Money Trends / Liquidity

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

Highlights The Federal Reserve’s temporary FIMA repo facility will go a long way in helping ease dollar-funding stress outside the US. However, with the duration of the lockdown highly uncertain, a liquidity crisis could rapidly evolve into a solvency one. If the containment measures prove successful by summer, then the global economy will be awash with much stimulus, which will be fertile ground for pro-cyclical currencies. However, in the event that we receive indications of a more malignant outcome, we could retest and break above the recent highs in the DXY. We assign a one-third probability to this outcome. For now, a barbell strategy is warranted. Hold a basket of the cheapest currencies, along with some safe-havens. Crude oil has approached capitulation lows, but conditions are not yet in place for a durable bottom. Stand aside on petrocurrencies for now. Feature Chart I-1The Fed's Liquidity Injections Are Working The Fed's Liquidity Injections Are Working The Fed's Liquidity Injections Are Working The DXY index has once again broken above the psychological 100 level. This has occurred alongside the backdrop of very generous swap lines offered by the Federal Reserve to foreign central banks, as well as a temporary repo facility for foreign and international monetary authorities (FIMA). In fact, the euro-dollar cross-currency basis swap is now in positive territory, suggesting that a key funnel for offshore dollar liquidity has now significantly widened (Chart I-1). Why then has the dollar continued to strengthen, despite a concerted effort by the Fed to flood the global system with dollars? We offer and explore three reasons: The Fed’s actions are still insufficient. The dollar crisis is evolving from a liquidity one to a solvency one. The liquidity-to-growth transmission mechanism needs time. The Fed’s Actions Are Still Insufficient The Fed’s actions so far to ease the offshore dollar funding stress have been to: Offer unlimited funding through swap lines to five major central banks at the overnight index swap + 25 basis points.1  This was effective the week of March 16. Extend the swap lines to nine more central banks, with a cap of US$60 billion and a maturity of 84 days.2 This was announced March 19. Allow FIMA account holders to temporarily exchange their Treasury securities held with the Fed for US dollars. This was announced on Tuesday. Have these actions been sufficient? For most developed market currencies, yes. Chart I-2 shows that the currencies that have been most hit in the first quarter were of the countries initially excluded from the swap agreement such as Australia, Norway and New Zealand. Since the March 19 agreement, these currencies have staged significant rallies. Chart I-2Very Few Winners In Q1 Capitulation? Capitulation? However, there are three reasons why the Fed’s actions are still insufficient. First, they are limited to only 14 central banks, and need to be expanded further. While currencies such as the Brazilian real and Mexican peso have stabilized, others like the Turkish lira or South African rand continue their freefall. In short, many emerging market central banks do not have swap agreements with the US. These are countries with huge dollar liabilities that could continue to see their currencies fall, pushing up the  aggregate dollar index. Developed market commodity currencies tend to be highly correlated to emerging market currencies (Chart I-3). There is a huge pool within the financial architecture unable to access funding through central bank swap lines.  The second reason is that the pool of Treasury securities available to swap for US dollars has shrunk significantly. This has been on the back of slowing global trade, which sapped the current account surpluses of many countries, dampening their foreign exchange reserves. Thus, while the Fed’s latest actions may prevent an international dumping of US Treasurys, it may be insufficient to completely assuage funding stresses (Chart I-4). Chart I-3Commodity Currencies Still At Risk Commodity Currencies Still At Risk Commodity Currencies Still At Risk Chart I-4A Smaller Pool Of Treasurys To Sell A Smaller Pool Of Treasurys To Sell A Smaller Pool Of Treasurys To Sell Finally, a recent report by the Bank of International Settlements3 showed that of the US$86 trillion in outstanding foreign exchange swaps/forwards, about 60% is among non-bank financial and other institutions. This suggests there is a huge pool within the financial architecture unable to access funding through central bank swap lines. Given that hedge funds are included in this group, this category entails a lot more credit risk than any central bank will be willing to bear (Chart I-5). Chart I-5Can The Fed Bail Out Non-Banks? Capitulation? Capitulation? Bottom Line: While the Fed’s injection of dollar liquidity has been massive and significant, access to these funds may be limited to entities that have significant credit risk. There is not much the Fed can do about this. But at the same time, it also suggests the Fed’s actions have been insufficient to quench the global thirst for dollar liquidity. From A Liquidity To A Solvency Crisis If the containment measures prove successful by summer, then the global economy will be awash with much stimulus, which will be fertile ground for pro-cyclical currencies. As a counter-cyclical currency, the dollar will buckle, lighting a fire under our favorites such as the Norwegian krone and the Swedish krona. The euro will be the most liquid beneficiary of this move. However, the DXY index has effortlessly broken above the psychological 100 level, suggesting we could catapult to new highs. When massive amounts of stimulus are injected into markets but prices keep falling (and the dollar keeps rallying), this portends a liquidity crisis morphing into a solvency one. What ensues is a liquidation phase where the only guiding signposts are technical indicators and valuation extremes. There are a few indications we could be stepping into this phase: During recessions, the dollar rally has tended to occur in two phases. The first phase prompts the US authorities to act, usually by dropping interest rates, which dampens the rally. The next phase epitomizes indiscriminate liquidation by financial markets (Chart I-6). Enter 2008. The US first introduced swap lines with a few central banks in December 2007. But from March to October 2008, the dollar soared by about 25%. This prompted the Fed to expand its swap lines to include even some emerging markets. Despite the knee-jerk fall in the dollar of 11%, we eventually made new highs by rallying 15%. While the Fed’s injection of dollar liquidity has been massive and significant, access to these funds may be limited. As the dollar rises, it takes time for economies to implode due to strong monetary and fiscal frameworks. The implosion of the euro area economy only surfaced well after the 2008 crisis. Specifically, there has been an epic rise in global nonfinancial corporate debt. As a result, credit default swaps across many countries are surging (Chart I-7). High-yield spreads are blowing out. Our bond strategists believe that even though there is value in investment-grade debt, high-yield paper remains at risk.4  Historically, whenever the default rate has breached 4% (as is the case now), a self-reinforcing feedback loop of higher refinancing rates and defaults ensues (Chart I-8). With a recovery rate that is going to be much lower than historical standards due to bloated balance sheets, this is worrisome. Chart I-6The Dollar Rally Occurs In Two Phases The Dollar Rally Occurs In Two Phases The Dollar Rally Occurs In Two Phases Chart I-7CDS Spreads Are Widening Significantly CDS Spreads Are Widening Significantly CDS Spreads Are Widening Significantly Chart I-8Large Defaults Are Ahead Large Defaults Are Ahead Large Defaults Are Ahead It is difficult to pinpoint where the epicenter of the potential default wave will be. The energy sector looks like a prime candidate, putting many commodity currencies at risk. Bottom Line: There is a non-negligible risk that the liquidity crisis evolves into a solvency one. Though this is not our base case, we assign a one-third probability to this outcome. Liquidity To Growth Transmission Channel Monetary stimulus only affects the economy with a lag, and fiscal stimulus is so far unlikely to completely plug the hole from economic disruption. This leaves currency technicals and valuation as among the only few guiding signposts towards a peak in the DXY. There is usually a significant lag between easing in offshore dollar funding costs and a respective bottom in the domestic currency (Chart I-1). The AUD/JPY cross has broken below the key support zone of 70-72. This defensive line held notably during the European debt crisis, China’s industrial recession and, more recently, the global trade war. This pins the next level of support in the 55-57 zone, on par with the recessions of 2001 and 2008. The USD/JPY is weakening again and will likely hit 100. A rising yen is usually accompanied by a dollar rally against other procyclical currencies. Outside of the Fukushima crisis, this has been a key indicator that the investment environment is becoming precarious (Chart I-9). Chart I-9The Yen Could Touch 100 The Yen Could Touch 100 The Yen Could Touch 100 Some high-beta currencies such as the USD/TRY, USD/ZAR, and USD/IDR are still in freefall. These currencies are usually good at sniffing out a change in the investment landscape, specifically one becoming perilous for carry trades. Similarly, the USD/CNY has tested and has failed to break above 7.12. This will be a key level to watch since a break above will send Asian currencies into the abyss. “Doctor” copper has failed to stage a meaningful rebound. In fact, the copper-to-gold and oil-to-gold ratios continue to head lower from oversold levels.  Whenever cyclical sectors are underperforming defensives at the same time as non-US markets underperforming US ones, this has signaled that the marginal dollar is rotating towards the US. This is usually dollar bullish (Chart I-10A and Chart I-10B). “Doctor” copper has failed to stage a meaningful rebound. In fact, the copper-to-gold and oil-to-gold ratios continue to head lower from oversold levels. This signifies impairment in the liquidity-to-growth transmission mechanism (Chart I-11). Earnings revisions continue to head lower across all markets. Chart I-10ACyclical Markets Are Not Confirming A Dollar Top Cyclical Markets Are Not Confirming A Dollar Top Cyclical Markets Are Not Confirming A Dollar Top Chart I-10BCyclical Markets Are Not Confirming A Dollar Top Cyclical Markets Are Not Confirming A Dollar Top Cyclical Markets Are Not Confirming A Dollar Top   Chart I-11Dr Copper Is Sick Dr Copper Is Sick Dr Copper Is Sick Bottom Line: Historically, signs of capitulation can usually be observed by paying close attention to market internals and currency technicals. While we have had some marginal improvement, we are not out of the woods yet. Portfolio Strategy Chart I-12Go Short CAD/NOK Go Short CAD/NOK Go Short CAD/NOK We recommend maintaining a barbell strategy – a basket of the cheapest currencies, along with some safe-havens such as the yen and Swiss franc. Overall, investors should maintain a small upward bias in the dollar in the near term. Meanwhile, short USD/JPY positions make sense. Oil plays are becoming attractive, but conditions for a durable bottom are not yet in place. The strong rebound in the NOK/SEK cross is just an unwinding of the flash crash. If the dollar and oil have been at the epicenter of these moves, then the cross is still at risk of relapsing in the near term. We were stopped out of a long position in this cross, and will discuss oil and petrocurrencies next week. That said, a short CAD/NOK position is a much safer way to express a longer-term bearish view on the dollar (Chart I-12). We are going short this cross today with a stop-loss at 7.5. Finally, the pound remains extremely cheap versus the dollar, but the rally in recent days has eroded the potential for tactical upside. We will await better opportunities to own sterling.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 These include the Bank Of Canada, Bank Of Japan, Bank Of England, European Central Bank, and the Swiss National Bank. 2 These include 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  Stefan Avdjiev, Egemen Eren and Patrick McGuire, “Dollar Funding Costs during the Covid-19 Crisis through the Lens of the FX Swap Market,” BIS Bulletin, dated April 1, 2020. 4 Please see US Bond Strategy and Global Fixed Income Strategy Joint Special Report, “Trading The US Corporate Bond Market In A Time Of Crisis,” dated March 31, 2020, available at usbs.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 University of Michigan's consumer sentiment index plunged to 89.1 in March from 101 the previous month, the fourth largest monthly decline over the past half a century. ADP employment recorded a loss of 27K jobs in total nonfarm private sector, including a 90K decrease in small businesses payroll which was offset by the 48K increase in healthcare. Initial jobless claims surged to 6.6 million for the week ended March 27. The ISM manufacturing index came in at a relatively benign 49.1, but this was boosted by supplier deliveries. The DXY index appreciated by 1.1% this week amid growing concerns over COVID-19 and disappointing data releases. Shortly after the $2 trillion coronavirus rescue package last week, President Trump is now calling for another "very big and bold" $2 trillion "Phase 4" package on infrastructure spending. Report Links: The Dollar Funding Crisis - March 19, 2020 Are Competitive Devaluations Next? - March 6, 2020 The Near-Term Bull Case For The Dollar - February 28, 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 business climate indicator dropped to -0.28 from -0.06 in March, as the COVID-19 crisis deepens. The March consumer price inflation fell across the euro area: headline inflation fell from 1.2% to 0.7% year-on-year and core inflation decreased from 1.2% to 1%.  EUR/USD depreciated by 1.1% this week. Euro zone countries have until April 9 to design another stimulus package to support the economy which might consist of financial loans and a short-term work scheme. The biggest challenge being faced is that while some member countries (including France, Italy and Spain) are calling for joint debt issuance, others (including Germany and Austria) are fiercely against it. Report Links: On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 On Money Velocity, EUR/USD And Silver - October 11, 2019 Japanese Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data in Japan have been negative: The jobs-to-applicants ratio dropped from 1.49 to 1.45 in February. Industrial production contracted by 4.7% year-on-year in February, down from -2.3% the previous month. Housing starts fell by 12.3% year-on-year in February.  The Japanese yen appreciated by 1.6% against the US dollar this week, supported by growing concerns over COVID-19 and a global recession. The quarterly Tankan Survey shows that the sentiment index fell to a 7-year low of -8 in Q1 among large manufacturers, and dived to 8 from 20 among non-manufacturers. Besides, the survey points to a further deterioration of confidence over the next three months. Report Links: The Near-Term Bull Case For The Dollar - February 28, 2020 Building A Protector Currency Portfolio - February 7, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data in the UK have been negative, despite some positive releases for Q4: Consumer confidence dropped from -7 to -9 in March. Markit manufacturing PMI slipped from 48 to 47.8 in March. The current account deficit narrowed from £15.9 billion to £5.6 billion in Q4. Annualized GDP growth was unchanged at 1.1% year-on-year in Q4. The British pound soared by 2% against the US dollar this week. To preserve cash during the pandemic, the BoE's Prudential Regulation Authority (PRA) suggested commercial banks to suspend dividends and buybacks until the end of this year in addition to cancelling outstanding 2019 dividends. Moreover, the PRA also expects banks not to pay any cash bonuses to senior staff. 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: Consumer confidence dropped from 72.2 to 65.3 in March. Manufacturing PMI slipped from 50.1 to 49.7 in March. New home sales increased by 6.2% month-on-month in February, up from 5.7% the previous month. Building permits grew by 20% month-on-month in February. However, we expect housing activities to slow down in March. The Australian dollar fell further by 0.4% against the US dollar this week. In the minutes released this Wednesday, the RBA warned that a "very material contraction" in economic activity was ahead. While the RBA said it was not possible to provide an update of the macro forecast given the "fluidity of the situation", it also expressed concerns that the contraction might linger beyond the June quarter. Report Links: On AUD And CNY - January 17, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 A Contrarian View On The Australian Dollar - May 24, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 Recent data in New Zealand have been negative: Building permits grew by 4.7% month-on-month in February. However, business confidence plunged from -19.4 to -63.5 in March. The activity outlook index also dived from 12 to -26.7 in March. The New Zealand dollar fell by 0.8% against the US dollar this week. Similar to the BoE, the RBNZ is now restricting all locally-incorporated banks from paying dividends on ordinary shares until the economy has sufficiently recovered in order to preserve cash and support the stability of the financial system. The RBNZ is also taking measures to help support banks to lend to businesses. 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: Bloomberg Nanos confidence dropped from 51.3 to 46.9 for the week ended March 27. Markit manufacturing PMI fell below 50 for the first time since last September to 46.1 in March. The Canadian dollar fell by 1.2% against the US dollar this week, weighed down by the sharp decline in oil prices. The BoC lowered the overnight target rate by another 50 bps in an emergency meeting last Friday. It also joined the QE club by launching the Commercial Paper Purchase Program (CPPP) which aims to ease short-term funding stress. Report Links: The Loonie: Upside Versus The Dollar, But Downside At The Crosses Updating Our Balance Of Payments Monitor - November 29, 2019 Making Money With Petrocurrencies - November 8, 2019 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Recent data in Switzerland have been negative: KOF leading indicator dropped from 100.9 to 92.9 in March. Total sight deposits increased from CHF 609 billion to CHF 621 billion for the week ended March 27. The manufacturing PMI plunged from 49.5 to 43.7 in March. Headline consumer prices fell by 0.5% year-on-year in March, further down from the 0.1% decline in February. The Swiss franc fell by 1.5% against the US dollar this week. The SNB is not only battling a weaker economic backdrop, but also strong demand for safe-haven currencies. While the SNB has less room to further lower interest rates, it is taking part in easing funding stress from the pandemic. Report Links: On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 Portfolio Tweaks Before The Chinese New Year - January 24, 2020 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Recent data in Norway have been negative: Retail sales increased by 2% month-on-month in February, up from 0.5% the previous month. Manufacturing PMI fell to 41.9 from 51.6 in March, the lowest since the Great Financial Crisis. The new orders, production and employment components all plunged below 40, while suppliers' delivery index soared to 74. The Norwegian krone rebounded by 2% against the US dollar this week, following the brutal selloff in recent weeks weighed by the sharp decline in oil prices. The Norges Bank is stepping up in currency intervention to reduce volatility including buying the krone in exchange for the US dollar. We believe there is now tremendous value in the krone once oil prices stabilize. Report Links: Building A Protector Currency Portfolio - February 7, 2020 On Oil, Growth And The Dollar - January 10, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 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: Retail sales grew by 2.8% year-on-year in February. Manufacturing PMI crashed to 43.2 in March from 52.7. The Swedish krona fell by 0.5% against the US dollar this week. In the Swedish Economy Report released on Wednesday, the NIER (Swedish National Institute of Economic Research) estimates that Sweden's GDP will fall by just over 6% in the second quarter. While the NIER believes that the current central bank measures are appropriate in supporting the economy in a wave of bankruptcies and mass unemployment, Sweden has more room to act with relatively lower government debt to its advantage. 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

