Money Trends / Liquidity

China: The Recovery And Equity Dichotomy China’s economic recovery has been gathering steam, and policymakers have become reasonably confident about the growth outlook. In fact, transaction activity in the property market has recovered to year-ago levels, auto sales and construction starts have bottomed following a 18 to 20-month contraction (Chart I-1). In line with this economic revival, authorities issued a statement following last week’s Politburo meeting contending that monetary policy should aim “to maintain adequate growth of money supply and credit.” This statement is a change in the monetary policy stance in May when the stated objective was to “significantly accelerate the growth rate of broad money supply and total social financing relative to last year.” This change in language highlights that authorities have become more comfortable with the recovery and are now becoming a bit concerned about amplifying credit and property market excesses. There will be no additional stimulus forthcoming, but policy tightening is not in the cards. In short, there will be no additional stimulus forthcoming, but policy tightening is not in the cards. Policymakers will therefore be in a wait-and-see mode for now, monitoring how economic conditions improve as the enacted stimulus works its way into the economy. Odds are high that the business cycle recovery will continue in China for now. Chart I-2 shows that the amount of credit and fiscal stimulus has been considerable, and that broad money and bank assets impulses remain in uptrend. All these should support the recovery into early next year. Chart I-1China: A Cyclical Recovery Is Underway China: A Cyclical Recovery Is Underway China: A Cyclical Recovery Is Underway Chart I-2China: The Stimulus Will Continue Working Its Way Into Economy China: The Stimulus Will Continue Working Its Way Into Economy China: The Stimulus Will Continue Working Its Way Into Economy As to the risks to Chinese growth emanating from depressed demand in the rest of the world, they are not substantial. First, global demand has already bottomed. Second, China’s total exports account for 17% of GDP, while investment expenditures and consumer spending account for 42% and 38% of GDP, respectively (Chart I-3). Hence, rising capital expenditures and household spending will offset the drag from exports. Finally, China exports many household and medical goods that are currently in very high demand worldwide due to the lockdowns and the pandemic. As a result, Chinese exports have recently done a bit better than global shipments in volume terms (Chart I-4). Chart I-3China Is Not Very Reliant On Exports China Is Not Very Reliant On Exports China Is Not Very Reliant On Exports Chart I-4Chinese Exports Are Doing A Better Than Global Shipments Chinese Exports Are Doing A Better Than Global Shipments Chinese Exports Are Doing A Better Than Global Shipments As to domestic growth drivers, output has been rising faster than consumer demand. Furthermore, capital spending and production by state-owned enterprises has been much stronger than that of private enterprises. However, with the stimulus in full force, both consumer demand and private investment will pick up in the second half of this year. An Equity Market Dichotomy Chart I-5Dichotomy Between Old And New Economy Stocks Dichotomy Between Old And New Economy Stocks Dichotomy Between Old And New Economy Stocks On the surface, the strong rally in Chinese equity indexes has validated the economic recovery thesis. However, a closer examination of the equity performance of various equity sectors reveals that the rebound in cyclical sectors has been rather tame and that the large gains in the equity indexes have been primarily due to tech and new economy businesses, benefiting from working and shopping from home, and to health care stocks (Chart I-5). Chart I-6 illustrates that industrials, materials, autos and real estate stocks are only modestly above their March lows. More importantly, large bank stocks trading in Hong Kong are reaching new lows in absolute terms (Chart I-6, bottom panel). Chart I-6China: Cyclicals Stocks And Banks China: Cyclicals Stocks And Banks China: Cyclicals Stocks And Banks Is such lackluster performance by Chinese cyclical stocks a warning sign to its business cycle recovery? Not necessarily. In our opinion, poor performance of cyclical stocks and banks in China reflects the long-term ramifications of repeated episodes of credit frenzy. A credit-driven growth recovery is always a double-edged sword for both borrowers and creditors. Companies that borrow and invest in new projects accumulate debt. Critically, it is unclear whether these investments will produce new recurring cash flows that would allow the debtors to service their debt. Hence, many companies that take on more debt and invest in financially non-viable projects undermine shareholder value. China has again doubled down on the same policies it has been deploying since the 2008 Lehman crisis. Namely, it has encouraged another boom in money and credit creation, as well as in infrastructure investment. Another outcome of this is that excess money creation leaks into the property market, further fueling the real estate bubble. As for banks, if debtors are unable to service their debt, bank shareholders will be at risk too. This does not mean that banks will be liquidated, but that their shareholders will be diluted. It is critical to put this round of stimulus into perspective: it comes amid already elevated debt levels, following a decade-long credit frenzy and a two decade-long capital spending boom (Chart I-7). Therefore, we doubt that the latest round of investments will be able to substantially increase shareholder value. On the whole, we believe the rally in Chinese stocks outside secular growth plays – such as Alibaba, Tencent – is cyclical not structural. The basis is that while more credit produces a cyclical recovery, it often undermines shareholder value. Chart I-6 on page 4 illustrates that Chinese cyclical stocks and bank share prices have been flat-to-down in the past 10 years despite recurring stimulus.   Finally, the near-term risks for Chinese stocks do not stem from the domestic economy, but from geopolitics and a correction in US FAANG stocks. President Trump may escalate the confrontation with China in order to “rally the nation behind the flag” if his polling does not improve ahead of the November elections. Chart I-8 illustrates that the Americans’ view of China has deteriorated significantly in recent years. This might be exploited by President Trump to boost his re-election chances. A heightened confrontation could produce a correction in Chinese stocks. Chart I-7China Credit Excesses Are Getting Larger China Credit Excesses Are Getting Larger China Credit Excesses Are Getting Larger Chart I-8Americans’ Perception Of China Has Deteriorated In Recent Years China, Indonesia And Turkey China, Indonesia And Turkey Also, if the FAANG mania is either paused or reversed, then Chinese tech and mega-cap stocks will correct, pulling down the broad Chinese equity indexes. Bottom Line: The current round of stimulus in China has made the credit, money and property excesses even larger. As we have written over the years, easy money and credit generally fuel a misallocation of capital. Ultimately, this slows productivity growth on the macro level and destroys shareholder value on the company level.   Small banks, not large ones, have been leading the massive money and credit boom for the past 10 years. Nevertheless, given that the cyclical recovery in China will endure for now, we continue overweighting Chinese investable stocks within an EM equity portfolio. Finally, we are closing our short CNY/long USD position given the change in our USD outlook on July 9. This position has produced a 4.2% loss since its initiation on December 9, 2015. A Stress Test For Bank Stocks Chart I-9China: Small and Medium Banks Versus Large 5 Ones China: Small and Medium Banks Versus Large 5 Ones China: Small and Medium Banks Versus Large 5 Ones Small banks, not large ones, have been leading the massive money and credit boom for the past 10 years. Chart I-9 demonstrates that the risk-weighted assets of smaller banks have risen much faster, and are presently larger, than those of large banks. We have performed a new stress test for both the Big Five and small & medium listed banks. Concerning large banks, our base-case scenario calls for risk-weighted non-performing assets to rise to 13% of total. Accordingly, their equity will be diluted by 46% if they were to provision for these losses (Table I-1). Consequently, the true (adjusted) price-to-book (PBV) ratio will be 1.1. Assuming that the fair value of these large banks corresponds to a PBV ratio of one, then Big Five banks remain moderately (10%) overpriced. For small banks, our baseline scenario assumes a risk-weighted non-performing asset ratio of 13%. If these banks were to provision for these write offs, their equity will be diluted by 61%, pushing the adjusted PBV ratio to 2 (Table I-2). If we use a PBV fair value ratio of 1.3, then small and medium listed banks are substantially overpriced. Table I-1Stress Test Of 5 Large Banks China, Indonesia And Turkey China, Indonesia And Turkey Table I-2Stress Test Of The Other 25 Listed Medium & Small Banks China, Indonesia And Turkey China, Indonesia And Turkey Chart I-10Favor Large 5 Banks Over Small And Medium Ones Favor Large 5 Banks Over Small And Medium Ones Favor Large 5 Banks Over Small And Medium Ones Bottom Line: Chinese banks stocks could rebound, but their structural outlook has deteriorated further following another round of credit binge. Among banks stocks, we reiterate our strategy of favoring large banks over smaller ones (Chart I-10).  Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com  Lin Xiang, CFA Research Analyst linx@bcaresearch.com Indonesia: Struggling To Recover Indonesian stocks and the rupiah have rebounded in line with global risk assets. However, the rebound might be waning. The rupiah has begun weakening anew against the US dollar despite a major weakness in the latter. Relative to EM, Indonesian equities are underperforming again (Chart II-1). Chart II-1Indonesian Stocks Are Underperforming EM Again Indonesian Stocks Are Underperforming EM Again Indonesian Stocks Are Underperforming EM Again Crumbling Economic Activity And Insufficient Stimulus Indonesia is experiencing its worst recession since the Asian Crisis in 1997. Consumer income has dwindled and consumer confidence collapsed (Chart II-2, top panel). In turn, passenger car and truck sales have contracted by 90% and 84%, respectively, from a year ago (Chart II-2, second and third panel). Meanwhile, domestic cement consumption plunged by 17% (Chart II-2, bottom panel). In the meantime, the Coronavirus pandemic is not subsiding and will continue weighing on the Indonesian economy. The authorities have been attempting to prop up domestic demand. Yet the total fiscal stimulus announced so far – which amounts to $48 billion or 4.3% of GDP – is unlikely to be enough, given the harsh nature of this recession. For instance, the commercial banks loan impulse has already dipped to -2.7% of GDP (Chart II-3, top panel). Provided that demand for credit stays weak and banks continue to be reluctant to lend, the credit impulse will drop even further. As a result, the negative credit impulse will offset the fiscal thrust. Chart II-2Indonesia: Domestic Demand Collapsed Indonesia: Domestic Demand Collapsed Indonesia: Domestic Demand Collapsed Chart II-3Indonesia: Lending Rates Are High Indonesia: Lending Rates Are High Indonesia: Lending Rates Are High   On the monetary policy front, Bank Indonesia (BI) has been aggressively cutting its policy rate and injecting banking system liquidity into the market. The BI has been also purchasing government bonds on the secondary and primary markets, de facto conducting quantitative easing. Still, the ongoing monetary easing has not translated into lower lending rates for the real economy. In particular, although the BI lowered its policy rate by 200 basis points since July 2019, bank lending rates have only fallen by 100 basis points (Chart II-3, middle panel). This is a major sign that the monetary transmission mechanism is broken. Furthermore, the commercial banks’ lending rate, in real (inflation-adjusted) terms, remains elevated (Chart II-3, bottom panel). This is severely hurting credit demand (Chart II-3, top panel). The deflationary pressures on the Indonesian economy are intensifying. As a result, the deflationary pressures on the Indonesian economy are intensifying. The top panel of Chart II-4 shows that the GDP deflator is flirting with deflation. Meanwhile, both core and headline inflation have undershot the central bank’s target (Chart II-4, bottom panel). Bottom Line: Very low inflation and crumbling real growth have caused nominal GDP growth to drop below borrowing rates (Chart II-5). This is hitting borrowers’ ability to service their debt and is leading to swelling non-performing loans (NPLs). Chart II-4Indonesia Is Facing Very Low Inflation Indonesia Is Facing Very Low Inflation Indonesia Is Facing Very Low Inflation Chart II-5Indonesia: Nominal GDP Growth Is Well Below Lending Rates Indonesia: Nominal GDP Growth Is Well Below Lending Rates Indonesia: Nominal GDP Growth Is Well Below Lending Rates   Bank Stocks Remain At Risk The outlook for bank stocks that make up 48% of the Indonesia MSCI equity index is bleak. Chart II-6 shows that non-performing loans and special-mention loans (which are composed of doubtful loans) were rising before the pandemic shock. This has forced commercial banks to boost their bad loans provisioning, which has hurt their profitability. Additionally, Indonesian commercial banks’ net interest margins (NIM) have been falling sharply (Chart II-7). This has occurred because, on the revenues side, interest earnings have mushroomed as debtors have halted their interest payments while, on the expenditures side, commercial banks were forced to keep on paying interests to depositors. To protect their profitability, commercial banks have kept their lending rates stubbornly high. However, doing so will end up backfiring – as elevated lending rates punish borrowers and end up causing NPLs to rise, leading to more profit weakness. Chart II-6Indonesia: Bad Loans Are On The Rise Indonesia: Bad Loans Are On The Rise Indonesia: Bad Loans Are On The Rise Chart II-7Indonesia: Banks' Net Interest Margins Are Falling Indonesia: Banks' Net Interest Margins Are Falling Indonesia: Banks' Net Interest Margins Are Falling   Crucially, Bank Central Asia and Bank Rakyat – which now account for a whopping 37% of the Indonesia MSCI market cap – are vulnerable. Both commercial banks are heavily exposed to state-owned enterprises (SOE) and small and medium (SME) companies. Particularly, 40% of Bank Central Asia’s loan book is linked to SOEs and government-led projects across electricity, ports, airports and cement among other sectors. Meanwhile, 68% of Bank Rakyat’s loan book is leveraged to the SME sector and 20% to large companies, including SOEs. Worryingly, both SOEs and SMEs have been undergoing stress. Their profitability and debt servicing ability were questionable even before the COVID-19 pandemic. State-Owned Enterprises (SOEs): The debt servicing ability for these companies has deteriorated. The debt-to-EBITDA ratio has risen considerably while the EBITDA coverage of interest expenses is set to fall from already low levels (Chart II-8). Small & Medium Enterprises (SME): The debt serviceability of the top 40% of the MSCI-listed small cap stocks is also deteriorating. The top panel of Chart II-9 shows that these companies’ debt-to-EBITDA has risen substantially, and that the EBITDA-to-interest expense ratio has plunged (Chart II-9, bottom panel). Chart II-8Indonesian SOEs: Weak Debt Servicing Capacity Indonesian SOEs: Weak Debt Servicing Capacity Indonesian SOEs: Weak Debt Servicing Capacity Chart II-9Indonesian SMEs: Weak Debt Servicing Capacity Indonesian SMEs: Weak Debt Servicing Capacity Indonesian SMEs: Weak Debt Servicing Capacity   Chart II-10Indonesia Equities: Banks, Non-Financials And Small Caps Indonesia Equities: Banks, Non-Financials And Small Caps Indonesia Equities: Banks, Non-Financials And Small Caps All in all, both Bank Central Asia and Bank Rakyat are set to experience a considerable new NPL cycle emanating from the poor profitability of SOEs and SMEs. Importantly, Bank Central Asia and Bank Rakyat’s respective NPLs at 1.3% and 2.6% were relatively low at the start of this year and have much room to rise. Neither are their valuations appealing. At a price-to-book value of 4.4 Bank Central Asia is expensive. As for Bank Rakyat while its multiples are not as high as Bank Central Asia’s (which is trading at a price-to-book value of 1.8), it is not particularly cheap either, considering its enormous exposure to Indonesia’s struggling SME sector.  