, 2020, available at uses.bcaresearch.com. 3    Please see BCA US Equity Strategy Weekly Report, “What Is Priced In?” dated March 30, 2020, available at uses.bcaresearch.com. 4    Please see BCA US Equity Strategy Daily Report, “Watch The Value Line Geometric Index” dated April 1, 2020, available at uses.bcaresearch.com. 5    Please see BCA US Equity Strategy Special Report, “Portfolio Positioning For A Late Cycle Surge” dated May 22, 2018, available at uses.bcaresearch.com. Current Recommendations Current Trades Strategic (10-Year) Trade Recommendations Fight Central Banks At Your Own Peril Fight Central Banks At Your Own Peril Size And Style Views June 3, 2019 Stay neutral cyclicals over defensives (downgrade alert)  January 22, 2018 Favor value over growth May 10, 2018 Favor large over small caps (Stop 10%) June 11, 2018 Long the BCA  Millennial basket  The ticker symbols are: (AAPL, AMZN, UBER, HD, LEN, MSFT, NFLX, SPOT, TSLA, V).

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

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

Highlights Europe’s dirty little secret: Euro area debt is already mutualised. Investment implication: Overweight Italian BTPs, underweight German bunds, and overweight the euro on a structural (2-year plus) horizon. ESM plus ECB plus OMT equals a compromise solution to fund stimulus at a mutualised euro area interest rate. Investment implication: Overweight Italian BTPs, underweight German bunds on a cyclical (6-12 month) horizon. Spain’s high early peak in morbidity means that it has taken its pain upfront, at least compared to other countries.  Investment implication: upgrade Spain’s IBEX to a tactical overweight – and remove it from the cyclical underweight basket. Feature Chart of the WeekThe Underperformances Of China, Italy And Spain Were A Mirror-Image Of Their Covid-19 Morbidity Curves The Underperformances Of China, Italy And Spain Were A Mirror-Image Of Their Covid-19 Morbidity Curves The Underperformances Of China, Italy And Spain Were A Mirror-Image Of Their Covid-19 Morbidity Curves More About Morbidity Curves Most analyses of the pandemic tend to focus on the grim daily mortality statistics. Yet the key to the pandemic’s evolution is not its mortality rate, but rather its morbidity (severe illness) rate. This is because, without a vaccine, the total area underneath the morbidity curve is fixed. The cumulative number of people who will fall severely ill is pre-determined at the outset (Figures 1-3). Figure I-1The Area Under The Morbidity Curve Is Fixed, A High First Peak Means A Low Second Peak Will Europe Unite Or Split? Will Europe Unite Or Split? Figure I-2A Low First Peak Means An Extended First Peak… Will Europe Unite Or Split? Will Europe Unite Or Split?   Figure I-3…Or A High Second Peak Will Europe Unite Or Split? Will Europe Unite Or Split? Very optimistically assuming a Covid-19 morbidity rate of 1 percent, and that 65 percent of the population must get infected to exhaust the pandemic, we know that Covid-19 will ultimately make 0.65 percent of the population severely ill. Absent a vaccine, this number is set in stone. But the number of deaths is not set in stone. It depends on the availability of emergency medical treatment for those that are severely ill. For Covid-19 this means access to ventilation in an intensive care unit (ICU). Yet even the best equipped countries only have ICUs for 0.03 percent of the population. Therefore, the emergency treatment must be rationed either by supply or by demand. Without a Covid-19 vaccine, we cannot change the cumulative number of people who will become severely ill. Rationing by supply means that we must deny emergency treatment to the severely ill – not just Covid-19 patients but victims of, say, heart attacks or car crashes. Accept more deaths. Rationing by demand means that we must flatten the demand (morbidity) curve so that demand is always satisfied by the limited ICU supply. During the pandemics of 1918-19 and 1957, countries could ration emergency medical treatment by supply. Not in 2020. In an era of universal healthcare, everybody is entitled to, and expects to get, emergency medical care. Which means we must ration emergency medical treatment by demand. As such, we must analyse the 2020 response differently to the responses in 1918-19 and 1957. To repeat, without a vaccine, we cannot change the area under the morbidity curve. There is no way of escaping this truth. A low first peak requires a very elongated peak or a high second peak (Chart I-2). Conversely, countries that have suffered a high first peak