Dear Client, I will be discussing the economic and financial implications of the pandemic with my colleague Caroline Miller this Friday, March 27 at 8:00 AM EDT (12:00 PM GMT, 1:00 PM CET, 8:00 PM HKT). I hope you will be able to join us for this webcast. Next week, we will send you a special report prepared by BCA’s Chief Economist Martin Barnes. Martin will provide his perspective on the current crisis, focusing on some of the longer-run implications. Best regards, Peter Berezin, Chief Global Strategist Highlights The world is in the midst of a deep recession. Growth should recover in the third quarter as the measures taken to compensate for the initial slow response to the crisis are relaxed and existing measures are better calibrated to reduce economic distress. Continued monetary support and unprecedented fiscal stimulus should help drive the recovery once businesses reopen and workers return to their jobs. Investors should maintain a modest overweight to global equities. US stocks will lag their foreign peers over the next 12 months. The US dollar has peaked. A weaker dollar should help lift commodity prices and the more cyclical sectors of the stock market. High-yield credit spreads will narrow over the next 12 months, but we prefer investment-grade credit on a risk-reward basis. Investors are understating the potential long-term inflationary consequences of all the stimulus that has been unleashed on the global economy. Buy TIPS and gold. I. Macroeconomic Outlook The global economy is now in recession. The recession has occurred because policymakers saw it as the lesser of two evils. They judged, with good reason, that a temporary shutdown of most non-essential economic activities was a price worth paying to contain the virus. Outside of China, the level of real GDP is likely to be down 1%-to-3% in Q1 of 2020 relative to Q4 of 2019, and down another 5%-to-10% in Q2 relative to Q1. On a sequential annualized basis, this implies that GDP growth could register a negative print of 40% in some countries in the second quarter, a stunning number that has few parallels in history. Growth in China should stage a modest rebound in the second quarter, reflecting the success the country has had in containing the virus. Nevertheless, the level of Chinese economic activity will remain well below its pre-crisis trend, with exports increasingly weighed down by the collapse in overseas spending. A One-Two Punch The “sudden stop” nature of the downturn stems from the fact that the global economy was simultaneously hit by both a massive demand and supply shock. When households are confined to their homes, they cannot spend as much as they normally would. This is particularly the case in an environment of heightened risk aversion, which usually leads to increased precautionary savings. At times like these, businesses also slash spending in a desperate effort to preserve cash. All this reduces aggregate demand. On the supply side, production has been impaired because of workers’ inability to get to their jobs. According to the Bureau of Labor Statistics, less than 30% of US employees can work from home (Chart 1). Since modern economies rely on an intricate division of labor, disturbances in one part of the economy quickly ripple through to other parts. The global supply chain ceases to function normally. Chart 1US: Who Can Work From Home And Who Cannot? Second Quarter 2020 Strategy Outlook: World War V Second Quarter 2020 Strategy Outlook: World War V Think of this as a Great Depression-style demand shock combined with a category five hurricane supply shock.  The fact that both of these shocks have been concentrated in the service sector, which represents at least two-thirds of GDP in most economies, has made the situation even worse (Chart 2). During most recessions, the service sector is the ballast that helps stabilize the economy in the face of sharp declines in the more cyclical sectors such as manufacturing and housing. This time is different. Chart 2The Service Sector Accounts For A Big Chunk Of GDP And Has Been Very Hard Hit Second Quarter 2020 Strategy Outlook: World War V Second Quarter 2020 Strategy Outlook: World War V The Shape Of The Recovery: L, U, or V? Provided that the number of new infections around the world stabilizes during the next two months, growth should begin to recover in the third quarter. What will the recovery look like? From the perspective of sequential quarterly growth rates, a V-shaped recovery is inevitable simply because a string of quarters of negative 20%-to-40% growth would quickly leave the world with no GDP at all. However, thinking in terms of growth rates is not the best approach. It is better to think of the level of real GDP. Chart 3 shows three scenarios: 1) An L-shaped profile for real GDP where the level of output falls and then remains permanently depressed relative to its long-term trend; 2) A sluggish U-shaped recovery where output slowly rebounds starting in the second half of the year; and 3) A rapid V-shaped recovery where output quickly moves back to its pre-crisis trend. Chart 3Profile Of The Recovery: L, U, or V? Second Quarter 2020 Strategy Outlook: World War V Second Quarter 2020 Strategy Outlook: World War V We had previously thought that the recovery from the pandemic would be V-shaped. Compared to the sluggish recovery following the Great Recession, that is likely still true. However, at this point, we would prefer to characterize the probable recovery as being more U-shaped in nature. This is mainly because the measures necessary to contain the virus may end up having to remain in place, in one form or another, for the next few years. Why Not L? Given the likelihood that containment measures will continue to weigh on economic activity, how can an L-shaped “recovery” be avoided? While such a dire outcome cannot be ruled out, there are three reasons to think “U” is more likely than “L”. Reason #1: We Will Learn From Experience It is almost certain that we will figure out how to fine-tune containment measures to reduce the economic burden without increasing the number of lives lost. There are still many questions that remain unanswered. For example: Are restaurants where family members sit together really more dangerous than bars or conferences where strangers are milling about talking to one another? How dangerous is air travel? Modern airplanes have hospital-grade filtration systems that recirculate all the air in the cabin every three minutes. Might this explain why there has only been a handful of flight attendants that have tested positive for the virus? How contagious are children, who often may not present any symptoms at all? Which drugs might slow the spread of the disease or perhaps even cure it? To what extent would widespread mask-wearing help? Yes, a mask may not prevent you from catching the virus, but if there is major social stigma associated with being unmasked in public, then people who have the virus and may not know it will be less of a threat to others. One study estimates that the virus could be completely eradicated if 80% of people always wore masks.1  With time, we will learn the answers to these questions. We will also be able to stockpile masks, ventilators, respirators, and test kits – all of which are currently in short supply – to better combat the virus. Reason #2: We Are NowOvercompensating For Lost Time Second, most countries are currently at the stage where they are trying not just to bring down the basic reproduction number for the virus to 1, but to drive it down to well below 1. There is merit in doing so. If you can reduce the reproduction number to say, 0.5, meaning that 100 people with the virus will pass it on to only 50 other people, then the number of new infections will fall rapidly over time. This is what China was finally able to achieve. A recent study documented that China succeeded in bringing down the reproduction number in Wuhan from 3.86 to 0.32 once all the containment measures had been implemented (Chart 4).2 Chart 4Severe Containment Measures Have Changed The Course Of The Wuhan Outbreak Second Quarter 2020 Strategy Outlook: World War V Second Quarter 2020 Strategy Outlook: World War V The critical point is that once you reduce the number of new infections to a sufficiently low level, you can then relax the containment measures by just enough so that the reproduction number rises back to 1. At that point, the number of new infections at any given point in time will be constant. One can see this point by imagining a bicycle coasting down a mountain road. Ideally, the rider should apply uniform pressure on the brakes at the outset of the descent to prevent the bicycle from accelerating too quickly. However, if the rider is too slow to apply the brakes and ends up going too fast, he or she will then need to overcompensate by pressing hard on the brakes to slow the bike down before easing off the brakes a bit. Most of the world is currently in the same predicament as the cyclist who failed to squeeze the brakes early on. We are overcompensating to get the infection rate down. However, once the infection rate has fallen by enough, we can ease off the most economically onerous measures, allowing GDP to slowly recover. Reason #3: Containment Measure Will Be Eased As More People Acquire Immunity Much of the popular discussion of the epidemiology of COVID-19 has failed to distinguish between the basic reproduction number, R0, and the effective reproduction number, Re. The former measures the average number of people a carrier of the virus will infect in an entirely susceptible population, whereas the latter measures the average number of people who will be infected after some fraction of the population acquires immunity either by surviving the disease or getting vaccinated. Mathematically, Re = R0*(1-P), where P is the proportion of the population which has acquired immunity. For example, suppose P=0.5, meaning that half the population has acquired immunity. In this case, the average number of people a carrier will infect will be only half as high as when no one has immunity. As we discuss below, there is considerable uncertainty about how fast P will increase over time, including whether it could spike upwards if a vaccine becomes widely available. Still, any increase in P will make it more difficult for the virus to propagate. Over time, this will permit policymakers to raise R0 at an accelerating rate towards the level it would naturally be in the absence of any containment measures (Chart 5). Such a strategy would allow economic activity to increase without raising Re; that is to say, without triggering an explosion in the number of new cases. Chart 5Populations Acquiring Immunity Is Key Second Quarter 2020 Strategy Outlook: World War V Second Quarter 2020 Strategy Outlook: World War V The Virus Endgame How long will it take to dismantle all the containment measures completely? This partly depends on what medical breakthroughs occur and what measures are needed to “flatten the curve” of new infections (Chart 6). Right now, most countries are trying to drive down the number of new infections to very low levels in the hopes that either a vaccine will be invented or new treatment options will become available. Chart 6Flattening The Curve Second Quarter 2020 Strategy Outlook: World War V Second Quarter 2020 Strategy Outlook: World War V We are not medical experts and will not offer an opinion on how likely a breakthrough may be. What we would say is that combating the virus has become a modern-day Manhattan project. If the project succeeds, a V-shaped recovery could still ensue. What if the virus evades the best efforts of scientists to eradicate it? In that case, the only way for life to return to some semblance of normalcy is for the population to acquire herd immunity. How many people would need to be infected? In the context of the foregoing discussion, this is equivalent to asking how high P needs to rise for Re to fall below 1. The equation above tells us this must correspond to the value of P for which R0 (1-P) <1. Solving for P yields P > 1-1/R0. In the absence of social distancing and other containment measures, most estimates of R0 for COVID-19 place it between 1.5 and 4. This implies that between one-third (1-1/1.5) to three-quarters (1-1/4) of the population would need to be infected for herd immunity to set in. Even if one allows for the likelihood that significantly more resources will be marshalled to allow hospitals to service a greater number of patients, we estimate that it would take 2-to-3 years to reach that point.3 To be clear, the virus’ ability to spread will decline even before herd immunity is achieved. An increase in the share of the population who survived and became naturally inoculated against the virus would allow policymakers to relax containment measures, perhaps to such an extent that eventually only the simplest of actions such as increased hand-washing and widespread mask-wearing would be enough to prevent hospitals from being overwhelmed. This underscores our baseline expectation of a U-shaped economic recovery. Second-Round Effects Suppose the global economy starts to recover in the third quarter of this year as the measures taken to compensate for the initial slow response to the crisis are relaxed, existing measures are better calibrated to reduce economic distress, and more younger and healthier people acquire natural immunity to the virus, thus reducing the vulnerability of the old and frail. Does that mean we are out of the woods? Not necessarily! We still have to worry about the second-round economic effects. Even if the virus is contained, there is a risk that the economy will be so scarred by the initial drop in output that it will fail to recover. A vicious circle could emerge where falling spending leads to higher unemployment, leading to even less spending. In the current environment, the tendency for unemployment to rise may be initially mitigated by the decision of a few large companies with ample financial resources to pay their workers even if they are confined to their homes. This would result in a decline in labor productivity rather than higher unemployment. That said, given the severity of the shock and the fact that many of the hardest-hit firms are in the labor-intensive service sector, a sharp rise in joblessness is still inevitable, particularly in countries with flexible labor markets such as the US. Chart 7Worries Over Job Security Abound Worries Over Job Security Abound Worries Over Job Security Abound Today’s spike in US initial unemployment claims is testament to that point (Chart 7). In fact, the true increase in the unemployment rate will probably be greater than what is implied by the claims data because many state websites did not have the bandwidth to handle the slew of applications. In addition, under existing rules, the self-employed and those working in the “gig economy” do not qualify for unemployment benefits (this has been rectified in the bill now making its way to the White House). The Role Of Policy Could we really end up in a world where the virus is contained, and people are ready and able to work, only to find that there are no jobs available? While such a sorry outcome cannot be dismissed, we would bet against it. This outcome would only arise if there is insufficient demand throughout the economy when it reopens. Unlike in 2008/09 when there was a lot of moralizing about how this or that group deserved to be punished for their reckless behavior, no one in their right mind today would argue that the workers losing their jobs and the companies facing bankruptcy somehow had it coming. What can policymakers realistically do? On the monetary side, policy rates are already close to zero in most developed economies. A number of emerging markets still have scope to cut rates, but even there, many find themselves not far from the zero bound (Chart 8). Chart 8DM Rates At The Zero Bound, With EM Rates Approaching DM Rates At The Zero Bound, With EM Approaching DM Rates At The Zero Bound, With EM Approaching Chart 9A Mad Scramble For Cash A Mad Scramble For Cash A Mad Scramble For Cash   That said, cutting interest rates right now is not the only, and probably not the most important, way for central banks to stimulate their economies. The global economy is facing a cash shortage. Companies are tapping credit lines at a time when banks would normally be looking to increase their own cash reserves. The mad scramble for cash has caused libor, repo, and commercial paper spreads to surge (Chart 9). And not just any cash. As the world’s reserve currency, the dollar is increasingly in short supply (Chart 10). This explains why cross-currency basis spreads have soared and why the DXY index has jumped to the highest level in 17 years. Chart 10Dollars Are In Short Supply Dollars Are In Short Supply Dollars Are In Short Supply   Flood The Zone Chart 11US Mortgage Spreads Have Spiked US Mortgage Spreads Have Spiked US Mortgage Spreads Have Spiked The good news is that there is no limit to how many dollars the Federal Reserve can create. The Fed has already expanded the supply of bank reserves by initiating the purchase of $500 billion in treasuries and another $200 billion in agency mortgage-backed securities (MBS) since relaunching its QE program on March 15th. Further MBS purchases will be especially useful given that mortgage rates have not come down as quickly as Treasury yields (Chart 11). The Fed has also dusted off the alphabet soup of programs created during the financial crisis to improve proper market functioning, and has even added a few more to the list, including a program to support investment-grade corporate bonds and another to support small businesses. In order to ease overseas funding pressures, the Fed has opened up swap lines with a number of central banks. We expect these lines to be expanded to more countries if the situation necessitates it. The Coming Mar-A-Lago Accord? We also think that there is at least a 50-50 chance that we could see coordinated currency interventions designed to drive down the value of the US dollar. Federal Reserve, Treasury, and IMF guidelines all permit currency intervention to counter “disorderly market conditions.” While a weaker dollar would erode the export competitiveness of some countries, this would be more than offset by the palliative effects of additional dollar liquidity stemming from US purchases of foreign securities, as well as the relief that overseas dollar borrowers would receive from dollar depreciation. Thus, on balance, a weaker dollar would result in an easing of global financial conditions. Liquidity Versus Solvency Risk Some might complain that the actions of the Fed and other central banks go well beyond their mandates. They might argue that it is one thing to provide liquidity to the financial system; it is quite another to socialize credit risk. We think these arguments are largely red herrings. For one thing, concern about credit risk can be addressed by having governments backstop central banks for any losses they incur. Moreover, there is no clear distinction between liquidity and solvency risk during a financial crisis. The former can very easily morph into the latter. For example, consider the case of Italy. Would you buy more Italian bonds if the yield rises? That depends on two competing considerations. On the one hand, a higher yield makes the bond cheaper. On the other hand, a higher yield may make it more difficult for the government to service its debt obligations, which raises the risk of default. If the second consideration outweighs the first, your inclination may be to sell the bond. To the extent that your selling causes yields to rise further, that could lead to another wave of selling. As Chart 12 illustrates, this means that there may be multiple equilibria in fixed-income markets. It is absolutely the job of central banks to try to steer the economy towards the good ”low yield” equilibrium rather than the bad “default” equilibrium. Chart 12Multiple Equilibria In Debt Markets Are Possible Without A Lender Of Last Resort Second Quarter 2020 Strategy Outlook: World War V Second Quarter 2020 Strategy Outlook: World War V In this light, ECB president Christine Lagarde’s statement on March 12th that “we are not here to close spreads” –  coming on the heels of a spike in Italian bond yields and a 13% drop in euro area stocks the prior day – was one of the most negligent things a central banker has ever said. To her credit, she has since walked back her comments. The ECB has also launched the Pandemic Emergency Purchase Programme (PEPP), a EUR 750bn asset-purchase program, which gives the central bank considerable flexibility over the timing, composition, and geographic makeup of purchases. Further actions, including upsizing the PEPP, creating a “conditionality-lite” version of the ESM program, and perhaps even issuing Eurobonds, are possible. All this should help Italy. Accordingly, BCA’s global fixed-income team upgraded Italian government bonds to overweight this week. Using Fiscal Policy To Align Financial Time With Economic Time While central banks will play an important role in mitigating the crisis, most of the economic burden will fall on fiscal policy. How much fiscal support is necessary and what should it consist of? To get a sense of what is optimal, it is useful to distinguish between the concept of financial time and economic time. Financial time and economic time usually beat at the same pace. Most of the time, people have financial obligations – rent, mortgage payments, spending on necessities – that they match with the income earned from work. Likewise, companies have expenses that they match with the revenue that they derive from various economic activities.  No one worries when economic time and financial time deviate in predictable ways. For example, GDP collapses around 5pm on Monday only to recover at 9am on Tuesday. The fact that many western Europeans take most of August off for vacation is also not a problem, since everyone expects this. The problem occurs when economic time and financial time deviate in unpredictable ways. That is the case at present. Today, economic time has ground to a halt as businesses shutter their doors and workers confine themselves to their homes. Yet, financial time continues to march on. This implies that in the near term, the correct course of action is for governments to transfer money to households and firms to allow them to service their financial obligations. One simple way of achieving this is through wage subsidies, where the government pays companies most of the wage bill of their employees who, through no fault of their own, are unable to work. Note that this strategy does not boost GDP. By definition, an idle worker is one who does not contribute to economic output. What this strategy does do is alleviate needless hardship, while creating pent-up demand for when businesses start to open their doors again. Once the virus is contained, traditional fiscal stimulus that boosts aggregate demand will be appropriate. How much money are we talking about? In the case of the US, suppose that annualized growth is -5% in Q1, -25% in Q2, and +10% in Q3 and Q4, respectively. That would leave the level of real GDP down 4% on the year compared to 2019. Assuming trend GDP growth of 2%, that implies an annual shortfall of income (consisting of wages and lost profits) that the government would have to cover amounting to 6% of GDP. The $2 trillion stimulus bill amounts to 10% of GDP, although not all of that will be spent during the next 12 months and about a quarter of the amount is in the form of loans and loan guarantees. Still, on size, we would give it an “A”. On composition, we would give it a “B”, as it lacks sufficient funding for state and local governments to cover the likely decline in the tax revenues that they will experience. This could result in layoffs of first responders, teachers, etc. Given that the US was running a fiscal deficit going into the crisis, all this additional stimulus could easily push the budget deficit to over 15% of GDP. While this is a huge number, keep in mind that in a world where interest rates are below the trend growth rate of the economy, a government can permanently increase its budget deficit by any amount it wants while still achieving a stable debt-to-GDP ratio over the long haul.4 Today, we are not even talking about a permanent increase in the deficit, but a temporary increase that could last a few years at most. If we end up in a depression, don’t blame the virus; blame politicians. Fortunately, given that the political incentives are aligned towards fiscal easing rather than austerity, our guess is that a depression will be averted. Appendix A summarizes the monetary and fiscal measures that have already been taken in the major economies. II. Investment Strategy As anyone who has ever watched a horror movie knows, the scariest part of the film is the one before the monster is revealed to the audience. No matter how good the makeup or set design, our imaginations can always conjure up something much more frightening than Hollywood can invent. Right now, we are fighting an invisible enemy that is ravaging the world. Victory is in sight. The number of new infections has peaked in China and South Korea. I mentioned during last week’s webcast that we should watch Italy very carefully. If the number of new infections peaks there, that would send an encouraging signal to financial markets that other western democracies will be able to get the virus under control. While it is too early to be certain, this may be happening: Both the number of new cases and deaths in Italy have stabilized over the past five days (Chart 13). Chart 13A Peak In The Number Of New COVID-19 Cases In Italy Would Send An Encouraging Signal Second Quarter 2020 Strategy Outlook: World War V Second Quarter 2020 Strategy Outlook: World War V Of course, there is still the risk that the number of new infections will rise again if containment measures are relaxed prematurely. However, as we spelled out in this report, there are good reasons to think that these measures will not need to be as severe as the ones currently in place. As such, it is likely that global growth will begin to rebound in the third quarter of this year. Equities: A Modest Overweight Is Warranted We turned more cautious on the near-term outlook for global equities earlier this year, but upgraded our recommendation on the morning of February 28th after the MSCI All-Country World Index fell by 12% over the prior week. While stocks did rally by 7% during the following three trading days, they subsequently plunged to multi-year lows. In retrospect, we should have paid more attention to our own warnings in our earlier report titled “Markets Too Complacent About The Coronavirus.” 