Bottom Line: The outlook for bank stocks is murky (Chart II-10). Apart from banks, the rest of the Indonesian stock market has been performing very poorly and there is no obvious evidence that this will change (Chart II-10, bottom two panels). Investment Conclusions Continue underweighting the Indonesian stock market. Bank stocks remain at risk. Moreover, there is evidence that retail investors have been active in the stock market as of late. When the stock market does relapse, retail investors will likely rush to sell their holdings, thereby magnifying the equity selloff. Dedicated EM local currency bonds and credit portfolios should continue underweighting Indonesia. Investors in Indonesia’s corporate US dollar bonds should tread carefully as the largest issuers are those SOEs that have experienced deteriorating creditworthiness. Chart II-11Return On Capital Drives EM Currencies Return On Capital Drives EM Currencies Return On Capital Drives EM Currencies If the US dollar continues to depreciate, the rupiah could stabilize and rebound but it will underperform other EM and DM currencies. Return on capital (ROC) is the ultimate driver of EM currencies. Given the magnitude of the recession Indonesia is in and the slow recovery it will experience, its ROC will remain weak. This will weigh on the rupiah (Chart II-11). We continue shorting the rupiah against an equally weighted basket of the euro, Swiss franc and Japanese yen. Ayman Kawtharani Editor/Strategist ayman@bcaresearch.com Turkey: The Ramifications Of A Money Plethora Turkey is facing another currency turmoil. At the core of significant currency depreciation pressures is an overflow of money. Chart III-1 demonstrates that narrow money (M1) and broad money (M3) are booming at 90% and 50%, respectively, from a year ago. These measures exclude foreign currency deposits. Bank loan annual growth has surged to 45% and commercial bank purchases of government bonds are skyrocketing (Chart III-2). Chart III-1Turkey's Money Overflow Turkey's Money Overflow Turkey's Money Overflow Chart III-2Rampant Credit Creation By Commercial Banks Rampant Credit Creation By Commercial Banks Rampant Credit Creation By Commercial Banks     In turn, the Central Bank of Turkey’s (CBRT) funding of commercial banks has surged (Chart III-3). By providing ample liquidity the CBRT has enabled commercial banks to engage in a credit frenzy and levy of government debt. The latter has capped local currency bond yields at a time when the private sector and foreign investors have been reluctant to finance the government bond given its current yields. At the core of significant currency depreciation pressures is an overflow of money. Consistent with this expanding money bubble, inflation in Turkey remains in a structural uptrend (Chart III-4). Core and service sector consumer price inflation is close to 12% and will rise even further due to the overflow of money in the economy. Besides, residential property prices are already soaring, in local currency terms, as residents are fleeing from liras. Chart III-3Central Bank's Funding Of Banks Central Bank's Funding Of Banks Central Bank's Funding Of Banks Chart III-4Structurally Rising Inflation Structurally Rising Inflation Structurally Rising Inflation   Still, the central bank refuses to acknowledge these inflationary pressures and to tighten its policy stance. Monetary authorities remain well behind the inflation curve. The policy rate, in real terms (deflated by core CPI), is -2%. In the past, when real policy rates have dropped to this level, the exchange rate has often tumbled, as in 2011, 2013, 2015 and 2018 (Chart III-5). Chart III-5Numerous Headwinds For The Lira Numerous Headwinds For The Lira Numerous Headwinds For The Lira In regard to balance of payments, the current account deficit is widening again due to the plunge in exports and tourism revenues and the recovering imports (Chart III-5, bottom panel). Historically, a widening current account deficit has weighed on the currency. Lastly, the central bank is not in the position to defend the exchange rate much longer. Not only has it depleted its own reserves but it has also used up $70 billion of commercial banks deposits and entered a $55 billion foreign exchange swap. Hence, its is massively short on US dollars. Bottom Line: As part of our broader currency strategy, on July 9, we replaced our short Turkish lira versus the US dollar position with a short in TRY versus a basket of the euro, CHF and JPY. This switch has proved to be very profitable and we continue recommending it. Consequently, investors should continue underweighting Turkish stocks, local currency bonds and credit markets relative to their EM counterparts. Fixed-income investors should consider betting on higher inflation expectations, i.e. going long domestic inflation adjusted yields and shorting nominal yields. Andrija Vesic Associate Editor andrijav@bcaresearch.com Footnotes   Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights The Fed’s emergency lending facilities have successfully stabilized markets … : Credit spreads have tightened dramatically since March and liquidity has been restored to the US Treasury market. … at very little cost to the central bank: Just the announcement of Fed lending facilities has been enough to push spreads lower in most cases. The facilities themselves have seen very little actual uptake. The only cost borne by the Fed has been a dramatic expansion of its balance sheet due to purchases of Treasury securities. We still want to “buy what the Fed is buying”: In US fixed income, we want to favor those sectors that are eligible for Fed support. This includes corporate bonds rated Ba and higher, municipal bonds and Aaa-rated securitizations. Keep portfolio duration at neutral: The Fed will be much more cautious about raising interest rates than in the past, and could wait until inflation is above its target before lifting off zero. Feature Back in April, we published a detailed explainer of the extraordinary actions taken by the Federal Reserve to combat the pandemic-induced recession.1 This week, we re-visit that Special Report to assess what the Fed has accomplished during the past three months and to speculate about what lies ahead. Overall, the Fed’s response has been highly effective. Stability was restored to financial markets almost immediately after the most dramatic policy interventions were announced, and it turns out that the announcements themselves did most of the work. The ultimate usage of the Fed’s Section 13(3) emergency lending facilities has been extremely low relative to their stated maximum capacities (Table 1). If you are the Fed, it is apparently enough to marshal overwhelming force and announce your willingness to deploy it. Like the ECB demonstrated in the fraught Eurozone summer of 2012, a bazooka can restore order without being fired.2 Table 1Usage Of The 2020 Federal Reserve Emergency Lending Facilities Alphabet Soup, Part 2: Shocked And Awed Alphabet Soup, Part 2: Shocked And Awed The only possible cost borne by the Fed has been an explosion in the size of its balance sheet, mostly attributable to purchases of Treasury securities. The ultimate usage of the Fed’s facilities has been extremely low relative to their stated maximum capacities. This report looks at how the Fed’s actions have influenced (and will influence) interest rates, Treasury market liquidity, the corporate bond market and other fixed income spread products. It also considers the potential impact of the size of the Fed’s balance sheet on the economy and financial markets. Interest Rates The Fed dropped the funds rate to a range of 0% to 0.25% on March 15, and since then it has aggressively signaled that rates will stay pinned at the zero-lower-bound for a long time. Investors quickly took this message on board (Chart 1). The median estimate from the New York Fed’s Survey of Market Participants has the funds rate holding steady at least through the end of 2022. Meanwhile, the overnight index swap curve isn’t pricing-in a rate hike until 2024. Chart 1The Fed And Market Agree: No Hikes Through 2022 The Fed And Market Agree: No Hikes Through 2022 The Fed And Market Agree: No Hikes Through 2022 Chart 2Better Signaling From The Fed Better Signaling From The Fed Better Signaling From The Fed The market adjusted much more quickly to the Fed’s zero interest rate policy this year than it did during the last zero-lower-bound episode (Chart 2). The MOVE index of Treasury yield volatility has already plunged to below 50. It took several years for it to reach those levels after the Fed cut rates to zero at the end of 2008. Similarly, the yield curve is much flatter today than it was during the last zero-lower-bound episode. This partly reflects the market’s expectation that rates will stay at zero for longer and partly the downward revisions to estimates of the long-run neutral fed funds rate that have occurred during the past few years. The bottom line is that the Fed has successfully achieved its goal on interest rate policy. The funds rate is at its effective lower bound and the entire term structure is priced for it to stay there for a very long time. There are two main reasons for this success. First, the Fed’s forward guidance has been more dovish this year than at any point during the last zero-lower-bound episode, with many FOMC participants calling for the Fed to target a temporary overshoot of the 2% inflation target. Second, the market is more skeptical about inflation ever returning to that target, as evidenced by much lower long-dated inflation expectations (Chart 2, bottom panel). What’s Next? The Fed has already made it clear that it won’t pursue negative interest rates. With those off the table, the next step will be for the Fed to make its forward rate guidance more explicit. In all likelihood this will involve the return of some form of the Evans Rule that was in place between 2012 and 2014. The Evans Rule was a commitment to not lift rates at least until the unemployment rate moved below 6.5% or inflation moved above 2.5%.3 The new version of the Evans Rule will be much more dovish. In a recent speech, Governor Lael Brainard favorably cited research suggesting that the Fed should refrain from liftoff until inflation reaches the 2% target.4 That may very well be the rule that ends up becoming official Fed guidance. If the Fed wants to strengthen its commitment to low rates even more, it could follow the Reserve Bank of Australia’s lead and implement a Yield Curve Control policy. This policy would involve setting caps for Treasury yields out to a 2-year or 3-year maturity. The Fed would pledge to buy as many securities as necessary to enforce the caps and would only lift the caps when the criteria of its new Evans Rule are met. While spreads have tightened across all credit tiers, investment grade corporates have become much more expensive than high-yield. For the time being, there is no rush for the Fed to deliver more explicit forward guidance and/or Yield Curve Control. As we noted above, bond yields are already pricing-in an extremely lengthy period of zero rates. But these policies will become more important as the economic recovery progresses and market participants start to speculate about an eventual exit from the zero bound. Explicit forward guidance and/or Yield Curve Control would then prevent a premature rise in bond yields and tightening of financial conditions. With all that in mind, we would not be surprised to see more explicit (Evans Rule-style) forward guidance rolled out at some point this year, but unless bonds sell off significantly beforehand, it probably won’t have an immediate impact on yields. The same is true for Yield Curve Control, though the odds of that being announced this year are lower as it is a tool with which the Fed is less comfortable. Treasury Market Liquidity Chart 3When Treasury Market Liquidity Evaporated When Treasury Market Liquidity Evaporated When Treasury Market Liquidity Evaporated As the COVID-19 crisis flared in March, there were several tense days when liquidity in the US Treasury market evaporated. Bond yields jumped even as the equity market plunged (Chart 3). Meanwhile, liquidity markers showed that it had become much more difficult to transact in US Treasuries. Treasury Bid/Ask spreads widened dramatically and the iShares 20+ Year Treasury ETF (TLT) traded at a huge discount to its net asset value (Chart 3, panel 3). During the past four months, researchers have identified hedge fund selling of Treasuries to meet margin calls and foreign bank selling of Treasuries to meet demands for US dollar funding as the proximate causes of March’s Treasury rout. However, it is clearly a failure of market structure that the Treasury market was unable to accommodate that selling pressure without liquidity disappearing. In a recent paper from The Brookings Institution, Darrell Duffie explains why the Treasury market was unable to maintain its liquidity during this tumultuous period.5 Essentially, he argues that it is the combination of rising Treasury supply and post-2008 regulations imposed on dealer banks that has led to an environment where there is a large and growing amount of Treasury supply, but where dealers have less balance sheet capacity to intermediate trading. To illustrate, Chart 4 shows the ratio between the outstanding supply of Treasury securities and the quantity of Treasury inventories for which primary dealers obtained financing. Quite obviously, the dealers’ intermediation activities have not kept pace with the expanding size of the market. Chart 4Primary Dealers Have Not Kept Up With Treasury Issuance Primary Dealers Have Not Kept Up With Treasury Issuance Primary Dealers Have Not Kept Up With Treasury Issuance What’s Next? Without changes to Treasury market structure or bank capital requirements (Duffie recommends abandoning the system of competing dealer banks altogether and moving all Treasury trades through one central clearinghouse), we are likely to see more episodes like March where a spate of Treasury selling leads to an evaporation of market liquidity. When that happens, the Fed will be forced to step in and buy Treasuries, as it did in March (Chart 3, bottom panel). The goal of that intervention is simply to remove enough supply from the market so that the remaining trading volume can be handled by the dealers. As this pattern repeats itself over time, it will cause the Fed’s presence in the Treasury market to grow. Bottom Line: Unless structural changes are made to the Treasury market or bank capital regulations are rolled back, we should expect more episodes of Treasury market illiquidity like we saw in March. We should also expect the Fed to respond to those episodes with aggressive Treasury purchases, and for the Fed’s presence in the Treasury market to grow over time. Corporate Bonds The Fed’s intervention in the corporate bond market consists of three lending facilities: The Secondary Market Corporate Credit Facility (SMCCF) where the Fed purchases investment grade corporate bonds and recent Ba-rated fallen angels in the secondary market. This facility also purchases investment grade and high-yield ETFs. The Primary Market Corporate Credit Facility (PMCCF) where the Fed buys new issuance from investment grade-rated issuers (and recent fallen angels) in the primary market. The Main Street Lending Facility (MSLF) where the Fed purchases loans off of bank balance sheets. The loans must be made to small or medium-sized firms with Debt-to-EBITDA ratios below 6.0. Chart 5Corporate Issuance Surged Following The Fed's Announcements Corporate Issuance Surged Following The Fed's Announcements Corporate Issuance Surged Following The Fed's Announcements As mentioned above, these facilities have barely been tapped. As of July 1, the Fed had purchased $1.5 billion of corporate bonds and just under $8 billion of ETFs through the SMCCF, while the PMCCF had not been used at all. However, the impact of the Fed’s promise to back-stop such a large portion of the corporate debt market has been immense. Corporate bond issuance surged following the announcement of the Fed’s facilities, and set monthly post-2008 records in March, April and May (Chart 5). The effect on corporate bond spreads has been just as dramatic. Spreads peaked on March 23, the day that the SMCCF and PMCCF were announced, and have tightened significantly since then. Further underscoring the importance of the SMCCF, PMCCF and MSLF announcements is that those segments of the corporate bond market most likely to have access to the Fed’s lending facilities have seen the most spread compression. Recall that investment grade issuers and recent fallen angels have access to the SMCCF and PMCCF, while the MSLF will benefit most issuers rated Ba or higher. Some B-rated issuers are able to tap the MSLF, but not the majority. Issuers rated Caa or below are much less likely to benefit from any of the Fed’s programs. Table 2 shows how the impact of the Fed’s facilities has played out across the different corporate credit tiers. It shows each credit tier’s option-adjusted spread and 12-month breakeven spread as of March 23 and today. It also shows the percentile rank of those spreads since 2010 (100% indicating the widest spread since 2010 and 0% indicating the tightest). While spreads have tightened across all credit tiers, investment grade corporates have become much more expensive than high-yield. The B-rated and below credit tiers are particularly cheap, with 12-month breakeven spreads all above their 80th percentiles since 2010. Table 2The Fed's Impact On Corporate Spreads Alphabet Soup, Part 2: Shocked And Awed Alphabet Soup, Part 2: Shocked And Awed Chart 6Spread Curve Back To Normal Spread Curve Back To Normal Spread Curve Back To Normal The market impact of the Fed’s corporate lending facilities is also apparent across the corporate bond term structure. In March, the investment grade corporate bond spread slope inverted, as 1-5 year maturity corporate bond spreads widened relative to spreads of securities with more than 5 years to maturity (Chart 6).6 The Fed concentrated its lending facilities on securities with less than 5 years to maturity, and it has successfully re-steepened the corporate spread curve. But the Fed’s corporate lending facilities are not all powerful. As Chair Powell likes to say: “the Fed has lending powers, not spending powers”. So while the promise of Fed lending is a big help, it still means that troubled firms will have to increase their debt loads to survive the economic downturn. Those firms that take on debt may still see their credit ratings downgraded as their balance sheet health deteriorates. Indeed, this is exactly what has happened. Ratings downgrades have jumped during the past few months, as have defaults (Chart 7). There has also been a spike in the number of fallen angels – firms downgraded out of investment grade – but not as big a jump as was seen during the last recession (Chart 7, panel 2). The Fed’s emergency lending facilities have likely prevented some downgrades, but not all. Chart 7Fed Can't Prevent Downgrades Fed Can't Prevent Downgrades Fed Can't Prevent Downgrades What’s Next? The Fed’s lending facilities are responsible for a huge portion of the spread compression we’ve seen since late March. That said, it is a potential problem for corporate bonds that those facilities are scheduled to expire at the end of September. Our sense is that the expiry date will be extended, and that the facilities will only be wound down after a significant period of time where they see zero usage. At that point, the Fed should be able to halt the facilities without unduly impacting markets. In terms of investment implications, we think that the Fed’s back-stop will continue to be the most important driver of corporate bond spreads during the next few months. This means we would avoid chasing the attractive valuations in bonds rated B & below, and would continue to focus our corporate bond exposure on bonds rated Ba and above. We make an exception to our “buy what the Fed is buying” rule when it comes to positioning across the corporate bond term structure. Here, we are inclined to grab the extra spread offered by longer-maturity securities even though Fed secondary market purchases are concentrated at the front-end. Our rationale is that the Fed’s secondary market purchases are already low and will likely decline as time goes on. Meanwhile, if firms with long-maturity debt outstanding need help they can still access the PMCCF if needed.  