will need a shorter peak and small (or no) second peak. Chart I-2Japan's Early Stabilisation Was A False Dawn Japan's Early Stabilisation Was A False Dawn Japan's Early Stabilisation Was A False Dawn Turning to an equity market implication, the underperformances of highly cyclical and domestically exposed Spain and Italy have closely tracked their morbidity curves (Chart I-1). Given that both countries have suffered very high first peaks in morbidity, the strong implication is that they have taken their pain upfront – at least compared to other countries. In the case of Spain, the market is also technically oversold (see Fractal Trading System). Investment implication: upgrade Spain’s IBEX to a tactical overweight – and remove it from the cyclical underweight basket. How Europe Could Unite Europe is dithering on its fiscal response to the pandemic. Specifically, Germany and the Netherlands are pushing back against the concept of mutualised euro area debt in the form of ‘corona-bonds’. But a pandemic is an act of nature, an indiscriminate exogenous shock. What is the point of the economic and monetary union if Italy must fund its response to an act of nature at the Italian 10-year yield of 1.5 percent rather than the euro area 10-year yield of 0 percent? (Chart I-3 and Chart I-4) Chart I-3To Fight An Act Of Nature Why Should Italy Borrow At A Higher Rate... To Fight An Act Of Nature Why Should Italy Borrow At A Higher Rate... To Fight An Act Of Nature Why Should Italy Borrow At A Higher Rate... Chart I-4...When It Could Borrow At A Lower Mutualised Rate? ...When It Could Borrow At A Lower Mutualised Rate? ...When It Could Borrow At A Lower Mutualised Rate? The good news is there is a compromise solution to fund stimulus at a mutualised interest rate. It uses the euro area’s €500 billion bailout fund, the European Stability Mechanism (ESM). But the compromise solution carries two problems which need mitigation. First, ESM credit lines come with conditionality. Italy would rightly balk if it were shackled like Greece, Portugal, and Ireland were after the euro debt crisis. Luckily, the ESM is likely to regard the current ‘act of nature’ crisis very differently to the debt crisis and impose only minimum and appropriate conditionality – for example, that credit lines should be used for healthcare and social welfare spending. Second, ESM credit lines come with a stigma. Taking fright that Italy is tapping the ESM, the bond market might drive up the yields on Italian BTPs. If this pushed up Italy’s overall funding rate, it would defeat the purpose of using the ESM in the first place. ESM plus ECB plus OMT equals a compromise solution to borrow at a mutualised interest rate. The hope is that the bond market, realising that Italy is using the bailout facility to counter an act of nature, would not drive up BTP yields. But if it did, the ECB could counter this by buying BTPs. One option would be to use its Outright Monetary Transactions (OMT) facility. Set up during the euro debt crisis, the OMT’s specific function is to counter bond market attacks when they are not justified by the economic fundamentals. In other words, to prevent a liquidity crisis escalating into a solvency crisis. Thereby, ESM plus ECB plus OMT equals a compromise solution to fund stimulus at a mutualised euro area interest rate. Investment implication: Overweight Italian BTPs, underweight German bunds on a cyclical (6-12 month) horizon. Europe’s Dirty Little Secret Outwardly, Germany and the Netherlands are reluctant to go down the slippery slope to mutualised euro area debt. But here’s the dirty little secret they don’t want you to know. Euro area debt is already mutualised. The stealth mutualisation has happened via the Target2 banking imbalance which now stands at €1.5 trillion. This imbalance is an accounting identity showing that Italy is owed ‘German euros’ via its large quantity of bank deposits in German banks while Germany is symmetrically owed ‘Italian euros’ via its large effective holding of Italian government bonds. The imbalance is irrelevant if a German euro equals an Italian euro. But if Italy defaulted on its bonds – by repaying them in a reinstated and devalued lira – then Target2 means that Germany must pick up the bill (Chart I-5). Chart I-5Target2 Means That If Italy Defaults, Germany Picks Up The Bill Will Europe Unite Or Split? Will Europe Unite Or Split? The Target2 imbalance is the result of the ECB’s QE program, in which the central bank has bought hundreds of billions of Italian bonds. If Italy repaid those bonds in a devalued lira, then