5 For now, we would recommend a modest overweight to stocks on both a 3-month and 12-month horizon. Monetary and fiscal easing and the prospect of a peak in the number of new cases in Italy could continue to support stocks in the near term, while a rebound in growth starting this summer should pave the way for a recovery in corporate earnings over a 12-month horizon. Chart 14US Equity Valuations Are Not Yet At Bombed-Out Levels US Equity Valuations Are Not Yet At Bombed-Out Levels US Equity Valuations Are Not Yet At Bombed-Out Levels Of course, when it comes to financial markets, one should always be prepared to adjust one’s conviction level if prices either rise or fall significantly. We mentioned two weeks ago that we would move to a high-conviction overweight if the S&P 500 fell below 2250. While the index did briefly fall below this level, it has since bounced back to about 2630. At its current level, the S&P 500 is trading at 15.3-times forward earnings (Chart 14). While this is not particularly expensive, it is still well above the trough of 10.5-times forward earnings reached in 2011 during the height of the euro crisis. And keep in mind that current earnings estimates are based on the stale assumption that S&P 500 companies will earn $172 over the next four quarters, down only 3% from the peak earnings estimate of $177 reached in February. With this in mind, we are introducing a lower and upper bound for global equity prices at which we will adjust our view. To keep things simple, we will focus on the S&P 500, which accounts for over half of global stock market capitalization. If the S&P 500 falls below (and stays below) 2250, we would recommend a high-conviction overweight to global stocks. If the index rises above 2750, we would recommend a neutral equity allocation. Anything between 2250 and 2750 would justify the current stance of modest overweight. Going forward, we will adjust this range as events warrant it. Our full slate of views can be found in the table at the end of this report. Sector And Regional Equity Allocation: Favor Cyclicals and Non-US Over A 12-Month Horizon Not surprisingly, defensive equity sectors outperformed cyclicals both in the US and abroad during this month’s selloff. Financials also underperformed on heightened worries about rising defaults and the adverse effect on net interest margins from flatter yield curves (Chart 15). Chart 15Cyclicals And Financials Underperformed On The Way Down Cyclicals And Financials Underperformed On The Way Down Cyclicals And Financials Underperformed On The Way Down Chart 16Non-US Stocks Are Cheaper Even After Adjusting For Differences In Sector Weights Second Quarter 2020 Strategy Outlook: World War V Second Quarter 2020 Strategy Outlook: World War V   Cyclicals and financials have outperformed the broader market over the past few days as risk sentiment has improved. They are likely to continue outperforming over a 12-month horizon as global growth eventually recovers and yield curves steepen modestly. To the extent that cyclicals and financials are overrepresented in stock market indices outside the US, this will give non-US equities the edge. Stocks outside the US also benefit from more favorable valuations. Even after adjusting for differences in sector weights, non-US stocks are quite a bit cheaper than their US peers as judged by price-to-earnings, price-to-book, and other valuation measures (Chart 16). The US Dollar Has Probably Peaked Another factor that should help cyclical stocks later this year is the direction of the US dollar. The greenback has been buffeted by two major forces this year (Chart 17). Chart 17The Dollar Has Been Facing Crosscurrents The Dollar Has Been Facing Crosscurrents The Dollar Has Been Facing Crosscurrents Chart 18USD Is A Countercyclical Currency USD Is A Countercyclical Currency USD Is A Countercyclical Currency   Between February 19 and March 9, the dollar weakened as US bond yields fell more than yields abroad. This eliminated some of the yield advantage that had been supporting the dollar last year. Starting around the second week of March, however, global financial stresses escalated. Money began to flow into the safe-haven Treasury market. Global growth prospects also deteriorated sharply. As a countercyclical currency, this helped the dollar (Chart 18). Looking out, interest rate differentials are unlikely to return anywhere close to where they were at the start of this year, given that the Fed will probably keep rates near zero at least until the middle of 2021. Meanwhile, aggressive central bank liquidity injections should reduce financial stress, while a rebound in global growth will allow capital to start flowing back towards riskier foreign markets. This should result in a weaker dollar. Once Growth Bottoms, So Will Commodities Chart 19Low Prices Force US Shale Cutbacks Second Quarter 2020 Strategy Outlook: World War V Second Quarter 2020 Strategy Outlook: World War V The combination of a weaker dollar, a rebound in global growth starting this summer, and increased infrastructure stimulus spending in China should help lift resource prices. This will also buoy currencies such as the AUD, CAD, and NOK in the developed market space, and RUB, CLP, ZAR, and IDR, in the EM space. Oil prices have tumbled on the back of the sudden stop in global economic activity and the breakdown of the agreement between OPEC and Russia to restrain crude production. BCA’s commodity strategists expect the Saudis and Russians to come to an agreement to reduce output, as neither side has an incentive to pursue a prolonged price war. They see Brent prices averaging $36/barrel in 2020 and $55/barrel in 2021. However, prices are not likely to go much higher than $60/barrel because that would take them well above the current breakeven cost for shale producers, eliciting a strong supply response (Chart 19). Spread Product: Favor IG Over HY A rebound in oil prices from today’s ultra-depressed levels should help the bonds of energy companies, which are overrepresented in high-yield indices. This, together with stronger global growth and improving risk sentiment, should allow HY spreads to narrow over a 12-month horizon. Chart 20High-Yield Credit Is Pricing In Only A Moderate Recession High-Yield Credit Is Pricing In Only A Moderate Recession High-Yield Credit Is Pricing In Only A Moderate Recession Nevertheless, we think investment grade currently offers a better risk-reward profile. While HY spreads have jumped to more than 1000 basis points in the US, they are still nowhere close to 2008 peak levels of almost 2000 basis points. Like the equity market, high-yield credit is pricing in only a modest recession, with a default rate on par with the 2001 downturn (Chart 20). Moreover, central banks around the world are racing to protect high-quality borrowers from default. The Fed’s announcement that it will effectively backstop the investment-grade corporate bond market could be a game changer in this regard. Unfortunately for HY credit, the moral hazard consequences of bailing out companies that investors knew were risky when they first bought the bonds are too great for policymakers to bear. Government Bonds: Deflation Today, Inflation Tomorrow? As noted at the outset of this report, the current economic downturn involves both an adverse supply and demand shock. Outside of a few categories of consumer staples and medical products, we expect demand to fall more than supply, resulting in downward pressure on prices. This deflationary impulse will be exacerbated by rising unemployment. Looking beyond the next 12-to-18 months, the outlook for inflation is less clear. On the one hand, it is possible that the psychological trauma from the pandemic will produce a permanent, or at least semi-permanent, increase in precautionary savings. If budget deficits are reined in too quickly, many countries could find themselves facing a shortage of aggregate demand. This would be deflationary. On the other hand, one can easily envision a scenario where monetary policy remains highly accommodative and many of the fiscal measures put in place to support households are maintained long after the virus is eradicated. This could be particularly true in the US, where our geopolitical team now expects Joe Biden to win the presidential election. In such an environment, unemployment could fall back to its lows, eventually leading to an overheated economy. Our hunch is that the more inflationary scenario will unfold over the next 2-to-3 years. Interestingly, that is not the market’s opinion. For example, the 5-year US TIPS breakeven inflation rate is currently only 0.69% and the 10-year rate is 1.07%. This means that a buy-and-hold investor will make money owning TIPS versus nominals if inflation averages more than 0.69% per year for the next five years, or 1.07% per year for the next decade. That is a bet we would be willing to take. Finally, a word on gold. Just as during the Global Financial Crisis, gold failed to be an attractive hedge against financial risk during the recent stock market selloff – bullion dropped by 15% from $1704/oz to $1451/oz, before rebounding back to $1640/oz over the past few days as risk sentiment improved. Nevertheless, gold remains a good hedge against long-term inflation risk. And with the US dollar likely to weaken over the next 12 months, gold prices should move up even if near-term inflationary pressures remain contained. As such, we are upgrading our outlook on the yellow metal. Peter Berezin Chief Global Strategist peterb@bcaresearch.com Appendix A Appendix A Table 1Central Banks Still Had Some Options When Crisis Hit Second Quarter 2020 Strategy Outlook: World War V Second Quarter 2020 Strategy Outlook: World War V Appendix A Table 2Massive Stimulus In Response To Pandemic Second Quarter 2020 Strategy Outlook: World War V Second Quarter 2020 Strategy Outlook: World War V Footnotes 1  Jing Yan, Suvajyoti Guha, Prasanna Hariharan, and Matthew Myers, “Modeling the Effectiveness of Respiratory Protective Devices in Reducing Influenza Outbreak,” U.S. National Library of Medicine, (39:3), March 2019. 2  Chaolong Wang, Li Liu, Xingjie Hao, Huan Guo, Qi Wang, Jiao Huang, Na He, Hongjie Yu, Xihong Lin, Sheng Wei, and Tangchun Wu, “Evolving Epidemiology and Impact of Non-pharmaceutical Interventions on the Outbreak of Coronavirus Disease 2019 in Wuhan, China,”medrxiv.org, March 6, 2020. 3  This calculation assumes that 5% of infected people need ICU care and each spends an average of 2 weeks in the ICU. It also assumes that hospitals are able to expand their capacity by 30 additional ICU beds per 100,000 people per year to treat COVID-19. 4  Please see Global Investment Strategy Weekly Report, “Is There Really Too Much Government Debt In The World?” dated February 22, 2019, available at gis.bcarearch.com. 5  Please see Global Investment Strategy Weekly Report, “Markets Too Complacent About The Coronavirus,” dated February 21, 2020, available at gis.bcaresearch.com. Global Investment Strategy View Matrix Second Quarter 2020 Strategy Outlook: World War V Second Quarter 2020 Strategy Outlook: World War V MacroQuant Model And Current Subjective Scores Second Quarter 2020 Strategy Outlook: World War V Second Quarter 2020 Strategy Outlook: World War V Strategic Recommendations Closed Trades

Highlights The global economy is in the midst of a painful recession. Monetary and fiscal authorities are responding forcefully to the crisis, but the lengths of the lockouts and quarantines remain a major source of downside risk to the economy. Investors should favor stocks over bonds during the next year. The short-term outlook remains fraught with danger, so avoid aggressive bets. Central banks can tackle the global liquidity crunch, thus spreads will narrow and the dollar will weaken. The long-term impact of COVID-19 will be inflationary. Feature “The only thing we have to fear is fear itself.”    Franklin Delano Roosevelt  1932 A violent global recession is underway. Last month, we wrote that a deep economic slump would be unavoidable if COVID-19 cases could not be controlled within two to three weeks.1 Since then, the number of new, recorded COVID-19 cases has mounted every day and fear prevails. Consumers are not spending; firms will face a cash crunch and/or bankruptcy, and employment will be slashed. The next few quarters could result in some of the worst GDP prints since the Great Depression. Risk assets have moved to discount this dire scenario. The global stock-to-bond ratio has collapsed by 47% since its peak on January 17th and stands at the 1st decile of it post-1980 distribution. 10-year US bond yields temporarily fell below 0.4%. The dollar has rallied against every currency and even gold traded below $1500 an ounce. Brent crude trades below $30/bbl. In this context, investors must assess if risk asset prices have declined enough to compensate for the economic hazards created by the COVID-19 pandemic. If the massive amount of monetary and fiscal stimulus announced can turn around the economy in the second half of the year, then stocks and risk assets are attractive. Otherwise, they are still not cheap enough and cash remains king. We think it is a good time to begin to parsimoniously deploy capital into risk assets. A Global Recession And An Extraordinary Response The global economy has suffered its worst shock since the Great Financial Crisis (GFC), but policymakers are deploying every tool available. In our base case, GDP will contract more quickly for two quarters than it did during the GFC, and then will recover smartly. It is hard to pinpoint exactly how quickly global GDP will contract in the next six months, but key indicators point to a grim outcome. Chart I-1Global Growth Is Plunging Global Growth Is Plunging Global Growth Is Plunging China’s economy was at the forefront of the COVID-19 pandemic and its trajectory provides a glimpse into what the rest of the world should anticipate. In February, Chinese retail sales contracted by 20.5% annually and industrial production plunged by 13.5%. The German ZEW survey for March paints an equally bleak picture. The growth expectations component for the Eurozone and Germany fell to its lowest level since the GFC. The same indicator, but computed as an average of US, European and Asian subcomponents is also collapsing at an alarming pace (Chart I-1). The European flash PMI for March also points to a deep slowdown, with the services PMI plunging to 28.4, an all-time low. The performance of EM carry trades flashes a somber warning for our Global Industrial Production Nowcast (Chart I-2). Carry trade returns are imploding because global liquidity is incapable of meeting the demand for precautionary money by economic agents. This lack of liquidity is inflicting enormous damage on worldwide growth. Live trackers for US and global economic activity are also melting down. Traffic in some of the US’s largest cities is a fraction of last year's (Chart I-3). Globally, restaurant bookings have dried up and fewer airlines are flying compared to 2008. Initial jobless claims in the US have surged to 3.28 million, rapidly and decisively overtaking the weaknesses seen during the GFC. Chart I-2The Liquidation Of Carry Trade Is A Bad Omen The Liquidation Of Carry Trade Is A Bad Omen The Liquidation Of Carry Trade Is A Bad Omen Chart I-3Live Trackers Are In Free Fall April 2020 April 2020   Despite the dismal situation, some positive developments are emerging. It has been demonstrated that quarantines contain the spread of the virus. On March 18th, Wuhan recorded no new COVID-19 cases. Moreover, 10 days after its January 24th quarantine began, new cases started to fall off quickly (Chart I-4) in the city. If the recent softening in new cases in Italy’s Lombardy region continues, it will illustrate that democratic regimes can also reduce the pace of infection. Chart I-4Quarantines Do Work April 2020 April 2020 Most importantly, policymakers around the world have shown their willingness to do “whatever it takes.” Governments are easing fiscal policy with abandon. Germany’s state bank KfW is setting aside EUR550 billion to support the economy. France will spend EUR45 billion and has earmarked EUR300 billion in small business loan guarantees. Spain announced EUR200 billion to protect domestic activity. The White House just passed a stimulus package of $2 trillion, and Canada follows suit with a CAD82 billion relief bill. (Table I-1). As A. Walter and J. Chwieroth showed, the growing financial wealth of the middle class is forcing governments to always provide large bailouts after financial crises and recessions. Otherwise, their political parties suffer extreme repudiation from power.2 Table I-1Massive Stimulus In Response To Pandemic April 2020 April 2020 Central bankers have also become extreme reflators. Nearly every central bank in advanced economies has cut interest rates to zero or into negative territory. Most importantly, central banks have become lenders of last resort. The US Federal Reserve has announced it will engage in unlimited asset purchases; it has reopened various facilities to provide liquidity to the market and is using the US Department of the Treasury to lend directly to the private sector. Among its many measures, the European Central Bank is scrapping artificial limits on its bond purchases that were its capital keys and has offered a EUR750 billion bond purchase program. The ECB is also looking to open its OMT program. Other central banks are injecting cash directly into their domestic markets (Table I-2). The list and size of actions will expand until the markets are satiated with enough liquidity. Table I-2The Central Banks Still Had Some Options When Crisis Hit April 2020 April 2020 The impact of these policy measures is threefold. First, the actions are designed to alleviate the global economy’s cash crunch. Secondly, they aim to support growth directly. The private sector needs direct backing to survive the lack of cash inflows that will develop in the coming weeks. If fiscal and monetary authorities can plug that hole, then spending will not have to collapse as deeply nor for as long as would otherwise be the case. Finally, it is imperative that policymakers boost confidence and ease financial conditions to allow “animal spirits” to stabilize. If risk-taking continues to tailspin, then spending will never recover and the demand for cash will only grow, creating the worst liquidity trap since the Great Depression. Policymakers around the world have shown their willingness to do “whatever it takes.” The economy will continue to weaken in the second half of 2020 if quarantines remain in place beyond the summer. Not being epidemiologists, we are not equipped to make this call with any degree of certainty. Much depends on the evolution of the disease and the political decisions taken. We do not yet know if the population will be willing to endure the economic pain of a depression, or if political pressures will rise to force isolation on those over age 60 and those suffering dangerous comorbidities who are at higher risk, and allow everyone else to return to work and school.3 Investment Implications Part 1: Bonds and Stocks Chart I-5The Stock-To-Bond Ratio Has Capitulated The Stock-To-Bond Ratio Has Capitulated The Stock-To-Bond Ratio Has Capitulated While the short-term outlook remains murky for asset markets, investors with a 12-month or longer investment horizon should begin to move capital into equities at the expense of bonds. Beyond the relative technical and valuation backdrops (Chart I-5), the outlook for fiscal and monetary policy favors this allocation decision. US Treasury yields have dropped from 1.9% at the turn of the year to as low as 0.31% on March 9th. According to the bond market, inflation will average less than 1% during the coming 10 years. The OIS curve is pricing in a fed funds rate of only 68 basis points in five years. In response to this extreme pricing, Treasury bonds are exceptionally expensive (Chart I-6). Moreover, using BCA Research’s Golden Rule of Treasury Investing, there is little scope for yields to fall any lower. The Golden Rule states that the return of Treasury bonds is directly linked to the Fed's rate surprises. If over the next year the Fed cuts interest rates more than is currently priced into the OIS curve, then bond yields will fall in the next 12 months (Chart I-7). Given that the fed funds rate is already at its lower limit, the Fed will not be able to deliver such a dovish surprise and yields will have limited downside. Chart I-6Bonds Are Furiously Expensive Bonds Are Furiously Expensive Bonds Are Furiously Expensive Chart I-7The Fed Cannot Pull Another Dovish Surprise Out Of Its Hat The Fed Cannot Pull Another Dovish Surprise Out Of Its Hat The Fed Cannot Pull Another Dovish Surprise Out Of Its Hat   The bond market is also vulnerable from a technical perspective. Our Composite Technical Indicator is as overbought today as it was in December 2008 (Chart I-8). Thus, bond prices are vulnerable to good news. Economic activity will be weak for many months, but the recent policy announcements will boost global fiscal deficits by more than $3 trillion in the next 12 to 18 months. Such a large supply of paper is bearish for bonds, especially when they are very expensive. Moreover, global central banks are engaging in large-scale quantitative easing (QE). Globally, monetary authorities have already announced the equivalent of at least $1.9 trillion in asset purchases. The GFC experience showed that QE programs put upward pressure on Treasury yields (Chart I-9). This time will not be different given the combination of QE, supply disruptions caused by quarantines and large fiscal stimulus. Chart I-8A Dire Combination For Bonds A Dire Combination For Bonds A Dire Combination For Bonds Chart I-9QE Pushes Yields Up QE Pushes Yields Up QE Pushes Yields Up     Equities offer the opposite risk/reward ratio to bonds. Technical indicators are consistent with maximum pessimism toward equities and imply that most of the selloff is behind us, at least for the time being. The Complacency-Anxiety Indicator developed by BCA Research’s US Equity Strategy service points to widespread pessimism among investors,4 an intuition confirmed by our Sentiment indicator (Chart I-10). Moreover, our Equity Capitulation Index is as depressed as in March 2009. Investors with a 12-month or longer investment horizon should begin to move capital into equities at the expense of bonds. Despite the magnitude of the shock hitting the global economy, equities will rally if they become cheap enough and monetary conditions are accommodative enough. The BCA Valuation indicator has collapsed to “undervalued” territory and our Monetary Indicator has never been more supportive of equities (both variables are shown on page 2 of Section III). The gap between these two indicators is at its lowest level since Q1 2009 or 1982, two points that marked the end of bear markets (Chart I-11). Chart I-10Equities Have Capitulated Equities Have Capitulated Equities Have Capitulated Chart I-11Supportive Combined Valuation And Monetary Backdrop For Equities Supportive Combined Valuation And Monetary Backdrop For Equities Supportive Combined Valuation And Monetary Backdrop For Equities   Equity multiples also offer some insight into the risk/reward ratio for stocks. The S&P 500 has collapsed by 34% since its February 19th peak and trades at 13 times forward earnings. True, analysts will revise their forecasts, but the market also only trades at 14 times trailing earnings, which cannot be downgraded. Most importantly, investors are extremely gloomy about expected growth when multiples and risk-free rates are so subdued. Risk assets cannot stabilize durably as long as the demand for dollar liquidity is not satiated. Table I-3Evaluating Where The Floor Lies April 2020 April 2020 We can use a simple discounted cash flow model to extract the expected growth rate of long-term earnings embedded in the S&P 500. To do so, we assume that the ERP is 300 basis points, close to the long-term outperformance of stocks versus bonds. At current multiples and 10-year yields, investors are pricing in a long-term growth rate of -2% annually for earnings (Table I-3). In comparison, investors were more pessimistic in 1974, 2008 and 2011 when they anticipated long-term earnings contractions of -2.5% annually. If we assume that the long-term growth of expected earnings will fall to that depth, then we can estimate trailing P/E multiples will be under different risk-free rates. If yields fall to zero, then the P/E would be 17.7 or a price level of 2,692; however, if they rise to 1.5%, then the P/E would decline to 13.9 or a price level of 2,115 (Table I-3). Chart I-12Expected Earnings Growth And Interest Rates Are Co-Integrated Expected Earnings Growth And Interest Rates Are Co-Integrated Expected Earnings Growth And Interest Rates Are Co-Integrated This method suggests that 2200 is the S&P 500’s likely floor. Risk-free rates and the expected growth rate of long-term earnings are correlated series because the anticipated evolution of economic activity drives both real interest rates and earnings (Chart I-12). Thus, it is unlikely that yields will climb if expected earnings growth falls. Instead, if the expected growth rate of long-term earnings drops to -2.5%, then yields should stand between 1% and 0.5%, implying equilibrium trailing P/Es of 15 to 16.3 times, or prices levels of 2,278 to 2,468. P/E will only fall much further if the dollar scramble lasts longer. As investors seek cash and liquidate all assets, the process can push anticipated growth rates lower while pulling bond yields higher (see next section).   