Other Fed Lending Facilities & Fixed Income Sectors Outside of the three programs geared toward the corporate bond market, the Fed also rolled out emergency lending facilities meant to back-stop: money market mutual funds (MMLF), the commercial paper market (CPFF), the asset-backed securities market (TALF), the municipal bond market (MLF) and the federal government’s new Paycheck Protection Program (PPPLF). Once again, the announcement effect did most of the work for all of these facilities and the Fed managed to quickly restore stability to each targeted market without doing much actual lending. For starters, the MMLF successfully halted a flight out of prime money market funds with a relatively modest $53 billion in loans (Chart 8). The CPFF caused the commercial paper/T-bill spread to normalize with only $4 billion of lending, and the LIBOR/OIS spread also tightened soon after the Fed rolled out its facilities (Chart 8, bottom panel). The Fed has dramatically expanded the size of its balance sheet through purchases of Treasury securities and agency MBS. In the asset-backed securities market, the Fed decided that only Aaa-rated securitizations are eligible for TALF. With that in mind, Aaa-rated consumer ABS and CMBS spreads have tightened considerably since TALF’s announcement (Chart 9). Non-Aaa consumer ABS spreads have tightened modestly despite the lack of Fed support. This is because fiscal stimulus has, so far, kept households flush with cash and prevented a wave of consumer bankruptcies. Non-Aaa CMBS, on the other hand, have struggled due to lack of Fed support and a sharp increase in commercial real estate delinquencies. Chart 8Stability Restored Stability Restored Stability Restored Chart 9Consumer ABS & CMBS Spreads Tightened Considerably... Consumer ABS & CMBS Spreads Tightened Considerably... Consumer ABS & CMBS Spreads Tightened Considerably...   The announcement of the MLF also successfully led to compression in municipal bond spreads (Chart 10), though the Aaa muni curve still trades cheap relative to Treasuries. Like the other facilities, the MLF has seen very low take-up. In this instance, low MLF usage results from its expensive pricing. Municipal governments can access loans through the MLF for a period of up to three years at a cost of 3-year OIS plus a fixed spread that varies depending on the municipality’s credit rating. However, current market pricing is well below the MLF rate for all credit tiers (Chart 10, bottom 2 panels). This means that the MLF provides a nice back-stop in case muni spreads widen again, but it is not currently an effective means of getting cash to struggling state & local governments. Chart 10...As Have Municipal Bond Spreads ...As Have Municipal Bond Spreads ...As Have Municipal Bond Spreads Finally, the PPPLF is a facility that purchases loans made through the Paycheck Protection Program (PPP) off of bank balance sheets. Essentially, it is an insurance policy designed to make sure that banks have the necessary balance sheet capacity to deliver all of the PPP loans authorized by Congress. It has achieved this goal with relatively little usage. Banks have doled out more than $500 billon of PPP loans and the Fed has purchased only $68 billion. What’s Next? As with the corporate lending facilities discussed above, there is a risk surrounding the scheduled expiry of these other lending facilities at the end of September. Once again, we see the Fed being very cautious in this regard. All facilities will be extended until they have seen long periods of no usage. In the near-term, we think it’s possible that the Fed will make MLF loans cheaper. They will likely feel intense pressure to do so if Congress fails to pass sufficient stimulus to state & local governments in the next bailout package. In terms of investment strategy, we want to stick with what has worked so far. We are overweight Aaa consumer ABS and Aaa CMBS due to the TALF back-stop. We are also overweight municipal bonds, especially in the Aaa-rated space where yields are attractive versus Treasuries and the risk of default is low. We would also advise taking some extra risk in non-Aaa consumer ABS. These securities have no TALF back-stop, but we expect Congress to deliver enough government stimulus to keep the underlying borrowers solvent. The Size Of The Fed’s Balance Sheet As this report has made clear, the Fed’s emergency lending facilities have accomplished a lot during the past four months with the Fed taking very little actual risk onto its balance sheet. But while its usage of the emergency lending facilities has been low, the Fed has dramatically expanded the size of its balance sheet through purchases of Treasury securities and agency MBS. To restore stability to the Treasury and MBS markets, the Fed avidly bought Treasuries and agency MBS from mid-March to mid-April, ballooning the size of its balance sheet by $2 trillion in just five weeks. Tacked onto the QE programs undertaken to battle the GFC, the Fed’s balance sheet expansion has been massive, and it is roughly six times larger as a share of GDP than it was in the three decades preceding the subprime crisis (Chart 11). Chart 11Massive Expansion Of The Fed's Balance Sheet chart 11 Massive Expansion Of The Fed's Balance Sheet Massive Expansion Of The Fed's Balance Sheet Investors and citizens may ask what that balance sheet expansion has achieved so far, and what it’s likely to achieve going forward. Are there unintended consequences that haven’t yet made their presence felt? What constitutes a normalized Fed balance sheet, and when will the Fed be able to get back to it? The immediate consequence many investors attribute to the balance sheet expansion is higher stock prices (Chart 12). Fans of the balance sheet/equities link are undeterred by the decoupling after 2015, arguing that standing pat/tapering the balance sheet by 15% helped precipitate its vicious sell-off in the fourth quarter of 2018. It probably has not escaped their notice that the spectacular bounce from March’s lows has occurred alongside a 70% balance sheet expansion. The money supply boost may prove short-lived, though, as it appears that businesses are borrowing to ensure their continued liquidity, rather than to spend or invest. We don’t think there is much to the observed relationship, however. Correlation is not causation and we have a hard time seeing how the Fed’s purchases of Treasuries, agencies and agency MBS flowed into the equity market. While the Fed’s pre-pandemic QE purchases turbo-charged the size of the monetary base, it only gently expanded the money supply, because the banks that sold securities to the Fed largely handed the proceeds right back to it as deposits (Chart 13). The net effect mainly filled the Fed’s vaults with the new money it had conjured up via its open-market operations. Chart 12Fed Balance Sheet & Stock Prices: Correlation Is Not Causation Fed Balance Sheet & Stock Prices: Correlation Is Not Causation Fed Balance Sheet & Stock Prices: Correlation Is Not Causation Chart 13Only A Modest Expansion Of Money Supply Only A Modest Expansion Of Money Supply Only A Modest Expansion Of Money Supply   Banks were not the only counterparties to the Fed’s QE purchases, of course. Fixed income mutual funds, insurance companies and pension funds must also have trimmed their holdings to accommodate the Fed. They were likely obligated by prospectus mandates or regulatory oversight to redeploy the proceeds into other bonds. Surely some unconstrained investors turned QE cash into new equity investments, but the larger QE effect on financial markets was likely to narrow credit spreads as dedicated fixed income investors redeployed their proceeds further out the risk curve. Tighter spreads helped reduce corporations’ cost of servicing newly issued debt, boosting corporate profits at the margin, but we think it’s a stretch to say QE drove the equity rally. What’s Next? Chart 14Wave Of Bank Deposits Wave Of Bank Deposits Wave Of Bank Deposits The picture is slightly different today, with the money supply popping amidst frenzied corporate borrowing. The money supply boost may prove short-lived, though, as it appears that businesses are borrowing to ensure their continued liquidity, rather than to spend or invest. The largest banks were inundated with deposits in the second quarter (Chart 14), possibly driven by corporations stashing their issuance proceeds in cash just as banks previously stashed their QE proceeds in excess reserves. With households actively paying down their debt and businesses having already pre-funded two or three years of cash needs, the deposits may not be lent out, hemming in the money multiplier and limiting the self-reinforcing magic of fractional-reserve banking. Liquidity that is being hoarded is not available to drive up equity multiples, so we don’t expect the Fed’s new balance sheet expansion will directly boost stock prices any more than we think it did post-crisis. Indirectly, we think it does contribute to economic growth and risk asset appreciation because we view QE and other extraordinary easing measures as a signal that zero interest rate policy will remain in place for a long time. The importance of that signal, and the possibility that nineteen months of tapering at the start of Jay Powell’s term as Fed chair did promote volatility and increased equities’ vulnerability to a sharp downdraft, may well keep the Fed from attempting to normalize the balance sheet any time soon. An outsized Fed balance sheet may well be the new normal, and it may well breed unintended consequences, but we don’t think that kiting stock prices will be one of them. Ryan Swift US Bond Strategist rswift@bcaresearch.com Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Jennifer Lacombe Associate Editor JenniferL@bcaresearch.com Jeremie Peloso Senior Analyst jeremiep@bcaresearch.com   Footnotes 1 Please see US Investment Strategy / US Bond Strategy Special Report, “Alphabet Soup: A Summary Of The Fed’s Anti-Virus Measures”, dated April 14, 2020, available at usis.bcaresearch.com and usbs.bcaresearch.com 2 The Outright Monetary Transactions facility at the heart of ECB President Mario Draghi’s “whatever it takes” pledge was never actually used. The ECB did eventually purchase government securities through a separate facility. But this didn’t occur until 2015, after sovereign bond yields had already fallen. 3 This explicit forward guidance was the brainchild of Chicago Fed President Charles Evans. It was official Fed forward guidance between December 2012 and March 2014. 4 https://www.federalreserve.gov/newsevents/speech/brainard20200714a.htm 5 https://www.brookings.edu/wp-content/uploads/2020/05/WP62_Duffie_v2.pdf 6 This inversion of the corporate spread curve is typical during default cycles. For more details on this dynamic please see US Bond Strategy Special Report, “On The Term Structure Of Credit Spreads”, dated July 10, 2013, available at usbs.bcaresearch.com

Highlights Rising Bond Yields: Global risk assets are discounting a V-shaped economic recovery. With economic data starting to revive as more economies emerge from virus-related shutdowns, bond yields are showing signs of following suit. Duration Strategy: Even with global yields showing signs of a cyclical bottom, we continue to recommend a neutral duration stance. Central banks will remain highly accommodative given the lack of inflationary pressures after the deep COVID-19 recessions. There are still significant risks in the coming months from a potential second wave of coronavirus after economies reopen, worsening US-China relations and domestic US sociopolitical turmoil. Duration Proxy Trades: Given those lingering uncertainties, we prefer to focus on “duration-lite” trades in the developed economies, like overweighting inflation-linked government bonds versus nominals as inflation expectations will drift higher over the next 6-12 months. Feature Dear Client, Next week, instead of publishing a regular Weekly Report, we will hold a webcast on Tuesday, June 16 at 10:00 am ET, discussing our latest views on global fixed income markets. The format will be a short presentation, followed by a Q&A session. We hope you will join us, armed with interesting questions. Kind regards, Rob Robis, Chief Fixed Income Strategist Chart of the WeekBond Yields Bottoming, But Backdrop Not Yet Bearish Bond Yields Bottoming, But Backdrop Not Yet Bearish Bond Yields Bottoming, But Backdrop Not Yet Bearish Bond yields around the world awoke from their COVID-19 induced slumber last week, responding to a growing body of evidence indicating that global growth has bottomed. Over a span of four days, benchmark 10-year government bond yields rose in the US (+20bps), Germany (+13bps), Canada (+20bps), China (+14bps), Japan (+4bps), Mexico (+13bps) and the UK (+12bps). There is potential for yields to continue drifting higher over the next few months, as more countries reopen from virus-related shutdowns. The bounce already seen in survey data like manufacturing and services PMIs, as well as economic sentiment measures like the global ZEW index, should soon translate into real improvements in activity data. This comes at a time when rising commodity prices, most notably oil, suggest that depressed inflation expectations can lead bond yields higher. The cyclical bottom for global yields has likely passed, based on the improvement already seen in our own Global Duration Indicator (Chart of the Week). However, economic policy uncertainty remains elevated as devastated economies try to reopen from lockdowns. In addition, our Central Bank Monitors continue to indicate pressure on policymakers to keep interest rates as low as possible to maintain easy financial conditions as easy as possible. Tighter monetary policies remain a distant prospect, given very high unemployment rates. The cyclical bottom for global yields has likely passed, based on the improvement already seen in our own Global Duration Indicator. Amid those uncertainties, we recommend maintaining a neutral strategic (6-12 months) and tactical (0-6 months) stance on overall duration exposure in fixed income portfolios. Instead, we prefer focusing on lower volatility trades that will benefit from improving global growth and policy reflation, like going long inflation-linked bonds versus nominal government debt throughout the developed markets with breakevens looking too low on our models. Why Are Bond Yields Rising Now? We see five main reasons why global bond yields have started to move higher: 1) Investor risk aversion is declining There has been a sharp recovery in global risk appetite since late March, diminishing the demand for risk-free global government debt. In the US, the S&P 500 is up 43% from its March lows, while the NASDAQ index is back to the all-time highs reached before the coronavirus turned into a global pandemic (Chart 2). US corporate debt has also performed well since the March 23rd peak in spreads, with investment grade and high-yield spreads down -227bps and -564bps, respectively. Non-US assets are also flying, with emerging market (EM) equities up 29% and EM USD-denominated corporate debt up 14% in excess return terms over US Treasuries since the March trough. Even severely lagging assets like European bank stocks are showing a pulse, up 38% since the lows of May 15. Commodity prices are also improving, led not only by gains in oil after the April crash by recoveries in the prices of growth-sensitive commodities like copper (+17%) and lumber (+42%). Add it all up, and the message is clear: investors now prefer risk to safety, which has tempered the demand for government bonds. The flipside of the boom in risk appetite is weakening prices for safe haven assets (Chart 3). The price of gold in US dollar terms is down -4% from the 2020 high on May 20, while the euro price of gold is down –6%. Safe haven currencies like the Japanese yen and Swiss franc have underperformed, while interest rate volatility measures like the US MOVE index and long-dated euro swaption volatility are back to the pre-coronavirus lows. Chart 2Risk Assets Are Booming Worldwide Risk Assets Are Booming Worldwide Risk Assets Are Booming Worldwide Chart 3Safe Haven Trades Losing Luster Safe Haven Trades Losing Luster Safe Haven Trades Losing Luster Add it all up, and the message is clear: investors now prefer risk to safety, which has tempered the demand for government bonds that helped drive yields lower when risk assets were tanking in late February and March. 2) Global growth is improving One of the reasons for the improvement in investor risk appetite is belief that the world economy has exited from the severe COVID-19 global recession. While timely real data is still coming in slowly given reporting lags, there has been a notable bounce in survey data in many countries. PMIs for both manufacturing and services climbed higher in May (Chart 4). The expectations components of economic confidence measures like the ZEW indices have also recovered the losses seen in February and March. Data surprises have also been increasingly on the positive side of late in China, Europe and the US, including the shocking 2.5 million increase in US employment in May. However, the US unemployment rate remains very high at 13.3%, indicating abundant spare capacity that will likely take years, not months, to work off – a problem that most of the world will continue to deal with post-recession. 3) Central bank liquidity is booming The other main reason for the boom in risk asset performance that has started to put upward pressure on bond yields is the extremely accommodative stance of global monetary policy. This is occurring through 0% policy rates in the developed economies but, even more importantly, the aggressive expansion of central bank balance sheets through quantitative easing (QE). The Fed has its foot firmly on the monetary accelerator, with year-over-year growth in its balance sheet of 87% (Chart 5). The European Central Bank (ECB) is no slouch, though, with its balance sheet up 19% from a year ago and having expanded its Pandemic Emergency Purchase Program (PEPP) by another €600 billion last week. Chart 4Signs Of Life In The Global Economy Signs Of Life In The Global Economy Signs Of Life In The Global Economy Chart 5'QE Forever' Driving Money From Bonds To Risk Assets QE Forever' Driving Money From Bonds To Risk Assets QE Forever' Driving Money From Bonds To Risk Assets The combined annual growth of the central bank balance sheets for the “G4” (the Fed, ECB, Bank of Japan and Bank of England) is now up to 26%. The rate of G4 balance sheet expansion has been a reliable leading indicator of global risk asset performance since the 2008 financial crisis (with about a 12-month lead), and the current boom in “liquidity” suggests that the current rise in global equity and corporate bond markets can continue over the next year. Easing global financial conditions are now returning to levels that should support economic growth in the coming months, helping to mitigate (but not eliminate) the potential credit stresses from companies that have suffered during the COVID-19 recession. This recovery remains fragile, however, and policymakers will continue to maintain an extremely dovish policy bias – even with significant fiscal stimulus measures also in place to help economies climb out of recession. This suggests that the current rise in global bond yields is not the start of a new bond bear market driven by expectations of tighter monetary policies. The current rise in global bond yields is not the start of a new bond bear market driven by expectations of tighter monetary policies. Chart 6Global Bond Sentiment Is Still Very Bullish Global Bond Sentiment Is Still Very Bullish Global Bond Sentiment Is Still Very Bullish 4) Bullish sentiment for bonds is at extremes From a contrarian perspective, another factor helping put a floor underneath bond yields is investor sentiment towards fixed income, which remains bullish. The widely followed ZEW survey of economic forecasters also contains a question on the expected change in bond yields over the next year. The latest read on the surveys shows a net balance still expecting lower bond yields in the US, Germany, the UK and Japan, nearing levels seen prior to the end of the recessionary bond bull markets in the early 2000s and after the 2008 financial crisis (Chart 6). In addition, the Market Vane survey of bullish sentiment on US Treasuries is nearing past cyclical peaks, suggesting limited scope for new bond buyers that could drive US yields to new lows. 5) Inflation expectations are moving higher Finally, global yields are rising because the inflation expectations component of yields has started to move higher. The hyper-easy stance of monetary policy is playing a role here. Market-based inflation expectations measures like the breakevens on inflation-linked bonds (or CPI swap rates) are a vote of confidence by investors in the “appropriateness” of policy settings. The fact that inflation expectations are now drifting higher suggests that bond markets now believe that central banks are now "easy" enough to give inflation a shot at rising sustainably as growth recovers. Global yields are rising because the inflation expectations component of yields has started to move higher. Chart 7Oil Prices & Breakeven Inflation Rates Are Both Recovering Oil Prices & Breakeven Inflation Rates Are Both Recovering Oil Prices & Breakeven Inflation Rates Are Both Recovering This move higher in inflation expectations can continue in the coming months, particularly with global oil prices likely to move even higher. Our colleagues at BCA Research Commodity & Energy Strategy are quite bullish on oil prices, forecasting the benchmark Brent oil price to rise to around $50/bbl by the end of 2020 and continuing up to $78/bbl by the end of 2021. Such an outcome would push up market-based inflation expectations, and likely put more upward pressure on nominal bond yields, given the strong correlation between oil and inflation breakevens in the developed economies that has existed over the past decade (Chart 7). Bottom Line: Global risk assets are discounting a V-shaped economic recovery. With economic data starting to revive as more economies emerge from virus-related shutdowns, bond yields are showing signs of following suit. Duration Strategy For The Next Few Months The trends in growth, inflation and financial conditions all suggest bond yields can continue to drift higher over at least the next 3-6 months. Yet given the potential for a negative shock from a second wave of coronavirus infection, or geopolitical uncertainties in a volatile US election year, a below-benchmark global duration stance is not yet warranted. This is especially true with unemployment rates in most countries remaining elevated even as growth rebounds from recession, forcing central banks to maintain a very dovish policy posture. Our “Risk Checklist” that we have been monitoring to move to a more aggressive recommended investment stance on global spread product – the US dollar, the VIX and the number of new COVID-19 cases - can also be helpful in helping us determine when to shift to a more defensive bias on global duration. On that note, the Checklist still argues for a neutral duration stance, rather than positioning for a big move higher in yields. The US dollar has started to soften, but remains at a very high level relative to interest rate differentials (Chart 8). A weaker greenback is a source of global monetary reflation, primarily through changes in the prices of commodities and other traded goods that are denominated in dollars, but also by helping alleviate funding pressures for companies that have borrowed heavily in US dollars (especially in the emerging world). The dollar is also an “anti-growth” currency that appreciates during periods of slowing global growth, and vice versa, so some depreciation should unfold as more of the world economy emerges from lockdown (middle panel). The VIX index – a measure of investor uncertainty - continues to climb down from the massive surge in February and March, now sitting at 26 after peaking around 80. This is the one part of our Risk Checklist that argues for reducing duration exposure now. We prefer trades that will benefit from the combination of continued global policy reflation and growing investor risk appetite. We call these “duration-lite” trades. The daily number of new reported cases of COVID-19 (using data from the World Health Organization) has come down dramatically in Europe, but in the US the decline in new cases has stalled over the past month – a worrisome sign as the country continues to reopen amid mass protests in major cities (Chart 9). New cases outside the US and Europe are rapidly moving higher, however, primarily in major Latin American countries like Brazil and Mexico. This suggests that while there is a concern about a “second wave” of coronavirus later in the year, the risks from the first wave are far from over. Chart 8Still Not Much Reflationary Push From A Weaker USD Still Not Much Reflationary Push From A Weaker USD Still Not Much Reflationary Push From A Weaker USD Chart 9The COVID-19 Threat Has Not Gone Away The COVID-19 Threat Has Not Gone Away The COVID-19 Threat Has Not Gone Away Instead of shifting to a below-benchmark recommended stance on overall portfolio duration too soon in the cycle, we prefer trades that will benefit from the combination of continued global policy reflation and growing investor risk appetite. We call these “duration-lite” trades. Specifically, we like owning inflation-linked government bonds versus nominal debt, while also positioning for steeper government yield curves (on a duration-neutral basis). Longer-dated breakeven inflation rates within the major developed markets are becoming increasingly correlated to both the level of 10-year government bond yields (Chart 10) and the slope of the 2-year/10-year yield curve (Chart 11). Chart 10Rising Inflation Expectations Will Lead To Higher Bond Yields ... Rising Inflation Expectations Will Lead To Higher Bond Yields ... Rising Inflation Expectations Will Lead To Higher Bond Yields ... Chart 11... And Steeper Yield Curves ... And Steeper Yield Curves ... And Steeper Yield Curves In terms of country selection for these trades, we look to the valuations on inflation-linked bond breakevens from our modeling framework that we introduced back in late April.1 In that framework, we model 10-year breakevens as a function of oil prices, exchange rates and the long-run trend in realized inflation. Chart 12Global Inflation Breakevens Look Cheap On Our Models Global Inflation Breakevens Look Cheap On Our Models Global Inflation Breakevens Look Cheap On Our Models In Chart 12, we show the deviation of 10-year inflation breakevens from the model-implied fair value, shown both terms of standard deviations and basis points. The “cheapest” breakevens from our models are for inflation-linked bonds in Italy and Canada, although almost all counties (outside of the UK) have breakevens to look far too low. This suggests that global bond investors should consider a multi-country portfolio of inflation-linked bonds versus nominal paying equivalents – or in countries where the inflation-linked bond markets are small and illiquid, duration-neutral yield curve steepeners - as a more efficient way to play for a continuation of the current reflationary global backdrop without taking duration risk. Bottom Line: Even with global yields showing signs of a cyclical bottom, we continue to recommend a neutral duration stance. Given the lingering uncertainties about a second wave of coronavirus, and the rising political and social tensions in the US only five months before the presidential election, we prefer to focus on “duration-lite” trades in the developed economies - like overweighting inflation-linked government bonds versus nominals as inflation expectations will drift higher over the next 6-12 months.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Please see BCA Research Global Fixed Income Strategy Weekly Report, "Global Inflation Expectations Are Now Too Low", dated April 28, 2020, available at gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Global Yields Are Stirring, But It’s Not Yet A Bond Bear Market Global Yields Are Stirring, But It’s Not Yet A Bond Bear Market Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Dear Client, With this weekly update on the Chinese economy, we are sending you a Special Report published by BCA Geopolitical Strategy team and authored by my colleague Matt Gertken. Lately we have been getting numerous questions from our clients, on the risk of a significant re-escalation in the US-China conflict. Matt’s report provides timely insights on the topic, and we trust you will find the report very helpful. Best regards, Jing Sima, China Strategist Feature An Update On The Chinese Economy Since mid-April, the speed of resumption in China’s domestic business activity has accelerated. Industrial enterprises appear to be operating at 87% of normal activity levels as of May 11, up from 81.8% one month ago. Small to medium-sized enterprise (SMEs) are estimated to now operate at 87.3% of their normal activity, a vast improvement from 82.3% just two weeks ago. Chart 1Pickup In M1 Still Modest Pickup In M1 Still Modest Pickup In M1 Still Modest The material easing in monetary conditions and strong flows of local government special-purpose bond issuance in the past two months helped jump start a recovery in the construction sector. But at this early stage of a domestic economic rebound and in the middle of a deep global economy recession, China’s corporate marginal propensity to invest remains muted (Chart 1). Household consumption showed some resilience during last week’s “Golden Week” holiday. The strength in big-ticket item purchases, however, was highly concentrated among consumers in China’s wealthiest urban areas (Chart 2). The COVID-19 pandemic has created a situation resembling a combination of SARS and the global financial crisis. Now the physical constraints on consumption have largely been lifted, consumers’ willingness to spend, after a brief period of compensatory spending, will be suppressed if their expectations of the medium-term job and income security remain pessimistic (Chart 3). Chart 2A Compensatory Rebound In Big-Ticket Item Sales A Compensatory Rebound In Big-Ticket Item Sales A Compensatory Rebound In Big-Ticket Item Sales Chart 3The Average Chinese Consumer Remains Cautious The Average Chinese Consumer Remains Cautious The Average Chinese Consumer Remains Cautious Next week we will publish a report, focusing on China’s consumption in a post-pandemic environment. Looking forward, we maintain the view that China’s business activity will pick up momentum in H2, when the massive monetary and fiscal stimuli continue working its way into the economy.  Downside risks to employment and income loom large, which makes it highly unlikely that the authorities will tighten their policy stance any time soon. As such, while we maintain our defensive tactical positioning due to near-term economic and geopolitical uncertainties, our view remains constructive on both the economy and Chinese financial asset prices in the next 6 to 12 months.  (Chart 4). Chart 4Recovery To Gain Traction In H2 Recovery To Gain Traction In H2 Recovery To Gain Traction In H2   Jing Sima China Strategist jings@bcaresearch.com     #WWIII The phrase “World War III” or #WWIII went viral earlier this year in response to a skirmish between the US and Iran (Chart 1). Only four months later, the US and China are escalating a strategic rivalry that makes the Iran conflict look paltry by comparison (Chart 2). Chart 1US-Iran Tensions Were Just A Warm-Up #WWIII #WWIII Chart 2The Thucydides Trap The Thucydides Trap The Thucydides Trap Fortunately, the two great powers are constrained by the same mutually assured destruction that constrained the US and the Soviet Union during the Cold War. They are also constrained by the desire to prevent their economies from collapsing further. Unfortunately, the intensity of their rivalry can escalate dramatically before reaching anything truly analogous to the Berlin Airlift or Cuban Missile Crisis – and these kinds of scenarios are not out of the question. Safe haven assets will catch a bid and the recovery in US and global risk assets since the COVID selloff will be halted. We maintain our defensive tactical positioning and will close two strategic trades to book profits and manage risk. In the wake of the pandemic and recession, geopolitics is the next shoe to drop. The War President Over the past 24 hours the White House has taken several steps indicating that President Trump is adopting the “war president” posture in the run-up to the US election: Export controls: Trump has gone forward with new export controls on “dual-purpose” technologies – those that have military as well as civilian applications, in a delayed reaction to China’s policy of civil-military technological fusion. The Commerce Department has wide leeway in whether to grant export licenses under the rule – but it is a consequential rule and would be disruptive if enforced strictly. Supply chain de-risking: Trump is also going forward with new restrictions on the import of foreign parts for US power plants and electricity grid. The purpose is to remove risks from critical US infrastructure. COVID investigation: Trump has hinted that the novel coronavirus that causes the COVID-19 disease may have originated in the Wuhan Institute of Virology. The Director of National Intelligence issued a statement indicating that the Intelligence Community does not view the virus as man-made (not a bio-weapon), but is investigating the potential that the virus transferred to humans at the institute. The State Department had flagged the institute for risky practices long before COVID. Trump avoided the bio-weapon conspiracy theory and is focused on the hypothesis that the laboratory’s investigations into rare coronaviruses led to the outbreak. New tariffs instead of reparations: Director of the National Economic Council Larry Kudlow denied that the US would stop making interest and principal payments on some Chinese holdings of US treasuries. He said that the “full faith and credit of the United States’ debt obligation is sacrosanct. Absolutely sacrosanct.” Trump denied that this form of reparations, first floated by Republican Senator Marsha Blackburn of Tennessee, was under consideration. Instead he suggested that new tariffs would be much more effective, raising the threat for the first time since the Phase One trade deal was agreed in principle in December. Strategic disputes: Tensions have flared up in specific, concrete ways across the range of US-Chinese relations – in the cyber-realm, psychological warfare, Korean peninsula, Taiwan Strait, and South China Sea. These could lead to sanctions. The war president posture is one in which President Trump recognizes that reelection is extremely unlikely in an environment of worse than -4.8% economic growth and likely 16% unemployment. Therefore he shifts the basis of his reelection to an ongoing crisis and appeals to Americans’ patriotism and desire for continuity amid crisis. Bottom Line: Protectionism is not guaranteed to work, and therefore it was not ultimately the path Trump took last year when he still believed a short-term trade deal could boost the economy. Now the bar to protectionism has been lowered. The Decline Of US-China Relations President Trump may still be bluffing, China may take a conciliatory posture, and a massive cold war-style escalation may be avoided. However, it is imprudent to buy risk assets on these reasons today, when the S&P 500’s forward price-to-earnings ratio stands at 20.15. It is more prudent to prepare for a historic escalation of tensions first, buy insurance, then reassess. Why? Because the trajectory of US-China relations is empirically worsening over time. US household deleveraging and the Chinese shift away from export-manufacturing (Chart 3) broke the basis of strong relations during the US’s distractions in Iraq and Afghanistan and China’s “peaceful rise” in the early 2000s. US consumers grew thriftier while Chinese wages rose. Not only has China sought economic self-sufficiency as a strategic objective since General Secretary Xi Jinping took power in 2012, but the Great Recession, Trump trade war, and global pandemic have accelerated the process of decoupling between the two economies. Decoupling is an empirical phenomenon, and it has momentum, however debatable its ultimate destination (Chart 4). Obviously policy at the moment is accelerating decoupling. Chart 3The Great Economic Divorce The Great Economic Divorce The Great Economic Divorce Chart 4Decoupling Is Empirical Decoupling Is Empirical Decoupling Is Empirical The US threat to cease payments on some of China’s Treasury holdings is an inversion of the fear that prevailed in the wake of 2008, that China would sell its treasuries to diversify away from dependence on the US and the greenback. China did end up selling its treasuries, but the US was not punished with higher interest rates because other buyers appeared. The US remains the world’s preponderant power and ultimate safe haven (Chart 5). By the same token, Trump and Kudlow naturally poured water on the threat of arbitrarily stopping payments because that would jeopardize America’s position. Instead Trump is threatening a new round of trade tariffs. Since the US runs a large trade deficit with China, and China is more exposed to trade generally, the US has the upper hand on this front. But it is important to notice that US tariff collections as a share of imports bottomed under President Obama (Chart 6). Chart 5Treasuries Can't Be Weaponized By Either Side... Treasuries Can't Be Weaponized By Either Side... Treasuries Can't Be Weaponized By Either Side... Chart 6... But Tariffs Can And Will Be ... But Tariffs Can And Will Be ... But Tariffs Can And Will Be   The US shift away from free trade toward protectionism occurred in the wake of the 2008 financial crisis. President Trump then popularized and accelerated this policy option in an aggressive and unorthodox way. Trade tariffs are a tool of American statecraft, not the whim of a single person, who may exit the White House in January 2021 anyway. The retreat from globalization is not a passing fancy. Today’s recession also marks the official conclusion of China’s historic 44 year economic boom – and hence a concrete blow to the legitimacy of the ruling Communist Party (Chart 7). The more insular, autarkic shift in the Communist Party’s thinking is not irreversible, but there are no clear signs that Xi Jinping is pivoting toward liberalism after eight years in power. Chart 7Recession Destabilizes The 'G2' Powers Recession Destabilizes The 'G2' Powers Recession Destabilizes The 'G2' Powers China’s unemployment rate has been estimated as high as 20.5% by Zhongtai Securities, which then retracted the estimate (!). It is at least at 10%. Moreover 51 million migrant workers vanished from the job rolls in the first quarter of the year. Maximum employment is the imperative of East Asian governments, especially the Communist Party, which has not dealt with joblessness since the late 1990s. The threat to social and political stability is obvious. The party will take extraordinary measures to maintain stability – not only massive stimulus but also social repression and foreign policy distraction to ensure that people rally around the flag. Xi Jinping has tried to shift the legitimacy of the party from economic growth to nationalism and consumerism, the “China Dream.” But the transition to consumer growth was supposed to be smooth. Financial turmoil, the trade war, and now pandemic and recession have forced the Communist Party off the training wheels well before it intended. Xi’s communist ideology, economic mercantilism, and assertive foreign policy have created an international backlash. The US is obviously indulging in nationalism as well. A stark increase in inequality and political polarization exploded in President Trump’s surprise election on a nationalist and protectionist platform in 2016 (Chart 8). All candidates bashed China on the campaign trail, but Trump was an anti-establishment leader who disrupted corporate interests and followed through with his tariff threats. The result is that the share of Americans who see China’s power and influence as a “major threat” to the United States has grown from around 50% during the halcyon days of cooperation to over 60% today. Those who see it as a minor threat have shrunk to about a quarter of the population (Chart 9). Chart 8A Measure Of Inequality In The US A Measure Of Inequality In The US A Measure Of Inequality In The US Chart 9US Nationalism On The Rise #WWIII #WWIII Chart 10Broad-Based Anti-China Sentiment In US #WWIII #WWIII As with US tariff policy, the bipartisan nature of US anger toward China is significant. More than 60% of Democrats and more than 50% of young people have an unfavorable view of China. College graduates have a more negative opinion than the much-discussed non-college-educated populace (Chart 10). Already it is clear, in Joe Biden’s attack ads against Trump, that this election is about who can sound tougher on China. The debate is over who has the better policy to put “America first,” not whether to put America first. Biden will try to steal back the protectionist thunder that enabled Trump to break the blue wall in the electorally pivotal Rust Belt in 2016 (Map 1). Biden will have to win over these voters by convincing them that he understands and empathizes with their Trumpian outlook on jobs, outsourcing, and China’s threats to national security. He will emphasize other crimes – carbon emissions, cyber attacks, human rights violations – but they will still be China’s crimes. He will return to the “Pivot to Asia” foreign policy of his most popular supporter, former President Barack Obama. Map 1US Election: Civil War Lite #WWIII #WWIII Bottom Line: Economic slowdown and autocracy in China, unprecedented since the Cultural Revolution, is clashing with the United States. Broad social restlessness in the US that is resolving into bipartisan nationalism against a peer competitor, unprecedented since the struggle with the Soviets in the 1960s, is clashing with China. Now is not the time to assume global stability. Constraints Still Operate, But Buy Insurance The story outlined above is by this time pretty well known. But the “Phase One” trade deal allowed global investors to set aside this secular story at the beginning of the year. Now, as Trump threatens tariffs again, the question is whether he will resort to sweeping, concrete, punitive measures against China that will take on global significance – i.e. that will drive the financial markets this year. Trump is still attempting to restore his bull market and magnificent economy. As long as this is the case, a constraint on conflict operates this year. It is just not as firm or predictable. Therefore we are looking for three things. First, will President Trump’s approval rating benefit so much from his pressure tactics on China that he finds himself driven into greater pressure tactics? This raises the risk of policy mistakes. Second, will Trump’s approval rating fall into the doldrums, stuck beneath 43%, as the toll of the recession wears on him and popular support during the health crisis fades? “Lame duck” status would essentially condemn him to electoral loss and incentivize him to turn the tables by escalating the conflict with China. Chart 11Trump May Seek A Crisis ‘Bounce’ To Popularity #WWIII #WWIII Presidents are not very popular these days, but a comparison with Trump’s two predecessors shows that while he can hardly obtain the popularity boost that Obama received just before the 2012 election, he could hope for something at least comparable to what George W. Bush received amid the invasion of Iraq (Chart 11). (Trump has generally been capped at 46% approval, the same as his share of the popular vote in 2016.) The reason this is a real risk, not a Shakespearean play, is outlined above: however cynical Trump’s political calculus, he would be reasserting US grand strategy in the face of a great power that is attempting to set up a regional empire from which, eventually, to mount a global challenge. Thus if he is convinced he cannot win the election anyway, this risk becomes material. Investors should take seriously any credible reports suggesting that Trump is growing increasingly frustrated with his trailing Biden in head-to-head polls in the swing states. Third, will China, under historic internal stress, react in a hostile way that drives Trump down the path of confrontation? China has so far resorted to propaganda, aircraft carrier drills around the island of Taiwan, and maritime encroachments in the South China Sea – none of which is intolerably provocative to Trump. A depreciation of the renminbi, a substantial change to the status quo in the East or South China Seas, or an attempt to vitiate US security guarantees regarding US allies in the region, could trigger a major geopolitical incident. A fourth Taiwan Strait crisis is fully within the realm of possibility, especially given that Taiwan’s “Silicon Shield” is fundamentally at stake. While we dismissed rumors of Kim Jong Un’s death in North Korea, any power vacuum or struggle for influence there is of great consequence in today’s geopolitical context. Aggressive use of tariffs always threatened to disrupt global trade and financial markets, but tariffs function differently in the context of a global economic expansion and bull market, as in 2018-19, than they do in the context of a deep and possibly protracted recession. Trump has a clear political incentive to be tough on China, but an equally clear financial and economic incentive to limit sweeping punitive measures and avoid devastating the stock market and economy. If events lower the economic hurdle, then the political incentive will prevail and financial markets will sell. Bottom Line: However small the risk of Trump enacting sweeping tariffs, the downside is larger than in the 2018-19 period. The stock market might fall by 40%-50% rather than 20% in an all-out trade war this year. Investment Takeaways Go tactically long US 10-year treasuries. Book a 9.7% profit on our long 30-year US TIPS trade. Close long global equities (relative to US) for a loss of 3.8%.   Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com   Footnotes Cyclical Investment Stance Equity Sector Recommendations

Highlights Ever since the Federal Reserve’s liquidity injections, the dollar has been trading in a bifurcated manner. Historically, this has been a rare event. The main bifurcation has been between developed market and commodity/emerging market currencies. Stability in the USD/CNY exchange rate is a key indicator to watch. Movements in this cross will indicate where the balance of forces are shifting. Feature Chart I-1A Tale Of Two Dollars A Tale Of Two Dollars A Tale Of Two Dollars The Federal Reserve’s dollar liquidity injections have been massive, but two dollars continue to fight a tug of war. The first is the DXY index, which has largely surrendered to the flood of liquidity offered through the Fed’s swap lines and temporary FIMA repo facility. In fact, cross-currency basis swaps in both Japan and the euro area, a measure of offshore dollar funding stress, have eased. As a result, volatility in the DXY index has been crushed, keeping it largely below the psychological 100 level. However, on the other side of the liquidity battle front have been emerging market and commodity currencies, some of which continue to make fresh lows. Remarkably, these have included currencies such as the Brazilian real that also have swap agreements with the US. In short, a rare divergence has opened up between two dollars (Chart I-1). Historically, whenever this has occurred, either the DXY index was on the verge of making new highs, or procyclical currencies were very close to a bottom. In our April 3rd report, we suggested three reasons as to why the dollar could remain well bid in the near term.1 In this report, we explore these reasons further and offer one variable to watch as the key arbiter between the two – the USD/CNY exchange rate. A Tale Of Two Dollars The bifurcated dollar performance has been underpinned by three factors. The 14 developed and emerging market currencies that have swap lines with the Fed2 all bottomed around March 19, when the funding announcement was made. These include currencies of countries that were initially excluded from a prior swap agreement such as Australia, Norway and New Zealand. The exception to this rule has been the Brazilian real. By extension, some currencies currently excluded from the swap agreement such as the Turkish lira and South African rand remain in freefall. The temporary repo facility for foreign and international monetary authorities (FIMA), which allows FIMA account holders to temporarily exchange their Treasury securities held with the Fed for US dollars, has instilled confidence. As such, this has assuaged selling pressure on currencies with ample dollar foreign exchange reserves. However, some currencies with low reserves such as the South African rand or Turkish lira continue to face downside risks. A huge portion of offshore dollar funding has been financed by non-bank entities. Not only does a rising dollar lift the debt burden of borrowers, but it also raises solvency risk for these concerns. Notably, non-banks have limited access to central bank swap lines. Of the US$12 trillion in dollar-denominated foreign debt outstanding, 32% is from emerging markets, a share that has increased massively since the financial crisis (Chart I-2). This might explain why currencies like the Brazilian real, exposed to significant foreign-currency corporate debt obligations, continue to see selling pressure, despite the Fed facilities in place (Chart I-3). Chart I-2Rising EM Dollar Debt Rising EM Dollar Debt Rising EM Dollar Debt Chart I-3Some EM Have High External Debt Some EM Have High External Debt Some EM Have High External Debt In short, with the Fed and many other developed-market central banks engaged in active purchases of corporate paper, a line in the sand has been drawn between currencies where the lenders of last resort have stepped in, and others where their central banks are still unwilling to take credit risk. Put another way, certain currency markets are starting to price USD solvency risk, resulting from the broad shutdown in their economies and the rise in the greenback. Unfortunately, there is nothing the Fed can do about this. Dollar liquidity shortages tend to be vicious because they trigger negative feedback loops. As offshore dollar rates among non-banks begin to rise, this lifts the cost of capital for borrowing entities, with debt repayment replacing capital spending. This is where China can step in. The People’s Bank of China has massive foreign exchange reserves, worth about US$3.1 trillion. This means it can provide swap agreements that will almost cover the totality of EM foreign dollar debt. The important distinction from foreign exchange reserves is that swap agreements entail no exchange of currency. As such, it is about confidence. With low external debt and massive FX reserves, the PBoC can instill this confidence in countries that have low and/or falling foreign exchange reserves.  Certain currency markets are starting to price USD solvency risk, resulting from the broad shutdown in their economies and the rise in the greenback.  There has been a precedent to this. Since the global financial crisis, as the PBoC has been engaging in powerful monetary stimulus, the number of bilateral swap lines offered to foreign central banks has also ballooned. Bloomberg no longer publishes swap data for the PBoC, but a recent article suggests that as recent as 2018, the Chinese central bank had bilateral local currency swap agreements with central banks or monetary authorities in 38 countries and regions, with a total amount of around 3.7 trillion yuan (Chart I-4).3 Remarkably, this excluded the US Fed. This means that the USD/CNY exchange rate will become a key arbiter of the divergence between the two dollars. If Asian and Latin American currencies can stabilize versus the RMB and the USD/CNY exchange rate can remain stable, then an informal accord has been established. So far, the RMB appears the arbiter between these two dollars (Chart I-5). Chart I-4Chinese Swaps To The Rescue? Chinese Swaps To The Rescue? Chinese Swaps To The Rescue? Chart I-5USD/CNY As A Dollar Arbiter USD/CNY As A Dollar Arbiter USD/CNY As A Dollar Arbiter We understand that geopolitical tensions between the US and China are escalating, and so the probability of such an event – if global growth rebounds earnestly – is low. However, should global growth remain weak, a fall in the RMB will highlight the PBoC is actively using its currency as a weapon. This will suggest all bets are off. Bottom Line: Developed market commodity currencies have a correlation of almost parity with EM FX (Chart I-6). An explicit swap agreement between China and emerging market countries could be the key to assuage dollar funding pressures within emerging markets. This will ease the selling pressure on developed-market commodity currencies. Chart I-6The Risk To Commodity Currencies The Risk To Commodity Currencies The Risk To Commodity Currencies Market Signals And Signposts Ever since Richard Nixon severed the gold-dollar link in the early ‘70s, there have been three major episodes when some currencies bucked the broad dollar trend. Historically, this has been driven by two major factors (Table I-1):4 Table I-1Summary Of Currency Divergence Episodes Line In The Sand Line In The Sand De-synchronized global growth A localized debt/economic crisis The first episode occurred in the early 1990s. As the world was exiting a recession in part triggered by tight US monetary policies, lower US interest rates allowed the dollar to fall along with rising global growth. Only the yen, on the back of an economy entering into a debt deflation spiral (where positive real rates begot more currency appreciation), was able to buck this trend. Developed market commodity currencies have a correlation of almost parity with EM FX. The late 1990s saw the capitulation of Asian currencies. As a safe haven, the US dollar started to benefit from repatriation flows. Asean and commodity currencies were under intense selling pressure from pegged exchange rates and a long period of low interest rates that had generated massive imbalances. Remarkably, the euro was the area of shelter..  The world in 2005-2006 was entering a full-blown mania. Procyclical currencies were benefitting from Chinese industrialization and the creation of the euro. Meanwhile, Japan continued to sag under a mountain of debt. This pushed market participants to increasingly use the yen as a funding currency for carry trades, allowing it to depreciate versus the US dollar. Enter 2020. The world today is in a synchronized slowdown, but varying degrees of policy measures suggest we could continue to see a lack of synchronicity in dollar trading over the near term: The euro area appears poised to recover faster than the US in the near term (Chart I-7). If this proves correct, any knee-jerk selloffs in the euro should be bought. This is directly linked to the speed at which European economies reopen, relative to the US. By extension, Asian currencies should do better than those in Latin America. Conclusion: the dollar could fall against the euro, but rise against some emerging market currencies. The easiest way to express this view is to buy the cheapest European currencies, such as the Norwegian krone and Swedish krona. We are long both. The yen, typically used as a funding currency, will be hostage to a sudden stop in funding flows. This is because there is no interest rate advantage anymore between Japanese and US paper, once accounting for hedging costs (Chart I-8). This suggests carry trades in developed markets, using the Japanese yen, are stuck in the barn for now. Meanwhile, as a safe haven currency, the yen will still benefit from a rise in FX volatility. Short USD/JPY hedges make sense. Chart I-7Euro Area Versus##br## US Growth Euro Area Versus US Growth Euro Area Versus US Growth Chart I-8The Yen Is No Longer An Attractive Funding Currency The Yen Is No Longer An Attractive Funding Currency The Yen Is No Longer An Attractive Funding Currency Commodity and emerging market FX will be the outlier against the US dollar for now. These continue to face downward pressure in the near term. In terms of commodities, the sudden stop in demand has been met with an overwhelmingly slow response to curtail supply. Eventually, higher demand will benefit these currencies, but the supply story dominates for now in crude oil and industrial commodities. That said, this week’s rise in Chinese commodity imports was encouraging. Stay tuned.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Please see Foreign Exchange Strategy Weekly Report, titled “Capitulation?,” dated April 3, 2020, available at fes.bcaresearch.com. 2 These include the Bank Of Canada, Bank Of Japan, Bank Of England, European Central Bank, the Swiss National Bank, the Reserve Bank of Australia, the Banco Central do Brasil, the Danmarks Nationalbank (Denmark), the Bank of Korea, the Banco de Mexico, the Norges Bank, the Reserve Bank of New Zealand, the Monetary Authority of Singapore, and the Sveriges Riksbank. 3 Please see The History Of Commerce, China. 4 Please see Foreign Exchange Strategy Special Report, titled “Can There Be More Than One US Dollar”, dated June 08, 2018, available at fes.bcaresearch.com. 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: The Markit manufacturing PMI fell to 36.1 in April; the services PMI also slipped to 26.7. ISM manufacturing PMI dropped to 41.5 and non-manufacturing PMI declined to 41.8. The trade deficit widened from $39.8 billion to $44.4 billion in March. Unit labor costs increased by 4.8% quarterly in Q1, while nonfarm productivity fell by 2.5%. Initial jobless claims continued to grow by 3169K last week. The DXY index surged by 1.5% this week. The Senior Loan Officer Survey released this week reported an increasing net percentage of domestic banks tightening standards for most loan types in Q1, including C&I, auto and mortgage loans. On Tuesday, the Fed’s Raphael Bostic said that there are great uncertainties around “V-shape” recovery. 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: The Markit manufacturing PMI fell further from 33.6 to 33.4 in April, while the services PMI stayed low at 12. Sentix investor confidence remained low at -41.8 in May. Retail sales contracted by 9.2% year-on-year in March, compared to a 3% increase the previous month.  The euro declined by 0.8% against the US dollar this week. The German court has criticized the ECB bond-buying programme, warning that the ECB’s purchases could be illegal under German law unless the ECB can prove otherwise. Continuing conflicts among Eurozone members and imbalances between countries could add more pressure on the ECB. In addition, the European Commission forecasts the euro zone economy to contract by a record 7.7% this year. 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 from Japan have been negative: The manufacturing PMI fell from 43.7 to 41.9 in April. Vehicle sales kept contracting by 25.5% year-on-year in April, following a decline of 10.2% in March. Monetary base increased by 2.3% year-on-year in April, down from a 2.8% increase the previous month. The Japanese yen appreciated by 0.4% against the US dollar this week, despite broad US dollar strength. Since the beginning of the Fed swap lines operation this year, the BoJ has the highest liquidity swaps with the Fed, amounting to US$220 billion as of April 30, helping to ease dollar funding pressure in Japan. 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 mostly negative: The Markit manufacturing PMI fell further to 32.6 from 32.9 in April, while services PMI remained low at 13.4. Nationwide housing prices increased by 3.7% year-on-year in April, up from 3% the previous month. Money supply (M4) surged by 7.4% year-on-year in March. The British pound plunged by 2.7% against the US dollar this week. The Bank of England held interest rates unchanged on Thursday morning, while warning that the coronavirus crisis will push the UK economy into its deepest recession in 300 years. The Bank is now forecasting the output to slip by 3% in Q1, followed by a 2.5% plunge in Q2. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 A Few Trade Ideas - Sept. 27, 2019 United Kingdom: Cyclical Slowdown Or Structural Malaise? - Sept. 20, 2019 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Recent data in Australia have been mixed: Building permits plunged by 4% month-on-month in March, down from 19.4% the previous month. Exports surged by 15.1% month-on-month while imports fell by 3.6% in March. The trade surplus expanded by A$6.8 billion to A$10.6 billion. The Australian dollar fell by 1.5% against the US dollar this week. On Tuesday, the RBA kept its interest rate unchanged at 0.25%. More importantly, the Bank has scaled back the size and frequency of bond purchases, which so far totalled A$50 billion, while stating that they are prepared to scale-up the purchases again should conditions worsen. In addition, the RBA forecasts the output to fall by roughly 10% in the first half of 2020 and by 6% over the year, followed by a rebound of 6% next year. Report Links: On AUD And CNY - January 17, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 A Contrarian View On The Australian Dollar - May 24, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 Recent data in New Zealand have been mixed: Building permits fell by 21.3% month-on-month in March, down from 5.7% increase in February. The unemployment rate ticked up from 4% to 4.2% in Q1, lower than the expected 4.4%. Employment increased by 0.7% quarter-on-quarter. The participation rate increased by 30 bps to 70.4%. In addition, wage rates increased by 2.5% annually. The New Zealand dollar dropped by 1.8% against the US dollar this week. While many may call the Q1 Labour Market Statistics a positive surprise, Statistics New Zealand has indicated that the March data from household labour force survey was interrupted due to the lockdown in March. In a typical quarter, around 25% of the interviews for this survey are carried out face-to-face. We expect the Q2 Labour Survey to show more clearly how the COVID-19 lockdown has changed New Zealand’s labour market. 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: The Markit manufacturing PMI plunged from 46.1 to 33 in April. Both exports and imports fell notably in March: exports narrowed by C$2.3 billion to C$46.3 billion. Imports decreased by C$1.8 billion to C$47.7 billion. The trade deficit widened from C$0.9 billion to C$1.4 billion. Bloomberg Nanos confidence ticked up from 37.1 to 37.7 for the week ended May 1. The Canadian dollar fell by 0.9% against the US dollar this week. The decline in exports was led by auto manufacturing, aircraft, and energy products. Moreover, a depreciating Canadian dollar has largely impacted the trade values in March. When expressed in US dollar terms, export fall by 9.2% month-on-month and imports by 8.1%, which compares favourably with 4.7% decrease in exports and 3.5% decline in imports in Canadian dollars. Report Links: More On Competitive Devaluations, The CAD And The SEK - May 1, 2020 A New Paradigm For Petrocurrencies - April 10, 2020 The Loonie: Upside Versus The Dollar, But Downside At The Crosses Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Recent data in Switzerland have been mostly negative: The manufacturing PMI fell from 43.7 to 40.7 in April, above the expectations of 34.6. Consumer climate plunged from -9.4 to -39.3 in Q2. Headline consumer prices fell by -1.1% year-on-year in April, down from -0.5% in March, also below the expectations of -0.8%.  The unemployment rate increased from 2.8% to 3.3% on a seasonally adjusted basis in April. The Swiss franc fell by 1% against the US dollar this week. With consumer prices decreasing for a third consecutive month, the SNB has stepped up the currency intervention. Total sight deposits have increased by nearly 77 billion CHF this year, compared to only 13.2 billion CHF in 2019 and 2.3 billion CHF in 2018. 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 There has been no significant data release from Norway this week. The Norwegian krone appreciated by 0.6% against the US dollar this week. On Thursday morning, the Norges Bank delivered a surprise rate cut by 25 bps to a record low of 0 due to the severity of the coronavirus and huge decline in oil prices. However, they also implied that further cuts into negative territory are unlikely. In addition, Governor Øystein Olsen said that they expect the output to drop by roughly 5% this year, a decline of a magnitude that has not been seen since World War II. 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: Manufacturing PMI fell from 42.6 to 36.7 in April. Industrial production fell by 0.1% year-on-year in March. Manufacturing new orders contracted by 2% year-on-year in March, down from 5.7% increase in February. The Swedish krona has been more or less flat against the US dollar this week. Like the ECB, the Riksbank might have some legal issues regarding its bond purchases program. The current Riksbank Act does not allow the bank to make outright purchases of corporate bonds or other private securities on the primary or secondary markets. So far, the Riksbank has purchased 5.6 billion SEK of corporate commercial papers to support the economy under the COVID-19. 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

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

Analyses on Chinese autos and Brazil are available below. Highlights The Fed’s aggressive monetization of public and some private debt has inspired investors to allocate cash to risk assets However, a number of cyclical indicators continue to flash red or amber, suggesting this rally is not about a cyclical economic recovery.  Continue underweighting EM equities and credit markets versus their DM counterparts. We will wait for a correction to assess whether to maintain or close our shorts on EM currencies. Feature Neither the ongoing plunge in corporate profits nor a great deal of uncertainty about the economic outlook justify this rally. It seems the sole driver of the rally from March’s lows has been the Federal Reserve’s enormous purchases of various securities. These unprecedented actions are crowding out investors into riskier parts of fixed-income markets and persuading them to purchase equities. Neither the ongoing plunge in corporate profits nor a great deal of uncertainty about the economic outlook justify this rally. It Has Not Been About Profits And Valuations In the past two months, the S&P 500 index has experienced not only the fastest and steepest crash on record, but also the speediest rebound (Chart I-1). Investors have had to make swift investment decisions amid extremely low economic visibility. Chart I-1The S&P 500: The Fastest Crash And Speediest Recovery The S&P 500: The Fastest Crash And Speediest Recovery The S&P 500: The Fastest Crash And Speediest Recovery Indeed, it is fair to say that during the mayhem and carnage many investors operated on a “sell now, think later” principle, and on the subsequent rebound with a “buy now, ask questions later” framework. Remarkably, the plunge and subsequent recovery in global share prices has been so rapid that even equity analysts’ forward earnings estimates cannot keep up. The top panel of Chart I-2 illustrates that the global forward EPS usually tracks the world equity index. When share prices rally, analysts upgrade their earning expectations; when equities sell off, analysts’ downgrade their earnings outlooks. In the past month, analysts have continued to slash forward EPS estimates despite the strong equity rebound. As a result, the 12-month forward P/E ratio for global stocks is back to its post-2008 highs (Chart I-2, bottom panel). Chart I-2Rising Share Prices Amid Collapsing Forward Earnings Rising Share Prices Amid Collapsing Forward Earnings Rising Share Prices Amid Collapsing Forward Earnings Chart I-3China: A Decoupling Between Economy And Equities China: A Decoupling Between Economy And Equities China: A Decoupling Between Economy And Equities Elsewhere, Chart I-3 illustrates China’s domestic orders for 5000 industrial enterprises historically correlated with the Shanghai Composite equity index. Since early this year, domestic orders have plummeted due to the country-wide lockdown. Yet equity prices in China have not fallen enough to reflect the downfall in economic activity and corporate profits. This underscores that investors’ purchases of global and Chinese stocks in the past month have been driven by factors other than the corporate profit outlook.   This leaves two rationales for justifying roaring equity purchases in recent weeks: (1) liquidity overflows due to central banks’ balance sheet expansion, and (2) valuations. We examine the first argument in this report and will revisit the topic of equity valuations in forthcoming publications. In a nutshell, although equity valuations may be cheap in EM, Europe and Japan, they are expensive in the US. Nevertheless, the US stock market has been substantially outperforming EM and DM ex-US equities. Further, the most expensive stocks in the US – FAANGM – have by far outperformed the rest. Chart I-4China: A Decoupling Between New And Old Economy Stocks China: A Decoupling Between New And Old Economy Stocks China: A Decoupling Between New And Old Economy Stocks In China, the ChiNext index – a Nasdaq proxy of the onshore market – has massively outperformed the Shanghai Composite index, which is dominated by “old” economy stocks (Chart I-4). The trailing P/E ratios on the ChiNext and Shanghai Composite indexes are 62 and 14, respectively. In short, the fact that most expensive equity segments/sectors have outperformed suggests that cheap valuation have not been the key driver of this rally. Bottom Line: Neither profits nor considerations of equity valuations have been the driving factor behind the recent equity rally.  The Sole Driver Of This Rally The Fed’s aggressive monetization of public and some private debt has inspired investors to allocate cash to risk assets. The US broad money supply is surging at a record pace, both in nominal and real terms (Chart I-5). Is there too much money relative to the size of financial assets? Chart I-5US Broad Money Supply Is Booming US Broad Money Supply Is Booming US Broad Money Supply Is Booming Today we explore how the level of US broad money supply (M2) relates to the market cap of all bonds and stocks denominated in US dollars. US broad money (M2) supply encompasses all deposits and cash of residents and non-residents in and outside the US. Chart I-6 exhibits the ratio of US broad money supply (M2) relative to the sum of: Chart I-6The US: Broad Money Supply Relative To Equity And Bond Market Capitalization The US: Broad Money Supply Relative To Equity And Bond Market Capitalization The US: Broad Money Supply Relative To Equity And Bond Market Capitalization the US equity market capitalisation (the Wilshire 5000); the market cap values of all US-dollar bonds, including government, corporate, mortgage-backed securities, asset-backed securities and commercial mortgage backed securities (the Bloomberg Barclays US Aggregate Index); the market cap value of US dollar-denominated bonds issued by EM governments and corporations; minus the Fed’s and US commercial banks’ holdings of all types of securities. The higher this ratio is, the more US dollar deposits (liquidity) is available per one dollar of outstanding securities – excluding those held by the Fed and US commercial banks. Based on the past 25 years, the US M2-to-market value of securities ratio is somewhat elevated. This means liquidity is relatively abundant. However, this may not preclude the ratio from drifting higher like it did in 2008. This scenario would be consistent with a renewed selloff in equity and credit markets. Interestingly, back in January, the ratio was almost at a 20-year low – i.e., money supply (liquidity) was tight relative to the market value of outstanding US dollar-denominated securities. This was contrary to the prevalent perception in the global investment community that in 2019 the advances in share prices and credit markets were liquidity-driven. We discussed what constitutes pertinent liquidity for financial assets in our January 16 report titled, A Primer On Liquidity. The key takeaways of the report were: Money supply – not central bank assets – is the ultimate liquidity available to economic agents to purchase goods and services as well as invest in both real and financial assets. Changes in the velocity of money are as important as those in money supply. Yet forecasting changes in the velocity of money is a near-impossible task, as it entails foreseeing the behavior of economic agents. A large and expanding stock of money in and of itself does not guarantee greater liquidity for asset markets. Gauging liquidity flows to asset markets boils down to predicting investor behavior. Liquidity flows into financial assets when “animal spirits” among investors improve, and vice versa. Bottom Line: Even though the US money supply is expanding at a record pace, the key to financial asset price fluctuations is willingness among investors to purchase those assets. In turn, willingness to allocate cash to securities is generally driven by (1) the potential income and cash flow generation by securities issuers; (2) uncertainty related to future income (the risk premium); and (3) the opportunity cost of holding cash. Presently, the opportunity cost of holding cash is the sole reason to buy risky securities. Cash flow/income generation is currently impaired for the majority of equities and credit instruments. Further, there is a great deal of uncertainty about issuers’ ability to generate cash/income for investors – i.e., the required risk premium should be very high. All of these circumstances make the risk-reward profile of this rally poor. Reasons To Fade This Rally There are several market-based indicators that do not corroborate a further run-up in EM and DM equity prices. Our Risk-On / Safe-Haven Currency Ratio has struggled to gain traction (Chart I-7, top panel). It is not confirming the rebound in EM share prices. It is essential to emphasize that this indicator is agnostic to the direction of the US dollar, as it is calculated as the ratio of cyclical commodities currencies (AUD, NZD, CAD, ZAR, BRL, MXN, CLP, RUB, and IDR) versus safe-haven currencies such as the Swiss franc and Japanese yen on a total-return basis – i.e., all exchange rates include the cost of carry. Chart I-7Various Reflation Indicators Have Been Slugish Various Reflation Indicators Have Been Slugish Various Reflation Indicators Have Been Slugish Our Reflation Confirming Indicator has not been sending a strong bullish reflation signal either (Chart I-7, bottom panel). This indicator is composed of an equally-weighted average of industrial metals, platinum and US lumber prices. The Global Cyclical-to-Defensive Equity Sectors Ratio has formed a classic head-and-shoulders pattern, and has broken down (Chart I-8, top panel). The latest rebound has not altered this pattern. Therefore, the path of least resistance for this ratio is still down, which entails underperformance of the global cyclical equity sector versus global defensives. The latter often occurs in selloffs. Similarly, the relative performance of Swedish versus Swiss non-financial stocks has failed to rebound, having experienced a major breakdown in March (Chart I-8, bottom panel). Swedish non-financial stocks are much more cyclical than Swiss ones. Finally, the global business cycle is experiencing its deepest recession in the post-World War II period, with the pace and nature of the recovery remaining highly uncertain. Chart I-9 portends global EPS in SDR, which is the proper measure given the greenback’s weight in SDR is 58%, the euro’s 39%, the yen’s 11%, and the yuan’s 1%. Chart I-8Global Cyclical Stocks Have Not Outperformed Global Cyclical Stocks Have Not Outperformed Global Cyclical Stocks Have Not Outperformed Chart I-9Global Corporate EPS In Perspective Global Corporate EPS In Perspective Global Corporate EPS In Perspective Global EPS shrank by 28% in 2001-2002 and by 40% in the 2008 recession. Given the current recession will be deeper, global EPS will likely shrink by about 50%. We do not think equity markets are discounting such a dire outcome after the recent rally. Bottom Line: A number of cyclical indicators continue to flash red or amber, suggesting this rally is not about a cyclical economic recovery.     Investment Strategy We closed our short position in EM equities on March 19, and on the March 26 report we argued that it was too late to sell but still too early to buy. Given the rally in global equities is overstretched from a short-term perspective, we will wait for a correction to assess whether to maintain or close our shorts on EM currencies. Chart I-10EM Currencies And S&P 500 EM Currencies And S&P 500 EM Currencies And S&P 500 That said, we maintained our underweights in both EM stocks and credit versus their DM peers. Also, we have continued to short EM currencies versus the US dollar. Chart I-10 demonstrates that EM currencies have failed to rally despite the strong rebound in the S&P 500.   Given the rally in global equities is overstretched from a short-term perspective, we will wait for a correction to assess whether to maintain or close our shorts on EM currencies. For dedicated EM equity managers, our recommended overweights are Korea, Thailand, Vietnam, Russia, central Europe, Mexico and Peru. Our underweights are Brazil, South Africa, Turkey, Indonesia, India and the Philippines. We are neutral on other bourses. Last week we published two reports for fixed-income investors: EM: Foreign Currency Debt Strains and EM Domestic Bonds And Currencies. In the first report we assessed individual EM countries' vulnerabilities to foreign debt and discussed strategies for EM sovereign and corporate credits. In the second report, we upgraded our stance on EM local markets from underweight to neutral. Before upgrading to a bullish stance, we would first need to upgrade our stance on EM currencies.   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Chinese Auto Sales: Disappointments Ahead Chinese automobile sales plunged 42% year-on-year over the first quarter of this year, due to the Covid-19 lockdowns (Chart II-1). We still expect auto sales in China to be flat or very mildly negative year-on-year over the period of April-December of this year. First, official data shows the growth rate for nominal disposable income was falling toward zero, but realistically it was probably negative in the first quarter (Chart II-2, top panel). Very sluggish household income growth – in combination with the still-elevated uncertainty of the job market (Chart II-2, bottom panel) – will restrain Chinese auto demand. Chart II-1Auto Sales In China: A Rate Of Change Recovery Ahead Auto Sales In China: A Rate Of Change Recovery Ahead Auto Sales In China: A Rate Of Change Recovery Ahead Chart II-2Sluggish Household Income Growth Will Constrain Chinese Auto Demand Sluggish Household Income Growth Will Constrain Chinese Auto Demand Sluggish Household Income Growth Will Constrain Chinese Auto Demand While household income growth will recover from current level later this year, it will likely remain much lower than the previous years’ 8-9% growth. Second, Chinese households are already quite leveraged. Their debt levels reached over 94% of annual disposable income, almost as high as in the US (Chart II-3). Third, peer-to-peer lending – an important source of auto loans in recent years – has shrunk considerably and is unlikely to pick up this year (Chart II-4). Chart II-3Chinese Household Debt Burden Is High Chinese Household Debt Burden Is High Chinese Household Debt Burden Is High Chart II-4Auto Financing Has Become More Scarce Auto Financing Is Becoming More Scarce Auto Financing Is Becoming More Scarce Bank lending rates for household consumption loans and peer-to-peer lending rates are currently about 5% and 10%, respectively. Such borrowing costs are restrictive given the tame growth of household income. Finally, the stimulus packages intended to boost automobile demand this year are no greater than they were last year. This entails that the net stimulus is close to zero. The focus of this year’s stimulus remains on the demand for new energy vehicles (NEV), which is in line with the central government’s strategic goal. Given that NEVs account for only 5% of auto sales, any boost to NEV demand is unlikely to make a huge difference in aggregate auto sales.  Another boost to auto sales is the relaxation of license controls in the first-tier cities. The extent of these measures is so far considerably smaller than it was last year. About 60,0001 additional new license plates have so far been added, accounting for only 0.2% of Chinese auto sales. This number was 180,000 last year.2  This year local governments in 16 cities announced cash subsidies for auto buyers.3 Despite larger geographic coverage, the amount of cash subsidies is similar to what it was last year – at about 3% of the retail price. This is too small to make any meaningful impact on auto sales. Investment Implications The lack of considerable new stimulus for auto purchases and lower household income growth will make the recovery in passenger car sales halting and hesitant. The lack of considerable new stimulus for auto purchases and lower household income growth will make the recovery in passenger car sales halting and hesitant. Chinese auto stock prices in the domestic A-share market are breaking down (Chart II-5). Lingering demand contraction as well as possible price cuts will further curtail auto producers’ profits. Disappointing Chinese auto sales will lead to sluggish auto production and, consequently, to weak demand for metals like steel, aluminum and zinc. Chinese auto exports will outpace its imports (Chart II-6). As China accounts for about 30% of global auto sales and production, rising net exports of automobiles from China may diminish other global producers’ margins. Chart II-5Avoid Chinese Auto Stocks For Now Avoid Chinese Auto Stocks For Now Avoid Chinese Auto Stocks For Now Chart II-6Rising Chinese Auto Net Exports Are Negative To Other Global Auto Producers Rising Chinese Auto Net Exports Are Negative To Other Global Auto Producers Rising Chinese Auto Net Exports Are Negative To Other Global Auto Producers   Ellen JingYuan He Associate Vice President ellenj@bcaresearch.com   Brazil: Not Out Of The Woods Yet We believe risks to Brazilian assets remain to the downside. Political infighting among various branches of power and state institutions will depress consumer and business confidence, lengthening the recession. Chart III-1Brazil: Recurring Crises Brazil: Recurring Crises Brazil: Recurring Crises Political infighting among various branches of power and state institutions will depress consumer and business confidence, lengthening the recession (Chart III-1). Political turmoil also reduces the probability of structural reforms. This combined with a delayed economic recovery will further strain the already precarious public debt dynamics.  First, the country is in a full-blown political crisis. The Supreme Court's decision to reject Bolsonaro's nomination for Director of the Federal Police manifests broad-based political infighting among Brazilian institutions. Further, the Supreme Court has started an investigation into the President as calls for impeachment intensify among both the public and the Congress. The rift between President Bolsonaro and Congressional President Maia is especially worrisome. Given Maia’s future political ambitions, we do not expect a truce between the two. On the contrary, they will continue to stand off in order to assert control over the fragmented Congress. As a result, structural reforms such as the national tax program and privatizations will be delayed. Second, Bolsonaro’s popularity is also plunging due to his slow and controversial response to the COVID-19 outbreak. This week, Bolsonaro’s disapproval ratings jumped above those of former president Lula da Silva, and public support for impeachment is now over 54%. Third, Congress has allowed the government to go over the limit of fiscal spending this year, which has resulted in almost 1.2 trillion reais in emergency fiscal spending, or about 16% of GDP. This will push the gross public debt-to-GDP ratio to well above 100% by the end of 2020. Chart III-2This Large Gap Makes Public Debt Dynamics Untenable This Large Gap Makes Public Debt Dynamics Untenable This Large Gap Makes Public Debt Dynamics Untenable In order to stabilize its public debt-to-GDP ratio, a government’s borrowing costs should be below nominal GDP growth. Brazil fails to meet this condition. Local currency interest rates at 5.5% are well above nominal GDP growth, which will likely be negative in 2020 (Chart III-2). This assures unsustainable debt dynamics. Finally, in terms of monetary policy, the central bank’s policy rate cuts have not been efficiently transmitted to the real economy, as discussed in our March 31st Special Report. Borrowing costs for companies and households remain elevated relative to their nominal income growth. Overall, the sole feasible way for Brazil to stabilize its public debt-to-GDP ratio is to push nominal GDP growth above interest rates. Further, this is only possible with falling interest rates and further material currency depreciation. The continued currency devaluation represents a risk to foreign investors holding local assets. Investment Recommendations Continue to underweight Brazil within EM equity and credit portfolios. We reiterate our trade to short the BRL versus the US dollar. Even though the BRL is moderately cheap (Chart III-3), there is still considerable downward pressure on the currency. The BRL is tightly correlated with commodities prices (Chart III-4). Until these do not bottom out, the real will continue depreciating. Critically, the real needs to depreciate to lift nominal GDP growth above borrowing costs. The latter is essential to stabilize public debt dynamics. Chart III-3The BRL Is Only Modestly Cheap The BRL Is Only Modestly Cheap The BRL Is Only Modestly Cheap Chart III-4The BRL Correlates With Commodities Prices The BRL Correlates With Commodities Prices The BRL Correlates With Commodities Prices Finally, we are underweight both local currency and US$ denominated bonds in Brazil due to worrisome public debt dynamics and high foreign currency stress.   Juan Egaña Research Associate juane@bcaresearch.com Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com     Footnotes 1    Shanghai announced to add 40,000 new license plates this year while Hangzhou increased 20,000 new license plates. 2   There were 100,000 additional license plates approved by Guangzhou province and an additional 80,000 by Shenzhen in 2019. 3   The cash subsidies are about RMB1000-3000 for buying regular cars, RMB3000-5000 for car replacement (e.g., scrapping their autos with Emission Standard 3 and buying autos with new Emission Standard 6), and RMB5000-10,000 for NEV purchases. Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

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

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 Banks have an unmatched perspective on the entire economy, … : BCA began by tracking money flows through the banking system to gain advance notice of the direction of markets and the economy. … so we review the five largest banks’ earnings calls every quarter to augment our standard macro analysis: We’re looking for insight into borrower performance, lender willingness, consumer behavior, business sentiment and the condition of the banking system. The biggest banks are bearish on the economic outlook, but bullish on their ability to get through it, … : No management teams are looking for a V-bottom, and their expectations about the duration of the downturn sound a good bit more pessimistic than most investors’. They all expressed confidence in their institutions’ preparedness, however, citing sizable capital buffers and high-quality loan portfolios. … and we agree with their self-assessment: Analysts were skeptical that the banks have adequately reserved for coming loan losses, but we take the more optimistic view that their earnings power will allow them to absorb repeated iterations of reserving while barely scuffing book value. Follow The Money The big banks reported their first quarter earnings last week, and equity investors were decidedly unimpressed, knocking the stocks down 15-19% through Thursday’s close while the S&P 500 was flat. We listen to the calls to hear banks’ observations about households’ and businesses’ financial activity and glean some insight into where lending might be headed. This time we also wanted to use what we heard to inform our investment view on their stocks. We have long been of the view that post-GFC regulatory reforms left the SIFI banks overcapitalized. Even staring down the barrel of the current downturn, it was our sense that the SIFIs had ample capital buffers to withstand a severely adverse scenario, and the sharp de-rating they’ve been subjected to was excessive. With the potential range of credit outcomes so wide, however, it was hard to assess how much their per-share book values might fall, and so we couldn’t state with conviction whether or not the SIFIs’ stocks were as cheap as they appeared to the naked eye. The uncertainty remains, but we heard enough on the calls to conclude that book values are likely to remain resilient. 4Q19 Big Bank Beige Book As a group, the banks offered a pretty grim take on the economy. JPMorgan Chase built its in-house economists’ late-March forecast of a 25% decline in 2Q GDP and an unemployment rate above 10% into its model for calculating its 1Q loan-loss reserve, only to have them revise their forecasts lower, to -40% and 20%, respectively, after the bank closed its books. The rest of the banks, which offered directional GDP and unemployment views instead of point forecasts, uniformly called for weakness well into 2021. The banks were downbeat on the economy, but confident in their ability to manage through it, and not a single one has any intention of cutting its dividend. On the bright side, every bank cited its sizable capital buffer when arguing that it is in a better position than it was in 2008. The banks’ contention that the mix and quality of their loan books makes them safer than they were then didn’t seem to get much traction. The mortgages they hold today were much more carefully underwritten than the ones they held in 2008, but the quality of the banks’ overall loan books won’t be known until the recession has run its course. Many business borrowers are weaker credits that they were when their loans were extended, though the record-low growth in bank lending in the expansion just concluded suggests that the banks committed fewer excesses in this cycle than they normally do (Chart 1). Chart 1An Expansion Without Bank Lending Excesses An Expansion Without Bank Lending Excesses An Expansion Without Bank Lending Excesses Businesses drew down their credit lines at a frenzied pace over the last two weeks of March (Chart 2), a sure sign that they feared that liquidity would be in short supply. Since many of the banks saw the funds return to them as deposits (Chart 3), it seems that the draws were precautionary, rather than emergency, measures. It is entirely possible that the lines will be paid down once businesses replace them with forgivable 1% loans from the Paycheck Protection Program (PPP) funded by the SBA,1 though legislative attempts to replenish the PPP's rapidly consumed initial resources are currently in limbo. Chart 2Corporate Borrowers Drew Down Their Credit Lines With Stunning Speed, ... Corporate Borrowers Drew Down Their Credit Lines With Stunning Speed, ... Corporate Borrowers Drew Down Their Credit Lines With Stunning Speed, ... Chart 3... Only To Put It Back In The Bank ... Only To Put It Back In The Bank ... Only To Put It Back In The Bank Every bank asserted that it had the capacity to continue to pay its dividend, and pledged to do so as long as conditions didn’t deteriorate dramatically. Operationally, the banks were largely able to perform their standard functions without interruption, despite having the majority of their employees working from home. Successful remote operations bode well for future productivity and profitability as they may herald a future in which banks are able to reduce their costly branch footprints. They also suggest that their ongoing IT investments are paying dividends. A Sudden Stop In Household Spending (Chart 4) And Borrowing Chart 4Sudden Stop Sudden Stop Sudden Stop [I]n March, we saw a rapid decline in spend initially in travel and entertainment, which then spread to restaurants and retail as social distancing protocols were implemented more broadly. … [W]e did see an initial boost to supermarkets, wholesale clubs and discount stores as people stocked up on provisions, but even that is now starting to normalize. (Piepszak, JPM CFO) [Credit card] spend in aggregate was down 13% in the month of March, year-over-year, and we are seeing trends like that continue here in April. (Piepszak, JPM) Consumer spend is down over 25% year-over-year this past week with food and drug increasing and other spend down significantly. (Scharf, WFC CEO) March 2020 [card] volumes declined approximately 15% from March 2019. (Shrewsberry, WFC CFO) [Our customers’] … overall spending … seems to have stabilized in the last few weeks. During mid-April, we’re seeing [weekly] spending running about a low $50 billion average level compared to $60 billion … before the crisis. (Moynihan, BAC CEO) [T]he last week of March, the card spend activity just broadly for us was down about 30%. … [W]e would expect there to be continued pressure on purchase sale volumes through most of the second quarter. (Mason, C CFO) A Sharp Rise In Credit Line Utilization, … C&I loans were up 26% [year-on-year] as revolver utilization increased to 44%, which is an all-time high. … [E]arly here in the second quarter, we have seen a pause on revolver draws but … we are assuming … that we will see [them] continue in the second quarter, albeit at lower levels than the first quarter. (Piepszak, JPM) [The draws] really have flattened out, and they have been negligible for the last several days, more than a week. And so they probably peaked at the end of the third week of March, and then came right back down. … It’s worth noting that the high rate of [utilization] growth … has backed off since credit markets have reopened. (Shrewsberry, WFC) The draw activity was pretty normal through the first week of March, but ramped up in the second week before peaking in the third. The requests have come down in every one of the last three weeks. (Moynihan, BAC) [C]oming into the second quarter, we’ve actually seen really de minimis draws on the facilities and … we don’t see or feel that [drawdown] pressure now. (Corbat, C CEO) [T]he drawdowns were high in the third and fourth week in March and started to level out in early April. So I think we saw the peak already occurring. (Dolan, USB CFO) … Accompanied By A Surge In Deposits [A]bout half of [the increase in deposits came] from clients drawing on their credit lines and holding their cash with us as they look to secure liquidity. (Piepszak, JPM) It’s worth noting [that] ... we saw many of those draws come back … as deposits. [T]he 75% of loan draws [that] were not used for other paydowns ended up as deposits with [us]. (Moynihan, BAC) The Current Situation Is Unprecedented, … [T]here is no model that [has] dealt with GDP down 40%, unemployment growing that rapidly. … [There are] no models that ever dealt with a government which is doing a PPP program which might be ... $550 billion, unemployment where it looks like 30-40% [of those unemployed will have] higher income than before they went on unemployment, … or that the government is going to make direct payments to people. So what does that mean for credit card [performance]? (Dimon, JPM CEO) The economy is in an unprecedented situation, but not all of the unknowns are bad. The monetary and fiscal stimulus programs will undoubtedly help at the margin, and they may dramatically reduce the second-round effects of the social distancing measures that have strangled activity. We all know we haven’t seen anything like this before. There is no clear path … with a narrow range of outcomes. And so [I just have a very hard time] making an analogy of what this environment is to other environments. Having said that, … we feel like the portfolios that we have are stronger than they were at other downturns as I think they certainly are in many banks out there. (Scharf, WFC) I would just [dis]courage anyone from imagining that at this point in time that any bank has got perfect clairvoyance about … the future …, and whether it gets better or … worse. (Shrewsberry, WFC) Obviously there are many unknowns including how government fiscal and monetary actions will impact the outcome and how our own deferral programs will impact losses, or perhaps the biggest unknown is how long economic activity and conditions will be significantly impacted by the virus. (Donofrio, BAC CFO) … But Credit Performance Might Not Be Horrendous The real question will ultimately be how long this shutdown actually continues, … but in addition to that, how our actions, … the things that we’re doing very actively to help our clients, and the huge amount of government intervention, whether those things will … bridge individuals and small businesses and larger corporations to the other side of this. (Scharf, WFC) It wouldn’t surprise me to continue to have to add to reserves, … [b]ut … what we know is, we’re strong and the industry is strong to be able to handle this. (Scharf, WFC) For years now, we have been focused on client selection. As you all know, what really impacts banks in recession is not the loans put on your books during stress, but rather the quality of your portfolio booked during the years leading up to the stress. (Donofrio, BAC) [T]his isn’t a financial crisis, it’s a public health crisis with severe economic ramifications. … [W]e entered [it] in a very strong position from capital, liquidity and balance sheet perspective. We have the resources we need to serve our clients without jeopardizing our safety and soundness. … I feel confident in our ability to manage through whatever scenario comes to pass. (Corbat, C) I think, generally speaking, all banks are in a good position right now, which is why we’re all able to help our customers while protecting employees. (Cecere, USB CEO) Today we received the first major distribution of the direct payments in terms of the $1,200 stimulus payment. We’re seeing now the unemployment benefits, the extra $600 … coming through. [T]hose programs are just barely hitting the general consumer, general business, et cetera. And so … the stimulus they’ll provide is actually going to be from now on, not from now backwards, because this is a program that didn’t exist literally three weeks ago. (Moynihan, BAC) [T]hese [fiscal and monetary] programs … are extraordinary and should have an extraordinary impact. (Piepszak, JPM) Buy The Banks? The uncertainty around loan losses remains extremely high. No one knows how long the economy will remain locked down, or how long it will take to restart the economy once the most restrictive social distancing measures begin to be relaxed. No one knows how large the package of fiscal and monetary assistance will become, or how effective it will ultimately be. Analysts were clearly skeptical that the amounts the banks set aside in the first quarter as reserves against future losses will be sufficient. They were concerned about the gaps between current reserve levels and the losses the banks realized in the global financial crisis, and the cumulative losses projected under the severely adverse scenario of the 2019 iteration of the Fed’s annual stress tests (Table 1). If the virus drag on the economy persists into the third quarter, as our base-case scenario projects, the banks will likely have to step up their reserving activity aggressively. Given that they were able to do so in the first quarter without impairing their book values (Table 2), however, we think they can handle it. Table 1Loan Loss Reserves Vs. Stress Test Projections The Big Bank Beige Book, April 2020 The Big Bank Beige Book, April 2020 Table 2Big Bank Book Values The Big Bank Beige Book, April 2020 The Big Bank Beige Book, April 2020 The bull case, as BAC’s CEO put it on the call, rests on the idea that the banks’ quarterly pre-tax pre-provision net revenue – their earnings power – is large enough to absorb the gathering tide of writedowns. After seeing the first quarter results, and believing that monetary and fiscal policy will be able to reduce the overall level of credit losses and spread them out across several quarters, provided the shutdown doesn’t last more than six months, we subscribe to it. We are a buyer of the largest banks on the view that the monetary and fiscal support will reduce and stretch out the inevitable writedowns enough to allow the banks to earn their way through them without suffering meaningful book-value declines. Let’s go back to the beginning on the pre-tax PPNR[.] [W]e feel [that earnings power] has us in good stead in terms of [our] ability to absorb whatever circumstances play out here. The reality is how much earnings capacity [we] have to keep generating capital and … earnings that [we] can offset whatever comes at [us] and that’s what we feel good about. (Moynihan, BAC) Table 3A Solid Month's Work The Big Bank Beige Book, April 2020 The Big Bank Beige Book, April 2020 The SIFI put options we flagged four weeks ago have expired worthless, yielding a tidy 9% one-month gain for investors who wrote them (Table 3). That call was founded on the interaction between low book-value multiples and astronomical implied volatilities, but didn’t fully embrace the banks. We are ready to take the next step now because we believe pre-provision earnings will match or exceed the somewhat attenuated stream of credit losses, allowing investors to buy the biggest banks at a price-to-tangible-book multiple with a margin of safety that would comfort Benjamin Graham. We recommend overweighting the largest banks in US equity portfolios.2   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 Please see the April 14, 2020 US Investment Strategy/US Bond Strategy Special Report, "Alphabet Soup: A Summary Of The Fed’s Anti-Virus Measures," available at usis.bcaresearch.com. 2 Our US Equity Strategy service rates the S&P 500 banks group overweight, albeit with a downgrade alert.