the ECB would become insolvent, and the central bank’s remaining shareholders would have to plug the hole. The biggest shareholder would be Germany. Could Germany force Italy to repay its bonds in euros? No. According to a legal principle called ‘lex monetae’ Italy can repay its debt in its sovereign currency, whatever that is. Meanwhile, because of the fragility of the Italian banking system, the Italians who sold the bonds to the ECB deposited the cash in German banks. Legally, these depositors must be paid back in whatever is the German currency. Euro area debt is already mutualised. If euro area debt is already mutualised, why do policymakers continue to pretend that it isn’t? There are three reasons. First no policymaker would want to publicise that Germany is now on the hook if Italy left the euro. Second, no policymaker would want to publicise that the ECB has put Germany in this position (Chart I-6). Chart I-6ECB QE Has Created The Target2 Imbalance ECB QE Has Created The Target2 Imbalance ECB QE Has Created The Target2 Imbalance Third, and most important, policymakers would point out that the mutualisation of debt only happens if the euro breaks up. They would argue that because the euro is irreversible, the debt is not mutualised. In fact, their argument is completely back to front. The truth is: Because euro area debt is now mutualised, the euro has become irreversible. Investment implication: Overweight Italian BTPs, underweight German bunds, and overweight the euro on a structural (2-year plus) horizon. Fractal Trading System* As already discussed, this week’s recommended trade is long Spain’s IBEX 35 versus the Euro Stoxx 600. The profit target is 3 percent with a symmetrical stop-loss. Meanwhile our other trade, long Australia versus New Zealand has moved into a 2 percent profit. The rolling 12-month win ratio now stands at 66 percent. Chart I-7IBEX 35 Vs. EUROSTOXX 600 IBEX 35 Vs. EUROSTOXX 600 IBEX 35 Vs. EUROSTOXX 600 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   Fractal Trading System   Cyclical Recommendations Structural Recommendations Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields   Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations  

Dear Client, Next week, we will send you a special report published by our Geopolitical Strategy service, authored by my colleague Roukaya Ibrahim. Roukaya will provide her insights on the global shortages of medical equipment as well as the risk of food shortages. A significant portion of the special report focuses on China. We trust you will find her report very useful. Additionally, I will be having three webcasts next week, discussing the economic and financial implications of the COVID-19 pandemic on China. The webcasts will be in both English and Mandarin. Please check out the dates and time on our website. Best regards, Jing Sima China Strategist   Highlights China’s official and Caixin manufacturing PMIs in March were weak at best. The indexes underscore that a quick recovery of Chinese and global economic growth is unlikely. A recent re-lockdown of a Chinese county, along with tightened containment measures in other key Asian economies, illustrates the risk of a second wave of infections and a precarious economic “return to normalcy”. Further policy supports announced in the past week suggest that Chinese authorities may be willing to match the size of stimulus from other major economies. In the next three months, risks to Chinese stock prices are still elevated barring a peak in the global pandemic. We maintain a neutral position in both Chinese investable and domestic stocks. Feature Global financial markets are unlikely to sustainably move higher in an environment where it is uncertain whether the COVID-19 virus is abating and business activities can start resuming (Chart 1). China’s economy and stock prices are not insulated from a deep global recession. Price volatility will remain high in Chinese stocks in the next three months and, therefore, we maintain a neutral position in Chinese investable and domestic stocks. Chart 1Close To A Peak In New Cases? China Macro And Market Review China Macro And Market Review In financial markets, cyclical stocks have underperformed defensives since early March. In particular, information technology, materials, industrials and consumer discretionary, all have underperformed the broad market. This reflects a delayed recovery in China’s economic fundamentals. Tables 1 and 2 highlight key developments in China’s economic and financial market performance in the past month. On the growth