Investment Implications Part 2: The Uncontrolled Liquidity Crunch Is Still An Immediate Risk Risk assets cannot stabilize durably as long as the demand for dollar liquidity is not satiated. The large programs announced around the world seem to be calming this liquidity crunch. However, the situation is fluid and the crunch can come back at a moment's notice. Despite the magnitude of the shock hitting the global economy, equities will rally if they become cheap enough and monetary conditions are accommodative enough. Credit spreads blew up as investors priced in the inevitable increase in defaults that accompanies recessions (Chart I-13). Junk spreads moved to as high as 1100 basis points, their highest level since 2009. If we assume that next year, US EBITDA contracts by its average post-war magnitude (a timid assumption), then the interest coverage ratio will deteriorate to readings not seen since the S&L crisis, which will force default rates higher (Chart I-14). Chart I-13Defaults Will Rise Defaults Will Rise Defaults Will Rise Chart I-14Corporate Fundamentals Will Deteriorate Corporate Fundamentals Will Deteriorate Corporate Fundamentals Will Deteriorate     The anticipated contraction in cash flows creates another more pernicious and dangerous consequence: an insatiable demand for dollar liquidity by the private sector. Companies are worried they may not generate the necessary cash flows to service their debt. This is especially worrisome for foreign borrowers who have loans in US dollars. The BIS estimates that foreign currency debt denominated in USDs stands at $12 trillion. Meanwhile, these foreign borrowers are hoarding dollars. The risk aversion of US-based companies is accentuating the dollar crunch. US companies have pulled on their credit lines en masse. US commercial banks must provide this cash to their clients. However, US banks must still meet liquidity requirements imposed by the Basel III rules. As a result, the banks are also hoarding as much cash as possible in the form of excess reserves and curtailed their capital market lending, especially in the repo market. Repos are the lifeblood of capital markets and without repos, market liquidity (the ability to sell and buy securities) quickly deteriorates. This chain of events has caused a sharp widening in Treasury bid-ask spreads, LIBOR-OIS spreads and commercial paper-T-Bill spreads, and has fueled weaknesses in mortgage and municipal bond markets (Chart I-15). The evaporation of the repo market accentuates the foreign liquidity crunch. Without functioning repo markets, dollar funding in offshore markets becomes more onerous, as highlighted by the widening in global cross-currency basis swap spreads (Chart I-16). Borrowers are buying dollars at any cost. This has led to the surge in the dollar from March 9th, which forced the collapse of risky currencies such as the NOK, the BRL or the MXN, but also of safe-haven currencies such as the JPY and the CHF. Chart I-15Symptoms Of A Liquidity Crunch Symptoms Of A Liquidity Crunch Symptoms Of A Liquidity Crunch Chart I-16Offshore Funding Pressures Point To A Dollar Shortage Offshore Funding Pressures Point To A Dollar Shortage Offshore Funding Pressures Point To A Dollar Shortage   The strength in the dollar is problematic. As a symptom of the liquidity crunch, it accompanies forced selling of assets by investors seeking to acquire cash. Moreover, the USD is a funding currency, hence a strong dollar also tightens the global cost of capital for all foreign borrowers who have tapped into US capital markets. For US firms, it also accentuates deflationary pressures and the resulting lower price of goods sold increases the risk of bankruptcies. Thus, a strong dollar would feed the weakness in asset prices and further widen credit spreads. Moreover, because the liquidity crunch hurts growth and can concurrently push yields higher, it could pull P/Es below 15 and drive equity prices far below our 2,200 floor. On the positive side, central banks worldwide are keenly aware of the danger created by the liquidity crunch. The Fed has started and restarted a long list of liquidity facilities (Table I-2). Its unlimited QE program also addresses the dollar shortage directly by expanding the supply of money. Crucially, the Fed has re-opened dollar swap lines with other central banks, including emerging markets such as Korea, Singapore, Mexico and Brazil. Even the ECB and the Bank of England are relaxing liquidity ratios for their banks, which at the margin will alleviate the supply of liquidity in their domestic economies. The Fed will likely follow its European counterparts, which could play a large role in alleviating the global dollar shortage. Investors seeking to assess if the supply of liquidity is large enough should pay close attention to gold prices. The global, large-scale fiscal stimulus programs will also address the dollar liquidity crisis. When investors judge there is sufficient fiscal stimulus to put a floor under global economic activity, the markets will take a more sanguine view of the risk of default. If large enough, government spending will support corporate cash flows and, therefore, limit corporate bankruptcies. Consequently, demand for liquidity will also decline and mass asset liquidations will ebb. Chart I-17Gold Is The Ultimate Liquidity Gauge Gold Is The Ultimate Liquidity Gauge Gold Is The Ultimate Liquidity Gauge Investors seeking to assess if the supply of liquidity is large enough should look for some key market signals. We pay close attention to gold prices; after March 9th they fell despite the global spike in risk aversion due to gold's extreme sensitivity to global liquidity conditions. Both today and in the fall of 2008, gold prices fell when illiquidity grew. Our gold fair-value model shows that the precious metal is extremely sensitive to inflation expectations and real bond yields (Chart I-17). As illiquidity grows and the dollar appreciates, inflation breakevens collapse and real yields spike. Thus, the recent gold rebound suggests that the Fed and other major central banks have expanded the supply of liquidity sufficiently to meet demand, the price of money will fall (real interest rates) and inflation expectations will rebound. Monitor whether gold can remain well bid. Investment Implications Part 3: FX And Commodity Markets Chart I-18China's Stimulus Will Once Again Be Paramount China's Stimulus Will Once Again Be Paramount China's Stimulus Will Once Again Be Paramount China’s stimulus will be a key driver of the FX market in the post-liquidity-crunch world. Historically, because Chinese reflation has lifted the global manufacturing cycle, it possesses a large influence on the dollar’s trend (Chart I-18). We believe that China’s stimulus will be comparable to the one implemented in 2008 and will boost global growth. Moreover, the interest rate advantage of the US has declined and global macro volatility will not remain at current extremes for an extended time. These three factors (Chinese stimulus, lower interest rate differentials and declining volatility) will weigh on the USD in the coming 18 months (Chart I-18, bottom panel). EM currencies and the AUD will benefit most from the dollar depreciation later this year. In the short term, these currencies remain exposed to any flare up in the liquidity crunch and can cheapen further. But, as Chart I-19 highlights, investing in those currencies will likely generate long-term excess returns because they have cheapened significantly. Commodities, too, are becoming attractive at current valuations. Industrial metals such as copper will benefit greatly from China’s stimulus. A rising Chinese credit and fiscal impulse lifts the price of base metals because it pushes up Chinese infrastructure spending as well as residential and capex investment (Chart I-20). Moreover, a lower dollar and accommodative global monetary policy will further boost the appeal of industrial metals. Chart I-19EM FX Is Cheap EM FX Is Cheap EM FX Is Cheap Chart I-20China Will Drive Metal Prices Higher China Will Drive Metal Prices Higher China Will Drive Metal Prices Higher China’s stimulus will be a key driver of the FX market in the post-liquidity-crunch world. The oil outlook is particularly unclear as both demand and supply factors are in flux. At $27/bbl, Brent is cheap enough to compensate investors for the decline in demand that will emerge between now and the end of the second quarter. However, the market-share war between Saudi Arabia and Russia layers on the problem of supply risk. Saudi Aramco is set to increase production to 12.3 million barrels by April and Saudi’s GCC allies have announced they are increasing output as well. According to BCA Research’s Commodity and Energy Strategy service, the oil market is already oversupplied by 1.6 million barrels per day, a number that will expand if the KSA and its allies fulfill their production pledges. If this situation persists, oil will lag behind industrial metals when global risk aversion recedes. Nonetheless, our commodity strategists believe that the collapse in oil prices is more painful for Russia than for KSA. We believe there will be a compromise between OPEC and Russia in the coming weeks that will push supply lower.5 Additionally, the Texas Railroad Commission is preparing to impose limitations on Texas oil production, which has not been done since the 1970s. Such a decision would magnify any rebound in oil prices. Thinking Long-Term: The Return Of Stagflation? The COVID-19 outbreak will likely be viewed as an epoch-defining moment. The policy response to the outbreak will be far reaching and the disease will change the way firms manage supply chains for decades to come. There will be a substantial pullback in globalization. COVID-19 has generated an inflationary shock in the medium term. Chart I-21War Spending Is Always Inflationary War Spending Is Always Inflationary War Spending Is Always Inflationary COVID-19 has generated an inflationary shock in the medium term. Governments have suddenly abandoned their preferences for fiscal rectitude. The US deficit will reach a peacetime record of 15% of GDP. These are war-like spending measures. In history, gold standard or not, wars were the main reason for inflationary outbreaks as they involved massive budgetary expansions (Chart I-21). The large monetary easing accompanying the current fiscal expansion will only add to this inflationary impulse. Many of the proposals discussed by governments involve funneling cash directly to households, while central banks buy bonds issued by the same government. This is very close to helicopter money. These policies will increase the velocity of money, which is structurally inflationary (Chart I-22). Naysayers may point to the lack of inflation created by QE programs in the direct aftermath of the GFC. However, at that time, households and commercial banks were much sicker. Today, capital ratios in the US and the Eurozone are 60% and 33% higher than in 2007, respectively (Chart I-23). Thus, banks are much more likely to add to money creation instead of retracting from it as they did in the last cycle. Chart I-22If Velocity Rises, So Will Inflation If Velocity Rises, So Will Inflation If Velocity Rises, So Will Inflation Chart I-23Banks Are Much Healthier Than In 2008 April 2020 April 2020   Chart I-24Financial Assets Have No Inflation Cushion Financial Assets Have No Inflation Cushion Financial Assets Have No Inflation Cushion Markets are not ready for higher inflation. The 5-year/5-year forward CPI swaps in the US and the euro area stand at only 1.6% and 0.7%, respectively. Household long-term inflation expectations are also at all-time lows (Chart I-24). Therefore, an increase in inflation will have a deep impact on asset prices. The first implication is that gold prices have probably begun a new structural bull market. Inflation will surprise on the upside and keep real interest rates lower. Both these factors are highly bullish for the yellow metal. Additionally, easy fiscal policy and money printing will devalue currencies versus hard assets, which will benefit all precious metals, including gold. EM central banks have recently been diversifying aggressively in gold, which will add another impetuous to its rally. The second implication is that the stock-to-bond ratio has structural upside. Equities are not a perfect inflation hedge, but their profits can rise when selling prices accelerate. However, bonds display rock bottom real yields, inflation protection and term premia. Moreover, their low-running yields are below the dividend yields of equities, which has also boosted bond duration to record levels. Therefore, bonds offer even less protection against higher inflation. Hence, the stock-to-bond ratio will probably follow the historical experience of the 20th century structural bull market and inflect higher (Chart I-25). However, this outperformance will not stem from the superior performance of stocks in real terms; rather, it will emerge from a very poor performance by bonds. Chart I-25The Stock-To-Bond Ratio Will Follow The 20th Century Road Map The Stock-To-Bond Ratio Will Follow The 20th Century Road Map The Stock-To-Bond Ratio Will Follow The 20th Century Road Map Thirdly, the structural relative bear market in EM equities will likely end soon. EM equities will enjoy strong real asset prices and EM assets have much more appealing valuations than DM stocks. This is an imbedded inflation protection. The world is witnessing a fiscal and monetary push that will result in lower productivity growth and profit margins, along with feared inflation. The next decade could increasingly look like the stagflationary 1970s. Mathieu Savary Vice President The Bank Credit Analyst March 26, 2020 Next Report: April 30, 2020   II. Revisiting The Neutral Rate Of Interest: A Contrarian View In A Time Of Crisis Global investors have come to accept the secular stagnation narrative as described by Larry Summers in November 2013, and have gravitated to the only available real time estimate of the real neutral rate of interest: the Laubach & Williams (“LW”) “R-star” estimate. With this apparent visualization of secular stagnation as a guide, many investors have concluded that monetary policy ceased to be stimulative last year and that recent Fed rate cuts will be of limited benefit to economic activity even once economic recovery takes hold unless inflation meaningfully accelerates (thus pushing real rates lower for any given nominal Fed funds rate). This report revisits the “LW” R-star estimate in detail, and demonstrates why the estimation is almost certainly wrong, at least over the past two decades. We also outline an inferential approach that investors can use to monitor where the neutral rate is in real time and whether it is rising or falling. The core conclusion for investors is that US Treasury yields reflect a “low rates forever” view with much higher certainty than is analytically warranted and thus appear to be anchored by a false narrative. While bond yields may not rise significantly in the near-term, investors should avoid dogmatic medium-to-longer term views about yields as they may rise meaningfully over a cyclical and secular horizon once a post-COVID-19 expansion takes hold. Over the past several weeks financial markets have moved rapidly to price in a global recession stemming from the COVID-19 outbreak. As financial market participants began to turn to policy makers for support, eyes focused first on the Federal Reserve, and then fiscal authorities. Earlier this week, the ECB joined the party and announced aggressive further measures of its own. When responding to the Fed’s return to the lower bound and its other recent monetary policy decisions, many market participants have expressed the view that the Fed is largely impotent to deal with a global pandemic. There are three elements to this view. The first is that interest rate cuts are ill equipped to stimulate domestic demand if quarantine measures or other forms of “social distancing” are in effect. The second element is that the Fed has only been capable of delivering a fraction of the reduction in interest rates compared to what has occurred in response to previous contractions. The third aspect of this view is that because the neutral rate of interest is so much lower now than it was in the past, Fed rate cuts will not be as stimulative as they were before. Chart II-1Monetary Policy Ceased To Be Stimulative Last Year, According To The LW R-star Estimate Monetary Policy Ceased To Be Stimulative Last Year, According To The LW R-star Estimate Monetary Policy Ceased To Be Stimulative Last Year, According To The LW R-star Estimate While we at least partly agree with the first and second elements of this view, we feel strongly that the third is flawed. Global investors have come to accept the secular stagnation narrative as described by Larry Summers in November 2013,6 and have gravitated to the only available real time estimate of the neutral rate of interest: the Laubach & Williams (“LW”) “R-star” estimate. This time series, which is regularly updated by the New York Fed,7 suggests that the real fed funds rate reached neutral territory in the first quarter of 2019 (Chart II-1). With this apparent visualization of secular stagnation as a guide, many investors have concluded that monetary policy ceased to be stimulative last year and that recent Fed rate cuts will be of limited benefit to economic activity even beyond the near term unless inflation meaningfully accelerates (thus pushing real rates lower for any given nominal Fed funds rate). In this Special Report we revisit the “LW” R-star estimate in detail, and demonstrate why the estimation is almost certainly wrong, at least over the past two decades. Our analysis does not reveal a precise alternative estimate of the neutral rate, although we do provide some inferential perspective on how investors may be able to monitor where the neutral rate is in real time and whether it is rising or falling. However, the core insight emanating from our report, particularly for US fixed income investors, is that US Treasury yields reflect a “low rates forever” view with much higher certainty than is analytically warranted and thus appear to be anchored by a false narrative. While bond yields may not rise significantly in the near-term, this underscores that they have the potential to rise meaningfully over a cyclical and secular horizon once economic activity recovers. As such, we caution fixed-income investors against dogmatic medium-to-longer term views about bond yields, as their potential to rise may be larger than many investors currently expect. Demystifying The LW R-star Estimate The LW estimate of the neutral rate of interest has gained credibility for three reasons. First, as noted above, the evolution of the series fits with the secular stagnation narrative re-popularized by Larry Summers. Second, the series is essentially sponsored by the Federal Reserve even if it is not officially part of the Fed’s forecasting framework, as its two creators are long-time Fed employees (Thomas Laubach is a director of the Fed’s Board of Governors, and John Williams is the current President of the New York Fed). But, in our view, there is a third important reason that global investors have accepted the LW R-star estimate of the neutral rate of interest: the methodology used to generate the estimate is extremely technically complex, and thus is difficult for most investors to penetrate. Much of the technical complexity of the LW estimate is centered around the use of a statistical procedure called a Kalman filter (“KF”). Simply described, the KF is an algorithm that tries to estimate an unobservable variable based on 1) an idea of how the unobservable variable might relate to an observable variable (the “measurement equation”), and 2) an idea of how the unobservable variable might change through time (the “transition equation”). Through a repeated process of simulating the unobserved variable based on a set of assumptions, the KF is able to compare predicted results to actual results on an observation-by-observation basis, and use that information to generate ever more reliable future estimates of the unobserved variable (Chart II-2). Chart II-2A Very Simplified Overview Of The Kalman Filter Algorithm April 2020 April 2020 We acknowledge that a full technical treatment of the Kalman Filter as it relates to the LW estimate of the neutral rate of interest is beyond the scope of this report, and we provide a more technical overview in Box II-1. But what emerges from a detailed analysis of the model is that the Kalman Filter jointly estimates R-star, potential GDP growth, potential GDP, and the variable “z”, the determinants of R-star that are not explained by potential GDP growth. As we will highlight in the next section, this joint estimation of these four variables is a crucial aspect of the model, because a valid estimate of R-star necessitates a valid estimate of the remaining variables. BOX II-1 A Technical Overview Of The Laubach & Williams R-star Model Chart Box II-1 shows that there are three sets of formulas involved in the LW estimation: the “law of motion” for the neutral rate of interest, two measurement equations, and three transition equations. The law of motion for the neutral rate is fairly simple: R-star is a function of trend real GDP growth, as well as “other factors” represented by the variable “z”. Laubach & Williams note that z “captures factors such as households’ rate of time preference”. The measurement equations are also fairly straightforward. First, the (unobservable) output gap is a function of lagged values of itself as well as the lagged real Fed funds rate gap (relative to the unobservable neutral rate). Second, inflation is a function of lagged values of itself, past values of the output gap, relative core import prices, and lagged relative imported oil prices (the latter two variables are included to capture potential supply shocks to inflation). Note that this second measurement equation is required for the model to work, as it relates the unobservable output gap to observable inflation. As presented in Chart II-2, the three transition equations are present to simulate how the unobservable variables might move through time. Potential growth and potential output are a random walk, and “z” from the law of motion follows either a random walk or an autoregressive process. Chart Box II-1The Laubach & Williams R-star Model April 2020 April 2020 Debunking The LW R-star Estimate Before criticizing the LW estimate of the neutral rate of interest, it is important for us to note that we have the utmost respect for the Federal Reserve and its research methods. We fully acknowledge that the LW R-star estimation is rooted in solid economic theory, and we have identified no technical errors in the setup of the LW model. Nevertheless, valid analytical efforts sometimes lead to problematic real-world results, and there are two key reasons to believe that the Kalman filter in the LW model is almost certainly misspecifying R-star, at least in terms of its estimate over the past two decades. The first reason relates to the sensitivity of the model to the interval of estimation (the period over which R-star is estimated). Chart II-3 presents the range of quarterly estimates of R-star since 2005, along with the difference between the high and low end of the range in the second panel. The chart shows that while previous estimates of R-star have generally been stable for values ranging between the early-1980s and 2006/2007, pre-1980 estimates have varied quite substantially and we have seen material revisions to the estimates over the past decade. Q1 2018 serves as an excellent example: in that quarter R-star was estimated to be 0.14%; today, the Q1 2018 R-star estimate sits at 0.92%. Chart II-3Since 2005, There Has Been Some Instability In The LW R-star Estimates Since 2005, There Has Been Some Instability In The LW R-star Estimates Since 2005, There Has Been Some Instability In The LW R-star Estimates However, Table II-1 and Chart II-4 highlight the real instability of the Kalman filter estimation by demonstrating the effect of varying the starting point of the model (please see Box II-2 for a brief description of how our estimation of R-star using the LW approach differs slightly from the original procedure). Laubach & Williams originally estimated R-star beginning in Q1 1961; Table II-1 shows what happens to today’s estimate of R-star simply by incrementally varying the starting point of the model from Q1 1958 to Q4 1979. Table II-1Alternative Current LW Estimates Of R-star By Model Starting Point April 2020 April 2020 Chart II-4Alternative Starting Points Produce Wildly Different Estimates Of R-star Today April 2020 April 2020 BOX II-2 The Laubach & Williams R-star Model With Simplified Inflation Expectations To proxy inflation expectations in their model, Laubach & Williams use a “forecast of the four-quarter-ahead percentage change in the price index for personal consumption expenditures excluding food and energy (“core PCE prices”) generated from a univariate AR(3) of inflation estimated over the prior 40 quarters”. The authors note that a simplified measure of expectations, a 4-quarter moving average of quarterly annualized core inflation, does not materially alter their results. For the sake of parsimony we use this simplified measure in our analysis. We find that the effect shifts the current estimate of R-star only slightly (+10 basis points), and that the historical differences between our version of the 1961 estimation and the official series are indeed minor. The table highlights that the model fails to even generate a result in a majority of the cases (only 39 out of 88 of the model runs were error-free). In addition, Chart II-4 shows that of the successful estimates of R-star using the LW procedure and alternate starting dates of the model, the estimate of R-star today varies from -2% (in one case) to +2%. Excluding the one extremely negative outlier results in an effective estimate range of 0% to 2%, but the key point for investors is that this range is massive and underscores that the original model’s estimate of R-star today is heavily and unduly influenced by the interval of estimation. Investors should also note that of all of the alternative estimates of R-star today shown in Chart II-4, the estimate using the original interval is very much on the low end of the distribution. The second (and most important) reason to believe that the LW estimate is misspecifying R-star is that the output gap estimate generated by the model is almost certainly invalid, at least over the past two decades. Chart II-5presents the LW output gap estimate alongside an average of the CBO, OECD, and IMF estimates of the gap; panel 1 shows the official current LW output gap estimate, whereas panel 2 shows the range of output gap estimates that are generated using the different estimation intervals highlighted in Table II-1 and Chart II-4. Chart II-5The LW Output Gap Estimates, Upon Which R-star Depends, Have Been Wrong For Two Decades The LW Output Gap Estimates, Upon Which R-star Depends, Have Been Wrong For Two Decades The LW Output Gap Estimates, Upon Which R-star Depends, Have Been Wrong For Two Decades Given that the Kalman filter in the LW model jointly determines R-star and the output gap (by way of estimating potential output via estimating potential GDP growth) and that these estimates are dependent on each other, Chart II-5 highlights that in order to believe the LW R-star estimate investors must believe three things: That the US economy was chronically below potential in the late-1990s when the unemployment rate was below 5%, real GDP growth averaged nearly 5%, and the equity market was booming, That output exceeded potential in 2004/2005 by a magnitude not seen since the late-1970s / early-1980s despite an average unemployment rate, That the 2008/2009 US recession was not particularly noteworthy in terms of its deviation from potential output, and that the economy had returned to potential output by 2010/2011 when the unemployment rate was in the range of 8-9%. Chart II-6The US Economy Was Definitely Not At Full Employment In 2010 The US Economy Was Definitely Not At Full Employment In 2010 The US Economy Was Definitely Not At Full Employment In 2010 While we do not believe any of these three statements, the third is especially unlikely. Chart II-6 highlights that the economic expansion from 2009 – 2020 was the weakest on record in the post-war era in terms of average annual real per capita GDP growth. To us, this is a clear symptom of a chronic deficiency in aggregate demand, and that it is essentially unreasonable to argue that the economy was operating at full employment prior to 2014/2015. This means that the Kalman filter is generating incorrect and unreliable estimates of the output gap, which means in turn that the filter’s estimation of R-star is almost assuredly wrong. How Can Investors Tell What The Neutral Rate Is? An Inferential Approach Table II-2 presents the sensitivity of the original Q1 1961 LW estimate of R-star to a series of counterfactual scenarios for inflation, real GDP growth, nominal interest rates, and import and oil prices since mid-2009. While these scenarios do not in any way improve the validity of the LW R-star estimate, they do help clarify the theoretical basis of the model and they help reveal how investors may infer whether the neutral rate of interest is higher or lower than prevailing market rates, and whether it is rising or falling. Table II-2Sensitivity Of Current LW R-star Estimate To Counterfactual Scenarios (2009 - Present) April 2020 April 2020 Chart II-7Core Import Price Growth Has Been Weak On Average During This Expansion Core Import Price Growth Has Been Weak On Average During This Expansion Core Import Price Growth Has Been Weak On Average During This Expansion Table II-2 highlights that today’s estimate of R-star using the original LW approach is mostly sensitive to our counterfactual scenarios for growth and interest rates, but not inflation or oil prices. Shifting down import price growth also has a meaningful effect on R-star, but since core import price growth has been particularly weak over the past several years (Chart II-7), it seems unreasonable to suggest that they have been abnormally high and thus “explain” a low R-star estimate today. Table II-2 essentially highlights that the entire question of the neutral rate of interest over the past decade, and the core contradiction that led to the re-emergence of the secular stagnation thesis, can effectively be boiled down to the following simple question: “Why hasn’t US economic growth been stronger this cycle, given that interest rates have been so low?” Based on the (hopefully uncontroversial) view that interest rates influence economic activity and that economic activity influences inflation, we propose the following checklist for investors to ask themselves in order to not only determine the answer to this important question, but to help identify whether R-star in any given country is likely higher or lower than existing policy rates at any given point in time. Are interest rates above or below the prevailing level of economic growth? Are interest rates rising or falling, and how intensely? Are there identifiable non-monetary shocks (positive or negative) that appear to be influencing economic activity? Is private sector credit growth keeping pace with economic growth? Are debt service burdens in the economy high or low? The first question reflects the most basic view of R-star, which is that the real neutral rate of interest should be equal to, or at least closely related to, the potential growth rate of the economy, ceteris paribus. Questions 2 through 5 attempt to determine whether ceteris paribus holds. In terms of how the answers to these questions relate to identifying the neutral rate, consider two economies, “Economy A” and “Economy B” (Chart II-8). Economy A has broadly stable or slightly rising interest rates that are well below prevailing rates of economic growth (questions 1 & 2), no obvious beneficial shocks to domestic demand from fiscal policy or other factors (question 3), and strong private sector credit growth that is perhaps above or strongly above the current pace of GDP growth (question 4). Chart II-8'Economy A', Versus 'Economy B' April 2020 April 2020 Inferentially, it would seem that interest rates in this hypothetical economy are below R-star today. Question 5 is in our list because the more that active private sector leveraging occurs (thus pushing up debt burdens), the more that we would expect R-star in the future to fall. This is because debt payments as a share of income cannot rise forever, and we would expect that the capacity of economy A’s central bank to raise interest rates in the future are negatively related to economy A’s private sector debt service burden today. Now, imagine another economy (“Economy B”) with interest rates well below average rates of economic growth, an interest rate trend that is flat-to-down, no identifiable non-monetary policy shocks that are restricting aggregate demand, persistently sluggish credit growth, and high private sector debt service burdens in the past. If economy B is growing (even sluggishly) and not in the middle of a recession, it would seem that prevailing interest rates are below R-star, but not significantly so. In this scenario it would seem reasonable to conclude that R-star in economy B has fallen non-trivially below its potential growth rate, and that interest rate increases are likely to move monetary policy into restrictive territory earlier than otherwise would be the case. Is The United States “Economy B”? From the perspective of some investors, our description of economy B above perfectly captures the experience of the US over the past decade: an extremely low Fed funds rate, sluggish to weak growth and inflation, all the result of a huge build-up in leverage and debt service burdens during the last economic cycle. We do not doubt that R-star fell in the US for some period of time during the global financial crisis and in the early phase of the economic recovery. But we doubt that it is as low today as the secular stagnation narrative would imply, in large part because it ignores several important aspects concerning questions 2 through 5 noted above. Chart II-9Fiscal Austerity Has Been A Serious Non-Monetary Shock To Aggregate Demand Fiscal Austerity Has Been A Serious Non-Monetary Shock To Aggregate Demand Fiscal Austerity Has Been A Serious Non-Monetary Shock To Aggregate Demand Non-monetary shocks to the US and global economies: Over the past 12 years, there have been at least five deeply impactful non-monetary shocks to both the US and global economies that have contributed to the disconnect between growth and interest rates: 1) a prolonged period of US household deleveraging from 2008-2014, 2) the euro area sovereign debt crisis, 3) fiscal austerity in the US, UK, and euro area from 2010 – 2012/2014 (Chart II-9), 4) the US dollar / oil price shock of 2014, and 5) the recent trade war between the US and China. Several of these shocks have been policy-driven, and in the case of austerity the negative consequences of that policy has led to a lasting change in thinking among fiscal authorities (outside of Japan) that is unlikely to reverse in the near-future. Chart II-10Recent Trends In US Private Sector Leverage Do Not Suggest R-star Is Very Low Recent Trends In US Private Sector Leverage Do Not Suggest R-star Is Very Low Recent Trends In US Private Sector Leverage Do Not Suggest R-star Is Very Low Private sector credit growth: Chart II-10 highlights the extent of household deleveraging noted above by showing the growth in total household liabilities over the past decade alongside income growth. Panel 2 shows the leveraging trend of firms, as represented by the nonfinancial corporate sector debt-to-GDP ratio. Chart II-10 underscores two points: the first is that while US household sector credit contracted for several years following the global financial crisis, it is now growing again and has largely closed the gap with income growth. The second point is that the nonfinancial corporate sector has clearly leveraged itself over the course of the expansion, arguing that interest rates have not in any way been restrictive for businesses. While it is true that firms have largely leveraged themselves to buy back stock instead of significantly increasing capital expenditures, in our view this reflects the fact that US consumer demand was impaired for several years due to deleveraging. We doubt that firms would have altered their capital structures to this degree if they did not view interest rates as extremely low. Debt service burdens: Chart II-11 highlights that US household debt service burdens were at very elevated levels prior to the financial crisis, suggesting that the neutral rate did fall for some time following the recession. But today, the debt burden facing households is the lowest it has been in the past 40 years due to both rate reductions and deleveraging, arguing against the view that household debt levels will structurally weigh on interest rates in the years to come. Chart II-12 shows that the picture is different for nonfinancial corporations, as the substantial leveraging noted above has indeed raised debt service burdens for firms. However, the nonfinancial corporate sector debt service ratio remains 400 basis points below early-2000 levels when excess corporate sector liabilities had a clear impact on the economy, suggesting that the Fed’s capacity to raise interest rates still exists following the onset of economic recovery if corporate sector credit growth does not rise sharply relative to GDP over the coming 6-12 months. Chart II-11The Debt Burden Facing US Households Is At A Record Low The Debt Burden Facing US Households Is At A Record Low The Debt Burden Facing US Households Is At A Record Low Chart II-12Businesses Have Levered Up Their Balance Sheets, But There Is Still Room For Rates To Rise Businesses Have Levered Up Their Balance Sheets, But There Is Still Room For Rates To Rise Businesses Have Levered Up Their Balance Sheets, But There Is Still Room For Rates To Rise   The intensity of recent interest rate changes: Finally, many investors have pointed to sluggish housing activity over the past three years as evidence of a low neutral rate. However, Chart II-13 highlights that the rise in the 30-year US mortgage rate from late-2016 to late-2018 was one of the largest two-year changes in US history, and Chart II-14 shows that the growth in household mortgage credit did not fall below its trend during this period until Q4 2018, when the US stock market fell 20% from its high in response to the economic consequences of the US/China trade war. Chart II-14 also shows that mortgage credit growth responded sharply to a recent reduction in interest rates. All in all, Charts II-13 & II-14 cast doubt on the notion that the level of mortgage rates over the past three years reached restrictive territory. Chart II-13Mortgage Rates Rose Very Significantly From Late-2016 To Late-2018 Mortgage Rates Rose Very Significantly From Late-2016 To Late-2018 Mortgage Rates Rose Very Significantly From Late-2016 To Late-2018 Chart II-14A Record Rise In Mortgage Rates Did Not Crack The Housing Market A Record Rise In Mortgage Rates Did Not Crack The Housing Market A Record Rise In Mortgage Rates Did Not Crack The Housing Market   Investment Conclusions In the face of a global pandemic and an attendant global recession this year, the idea of eventual Fed rate hikes and the notion that the US economy will be able to tolerate them likely seems preposterous to many investors. We agree that over the coming 6-12 months US Treasury yields are unlikely to rise; even at current levels of the 10-year Treasury yield, we are reluctant to call a trough. Chart II-15US 10-Year Treasurys Are Mostly Priced For A Repeat Of The Past Decade US 10-Year Treasurys Are Mostly Priced For A Repeat Of The Past Decade US 10-Year Treasurys Are Mostly Priced For A Repeat Of The Past Decade However, Chart II-15highlights that over a long-term time horizon, the bond market is now essentially priced for a repeat of the ten-year path of the Fed funds rate following the global financial crisis. While some investors will view this as a reasonable expectation in the face of what they see as a persistent and unexplainable gap between growth and interest rates over the past decade, we think this gap is explainable and we highly doubt that a pandemic with minimal mortality risk to the working age population and the young will cause the US economy to be afflicted with active consumer deleveraging lasting 4 to 6-years, substantial and wide-ranging fiscal austerity, persistently rising trade tariffs, and sharply lower oil prices. So while we agree that the US economy will be substantially cyclically affected by COVID-19, US Treasury yields reflect a “low rates forever” view with much higher certainty than is analytically warranted and thus appear to be anchored by a false narrative. As such, we caution fixed-income investors against dogmatic medium-to-longer term views about bond yields, as their potential to rise following the upcoming recession may be larger than many investors currently believe.   Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com III. Indicators And Reference Charts Last month, we continued to strike a cautious tactical tone. Valuations were not depressed enough to compensate investors for the lack of clarity around the path of COVID-19. In other words, there was not enough of a risk premium imbedded in asset prices if COVID-19 cases were to spread around the world. Now that COVID-19 has spread around the planet, asset valuations have adjusted massively. The BCA Valuation Indicator for the S&P 500 is now in undervalued territory, thanks to both lower prices and interest rates. Meanwhile, the BCA Monetary Indicator has never been more accommodative than it is today. Together, these two indicators suggest that twelve months from now, equities will stand at higher levels than they do today. Tactically, equities have most probably found their floor. Both our Composite Sentiment Indicator and the VIX are consistent with a capitulation. Anecdotal evidences also point to a capitulation by retail investors. Additionally, Our RPI indicator is finally starting to try to turn up. Nonetheless, equities will likely re-test their Monday March 23rd floor as the length of US and global quarantines that are so damaging to growth (but for now, necessary) remain uncertain. The cleanest way to express a positive 12-month outlook on equities is to bet on a rise in the stock-to-bond ratio. 10-year Treasurys are as expensive as they were in late 2008 and early 1986, two periods followed by rapid rises in yields. Moreover, our Composite Technical Indicators is 2.5 sigma overbought. The yield curve is steepening anew, which confirms the intuition that yields will experience significant upside over the coming 12 months. On a longer-term basis, inflation expectations are too low to compensate investors for the inflation risk created by a larger monetary and fiscal expansion than the one witnessed in 2008. That being said, EM sovereigns are getting attractive for long-term investors.  Following the surge in the dollar that accompanied the liquidity crunch that surrounded the COVID-19 panic, the dollar is now trading at its most expensive level since 1985. The large liquidity injections by the Fed should cap the dollar for now, but the greenback will need more clarity on the end of global quarantines before it can fall decisively. Nonetheless, it will depreciate significantly once the global economy rebounds due to the powerful reflationary impulse building up around the world. Finally, commodity prices are retesting their 2008 lows. They are not as oversold as they were then, but this is good sign as the advance/decline line of our Continuous Commodity Index continues to trend higher. Thus, if as we expect, the dollar’s surge is ending, commodities are likely to be in the process of finding a floor right now. Once investors become more optimistic about the outlook for global growth, commodities will likely rebound sharply, maybe even more so than stocks. Therefore, it is a good time to begin accumulating metals, energy and equities as well as FX linked to natural resources prices. 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 The Bank Credit Analyst "March 2020," dated February 27, 2020, available at bca.bcaresearch.com 2  Chwieroth, Jeffrey M., Walter, Andrew, The Wealth Effect: How the Great Expectations of the Middle Class Have Changed the Politics of Banking Crises, 2019. 3  A relaxation of social-distancing measures would likely mean that large-scale gatherings are still prohibited, and life would not return to normal for a long time. 4  Please see US Equity Strategy "The Darkest Hour Is Just Before The Dawn," dated March 23, 2020, available at uses.bcaresearch.com 5  Please see Commodity & Energy Strategy "KSA, Russia Will Be Forced To Quit Market-Share War," dated March 19, 2020, available at ces.bcaresearch.com 6  "IMF Fourteenth Annual Research Conference in Honor of Stanley Fischer," Washington DC, November 8, 2013. 7  "Measuring the Natural Rate of Interest," Federal Reserve Bank of New York.

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

Dear clients, In addition to this short weekly report, you will also receive a Special Report penned by my colleague Jonathan LaBerge on Sweden, with implications for the SEK. I hope you will find the report both useful and insightful. In the interim, I wish safety for you and your families. Best Regards, Chester Ntonifor Highlights The lack of dollar liquidity had been a tailwind behind the dollar bull market. However, an expansion in the Federal Reserve’s balance sheet should help stem the global shortage of dollars. Ditto if there is an expansion of swap lines beyond the five major central banks. The risk is that the shortage of dollars has already begun to trigger negative feedback loops in a few countries. Until tentative signs emerge that the global economy is on better footing, expect spikes in the dollar. The caveat is that a big fiscal spending package in the US should lead to a deterioration in the current account. This will improve the offshore dollar liquidity situation. Feature The latest flare-up in risk aversion has also rotated to the offshore dollar funding market. Across G10 countries, US dollar cross-currency basis swaps - a measure of the costs to obtain greenbacks domestically - have been rising at an alarming pace. During the Federal Reserve’s emergency meeting on Sunday, swap lines were extended to five major central banks. The terms were very generous, with costs at the overnight index swap rate + 25 basis points, as well as a maturity of 84 days. However, the following day, the dollar continued its fervent rally, with the euro-US cross-currency basis swap touching -120 points (Chart 1). Chart 1A Broad-Based Funding Crisis A Broad-Based Funding Crisis A Broad-Based Funding Crisis The lack of follow through from the Fed’s liquidity injection highlights a fundamental risk to our sanguine view that the dollar should top out sooner rather than later. While we maintain this view, it has been discouraging that the DXY has broken above 100. We had anticipated a move higher on February 21, prompting us to close our long DXY position for a loss. Today, we suggest waiting for better signposts to short the greenback outright.1 US Dollar Flows The dollar remains the reserve currency of today, with the Fed at the center of the global financial architecture. The process behind dollar shortages is a simple one: Chart 2Global FX Reserve Growth Was Anemic Global FX Reserve Growth Was Anemic Global FX Reserve Growth Was Anemic Countries that are experiencing falling trade balances (because of a trade slowdown or trade war) will see a fall in their foreign exchange reserves. This naturally means that their supply of dollars is declining (Chart 2). Wary of seeing local dollar interest rates rise (leading to a higher dollar, and some companies going bust), central banks could sell dollars to the private sector in exchange for local currency. As a reserve currency, the US trade deficit is also settled in dollars. This naturally leads to a flow of greenbacks outside US borders. However, it also means that the current account deficit finances the budget deficit. Therefore, a falling trade surplus in exporting countries naturally means a falling deficit in the US. In order to stimulate the US economy, the authorities pursue macroeconomic policies that tend to weaken the dollar, such as lowering rates and/or running a wider fiscal deficit. The central bank helps finance this fiscal deficit via expanding the monetary base (Seigniorage). The drop in rates causes the yield curve to steepen. This incentivizes banks to lend, which in turn boosts US money supply. As the economy recovers and demand for imports (machinery, commodities, consumer goods) rises, the current account deficit widens. This leads to a renewed outflow of dollars. It is easy to see where the process can get short-circuited, especially via an external shock. If you accept the premise that the sum of the Fed’s custody holdings together with the US monetary base constitutes the root of global dollar liquidity, then it is not yet accelerating fast enough.2 Like in the past, the Fed has been quick to correct the situation: Recently, it has instituted swap lines. However, they remain inadequate for three key reasons: The swap lines should be extended from the five central banks to many countries, because Covid-19 is now a global pandemic. Not even China (along with other emerging markets) was  included in the swap agreements. The swap lines usually have terms/limits/amounts, which means that even if the domestic central bank decided to be the lender of last resort, it could still run short of dollars. Widespread fiscal measures have been announced, but this has been mostly geared towards sustaining income. Until governments unilaterally backstop airlines, shipping firms, restaurants, or any other company afflicted by the virus from going bankrupt, a negative self-reinforcing feedback loop will remain. Chart 3The Dollar As An Arbiter Of Growth The Dollar As An Arbiter Of Growth The Dollar As An Arbiter Of Growth We continue to recommend standing aside on the dollar until the dust has settled. Longer-term fundamentals suggest a dollar-bearish view, but until the world gets a sense that global growth is bottoming soon, the dollar uptrend remains intact (Chart 3). We continue to use internals and market fundamentals as a guide for when to time a top.3  Finally, we have been stopped out of a few trades and are tightening stops on a few. Please see this week’s trade table for a few recommendations.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com     Footnotes 1    Please see Foreign Exchange Strategy Weekly Report,  “The Near-Term Bull Case For The Dollar”, dated February 28, 2020, available at fes.bcaresearch.com. 2   Please see Foreign Exchange Strategy Weekly Report,  “Is The World Short Of Dollars?”, dated September 13, 2019, available at fes.bcaresearch.com. 3   Please see Foreign Exchange Strategy Weekly Report,  “Currency Technicals And Market Internals”, dated March 13, 2020, available at fes.bcaresearch.com. Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Dear Client, Next week we will be publishing a joint Special Report on the Chinese infrastructure investment outlook with our Emerging Markets Strategy service, authored by my colleague Ellen JingYuan He. Best regards, Jing Sima, China Strategist Feature Chart I-1Chinese Non-Financial Corporations Are Heavily Indebted Chinese Non-Financial Corporations Are Heavily Indebted Chinese Non-Financial Corporations Are Heavily Indebted There are fears that the two-month hiatus in China’s business activities due to the COVID-19 epidemic has sparked acute cash shortages among Chinese companies. In turn, this has increased the danger that the highly leveraged Chinese corporate sector may be pushed into widespread insolvency (Chart I-1). The number of bankruptcies will undoubtedly climb, but small and micro firms are most at risk versus larger companies that have deeper cash reserves and easier access to financing. Our analysis shows that, before the outbreak hit China in January, companies listed in China’s onshore and offshore equity markets exhibited relatively healthy financial statements with adequate operating cash flows to cover debt obligations. This increases the probability that Chinese listed companies will survive the economic and financial shocks from the epidemic, and that their stock prices will rebound along with the expectations of a recovery in the Chinese economy. Chart I-2Both Chinese Economy And Corporate Profits Are Largely Driven By Domestic Demand Both Chinese Economy And Corporate Profits Are Largely Driven By Domestic Demand Both Chinese Economy And Corporate Profits Are Largely Driven By Domestic Demand It also appears that China’s domestic economy is relatively insulated from the global financial market turmoil and impending global recession. China’s corporate profit outlook is dominated by domestic economic conditions rather than external demands. This view is also reflected in the relative performance of Chinese onshore and offshore stocks (Chart I-2). Moreover, the charts in the Appendix illustrate that corporate financial ratios in almost all sectors of China’s onshore and offshore equity markets have somewhat improved from the previous economic down cycle that began in 2014. This underscores our view that if reflationary measures overcompensate for the economic slowdown, as in the 2015/2016 easing cycle, then Chinese stocks will likely rally in absolute terms, as well as outperform global benchmarks. We selected three categories of financial ratios to monitor profitability, leverage and operating cash flow conditions of Chinese domestic and investable listed non-financial companies (Table I-1).1 The financial data in our exercise are from Refinitiv Datastream Worldscope. Its corresponding stock price indexes for China’s overall market and sectors most closely resemble the MSCI China Index and the MSCI China Onshore index. Table I-1 Monitoring Cash Flow Conditions In Chinese Listed Companies Monitoring Cash Flow Conditions In Chinese Listed Companies It is also noted that the Chinese investable index, excluding financial companies, is dominated by large technology companies such as Alibaba, Tencent, and Baidu.2 These tech companies generally have more adequate cash flows and lower debt ratios than the more capital intensive sectors such as industrial and energy. The analysis we present in this report on non-financial companies in the offshore market, therefore, is not indicative of China’s overall corporate financial health. Rather, our findings are indicative of how investors should view the listed companies and their sector performance within China’s investable market. Several observations from our analysis of the listed companies’ financial ratios are noteworthy: Chinese non-financial corporations are highly leveraged, and have not de-levered much despite the financial deleverage campaign that began in late 2017. Contrary to the belief that Chinese corporates’ financial health is significantly weaker than that in developed economies, the leverage ratio, profit margins, and debt-servicing ability among Chinese domestic and investable non-financial companies are actually in the range of their global peers (Chart I-3). Yet, Chinese companies trade at substantial discounts to global benchmarks. This is particularly evident in the offshore market, whereas domestic Chinese stocks were priced at a discount until the recent global market selloffs (Chart I-4). This underpins our view that, when China’s economy and corporate profits recover, Chinese stocks should outperform their global benchmarks on a cyclical time horizon. Importantly, with a stronger aggregate corporate financial health and a large price discount. Chinese investable non-financial stocks have more upside potential than their domestic counterparts. Chart I-3Financial Health Among Listed Chinese Companies Comparable With DMs Financial Health Among Listed Chinese Companies Comparable With DMs Financial Health Among Listed Chinese Companies Comparable With DMs Chart I-4Chinese Investable Stock Prices Remain Deeply Discounted Relative To Global Benchmarks Chinese Investable Stock Prices Remain Deeply Discounted Relative To Global Benchmarks Chinese Investable Stock Prices Remain Deeply Discounted Relative To Global Benchmarks   Utilities, machinery, industrials and construction materials are among the sectors with the lowest cash flow-to-interest expense ratios, in both China’s domestic and investable markets. In particular, machinery, industrials and construction materials are pro-cyclical sectors and their profit growth is positively correlated with economic growth. Their low profitability and high leverage contribute to their poor cash flows. Those sectors have been severely impacted by the stoppages in manufacturing and construction activities due to the COVID-19 epidemic in China, making them vulnerable to cash shortages. However, there is a low risk of a broad-based default among these firms, because state-owned enterprises (SOEs) dominate these sectors in the Chinese equity market. The stock performance in these sectors is also extremely sensitive to shifts in China’s monetary and policy stance, and thus should benefit from the recent loosening in monetary conditions and the push for a substantial increase in infrastructure investment this year. Chart I-5Small Property Developers In China Are Much More Vulnerable To Cash Shortages Than Large Ones Small Property Developers In China Are Much More Vulnerable To Cash Shortages Than Large Ones Small Property Developers In China Are Much More Vulnerable To Cash Shortages Than Large Ones The leverage ratio in the real estate sector has doubled in the past 10 years. The sector’s cash flow-to-total liabilities ratio has also declined sharply since 2017, when the authorities tightened lending standards to property developers. However, the sector’s aggregate cash flow situation is still an improvement from its lowest point in 2014, in both China’s domestic and investable markets. The countrywide lockdowns in January and February will undoubtedly have severe impacts on Chinese property developers’ cash flows. But the real estate sector is perhaps the best example in exhibiting a pronounced divergence in cash flow conditions between larger and smaller firms. Chart I-5 shows that, while the median ratio of cash-to-total liabilities tuned negative among 76 domestic listed real estate developers, the average ratio from total companies in the same sector suggests that the cash situation has actually improved since mid-2018. This divergence indicates that larger developers have more solid financial fundamentals and easier access to liquidity compared with their smaller counterparts, even before the lockdowns. We expect the divergence in cash flow conditions to widen in the coming months, and smaller property developers will face intensifying pressure to consolidate. China’s domestic healthcare companies have a much better cash balance than the investable healthcare sector, which has the lowest ratio of cash-to-interest expenses among all sectors. The poor cash flow conditions in investable healthcare companies are due to high leverage and low profitability, as well as high operating costs and R&D expenses. Chinese domestic healthcare sector has outperformed the broad market since the epidemic broke out in January. While we think the overall Chinese investable stocks have more upside than their domestic peers, domestic healthcare companies’ lower leverage ratio, stronger cash flows, and much higher profit margin make the sector a better bet than investable healthcare stocks on a cyclical time horizon (Chart I-6).  Chart I-6Domestic Healthcare Sector Likely To Continue Outperforming The Broad Market Domestic Healthcare Sector Likely To Continue Outperforming The Broad Market Domestic Healthcare Sector Likely To Continue Outperforming The Broad Market Chart I-7Energy Stocks Will Remain Depressed Until Oil Prices Rebound Energy Stocks Will Remain Depressed Until Oil Prices Rebound Energy Stocks Will Remain Depressed Until Oil Prices Rebound Historically, there has been a strong positive correlation between the energy sector’s profitability, cash flow conditions, stock performance and crude oil prices (Chart I-7). In the past two years, the sector’s leverage ratio has risen, profit margins have thinned and the cash flow situation has sharply deteriorated to the same level as in 2014 when oil prices collapsed. The ongoing oil price rout will generate powerful deflationary forces in the energy sector and will likely further deteriorate energy firms’ profitability and cash flow. While we stay long cyclical stocks versus defensives on both a 0-3 month and a 6-12 month view, we recommend a cautious stance towards energy stocks until the evolving oil price war situation is clarified.   Qingyun Xu, CFA Senior Analyst qingyunx@bcaresearch.com Jing Sima China Strategist jings@bcaresearch.com Appendix Overall Markets Excluding Financials Overall Markets Excluding Financials Sector Overall Markets Excluding Financials Sector Consumer Discretionary Sector Consumer Discretionary Sector Consumer Discretionary Sector Consumer Staples Sector Consumer Staples Sector Consumer Staples Sector Real Estate Sector Real Estate Sector Real Estate Sector Automobile Sector Small Property Developers In China Are Much More Vulnerable To Cash Shortages Than Large Ones Small Property Developers In China Are Much More Vulnerable To Cash Shortages Than Large Ones Machinery Sector Machinery Sector Machinery Sector Industrials Sector Industrials Sector Industrials Sector Construction Materials Sector Construction Materials Sector Construction Materials Sector Telecommunications Sector Telecommunications Sector Telecommunications Sector Technology Sector Technology Sector Technology Sector Healthcare Sector Healthcare Sector Healthcare Sector Energy Sector Energy Sector Energy Sector   Utilities Sector Utilities Sector Utilities Sector   Footnotes 1    We exclude banks and financial institutions from this analysis, due to discrepancy in Chinese banks’ accounting measures from those of non-financial corporations’. 2   Alibaba, Tencent, Baidu, and JD together account for nearly 40% of the non-financial market cap in Chinese investable index. Cyclical Investment Stance Equity Sector Recommendations

Highlights At the current rate of work resumption, March’s PMI should rebound to its “normal range” from February’s historic lows. If so, our simple calculation, using China’s PMI figures and GDP growth in Q4 2008 as a template, suggests that China's economic growth in Q1 2020 should come in at around 3.2%. Chinese stocks passively outperformed global benchmarks in the last two weeks.  The likelihood of a stimulus overshoot in the next 6-12 months continues to rise, supporting our view that Chinese stocks will actively outperform global benchmark in the coming months. Cyclical stocks have significantly outperformed defensives lately. While this is consistent with our constructive view towards Chinese equities in general, the magnitude of a tech stock rally in the domestic market of late appears to be somewhat excessive. As such, investors should focus their sector exposure in favor of resources, industrials, and consumer discretionary. The depreciation in the RMB against the dollar will come primarily from a stronger dollar rather than a weaker RMB, and the downside in the value of the RMB should be limited. Feature Despite the past week’s plunge in global equities due to the threat of a worldwide COVID-19 pandemic, Chinese stocks have outperformed relative to global benchmarks. This underscores our view that epidemic risks within China are slowly abating, and China’s reflationary response to the crisis will likely overcompensate for the short-term economic shock. Tables 1 and 2 highlight key developments in China’s economy and its financial markets in the past month. On the growth front, both the February official and Caixin PMIs dropped to historic lows as a result of the virus outbreak and nationwide lockdown. On the other hand, economic data from January confirmed that pre-outbreak activity in China was on track to recovery. Daily data also suggests that production in China continues to resume. Moreover, monetary conditions have significantly loosened and fiscal supports have materially stepped up.  Chinese equities in both onshore and offshore markets dropped by 2% and 7% respectively (in absolute terms) from their January 13 peaks. Nevertheless, they have both significantly outperformed global equities, particularly in the past week. Equally-weighted cyclical stocks versus defensives in the onshore market have also moved up sharply, driven by a rally in the technology sector stocks. While the outperformance of cyclical stocks is consistent with our constructive view towards Chinese stocks, the magnitude appears to be excessive. Thus, we would advise investors positioning for a cyclical recovery in China to favor exposure in resources, industrials and consumer discretionary stocks. Table 1China Macro Data Summary China Macro And Market Review China Macro And Market Review Table 2China Financial Market Performance Summary China Macro And Market Review China Macro And Market Review In reference to Tables 1 and 2, we have a number of observations concerning developments in China’s macro and financial market data: Chart 1Inventory And Production Shortages Are A Bigger Near-Term Concern Than Weaknesses In Demand Inventory And Production Shortages Are A Bigger Near-Term Concern Than Weaknesses In Demand Inventory And Production Shortages Are A Bigger Near-Term Concern Than Weaknesses In Demand February’s drop in the official PMI below 40% is reminiscent of November 2008, which was the height of the global financial crisis. The raw material inventory sub-index of the PMI in February fell to a record low, a clear indication of strain in China’s manufacturing sector. While the finished goods inventory sub-index ticked up slightly compared with January, factories will likely run out of existing raw materials to produce goods if transportation logistics do not return to normal soon (Chart 1). A higher number in the new orders sub-index relative to production output also suggests the pressure on the supply side will intensify if the virus outbreak in China worsens and continues to disrupt manufacturing activities. This will in turn undermine the effectiveness of Chinese policy response.   Daily data from various sources suggests Chinese industrial activities continue to pick up. Between February 10 (the first official return-to-work day after an extended Chinese New Year holiday) and February 25 (the cutoff date for responding to PMI surveys), daily coal consumption in China’s six largest power plants was only about 60% of consumption compared from the same period last year (adjusted for the Lunar Year calendar). This is in line with the 35.7 reading in February’s manufacturing PMI, versus 49.2 a year ago. In the last four days of February, however, coal consumption reached nearly 70% of last year’s consumption. This figure is in keeping with a 10 percentage point increase in the rate of work resumption of enterprises above-designated size in China’s coastal regions.1 If energy consumption and work resumption rates reach about 90% by the end of March compared with Q1 2019, then PMI in March should pick up to 45% or higher. A 45% or higher reading in March’s PMI will imply economic impact from the virus outbreak is mostly limited to February. A simple calculation using China’s GDP growth in Q4 2008 as a template suggests that China's economic growth in Q1 2020 should come in at around 3.2% in real terms. This is in line with the estimate from BCA's Global Investment Strategy service.2 As we pointed out in November last year,3 China is frontloading additional fiscal stimulus in Q1 2020 to secure the economic recovery, which started to bud prior to the virus outbreak. The increase in January’s credit numbers confirms our projection. The monthly flow in total social financing in January (with only three work weeks effectively) reached above RMB 5 trillion. This figure exceeded that in January 2019, the highest monthly credit number last year. Local government bond issuance in January was almost double that a year ago, and a total of 1.2 trillion local government bonds were issued in the first two months of this year - a 53% jump from the same period last year. This suggests that fiscal stimulus has indeed stepped up in 2020. Money supply in January was slightly distorted by the earlier Chinese New Year (it fell in January this year instead of February as in most years) and the COVID-19 outbreak.  M1 registered zero growth from a year ago, whereas it grew by 0.4% in January 2019.4 Normally, during the month of the Chinese New Year, households have more cash in deposits whereas corporations have less as they pay pre-holiday bonuses to employees. This seasonality factor causes the growth rate in M0 to rise and M1 growth to fall. The seasonality was exacerbated by the nationwide lockdown on January 20 this year, as many real estate developers reportedly suffered from a significant reduction in home sales and delays in deposits for down payments. Household consumption in the service sector during the Chinese New Year was also severely suppressed. This explains near-zero growth in M1 and a larger-than-expected increase in household deposits in January (Chart 2). We expect the growth in both M0 and M1 to start normalizing in March, as production and household consumption continue to resume. While we do not expect large fluctuations in housing prices, we think growth in home sales may accelerate from Q2 2020. There are early signs that the government is starting to relax restrictions on the real estate sector, on a region by region basis. Land sales remain a major source of local governments’ income, accounting for more than half of total revenues as of last year. Chart 3 shows that as government expenditures lead land sales, a major increase in fiscal stimulus and local government spending means that a significant bump in land sales will be needed in 2020. A strengthening supply of land, coupled with the unlikelihood of large fluctuations in property prices, suggests that there will be more policy supports to the real estate sector and more incentives to boost housing demand. Chart 2Corporates Are Short On Cash Corporates Are Short On Cash Corporates Are Short On Cash Chart 3Land And Home Sales Likely To Pick Up In 2020 Land And Home Sales Likely To Pick Up In 2020 Land And Home Sales Likely To Pick Up In 2020 In the past two weeks, China’s equity market has registered a near-vertical outperformance in both investable and domestic stocks relative to global benchmarks (Chart 4). While this recent outperformance was passive in nature, our policy assessment supports future active outperformance. The recently announced pro-growth policy initiatives increasingly resemble those rolled out at the start of the last easing cycle in 2015/2016. These policy initiatives increase the odds that the upcoming “insurance stimulus” will overcompensate for the short-term economic shock, and will likely lead to a significant rebound in corporate profits in the next 6-12 months.  This supports our bullish view on Chinese stocks. Chart 5 also shows that, unlike during the 2015’s “bubble and bust” cycle, both the valuation and margin trading as a percentage of total market cap in China’s onshore market remain materially lower than 2015. Equally-weighted cyclical sectors continue to outperform defensives in both China’s investable and domestic markets, particularly the latter where stock prices in the technology sector were up 12% within the past month. While the outperformance of cyclical stocks relative to defensives is consistent with our constructive view towards Chinese equities in general, the magnitude appears to be somewhat excessive. Given this, we would advise investors positioning for a cyclical recovery in China’s economy to focus their sector exposure in favor of resources, industrials, and consumer discretionary stocks. Chart 4Chinese Stocks Strongly Outperformed Global Benchmarks Over The Past Two Weeks Chinese Stocks Strongly Outperformed Global Benchmarks Over The Past Two Weeks Chinese Stocks Strongly Outperformed Global Benchmarks Over The Past Two Weeks Chart 5Onshore Market Trading Does Not Seem Overly Leveraged Onshore Market Trading Does Not Seem Overly Leveraged Onshore Market Trading Does Not Seem Overly Leveraged China’s three-month repo rate (the de facto policy rate) has fallen significantly in the past month, roughly 30bps below its lowest level in 2016 (Chart 6). China’s government bond yields have also reached their lowest level since 2016. While corporate bond yield spreads in other major economies have picked up sharply in the past month, the reverse is happening in China. This suggests that the market is pricing in further easing and the notion that policy supports will be effective in preventing a surge in corporate bond default rate. From a global perspective, yield spreads on China’s onshore corporate bonds have been elevated since 2016. This indicates that investors have long either priced in a much higher default rate among Chinese corporate bond issuers, or demand an unjustifiably large risk premium (Chart 7). Since we expect Chinese policymakers to continue easing, risks of a surge in China’s corporate bond default rate remain low this year. As such, until we see signs that the Chinese authorities are reverting to a financial de-risking mode, we will continue to favor onshore corporate versus duration-matched government bonds. Chart 6Monetary Policy Now More Accommodative Than 2015-2016 Monetary Policy Now More Accommodative Than 2015-2016 Monetary Policy Now More Accommodative Than 2015-2016 Chart 7Chinese Corporates Pay High Risk Premium For Their Bonds, Even At A Relatively Low Default Rate Chinese Corporates Pay High Risk Premium For Their Bonds, Even At A Relatively Low Default Rate Chinese Corporates Pay High Risk Premium For Their Bonds, Even At A Relatively Low Default Rate Chart 8The RMB Likely To Continue Outperforming Other EM Currencies The RMB Likely To Continue Outperforming Other EM Currencies The RMB Likely To Continue Outperforming Other EM Currencies As we go to press, the Federal Reserve Bank has just made a 50bps cut to the Fed rate, the first emergency cut since the global financial crisis. The USD weakened against the Euro, the Japanese Yen, as well as the RMB immediately following the rate cut. While this reflects the market’s concerns of a worsening virus outbreak and the rising possibility of an economic slowdown in the US, the USD as a countercyclical currency will likely appreciate against most cyclical currencies as the virus continues spreading globally. Hence, the depreciation in the RMB against the dollar will come primarily from a stronger dollar rather than a weaker RMB, and the downside in the value of the RMB should be limited. The continuation of resuming production in China and the expectations of a Chinese economic recovery in Q2 will support an appreciation in the RMB against other EM currencies (Chart 8).   Qingyun Xu, CFA Senior Analyst qingyunx@bcaresearch.com Jing Sima China Strategist jings@bcaresearch.com   Footnotes 1    http://app.21jingji.com/html/2020yiqing_fgfc/ 2   Please see Global Investment Strategy Weekly Report "Markets Too Complacent About The Coronavirus," dated February 21, 2020, available at gis.bcaresearch.com 3   Please see China Investment Strategy Weekly Report "Questions From The Road: Timing The Turn," dated November 20, 2020, available at gis.bcaresearch.com 4   M1 is mainly made up by cash demand deposits from corporations, whereas M0 is mainly deposits from households Cyclical Investment Stance Equity Sector Recommendations

Highlights Chinese policymakers will deliver more growth-supporting measures in the coming months, but Chinese government bond yields have already priced in a much weaker economic slowdown and a more aggressive policy response. While we think monetary policy may get even looser in the very near term, there is limited potential for the short-end of the Chinese government bond yield curve to remain at such low levels. The PBoC’s recent liquidity injections are mostly a preventive measure to avoid an acute cash crunch in the real economy, and the historical path following the 2003 SARS outbreak suggests the additional monetary easing action is unlikely to be sustained over the coming 6-12 months. As such, Chinese government bond yields will rebound in expectation of better economic conditions and more restrictive monetary conditions. On a cyclical basis, we continue to overweight Chinese equities over government bonds. Feature Chinese bond yields have declined sharply over the past two weeks, as investors weighed both the economic consequences of the Covid-19 outbreak and the likelihood of more accommodative monetary policy. Following the extended Chinese New Year holiday, China’s central bank (PBoC) has carried out five cash injections, pumping nearly 3 trillion yuan into the interbank market (Chart 1). It also lowered the de jure policy rate - the 7-day reverse repo rate - by 10bps to cut the cost of funding for commercial banks. The 3-month SHIBOR (which trades very closely to the 3-month repo rate), which we have long viewed as China’s de facto short-term policy rate, quickly reversed its January rise and fell back to its July-2018 low (Chart 2). Chart 1Large And Frequent Liquidity Injections Since The Onset Of The Virus Outbreak Large And Frequent Liquidity Injections Since The Onset Of The Virus Outbreak Large And Frequent Liquidity Injections Since The Onset Of The Virus Outbreak Chart 2Monetary Conditions Turned Much Easier In Just Three Weeks Monetary Conditions Turned Much Easier In Just Three Weeks Monetary Conditions Turned Much Easier In Just Three Weeks The PBoC’s aggressive easing measures of late have sparked market speculation that China is entering another major monetary and credit easing cycle, and that a government bond rally is well underway with even lower yields to come. Chart 3Extremely Tight Relationship Between Interbank Lending Rate And Government Bond Yields Extremely Tight Relationship Between Interbank Lending Rate And Government Bond Yields Extremely Tight Relationship Between Interbank Lending Rate And Government Bond Yields In our January 29 Special Report1 on China’s government bond market, we discussed how there has been a strong relationship in the past decade between unexpected changes in the 3-month SHIBOR and the long-end of China’s government bond yields. In order for the current rally in government securities to be sustained, investors need to believe that the PBoC’s easing measures are here to stay and that there will be additional policy rate cuts in the months to come (Chart 3). There are indications that Chinese policymakers are looking to deliver more growth-supporting measures over the coming months. However, it is likely that the current bond rally will be a near-term event rather than a cyclical (6-12 months) trend. Therefore, on a cyclical time horizon, we continue to recommend overweighting Chinese stocks versus Chinese government bonds and would advise against an aggressively long duration stance. Has The Covid-19 Epidemic Peaked? The fact that the number of new suspected cases is also in decline sends a signal that the outbreak outside Hubei may have largely been contained.  Chart 4Financial Market Shakes Off Some Of The "Fear Element" From The Outbreak Financial Market Shakes Off Some Of The "Fear Element" From The Outbreak Financial Market Shakes Off Some Of The "Fear Element" From The Outbreak Investors appear to concur with our view that the Covid-19 outbreak has largely become a Hubei-specific crisis.2 Chinese stocks in the onshore and offshore markets have recovered more than half of the losses from their bottom on February 3, when the number of new cases outside of the Hubei epicenter reached a tentative peak. The 12-month change in the yields of Chinese 3 and 10-year government bonds also inched up since then (Chart 4). While the Chinese government’s rollout of supportive measures, including liquidity injections and policy rate cuts since early February might have helped improve market sentiment, the fact the epidemic outside Hubei province seems to be contained also helps explain the bottom in equity prices and bond yields. In addition, the number of new suspected cases outside Hubei province has trended down since February 9 (Chart 5). The diagnosis methodology was recently revised to include suspects with clinical symptoms, regardless of whether they had a history of contact with infected cases from Wuhan. This new methodology has lowered the bar for registering newly suspected cases. While the situation surrounding the Covid-19 outbreak is still fluid, the fact that the number of new suspected cases is also in decline sends a signal that the outbreak outside Hubei may have largely been contained. Bottom Line: Outside of the epicenter, the Covid-19 outbreak may have peaked. This means the fear element driving down Chinese government bond yields may soon end. Chart 5The Situation Continues To Get Better Outside Of The Epicenter Don’t Chase China’s Bond Yields Lower Don’t Chase China’s Bond Yields Lower Current Bond Rally Unlikely A Cyclical Play Bond yields now appear to have largely priced in a delayed economic recovery and more aggressive policy response. We think the current rally in Chinese government bonds will thus only be a short-term event rather than a cyclical (6-12 month) play. The rally in China’s government bond market since mid-2018 was largely driven by market expectations of a significant slowdown in the Chinese economy, and a much easier monetary policy in responding to a slowing Chinese domestic demand and a protracted Sino-US trade war. Bond market is pricing in a 2015-2016-style economic slowdown and a policy response that is more aggressive than four years ago. Cyclically, we think both of these factors are absent from the current situation, and a normalization back to the pre-outbreak monetary stance may come earlier than the market expects. In the last two weeks, Chinese government bond markets have discounted a sharp slowdown in economic activity; 10-year Chinese government bond yields are back below 3.0% for the first time since 2016 and the 3-month SHIBOR is now 25bps lower than the bottom in 2015-2016 (Chart 6). This suggests the market is pricing in a 2015-2016-style economic slowdown and a policy response that is more aggressive than four years ago. The nature of the current situation, as we pointed out in our previous reports,3 represents a temporary delay rather than a derailing of an economic recovery in China.  The Covid-19 outbreak and the unprecedented containment measures paused the Chinese economy in the first quarter, just as it was coming off of a two-year soft patch. But domestic demand was not nearly as weak as in 2015-2016 before the outbreak (Chart 7). Chart 6Bond Market Is Pricing In A 2015-2016-Style Economic Slowdown Bond Market Is Pricing In A 2015-2016-Style Economic Slowdown Bond Market Is Pricing In A 2015-2016-Style Economic Slowdown Chart 7A Chinese Economic Recovery Was Budding Pre-Outbreak A Chinese Economic Recovery Was Budding Pre-Outbreak A Chinese Economic Recovery Was Budding Pre-Outbreak Chart 8The PBoC Is Generally A Reactive Central Bank, But A Proactive Central Bank In Reversing Crisis Easing The PBoC Is Generally A Reactive Central Bank, But A Proactive Central Bank In Reversing Crisis Easing The PBoC Is Generally A Reactive Central Bank, But A Proactive Central Bank In Reversing Crisis Easing If the virus is contained outside of the epicenter in the next couple of weeks and the hit to China’s overall economy is limited to Q1, then the PBoC will likely normalize policy back to its pre-outbreak stance. While the PBoC is generally a reactive central bank and has historically lagged a pickup in economic activity, it was proactive in normalizing its monetary policy following short-term shocks. Chart 8 shows the historical path of 3-month SHIBOR in the year following a bottom in economic activity in 2009, 2012, and 2015.  In all three economic slowdowns, there has not been a significant rise in interbank rates in the first nine months of an economic recovery. Following the SARS outbreak, however, the PBoC reversed its easy stance and significantly tightened liquidity conditions in the banking system only four months after the peak of the SARS outbreak. While we do not expect the PBoC to shift into a tightening mode this year, a shift back to the pre-outbreak policy trajectory sometime in Q2 is highly likely, provided the Covid-19 outbreak is contained outside of Hubei province.  In turn, Chinese government bond yields will rebound in expectation of better economic conditions and more restrictive monetary conditions. PBoC is also unlikely to open a liquidity floodgate. Despite large liquidity injections in the past two weeks, we are not convinced that the PBoC intends to fully open the liquidity tap in the interbank market.  So far, most of the financial support measures have been a combination of targeted low-cost funding to non-financial corporations and fiscal subsidies to local governments and businesses. This differs from 2015-2016 when the PBoC aggressively cut interbank rates and the 1-year benchmark lending rate, and kept excessive liquidity in the interbank system for a prolonged period (Chart 9). As Chart 9 (bottom panel) shows, PBoC’s net fund injections have been extremely volatile since Covid-19 erupted in January. This suggests that while the PBoC has added large doses of liquidity into the interbank market, demand for financial support in the banking system has mostly matched or even outstripped supply. In other words, the PBoC is not flooding the interbank system with cash, rather it is preventing an outbreak-induced illiquidity issue from turning into a widespread insolvency problem.  The PBoC is trying to prevent an outbreak-induced illiquidity issue from turning into a widespread insolvency problem.  Chart 9Monetary Policy Not Turning Back To A 2015-2016-Style "Floodgate Irrigation" Monetary Policy Not Turning Back To A 2015-2016-Style "Floodgate Irrigation" Monetary Policy Not Turning Back To A 2015-2016-Style "Floodgate Irrigation" Chart 10Private Sector Highly Leveraged... Private Sector Highly Leveraged... Private Sector Highly Leveraged... This approach is warranted. Small businesses have been disproportionally hit by the outbreak and are reporting a severe shortage of cash. China’s private sector is particularly vulnerable to cash flow restrictions because many businesses are highly leveraged (Chart 10).  A joint survey of 995 small and mid-size companies by Tsinghua and Peking universities showed that more than 60% of respondents said they can survive for only one to two months with their current savings (Chart 11).   Chart 11…Making Small Businesses Especially Vulnerable To Cash-Flow Constraints Don’t Chase China’s Bond Yields Lower Don’t Chase China’s Bond Yields Lower Additionally, there is a risk that the PBoC is underestimating the demand for cash in the banking system, particularly from small- and medium-sized banks. This underestimation could lead to a rise in the interbank lending rate. This occurred in 2017 when the crackdown of shadow bank lending caused a funding squeeze for China’s small and mid-sized banks, which led to a material rise in interbank lending rates and government bond yields (shown in Chart 6). It is also the reason that we primarily track the 3-month SHIBOR over the 7-day rate, as the former tends to capture the effects of these funding squeezes whereas the latter does not. The demand for cash in the interbank market in the current quarter will be higher than in the same period last year. The government has announced an additional debt quota of 848 billion yuan, on top of the previously authorized quota of 1 trillion yuan worth of local government bonds that would be frontloaded in Q1. This is a 32% increase from a total of 1400 billion yuan of bonds that local government frontloaded in Q1 2019. This implies the demand for cash in the interbank market will remain high as commercial banks account for about 80% of local government bond purchases.4 A temporary spike in corporate bond defaults leading to a jump in the interbank rate could also push up government bond yields. Additionally, the delayed resumption of work, the loss of production and the cash crunch facing small companies raise the risk of a surge in overdue bank loans and defaults. This could also escalate the demand for cash from smaller banks, because large commercial banks may be unwilling to lend to riskier borrowers in the interbank market. The 3-month SHIBOR has inched up since the takeover of Baoshang Bank in May 2019. Chart 12Average Lending Rates Lag Short-Term Bond Yields Average Lending Rates Lag Short-Term Bond Yields Average Lending Rates Lag Short-Term Bond Yields We expect the PBoC to lower the loan prime rate (LPR), following the 10bps cut in the medium lending facility rate (MLF) on February 17. As we pointed out in our January 29 Special Report, this easing by the PBoC will reduce corporate lending rates, but not necessarily interbank rates. Chart 12 shows that the change in average lending rates lags the change in Chinese government bond yields. Therefore, the upcoming cuts in the LPR are a result of lowered interbank rates and bond yields, not a cause for changes in government bond yields going forward. Bottom Line: Monetary policy will remain relatively loose this year, but we think the PBoC’s recent aggressive easing will be a temporary event. Any additional easing by the PBoC this year will likely be through providing short-term cash relief and temporarily lowered funding costs to non-financial corporations. There are also near-term risks that interbank rates may be pushed up due to a liquidity crunch.  Hence, yields at the short-end will likely be volatile in the near term whereas yields at the long-end are unlikely to stay at their current low levels. Investment Conclusions While we think monetary policy may get even looser in the very near term, there is limited potential for the short-end of the Chinese government bond yield curve to remain at such low levels. Barring a lasting economic slowdown from the Covid-19 outbreak, the long-end of the curve has the potential to move moderately higher in the second half of the year, as China’s economy recovers from the outbreak-induced shock. Bond yields at the short-end will likely be volatile in the near term whereas yields at the long-end are unlikely to stay at their current low levels. Given this, we continue to expect Chinese domestic and investable equities to outperform government bonds in the next 6-12 months, and we would advise Chinese fixed-income investors against an aggressively long duration stance. Onshore corporate bonds, while risking a higher default rate in the near term, shares a similar outlook on a cyclical basis: onshore spreads are pricing in (massively) higher default losses than we believe are warranted. This means that onshore corporate bonds will still outperform duration-matched government bonds without any changes in yield, underpinning another year of Chinese corporate bond market outperformance versus government bonds.   Jing Sima China Strategist jings@bcaresearch.com   Footnotes 1    Please see China Investment Strategy Special Report "How To Analyze And Position Towards Chinese Government Bonds," dated January 29, 2020, available at cis.bcaresearch.com 2   Please see China Investment Strategy Weekly Report "The Evolving Crisis," dated February 13, 2020, available at cis.bcaresearch.com 3   Please see China Investment Strategy Weekly Report "Recovery, Temporarily Interrupted," dated February 5, 2020, available at cis.bcaresearch.com 4   ChinaBond, as of 2019 Cyclical Investment Stance Equity Sector Recommendations

Highlights Money supply, not central banks’ 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 investors’ behavior. Liquidity flows into financial assets when “animal spirits” among investors improve, and vice versa. Feature Investors and market commentators often refer to “liquidity” as a driving force for financial markets. Yet definitions and calculations of liquidity vary tremendously. This report aims to define and differentiate among various categories of liquidity and assess their relevance for asset markets. What investors refer to as “liquidity” can by and large be classified into three groupings: (1) banking system liquidity; (2) broad money supply (all deposits and cash in circulation) available to purchase goods, services and assets, including securities; and (3) liquidity in asset markets - the portion of broad money supply that is channeled to purchase financial assets. Diagram I-1 on page 2 provides visual representation of money and liquidity groupings. All other measures of “liquidity” generally fall into one of these three groupings. Diagram I-1Liquidity Groupings And Linkages A Primer On Liquidity A Primer On Liquidity Banking System Liquidity At the core of any monetary system is the monetary base, which is also referred to as high-powered money. This consists of commercial banks’ reserves at the central bank, and cash in circulation. Provided the quantity of cash in circulation is determined by the economy’s demand for cash, it is beyond the control of central banks and commercial banks.1 Besides, cash in circulation is a part of broad money supply, while bank reserves at the central bank are not. Broad money is the focal point of the next section. In this section, we deliberate on the genuine liquidity within the banking system, which is banks’ excess reserves at the central bank. Banks require excess reserves to settle payments with other banks arising both from their own and their clients’ transactions. Only the central bank can create bank reserves, and does so “out of thin air” when it purchases assets or lends. The central bank creates reserves electronically simply by crediting commercial banks’ reserve accounts held at the central bank. Chart I-1Excess Reserves And Share Prices: No Strong Correlation Excess Reserves And Share Prices: No Strong Correlation Excess Reserves And Share Prices: No Strong Correlation The amount of excess reserves each individual bank holds as well as the cost of borrowing these reserves influence commercial banks’ willingness to expand their balance sheets – i.e., originate loans and purchase assets. Yet excess reserves do not flow into the economy and financial markets. Banks do not lend out excess reserves to borrowers. Banks require excess reserves to settle payments with other banks arising both from their own and their clients’ transactions.   Furthermore, banks do not use deposits – which are liabilities owed by banks – to settle payments with other banks or the central bank. Rather, they draw down their excess reserves to conduct settlements. When banks are short on excess reserves, they borrow them from the central bank or other banks. In short, all types of deposits at banks – those of households, companies, organizations and governments – do not constitute liquidity for banks. The incentive for banks to attract deposits from their peers is not the deposits themselves but rather the handover of excess reserves that occurs when a deposit is transferred from one bank to another. In a nutshell, banks compete with one another not for deposits, per se, but for excess reserves. How well do excess reserves correlate with share prices? Chart I-1 reveals that there has been no stable correlation between excess reserves and share prices in the US, the Euro Area, Japan and China. Bottom Line: Excess reserves do not constitute broad purchasing power for goods and services as well as real and financial assets. Excess reserves can be thought of as “core” liquidity that has a bearing on banks’ willingness to create money “out of thin air.” Money Supply Broad money supply is the sum of all types of deposits and cash in circulation. Narrow money (M1) supply is comprised of demand deposits and cash in circulation. Thereby, broad money supply determines potential purchasing power for goods, services and all types of assets. Outside of quantitative easing (QE), central banks do not typically create deposits/broad money; they typically create reserves only. When a central bank lends to or purchases an asset from a bank, it creates reserves, but not deposits. When a central bank purchases an asset from a non-bank, it creates both deposits (money) and reserves. Critically, as highlighted previously, reserves are not a part of narrow or broad money supply. Chart I-2Money Multiplier = Broad Money / Excess Reserves Money Multiplier = Broad Money / Excess Reserves Money Multiplier = Broad Money / Excess Reserves This is why fears that QE will immediately lead to high inflation are false. QE in advanced economies have generated a lot of reserves but little in the way of new money supply. Ultimately, it is deposits/money – not reserves – that determine purchasing power. Outside of QE, money is created by banks, not central banks. Both a loan origination to and a purchase of a security from a non-bank by a bank leads to new deposit/money creation “out of thin air.” Also, savings versus spending decisions by economic agents (non-banks) do not change the amount of money supply. We have deliberated on these topics at length in past reports. In turn, the willingness of banks to expand their assets for a given level of excess reserves and interest rates is measured by the money multiplier. The latter is computed as a ratio of broad money to excess reserves. Chart I-2 illustrates money multipliers in the US and China. The US money multiplier has been rising since late 2014. America’s broad money supply (M2) has been expanding in recent years, even though the Federal Reserve – until this past September – had been draining banking system excess reserves. In China, by contrast, the money multiplier has been declining since late 2017.  Remarkably, the level of the money multiplier is considerably higher in China (62) than in the US (11). In other words, for each unit of excess reserves, there are 62 outstanding units of broad money in China, and only 11 units in the US. China’s higher money multiplier signifies the following: (1) Its banks are more overextended in terms of liquidity – i.e., they are more likely to experience liquidity shortages than their US peers; and (2) mainland banks have been acquiring more assets and originating more loans per unit of excess reserves. The willingness of banks to expand their assets (captured by the money multiplier) is often more important for money creation than excess reserves provisions by central banks. For example, since January 2009 - the onset of the credit boom in China - the country’s excess reserves have almost doubled. Yet broad money has expanded more than 4-fold (Chart I-2, bottom panel). This compares with an 85% rise in US broad money and 40% in the euro area's since January 2009 (Chart I-3, top panel).   Chart I-3“Helicopter” Money In China Helicopter Money In China Helicopter Money In China Chinese commercial banks have literally been dropping “helicopter” money from the time when the country embarked on a massive credit binge in early 2009. Since that time, Chinese banks have created 178 trillion yuan ($25 trillion) of new broad money, based on our measure of broad (M3) money supply. This is almost triple the $8.4 trillion broad money supply created in the US and euro area combined over the same period. China’s broad (M3) money supply2 now stands at 232 trillion yuan, equivalent to US$33 trillion (Chart I-3, bottom panel). What is astonishing is that Chinese broad money is larger than the sum of broad money in both the US and euro area, which is roughly equivalent to $30 trillion (i.e., the sum of all outstanding US dollars and euros in the world). Yet China’s nominal GDP is equivalent to only 40% of US and euro area GDP combined. In China, broad money supply has been a good leading indicator for its business cycle (Chart I-4, top panel). In the US and Europe, however, broad money has been much less successful in predicting the direction of the business cycle (Chart I-4, middle and bottom panels). Money supply is liquidity available to economic agents to purchase goods and services as well as invest in both real and financial assets. Why does money supply correlate better with business cycles in some economies than others? The answer is the velocity of money. Even when two economies experience similar rates of money growth, the pace of their economic growth will differ due to differences in their velocity of money. Specifically: Nominal GDP Income = Money Supply x Velocity Of Money Hence, a change in nominal GDP growth is driven by both changes in the money supply and the velocity of money. Therefore, it is a mistake to think that new money creation is the only source of new demand and growth. When the existing money supply turns faster – i.e. the velocity of money rises – nominal GDP will expand without new money being created. The velocity of money reflects households’ and companies’ willingness to spend versus save. For the same amount of outstanding money supply, households and businesses can spend more (turn over money faster) or less (turn over money more slowly). It is much harder to gauge changes in the velocity of money than in money supply. Changes in the velocity of money reflect variations in the willingness to spend, save and invest among households, companies and institutions. Chart I-5 illustrates the velocity of money in China, the US, the euro area and Japan have not been constant. Chart I-4Money And The Business Cycle Money And The Business Cycle Money And The Business Cycle Chart I-5Velocity Of Money Changes Over Time Velocity Of Money Changes Over Time Velocity Of Money Changes Over Time   Therefore, forecasting money growth is in and of itself insufficient to predict the business cycle. One also needs to consider changes in the velocity of money – i.e. the spending versus saving preferences of economic agents. How do interest rates impact money supply and the velocity of money? Low and falling interest rates boost demand for credit and lead to more loan origination, resulting in greater money supply. In addition, low interest rates encourage more spending versus savings. As a result, the velocity of money rises. Faster money growth accompanied by an acceleration in the velocity of money ensures more rapid nominal GDP growth.  Bottom Line: Money supply is liquidity available to economic agents to purchase goods and services as well as invest in both real and financial assets. However, knowing money supply’s future trajectory is insufficient to gauge the prospects for economic growth or direction of financial markets. Changes in the velocity of money are as important as those in money supply. Yet, forecasting changes in the velocity of money literally amounts to predicting the behavior of economic agents. Liquidity In Asset Markets Deposits/money supply can be used to acquire both financial and real assets as well as purchase goods and services. They could also be kept idle. In a given period of time, it is impossible to envisage what portion of deposits in the banking system will be allocated to securities investments. Ultimately, this decision rests with each individual and institution. There is no way to foresee both the amount of deposits that will be channeled to purchase financial assets as well as the velocity of these funds. Therefore, it is impossible to forecast the true size of liquidity overflow into and out of asset markets. Overall, gauging liquidity flows to asset markets boils down to predicting investors’ behavior. Liquidity flows into financial assets when “animal spirits” among investors improve, and vice versa. Please refer to Diagram I-1 on page 2 for a visual illustration. Many market participants monitor fund flows to gauge liquidity tides into and out of various asset classes. Nevertheless, there are some common problems with these fund-flow datasets. First, reported data on fund flows into an asset class or a region are often old news. The basis is that capital has already been allocated – i.e., transactions have already taken place, and asset prices already reflect these flows. In fact, fluctuations in asset prices are the best timely reflection of fund flows into a particular asset class. Second, to our knowledge, there is no comprehensive fund flows dataset that encompasses fund flows across all types of investors globally – including but not limited to all pension and sovereign funds, institutional money managers, wealth managers and family offices as well as hedge funds. Hence, existing fund flows datasets are incomplete.  Chinese broad money is larger than the sum of broad money in both the US and euro area. How do we deal with the lack of comprehensive fund flow data? Our framework is as follows: We assume that liquidity (money) will flow into/out of countries offering a superior/poor risk-reward profile, respectively. Our analysis of each asset class/country takes into consideration both the ability of this particular asset class/country to generate sustainable cash flows as well as valuations. Our underlying conjecture is that capital will ultimately flow into the areas that generate high or improving return on capital, and will flow out of segments that experience low or falling return on capital. Thereby, we try to predict whether capital will flow in or flow out based on these fundamentals, and position a portfolio accordingly. This approach assumes that global capital allocation in the medium to long term is efficient and rational – i.e., financial markets will reward good companies/countries and penalizes bad ones. Finally, we constantly monitor various liquidity proxies to make sense of marginal shifts in money supply as well as investors’ risk tolerance – the latter being a proxy for the velocity of money in the investment industry. Both are critical to gauging liquidity circulation in financial markets. Bottom Line: A large and expanding stock of money in and of itself does not guarantee plentiful liquidity for asset markets. Investors’ willingness to invest is required for money (liquidity) to flow into financial assets. In turn, deteriorating investor confidence can lead to a dearth of liquidity in asset markets, despite abundant broad money supply.  Key Questions And Summary What is the connection between interest rates and liquidity? Why do many investors use interest rates and liquidity inter-changeably? Low and/or declining interest rates entail rising odds that substantial liquidity will flow into various risk assets, and vice versa. This is why many commentators use interest rates as a proxy for liquidity for financial assets. Is there too much liquidity in the world? Apart from China, broad money supply has not expanded tremendously since 2009 (please refer to Chart I-3 on page 6). The QE efforts by central banks in advanced economies have significantly boosted bank reserves, but broad money supply has expanded relatively modestly.   In China, however, broad money supply in RMB has more than quadrupled to $33 trillion. In brief, China has a money bubble. Is there a shortage of financial assets relative to available liquidity? Yes. QE programs in advanced economies have removed high-quality financial assets – valued at about $9 trillion – from global markets (Chart I-6). Yet money supply has expanded. This has left money chasing few assets. Also, low policy rates reduce the opportunity cost of owning financial securities. These two phenomena have led investors to bid up prices of available financial assets. Consequently, high-quality financial assets have become expensive, and those that appear attractive are likely “cheap for a reason.” Does the Fed’s balance sheet expansion since September amount to additional QE and more liquidity provision for financial markets? There is a difference between a central bank’s balance sheet/assets and banks’ excess reserves. They are not always the same. For example, since September, the Fed has expanded its assets by about $400 billion but US banks’ excess reserves have risen by only $190 billion (Chart I-7, top panel). Chart I-6QE Removed $9 Trillion Worth Of Financial Assets From Global Markets QE Removed $9 Trillion Worth Of Financial Assets From Global Markets QE Removed $9 Trillion Worth Of Financial Assets From Global Markets Chart I-7Beware Of Difference Between Fed’s Assets And Excess Reserves Beware Of Difference Between Fed Assets And Excess Reserves Beware Of Difference Between Fed Assets And Excess Reserves   This discrepancy is largely due to the rise in the Treasury’s General Account (TGA) at the Fed. Since September, the US Treasury has shifted $200 billion of deposits from banks to its TGA at the Fed (Chart I-7, middle panel). By doing so, the Treasury has destroyed a similar amount of banks’ excess reserves. Overall, the net excess reserves injection by the Fed has been shallower than is generally perceived by looking at its balance sheet. A large and expanding stock of money in and of itself does not guarantee plentiful liquidity for asset markets. Is the Fed’s balance sheet expansion a reason behind strong US money growth since September? Not really. Most of the US money supply (deposits) is created by US banks – not the Fed. When banks originate a loan or purchase a security from a non-bank, they create a new deposit/money “out of thin air.” Not only has US banks’ loan origination growth been brisk, but they also have purchased a substantial amount of US Treasurys since late 2018 to meet Basel III liquidity requirements. These operations have created new money supply, as evidenced in Chart I-8.  Chart I-8US Commercial Bank Assets And Components US Commercial Bank Assets And Components US Commercial Bank Assets And Components In short, US money supply growth has been robust due to strong loan demand and the willingness of banks to lend as well as to their purchases of high-quality securities for regulatory reasons. The latter has depressed US government bond yields facilitating the rally in risk assets. Are fluctuations in global narrow and broad money reliable indicators for global share prices? Chart I-9 illustrates that both the global narrow and broad money impulses – their second derivatives – have some correlation with global share prices, but not a strong one. Chart I-9Global Money Impulse And Global Share Prices Global Money Impulse And Global Share Prices Global Money Impulse And Global Share Prices On the whole, banking system reserves, money supply and interest rates are important drivers of liquidity allocated to financial assets. Nevertheless, the amount of liquidity flowing into and out of financial assets is ultimately contingent on investor behavior. When investors are willing to invest, liquidity flows into asset markets. On the contrary, when investors turn cautious, they withhold liquidity and asset prices drop.    Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Footnotes 1     Commercial banks in this report are referred to as banks. 2     China’s broad money (M3) is calculated by BCA as the sum of deposits of non-financial institutions, households and other financial corporations at commercial banks; the calculation also includes commercial banks’ other liabilities as well as nonfinancial institutions’ deposits at PBoC but excludes commercial banks’ borrowing from the PBoC, interbank borrowing, foreign liabilities and bonds issued. Equities Recommendations Currencies, Credit And Fixed-Income Recommendations