front, both the official and Caixin PMIs rebounded to above the 50% boom-bust threshold from historic lows in February. However, the indexes suggest that headwinds to China’s economic recovery are not yet subsiding. Table 1China Macro Data Summary China Macro And Market Review China Macro And Market Review Table 2China Financial Market Performance Summary China Macro And Market Review China Macro And Market Review Chart 2Supply Shock Meets A Collapse In Demand Supply Shock Meets A Collapse In Demand Supply Shock Meets A Collapse In Demand The methodology in calculating PMI indexes reflects the net reported improvement in activity relative to the previous month; a reading of 50 represents no month-over-month change. As such, a 52 reading in March’s official PMI suggests that manufacturing activity in China barely ticked up over February. This is concerning given the extremely depressed level of manufacturing activity in February (Chart 2).  Furthermore, two important subcomponents of the PMI remained in contractionary territory even after February’s plunge. While the new orders subcomponent modestly improved in line with the overall index, new export orders and the imports index continued to contract (Chart 2, middle panel). The latter is particularly important for investors who focus on global growth because a modest improvement in Chinese domestic demand that does not translate into import growth is of limited benefit to China's trade partners and global economic activity. In our view, China's March PMI reflects a return to normalcy for the supply side, but it also indicates that domestic demand remains very weak (Chart 2, bottom panel). This is a discouraging result. While March’s economic data in the developed world will likely be uniformly negative, China’s weak PMI readings suggest that its economy may have been impacted by “second-round effects”. This aspect is an ominous sign for developed economies, particularly the US, where the number of new cases continues to escalate. A second wave of infections in China and other Asian nations also underlines the fragility of the rebound, both on the social and economic fronts. Although the pandemic in Asia was largely contained domestically by early March, there is now an increasing number of both imported and domestically transmitted cases. China recently locked down a county of about 600,000 residents and Singapore closed schools and workplaces last week due to a re-emergence of domestic cases.1 There are some encouraging signs in China’s housing market. The monthly real estate sector indicators in Table 1 show the severe impact of the pandemic on China’s property market in the first two months of the year. However, the seasonally adjusted daily data indicate that home sales in China’s 30 large- and medium-sized cities steadily picked up in March (Chart 3). By the end of March, the amount of floor space sold in those cities surpassed the same period of the previous year. A return to normal in housing demand and activity will be crucial for easing property developers’ cash constraints and a recovery in China’s construction sector. On the policy response front, monetary and fiscal stimulus measures continue to roll out. The PBoC chopped its 7-day reverse repo rate by 20bps on March 30, which was the third rate cut in 5 months. It helped to push the 3-month interbank repo rate back to its early-2010 low. We noted in a previous report2  that the 3-month repo rate is China's de facto short-term policy rate and that changes in the rate are strongly linked to average lending rates in the economy (Chart 4). A lowering in the repo rate will help to ease financial conditions and support an eventual rebound in China’s economic activity. Chart 3Signs Of A Gradual Revival In The Housing Market China Macro And Market Review China Macro And Market Review Chart 4Lending Rates Bound To Drop Further Lending Rates Bound To Drop Further Lending Rates Bound To Drop Further Further monetary and fiscal stimulus are also pending. The timing and magnitude of these measures suggest that Chinese policymakers may be willing to step up their efforts to match the size of stimulus from other major economies, such as the US.3 If so, it will support our cyclical (i.e. 6-12 months) overweight investment call on Chinese stocks relative to global benchmarks, even though we believe that the short-term risks to Chinese stock prices are still quite elevated. The PBoC adjusted down the interest rate on financial institutions’ central bank excess reserves from 0.72% to 0.35%, effective April 7. The move is significant: the last time that the PBoC reduced the excess reserve rate was in November 2008 during the global financial crisis. The excess reserve rate drop of 0.37% is also larger than the 0.27% dip in 2008. The cut in excess reserves will free up more liquidity for commercial banks and encourage them to lend to businesses. More importantly, the decrease will lower the floor of PBoC’s “interest rate corridor” and pave the way for further reduction in the MLF (the ceiling of the corridor), LPR, and even the benchmark deposit rate which has remained unchanged for the past five years (Chart 5). Last week’s Politburo meeting approved an increase in this year’s quota of local government special purpose bonds (SPBs) along with a bigger fiscal deficit, and the issuance of special treasury bonds (first time since 2007).  We believe the fiscal support will help facilitate double-digit growth in infrastructure spending this year. The exact quantity of the SPB quota will be approved at the upcoming National People’s Congress (NPC), but we think the quota will be close to 4 trillion yuan. This amount, which is equivalent of 4% of China’s GDP, will almost double the 2.15 trillion yuan SPBs issued in 2019. Chart 5Lowering The Floor Opens The Door Lowering The Floor Opens The Door Lowering The Floor Opens The Door Chinese stocks have lost more than 10% of their value year-to-date. In addition, cyclical stocks have underperformed defensives in the past month (Chart 6). We noted in our October 30 Special Report4 that historically these cyclical sectors have been positively correlated with pro-cyclical macroeconomic and equity market variables. Therefore, a return to outperformance in both the aggregate Chinese stocks and cyclical sectors will likely require strong evidence of an upturn in China’s business cycle. Chart 6Cyclicals Vs. Defensives Performance Has Reversed Course Cyclicals Vs. Defensives Performance Has Reversed Course Cyclicals Vs. Defensives Performance Has Reversed Course Chart 7RMB Depreciated Due To A Dollar Rally... RMB Depreciated Due To A Dollar Rally... RMB Depreciated Due To A Dollar Rally... The recent devaluation in the RMB against the USD is linked to the dollar’s strength. In the near term, the downward pressure on the RMB against the greenback will persist because the dollar will strengthen from signs that the global economy is entering a more protracted slowdown5 (Chart 7). We think it is unlikely that the PBoC will intervene in the exchange rate market to prop up the RMB; the weakness in the RMB has been benign and limited compared with a collapse in EM currencies (Chart 8). A strong RMB does not bode well either for China’s export price competitiveness or corporate profits (Chart 9). As such, we think that the PBoC will allow the RMB’s value to remain weak against the dollar. The ongoing race-to-the-bottom in interest rates and competitive currency devaluations have indeed provided a window for the PBoC to cut interest rates even more. Chart 8...But Appreciated Against EM Currencies ...But Appreciated Against EM Currencies ...But Appreciated Against EM Currencies Chart 9A Strong RMB Is Not Desired In The Current Environment A Strong RMB Is Not Desired In The Current Environment A Strong RMB Is Not Desired In The Current Environment   Qingyun Xu, CFA Senior Analyst qingyunx@bcaresearch.com Jing Sima China Strategist jings@bcaresearch.com       Footnotes 1 https://www.bloomberg.com/news/articles/2020-04-02/chinese-county-back-under-lockdown-after-infection-re-emerges?mc_cid=e33ef3872b&mc_eid=9da16a4859 https://www.scmp.com/week-asia/health-environment/article/3078297/singapore-close-schools-most-workplaces-next-week 2Please see China Investment Strategy Special Report "How To Analyze And Position Towards Chinese Government Bonds," dated January 29, 2020, available at cis.bcaresearch.com 3China has deployed bank re-lending programs and supplementary funds totaling about 1.5% of its 2019 GDP. A 4 trillion yuan local government SPBs will add more than 4% of GDP in fiscal spending. Fiscal deficit is likely to be augmented by 2% of GDP, and the issuance of special treasury bonds and local government general purpose bonds should amount to more than 2% of GDP. 4Please see China Investment Strategy Special Report "A Guide To Chinese Investable Equity Sector Performance," dated October 30, 2019, available at cis.bcaresearch.com 5Please see Foreign Exchange Strategy Weekly Report "Which Are The Most Attractive G10 Currencies?" dated March 27, 2020, available at fes.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations