Technology

Highlights The economic performance of Sweden, which did not have a lockdown, has been almost as bad as Denmark, which did have a lockdown. This proves that the current recession is not ‘man-made’, it is ‘pandemic-made’. While the pandemic remains in play, investors should maintain a defensive bias to their portfolios: favouring US T-bonds in bond portfolios, and technology and healthcare in equity portfolios. The technology sector has become defensive, largely because it has flipped from hardware dominance to software dominance. A new recommendation is to overweight technology-heavy Netherlands. Fractal trade: short AUD/CHF. Feature Chart I-IASweden: Avoiding A Lockdown Did Not Prevent A Slump In Consumption... Sweden: Avoiding A Lockdown Did Not Prevent A Slump In Consumption... Sweden: Avoiding A Lockdown Did Not Prevent A Slump In Consumption... Chart I-1B...But Led To Many More ##br##Infections ...But Led To Many More Infections ...But Led To Many More Infections Sweden and Denmark are neighbours. They speak near-identical languages and share a broadly similar culture and demographic. Yet the two countries have followed completely different strategies to halt the coronavirus pandemic. Sweden chose not to impose a lockdown. Instead, it opted for a ‘trust based’ approach, relying on its citizens to act sensibly and appropriately. Whereas Denmark imposed one of Europe’s earliest and most draconian lockdowns. The contrasting approaches of Sweden and neighbouring Denmark provide us with the closest thing to a controlled experiment on pandemic strategies. The Recession Is Not ‘Man-Made’, It Is ‘Pandemic-Made’ The surprising thing is that the economic performance of Sweden, which did not have a lockdown, has been almost as bad as Denmark, which did. This year, the unemployment rates in both economies have surged by 2 percentage points (albeit the latest data is for May in Sweden and April in Denmark). Furthermore, high-frequency measures of consumption show that Sweden suffered almost as severe a contraction as Denmark (Chart of the Week and Chart I-2). Chart I-2Unemployment Has Surged In Both No-Lockdown Sweden And Lockdown Denmark Unemployment Has Surged In Both No-Lockdown Sweden And Lockdown Denmark Unemployment Has Surged In Both No-Lockdown Sweden And Lockdown Denmark This surprising result challenges the popular view that this global recession is man-made. This view argues that without the government-imposed lockdowns, the global economy would not have entered a tailspin. But if this view is right, then why did consumption crash in Sweden? The simple answer is that in a pandemic, most people will change their behaviour to avoid catching the virus. The cautious behaviour is voluntary, irrespective of whether there is no lockdown, as in Sweden, or there is a lockdown, as in Denmark. People will shun public transport, shopping, and other crowded places, and even think twice about letting their children go to school. In a pandemic, the majority of people will change their behaviour even without a lockdown. But if the cautious behaviour is voluntary, then why impose a lockdown? The answer is that without a lockdown, the majority will behave sensibly to avoid catching the virus, but a minority will take a ‘devil may care’ attitude. In the pandemic, this is critical because less than 10 percent of infected people are responsible for creating 90 percent of all coronavirus infections. If this tiny minority of so-called ‘super-spreaders’ is left unchecked, then the pandemic will let rip. All of which brings us back to Sweden versus Denmark.  As a result of not imposing a mandatory lockdown to rein in its super-spreaders, Sweden now has one of the world’s worst coronavirus infection and mortality rates, four times higher than Denmark (Chart I-3, Chart I-4, Chart I-5). Chart I-3No-Lockdown Sweden Has Suffered Many More Deaths Than Lockdown Denmark No-Lockdown Sweden Has Suffered Many More Deaths Than Lockdown Denmark No-Lockdown Sweden Has Suffered Many More Deaths Than Lockdown Denmark Chart I-4Avoiding A Lockdown Meant More Infections… Who’s Right On The Pandemic – Sweden Or Denmark? Who’s Right On The Pandemic – Sweden Or Denmark? Chart I-5…And More ##br##Deaths Who’s Right On The Pandemic – Sweden Or Denmark? Who’s Right On The Pandemic – Sweden Or Denmark? Put simply, containing the pandemic depends on reining in a minority of super-spreaders. Which explains why no-lockdown Sweden suffered a much worse outbreak of the disease than lockdown Denmark. In contrast, the economy depends on the behaviour of the majority. In a pandemic the majority will voluntarily exercise caution. Which explains why no-lockdown Sweden and lockdown Denmark suffered similar contractions in consumption. Looking ahead, will the widespread adoption of face masks and plexiglass screens change the public’s cautious behaviour? To a certain extent, yes – it will permit essential activities and let people take calculated risks. That said, if you are forced to wear a mask on public transport and in the shops, and you have to spread out in restaurants while being served by a masked waiter, then – rightly or wrongly – you are getting a strong signal: the danger is still out there. Meaning that many people will continue to shun discretionary activities and spending. The upshot is that while the pandemic remains in play, investors should maintain a defensive bias to their portfolios. Explaining Why Technology Is Now Defensive A defensive bias to your portfolio now requires an exposure to technology – because in 2020 the tech sector is behaving like a classic defensive. Its relative performance is correlating positively with the bond price, like other classic defensive sectors such as healthcare (Chart I-6 and Chart I-7). Chart I-6In 2020, Tech Is Behaving Like A Defensive... In 2020, Tech Is Behaving Like A Defensive... In 2020, Tech Is Behaving Like A Defensive... Chart I-7...Like Healthcare ...Like Healthcare ...Like Healthcare The behaviour of the technology sector in the current recession contrasts with its performance in the global financial crisis of 2008. Back then, it behaved like a classic cyclical – its relative performance correlated negatively with the bond price (Chart I-8). Begging the question: why has the tech sector’s behaviour flipped from cyclical to defensive? Chart I-8In 2008, Tech Behaved Like A Cyclical In 2008, Tech Behaved Like A Cyclical In 2008, Tech Behaved Like A Cyclical The main reason is that the tech sector’s composition has flipped from hardware dominance to software dominance. In 2008, the sector market cap had a 65:35 tilt to technology hardware. But today, it is the mirror-image: a 65:35 tilt to computer and software services (Chart I-9). Chart I-9Tech Is More Defensive Now Because It Is Dominated By Software Tech Is More Defensive Now Because It Is Dominated By Software Tech Is More Defensive Now Because It Is Dominated By Software Computer and software services have many defensive characteristics suited to the current environment: For many companies, enterprise software is now business critical. It is a must-have rather than a like-to-have. Computer and software services use a subscription-based revenue model, minimising the dependency on discretionary spending. Computer and software services are helping firms to cut costs through automation and back-office efficiencies as well as facilitating the boom in ‘working from home’. The sector is cash rich. Despite these defensive characteristics, there remains a lingering worry: is the tech sector overvalued? The Rally In Growth Defensives Is Not A Mania  Some people fear that the recent run-up in stock markets does not make sense, other than as a ‘Robin Hood’ day-trader fuelled mania. After all, the pandemic is still very much in play, and so are other geopolitical risks, so how can some stock prices be near all-time highs? Yet the recent run-up in growth defensives such as tech and healthcare does make sense. Their valuations have moved in near-perfect lockstep with the bond yield, implying that the rally is based on fundamentals (Chart I-10). Chart I-10Tech And Healthcare Valuations Are Tracking The Bond Yield Tech And Healthcare Valuations Are Tracking The Bond Yield Tech And Healthcare Valuations Are Tracking The Bond Yield Simply put, if the 10-year T-bond is going to deliver a pitiful 0.7 percent a year over the next decade, then the prospective return from growth defensives must also compress. It would be absurd to expect these stocks to be priced for high single digit returns. Since late 2018, the decline in growth defensives’ forward earnings yield has broadly tracked the 250bps decline in the 10-year T-bond yield. Given that the forward earnings yield correlates well with the 10-year prospective return, the depressed bond yield is depressing the prospective return from growth defensives – as it should. Tech and healthcare valuations have moved in near-perfect lockstep with the bond yield. But with the pandemic and geopolitical risks menacing in the background, shouldn’t the gap between the prospective return on stocks and bonds – the equity risk premium – be larger? This is open to debate. When bond yields approach the lower bound, the appeal of owning bonds also diminishes because bond prices have limited upside. Nevertheless, the gap between the tech and healthcare forward earnings yield and the bond yield has gone up this year and is much larger than in 2018 (Chart I-11). This suggests that valuations are taking some account of the pandemic and other risks. Moreover, in a longer-term perspective the current gap between the tech and healthcare forward earnings yield and the bond yield, at +4 percent, hardly indicates a mania. In the true mania of 2000, the gap stood at -4 percent! (Chart I-12) Chart I-11The Equity Risk Premium Has Risen In 2020 The Equity Risk Premium Has Risen In 2020 The Equity Risk Premium Has Risen In 2020 Chart I-12Tech And Health Care Valuations Are Not In A Mania Tech And Health Care Valuations Are Not In A Mania Tech And Health Care Valuations Are Not In A Mania In summary, until the pandemic is conquered, investors should maintain a defensive bias to their portfolios. Bond investors should overweight US T-bonds versus core European bonds. Equity investors should overweight the growth defensives, technology and healthcare, which implies overweighting the technology-heavy US versus Europe. A new recommendation is to overweight technology-heavy Netherlands. Stay overweight healthcare-heavy Switzerland, and bank-light France and Germany (albeit expect a technical 5 percent underperformance of Germany versus the UK in the coming weeks). And stay underweight bank-heavy Austria. Fractal Trading System* The AUD is technically overbought and vulnerable to a tactical reversal. Accordingly, this week’s recommended trade is short AUD/CHF, with a profit target and symmetrical stop-loss set at 4.2 percent. The rolling 1-year win ratio now stands at 63 percent. Chart I-13AUD/CHF AUD/CHF AUD/CHF When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated  December 11, 2014, available at eis.bcaresearch.com.   Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading System   Cyclical Recommendations Structural Recommendations Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields   Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations  

China became the world’s number one source of Patent Cooperation Treaty (PCT) patent applications last year. China is the world’s innovation leader in such areas as digital communications, computer technology, audio-visual technology and telecommunications.

Highlights Treasuries: Keep portfolio duration close to benchmark on a 6-12 month horizon, but continue to hold tactical overlay positions that will profit from modestly higher bond yields: Overweight TIPS versus nominal Treasuries, hold duration-neutral nominal curve steepeners, hold real yield curve steepeners. IG Tech: Given our positive outlook for investment grade corporate bond spreads, the Technology sector’s high credit rating and defensive characteristics make it decidedly un-compelling. However, Tech spreads are attractive compared to other A-rated corporate bonds. HY Tech: We want to focus our high-yield allocation on defensive sectors where a large proportion of issuers are able to benefit from Fed support. The high-yield Technology sector checks both of those boxes and offers attractive risk-adjusted compensation to boot. Feature Chart 1Three Treasury Trades Three Treasury Trades Three Treasury Trades As we have previously written, bond yields should move modestly higher over the course of the summer as the US economy re-opens.1 However, there are enough potential medium-term pitfalls related to US politics and COVID transmission that we aren’t yet comfortable with below-benchmark portfolio duration. Instead, we recommend that investors keep portfolio duration close to benchmark on a 6-12 month horizon, but add three tactical overlay positions that will profit from higher bond yields: Overweight TIPS versus nominal Treasuries Duration-neutral nominal Treasury curve steepeners Real yield curve steepeners All three of these positions have performed well during the past couple of months (Chart 1), and in the first section of this report we assess whether they have further to run. The remaining two sections of this week’s report consider the outlooks for investment grade and high-yield Technology bonds, respectively. Three Trades To Profit From Higher Yields 1) Overweight TIPS Versus Nominals Chart 2Adaptive Expectations Model Adaptive Expectations Model Adaptive Expectations Model TIPS breakeven inflation rates have moved up considerably since mid-March. Back then, the 10-year TIPS breakeven rate troughed at 0.50%. It currently sits at 1.31%. Despite the large move, TIPS breakeven inflation rates still have a considerable amount of upside. One way to assess how much is through the lens of our Adaptive Expectations Model (Chart 2).2 This model considers several different measures of inflation expectations (based on realized CPI inflation and surveys) and uses the difference between those measures of inflation expectations and the 10-year TIPS breakeven inflation rate to forecast the future 12-month change in the 10-year TIPS breakeven. At present, the model forecasts that the 10-year TIPS breakeven inflation rate will rise 23 bps during the next 12 months, bringing it to 1.54%. It’s important to note that our model is biased towards measures of longer-run inflation expectations. As a result, it can be surprised from time to time by large fluctuations in drivers of short-term inflation expectations, like the oil price. This year’s massive drop in oil – and concurrent decline in headline inflation – were the main factors that caused the 10-year TIPS breakeven inflation rate to fall so far below our model’s fair value. However, as we discussed in last week’s report, the oil price looks to have troughed and there is preliminary evidence that we might also be past the lowest point for headline CPI.3 Profit from rising bond yields by entering a duration-neutral yield curve steepener. We see TIPS continuing to outperform nominal Treasuries over both short- and long-run horizons. 2) Duration-Neutral Yield Curve Steepeners Chart 3Stick With Steepeners Stick With Steepeners Stick With Steepeners Another way to profit from rising bond yields without taking a large duration bet is via a duration-neutral yield curve steepener. One example would be a long position in the 5-year note and a short position in a duration-matched barbell consisting of the 2-year and 10-year notes. Alternatively, you could use the 2-year note and 30-year bond as the two legs of the barbell. These sorts of duration-matched trades where you take a long position in a bullet maturity near the middle of the curve and go short the wings are designed to perform well in periods of yield curve steepening.4  In the current environment, where dovish Fed guidance has dampened volatility at the front-end of the yield curve, any bond sell-off will be felt disproportionately at the long-end, leading to a steeper curve. The only problem with this proposed trade is that it is no longer cheap. The spread between the 5-year bullet and 2/10 barbell is -6 bps and the spread relative to the 2/30 barbell is -3 bps (Chart 3). What’s more, the 5-year bullet trades expensive relative to the 2/10 and 2/30 barbells, according to our fair value models (Chart 3, bottom panel). However, for the time being we are inclined to overlook stretched valuations. The 5-year bullet does appear expensive but it has been more expensive in the past, most notably during the last zero-lower-bound episode from 2010 to 2013. Similar to then, the market is now priced for an extended period of a zero fed funds rate. We would not be surprised to see bullets become much more expensive in that sort of environment, and possibly even return to extended 2010-2013 valuations.   We recommend holding onto duration-neutral yield curve steepeners, despite unattractive valuations. Specifically, we favor going long the 5-year bullet and short a duration-matched 2/10 barbell. 3) Real Yield Curve Steepeners Chart 4Higher Inflation Means Steeper Real Yield Curve Higher Inflation Means Steeper Real Yield Curve Higher Inflation Means Steeper Real Yield Curve The final position we recommend is a steepener along the real yield curve. We first recommended this trade on April 28 when a plunge in oil (and spike in deflationary sentiment) caused the real 2-year yield to jump to 0.28% compared to a real 10-year yield of -0.70%.5 Since then, the real 2-year yield has collapsed to -1% compared to a real 10-year yield of -0.87%. Although the real 2-year/10-year slope is once again positive, it has typically been higher during the past few years (Chart 4). We therefore expect further steepening as long as the oil price and headline inflation continue to recover from April’s lows. Much like during the 2008/09 financial crisis, the combination of the Fed’s zero-lower-bound forward guidance and a massive drop in both oil and headline inflation caused short-dated real yields to jump. Subsequently, this led to a massive steepening of the real yield curve, once the oil price and headline inflation started to recover. We believe that same dynamic is playing out today. Investors should continue to hold real yield curve steepeners, at least until rebounding oil and headline CPI return short-dated inflation expectations to more reasonable levels. Investment Grade Tech Risk Profile Technology accounts for 9% of the overall Bloomberg Barclays investment grade corporate index, which makes it the second biggest industry group, after Banking. Its large index weight is due to the presence of three tech giants: Microsoft (Aaa-rated), Apple (Aa-rated) and Oracle (A-rated) which, combined, constitute 38% of the Tech sector.  Investment grade Technology is a highly defensive corporate bond sector. In sharp contrast with the equity market, Technology is a highly defensive corporate bond sector. That is, it tends to outperform the overall corporate bond index during periods of spread widening and underperform during periods of spread tightening. This largely comes down to the fact that Tech has a higher credit rating than the overall corporate index. Twenty five percent of the Tech sector’s market cap carries a Aaa or Aa rating compared to just 9% for the overall index (Chart 5). Further, of the high-flying FAANG stocks that garner a lot of attention from equity analysts, only Apple is a significant presence in the Technology bond index.6 Chart 5Investment Grade Credit Rating Distributions* Take A Look At High-Yield Technology Bonds Take A Look At High-Yield Technology Bonds Chart 6IG Technology Risk ##br##Profile IG Technology Risk Profile IG Technology Risk Profile The Tech sector’s defensive nature is confirmed by looking at its duration-times-spread (DTS) ratio and historical excess returns (Chart 6).7 The sector’s DTS ratio is consistently below 1.0, and its excess returns show a clear pattern of outperformance during periods of spread widening and underperformance during periods of spread tightening. Valuation In terms of valuation, although the Tech sector does not offer a spread advantage over the corporate index – which should be expected given its higher credit rating – we find that it trades cheap relative to its comparable credit tier (Table 1). Tech offers an option-adjusted spread of 115 bps versus 111 bps for the A-rated corporate index, and the sector still appears attractive after controlling for duration differences by looking at the 12-month breakeven spread. In absolute terms, Tech sector spreads are just above their median since 2010. The A-rated corporate index spread currently sits right on top of its post-2010 median. Table 1IG Technology Valuation Take A Look At High-Yield Technology Bonds Take A Look At High-Yield Technology Bonds Balance Sheet Health Chart 7IG Technology Debt Growth IG Technology Debt Growth IG Technology Debt Growth The Technology sector added a large amount of debt during the last recovery. The par value of the Tech index’s outstanding debt has grown 5.2 times since 2010 compared to 2.4 times for the benchmark. As a result, Tech’s weight in the corporate index has more than doubled, from 4% to 9% (Chart 7). However, earnings have done a pretty good job of keeping pace with the large increase in debt. The market cap-weighted net debt-to-EBITDA ratio for the investment grade Tech index is only 2.4, and the sector’s average credit rating has been stable since 2010. At the individual issuer level, there are 58 issuers in the Tech index and only 4 currently have a negative ratings outlook from Moody’s (Appendix B). What’s more, of the 16 Tech sector ratings that Moody’s has reviewed this year, 12 have been affirmed with a stable outlook, 1 was assigned a positive outlook and only 3 were assigned negative outlooks. Macro Considerations Chart 8Technology Sector Macro Drivers Technology Sector Macro Drivers Technology Sector Macro Drivers The Tech sector can be split into three major segments that have distinct macro drivers: Software (26% of Tech index market cap, includes Microsoft and Oracle) Hardware (29% of Tech index market cap, includes Apple, IBM and Dell) Semiconductors (24% of Tech index market cap, includes Intel and Avago Technologies) Software investment has been in a structural bull market for many years, and should remain resilient during the COVID recession as demand for remote working solutions increases. While we only have data through the end of March, software investment did not see the same collapse as other sectors during the first quarter (Chart 8). The Hardware and Semiconductor segments are more cyclical and geared toward manufacturing. As such, their macro outlooks were already challenged pre-COVID, due to the US/China trade war and manufacturing downturn of 2019. Both US computer exports and global semiconductor sales were showing signs of life near the end of last year, but were decimated when the pandemic struck in 2020 (Chart 8, panels 3 & 4). A revival in this space is contingent upon continued gradual re-opening and a return to economic growth. More optimistically, US consumer spending on personal computers and peripheral equipment has not fallen as much as broad consumer spending during the past few months (Chart 8, bottom panel). In the long-run, the 5G smartphone rollout is a significant structural tailwind for both semiconductor issuers and Apple. Meanwhile, the threat of significant regulatory crackdown on Tech firms remains a long-run risk. Our sense is that any push toward stricter regulations won’t have that much impact on Technology bond returns. This is because the subjects of most lawmaker scrutiny – Facebook, Amazon and Google – are largely absent from the Bloomberg Barclays Tech index. Investment Conclusions We expect that investment grade corporate bond spreads will tighten during the next 6-12 months. Against this positive back-drop, investors should focus exposure on cyclical (lower-rated) sectors that offer greater expected returns. With that in mind, the Tech sector’s high credit rating and defensive characteristics make it decidedly un-compelling. However, Tech does offer a slight spread advantage compared to other A-rated bonds and the macro back-drop is reasonably supportive. We would therefore recommend Tech bonds to investors looking for some A-rated corporate bond exposure. But in general, we prefer the greater spreads on offer from sectors that occupy the high-quality Baa space, such as subordinate bank debt.8 High-Yield Tech Risk Profile High-Yield Technology’s credit rating profile is similar to that of the overall benchmark, but with a slightly larger presence of low-rated (Caa & below) issuers (Chart 9). The largest issuers in the space are Dell (5.7% of Tech index market cap, Ba-rated), MSCI Inc. (5.1% of Tech index market cap, Ba-rated, see copyright declaration) and CommScope (8.1% of Tech index market cap, B-rated). High-yield Tech recently transitioned from being a cyclical sector to a defensive one. Interestingly, the high-yield Tech sector recently transitioned from being a cyclical sector to a defensive one. The sector behaved cyclically during the 2008 recession, underperforming the index when spreads widened and outperforming when they tightened. But Tech then outperformed the High-Yield index during the spread widening episodes of 2015 and 2020. Based on the sector’s low DTS ratio, this defensive behavior should persist for the next 12 months (Chart 10). Chart 9High-Yield Credit Rating Distributions* Take A Look At High-Yield Technology Bonds Take A Look At High-Yield Technology Bonds Chart 10HY Technology Risk Profile HY Technology Risk Profile HY Technology Risk Profile Valuation The High-Yield Technology option-adjusted spread (OAS) is significantly lower than the average OAS for the benchmark High-Yield index. However, it offers a spread premium compared to other Ba-rated issuers (Table 2). Adjusting for duration differences by looking at the 12-month breakeven spread makes high-yield Tech look significantly more attractive. The high-yield Tech spread would have to widen by 146 bps for the sector to underperform duration-matched Treasuries during the next 12 months. This compares to 96 bps for other Ba-rated issuers and 152 bps for the overall junk index. Table 2HY Technology Valuation Take A Look At High-Yield Technology Bonds Take A Look At High-Yield Technology Bonds It is apparent that the Tech sector’s low average duration (Chart 10, bottom panel) is a major reason for its relatively tight OAS. On a risk-adjusted basis, high-yield Tech valuation actually appears quite compelling, with a 12-month breakeven spread only 6 bps below that of the overall index. Balance Sheet Health Chart 11HY Technology Debt Growth HY Technology Debt Growth HY Technology Debt Growth The amount of outstanding high-yield Technology debt has grown a bit more rapidly than overall junk index debt since 2010 (Chart 11). As a result, Technology’s weight in the index has increased from 5% in 2010 to 6% today. At the issuer level, the Tech sector should benefit from having a large number of issuers that will be able to take advantage of the Fed’s Main Street Lending facilities. To be eligible for the Main Street facilities, issuers must have less than 15000 employees or less than $5 billion in 2019 revenue. Also, the issuers must be able to keep their Debt-to-EBITDA ratios below 6.0, including any new debt added through the Main Street programs. Of the 43 high-yield Tech issuers with available data, we estimate that 30 are eligible to receive support from the Main Street facilities (Appendix C). This even includes 11 out of the 16 B-rated issuers. Typically, we don’t expect that many B-rated issuers will be eligible for the Main Street facilities, which makes this result encouraging for Tech sector spreads. Investment Conclusions We recommend an overweight allocation to high-yield Technology bonds. As we wrote last week, high-yield spreads appear too tight if we ignore the impact of the Fed’s emergency lending facilities and consider only the fundamental credit back-drop.9 With that in mind, we want to focus our high-yield allocation on defensive sectors where a large proportion of issuers able to benefit from Fed support. The Technology sector checks both of those boxes and offers attractive risk-adjusted compensation to boot. Appendix A: Buy What The Fed Is Buying The Fed rolled out a number of aggressive lending facilities on March 23. These facilities focused on different specific sectors of the US bond market. The fact that the Fed has decided to support some parts of the market and not others has caused some traditional bond market correlations to break down. It has also led us to adopt of a strategy of “Buy What The Fed Is Buying”. That is, we favor those sectors that offer attractive spreads and that benefit from Fed support. The below Table tracks the performance of different bond sectors since the March 23 announcement. We will use this to monitor bond market correlations and evaluate our strategy’s success. Table 3Performance Since March 23 Announcement Of Emergency Fed Facilities Take A Look At High-Yield Technology Bonds Take A Look At High-Yield Technology Bonds Appendix B Table 4Investment Grade Technology Issuers Take A Look At High-Yield Technology Bonds Take A Look At High-Yield Technology Bonds Appendix C Table 5High-Yield Technology Issuers Take A Look At High-Yield Technology Bonds Take A Look At High-Yield Technology Bonds   Ryan Swift US Bond Strategist rswift@bcaresearch.com Jeremie Peloso Senior Analyst jeremiep@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “Bonds Vulnerable As North America Re-Opens”, dated May 26, 2020, available at usbs.bcaresearch.com 2 For more details on our Adaptive Expectations Model please see US Bond Strategy Weekly Report, “How Are Inflation Expectations Adapting?”, dated February 11, 2020, available at usbs.bcaresearch.com 3 Please see US Bond Strategy Weekly Report, “No Holding Back”, dated June 16, 2020, available at usbs.bcaresearch.com 4 For an explanation of why this works please see US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com 5 Please see US Bond Strategy Weekly Report, “Negative Oil, The Zero Lower Bound And The Fisher Equation”, dated April 28, 2020, available at usbs.bcaresearch.com 6 Of the other FAANG stocks: Google accounts for just 0.5% of Tech bond sector market cap, Facebook has close to no debt, Amazon is included in the Consumer Cyclical corporate bond index and Netflix is included in the Media: Entertainment sector of the High-Yield index. 7 Duration-Times-Spread (DTS) is a simple measure that is highly correlated with excess return volatility for corporate bonds. The DTS ratio is the ratio of a sector’s DTS to that of the benchmark index. It can be thought of like the beta of a stock. A DTS ratio above 1.0 signals that the sector is cyclical (or “high beta”), a DTS ratio below 1.0 signals that the sector is defensive or (“low beta”). For more details on the DTS measure please see: Arik Ben Dor, Lev Dynkin, Jay Hyman, Patrick Houweling, Erik van Leeuwen & Olaf Penninga, “DTS (Duration-Times-Spread)”, Journal of Portfolio Management 33(2), January 2007. 8 For more details on our recommendation to overweight subordinate bank bonds please see US Bond Strategy Weekly Report, “Negative Oil, The Zero Lower Bound And The Fisher Equation”, dated April 28, 2020, available at usbs.bcaresearch.com 9 Please see US Bond Strategy Weekly Report, “No Holding Back”, dated June 16, 2020, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

The Fed’s efforts to jawbone the US dollar are paying off as investors have been shedding their greenback exposure over the past several weeks. In recent research,1 we have also been highlighting that although Powell would never admit it, the Fed is trying to devalue the greenback and reflate the global economy. The knock-on effect of a depreciating USD is to rekindle S&P sales. According to S&P Dow Jones Indices,2 the SPX derives approximately 43% of its sales from abroad making the US dollar among the key macro profitability drivers (Chart 1, middle panel, US dollar shown advanced and inverted). One of the mechanisms to undermine the greenback is to flood the market with dollars. Ample US dollar based liquidity has historically served as a catalyst to reignite global growth and consequently S&P earnings (Chart 1, bottom panel). Chart 1US Dollar - The Key Driver US Dollar - The Key Driver US Dollar - The Key Driver Chart 2Bearish Across All Timeframes Bearish Across All Timeframes Bearish Across All Timeframes The Dollar: A Bearish Case The fate of the US dollar is yet to be sealed, but piling evidence suggests that the path of least resistance will be lower. Looking at structural (five years+) dynamics, swelling twin deficits emit a bearish USD signal. In more detail, prior to COVID-19 outbreak, the US twin deficits were estimated to gradually rise towards the 7.5% mark (Chart 2, top panel, dotted red line), but now the US Congressional Budget Office (CBO) estimates3 that the US fiscal deficit alone will be approximately 11% of nominal GDP for 2020. In other words, the recent pandemic has exacerbated already structurally bearish dynamics for the US dollar. Switching gears from a structural to a medium term horizon (2-3 years), BCA’s four-factor macro model, is sending an unambiguous bearish message regarding the greenback’s fate (Chart 2, middle panel). Finally, on a short-term time horizon, the USD is lagging the money multiplier by approximately 3 months. The COVID-19 induced recession and resulting money printing will likely exert extreme downward pressure on the US dollar (Chart 2, bottom panel). Summarizing, when looking across three different time horizons, the evidence is pointing toward a weakening US dollar for the foreseeable future. SPX Sectors And US Dollar Correlations With a rising probability of a US dollar bear market on the horizon, it pays to look back in time and examine which S&P GICS1 sectors benefited from a depreciating US dollar. The purpose of this Special Report is to shed light on the empirical evidence of SPX sectors and USD correlations and serve as a roadmap of sector winners and losers during USD bear markets. Table 1 provides foreign sales exposure for each of the sectors. All else equal, a falling greenback should be synonymous with technology, materials, and energy sectors outperforming as they are the most internationally exposed sectors. In contrast, should the USD change its course and head north, financials, telecom, REITs, and utilities will be the key beneficiaries. Why? Because most of these industries are landlocked in the US and thus in a relative sense should benefit when the US dollar roars. Table 1S&P 500 GICS1 Foreign Sales As A Percent Of Total Sales* US Dollar Bear Market: What To Buy & What To Sell US Dollar Bear Market: What To Buy & What To Sell To confirm the above hypothesis, we have identified three previous US dollar bear markets (Chart 3) and computed GICS1-level sector relative returns (Table 2). Chart 3US Dollar Bear Markets US Dollar Bear Markets US Dollar Bear Markets Table 2S&P 500 Gics1 Returns* During US Dollar Bear Markets US Dollar Bear Market: What To Buy & What To Sell US Dollar Bear Market: What To Buy & What To Sell Looking at median return profile reveals that our hypothesis held as all three: technology, materials, and energy decisively outperformed the market when the US dollar headed south. Similarly, domestically focused and predominately defensive industries such as utilities and telecoms underperformed the market with the consumer staples sector being a notable outlier – something that we address in the consumer staples section of the report. What follows next is a detailed discussion on each of the GICS1 sectors historical relationship with the US dollar, ranked in order of foreign sales exposure from highest to lowest. For completion purposes, we also provided S&P 500 GICS1 relative sector performance against the US dollar charts since 1970 in the Appendix.     Arseniy Urazov Research Associate arseniyu@bcaresearch.com   Technology (Neutral)  Technology sits atop the foreign sales exposure table garnering 58% of revenues from abroad, which is a full 15% percentage points higher than S&P 500 (Table 1). In two out of the three periods of USD bear markets that we examined, tech stocks bested the broad market and the median outperformance sat over 9%. Nevertheless, the correlation between the US dollar and relative share prices is muted over a longer-term horizon (see Appendix Chart A1 below). Likely, one reason for the inconclusive long-term correlation between tech and the greenback is that the majority of tech gadgets are manufactured overseas (Chart 4, third panel). Therefore, an appreciating currency boosts margins via deflating input costs. Tack on the resilient nature of demand for tech hardware goods and especially software and services which preserves high selling prices and offsets and negative P&L losses from a rising greenback. We are currently neutral the S&P technology sector and employ a barbell portfolio approach preferring software and services and avoiding hardware and equipment. Chart 4Technology Technology Technology Materials (Neutral) The materials sector behaves similarly to its brother the energy sector as both move in the opposite direction of the greenback (Chart 5, top panel). Consequently, materials stocks have outperformed the market during periods of US dollar weakness that we analyzed. The third panel of Chart 5 shows that our materials exports proxy is the flip image of the greenback. This tight inverse relationship is exacerbated by the negative impact of a firming dollar on underlying metals commodity prices (Chart 5, second panel). As a result, materials profit margins widen when the dollar falls and narrow when it rises. Ultimately, S&P materials earnings reflect this USD-commodity dynamic (Chart 5, bottom panel) We are currently neutral the S&P materials index. Chart 5Materials Materials Materials Energy (Overweight) The energy sector enjoys a tight inverse correlation with the US dollar (Chart 6, top panel) as it is the third most globally exposed sector as shown in Table 1 with 51% of sales coming from abroad. As nearly all of the global oil trade is conducted in US dollars, a weakening USD underpins the price of crude oil (Chart 6, second panel). In turn, US energy sector exports rise reflecting the fall in the greenback (Chart 6, third panel). Finally, the S&P energy companies enjoy a boost to their income statements (Chart 6, bottom panel), which explains the sizable median sector outperformance of 43% during dollar bear markets as highlighted in Table 2. We are currently overweight the S&P energy sector and have recently capitalized on 40%+ combined gains in the long XOP/short GDX pair trades.4 Chart 6Energy Energy Energy Industrials (Overweight) US industrials stocks’ foreign sales exposure is on a par with the S&P 500, which explains why the sector only barely outperformed the broad market during periods of dollar weakness. Still, the correlation between this manufacturing-heavy sector and the greenback is negative (Chart 7, top & second panels). Similar to its deep cyclical brethren (materials and energy), the link comes via the commodity channel. A softening dollar boosts global growth, which in turn supports higher commodity prices. Not only do US capital goods producers benefit from overall rising demand (i.e. infrastructure spending), but also via market share gains in global markets as the falling greenback results in a comparative input cost advantage (Chart 7, third panel). Finally, P&L translation gain effects act as another fillip to industrials stocks profits when dollar heads south. We are currently overweight the S&P industrials index. Chart 7Industrials Industrials Industrials Health Care (Overweight) The defensive health care sector is positively correlated with the dollar as its foreign sales revenues are below the ones of the SPX (Chart 8, top panel). Moreover, empirical evidence suggests that the relationship between the sector’s exports and the USD has been mostly positive, which is counterintuitive (Chart 8, middle panel). Keep in mind that pharma and biotech represent roughly half the index and derive 75%+ of their profits domestically as they dictate pricing terms to the US government (it is written into law). This is not the case in Europe where the NHS and the German government for example, have a big say on what pharmaceuticals can charge for their drugs. The bottom panel of Chart 8 summarizes the domestic nature of the health care sector, highlighting the tight positive relationship between the sector’s earnings and the greenback. We are currently modestly overweight the S&P health care sector. Chart 8Health Care Health Care Health Care Consumer Discretionary (Overweight) While the impact of the US dollar on the consumer discretionary sector varied over time switching from a positive to a negative and vice versa, today the sector enjoys a positive correlation with the currency (Chart 9, top panel). The 33% foreign sales exposure may appear as a significant proportion, but it is still a full 10% percentage points below the SPX (Table 1). The implication is that even though the exports benefit from a falling dollar (Chart 9, middle panel), this bump is not enough to drive sector outperformance. Likely, the key reason why consumer discretionary stocks currently enjoy a positive correlation with the dollar is the US large trade deficit. In other words, the US imports the lion’s share of its consumer goods. As the dollar grinds higher, the cost of imports decreases for the US consumer, which provides a boost to companies’ earnings (Chart 9, bottom panel). Tack on the heavy weight AMZN has in the sector (comprising 40% of consumer discretionary sector market cap) and the positive correlation with the currency is explained away. We are currently overweight the S&P consumer discretionary index. Chart 9Consumer Discretionary Consumer Discretionary Consumer Discretionary Consumer Staples (Neutral) While a softening US dollar generally favors cyclical industries as it reignites global trade, the defensive S&P consumer staples sector outperformed the overall market on a median basis during USD bear markets (Table 2). Granted, the results are likely skewed as staples stocks rallied more than 300% in the last two decades of the 20th century. Nevertheless, there is a key differentiating factor at play that helped the consumer staples sector trounce other defensive industries during US dollar bear markets. Staples stocks derive 33% (Table 1) of their sales from abroad, whereas other traditional defensive industries (utilities, telecom services) have virtually no export exposure. In other words, given that staples companies are mostly manufacturers, a depreciating currency acts as a tonic to sales via the export relief valve (Chart 10, bottom panel). We are currently neutral the S&P consumer staples sector. Chart 10Consumer Staples Consumer Staples Consumer Staples Financials (Overweight) Financials sit at the bottom half of our Table 1 in terms of their foreign sales exposure, which underpins the sector’s positive correlation with the greenback (Chart 11, top panel), and explains why the sector underperforms the market during dollar bear markets. One of the transmission channels between this sector’s performance and the currency is via increased credit demand. Currency appreciation suppresses inflation and supports purchasing power, and thus loan demand, in addition to keeping bond yields low (Chart 11, middle panel). The process reverses as the US dollar stars to depreciate. We are currently overweight the S&P financials index. Chart 11Financials Financials Financials Utilities (Underweight) Utilities underperformed in all three dollar bear markets we analyzed. As we highlighted in the energy section of the report, a softening dollar is synonymous with higher crude oil prices, which in turn raise inflation expectations. The ensuing selloff in the 10-year Treasury, compels investors to shed this bond proxy equity sector (Chart 12, middle panel). With virtually no exports, utilities also miss on the positive currency translation effects that other GICS1 sectors enjoy. In fact, utilities underperformed by the widest margin on a median basis across all GICS1 sectors (Table 2). This defensive sector typically attracts safe haven flows when the dollar spikes and investors run for cover. This positive correlation with the dollar is clearly reflected in industry earnings, which rise and fall in lockstep with momentum in the greenback (Chart 12, bottom panel). We are currently underweight the S&P utilities sector. Chart 12Utilities Utilities Utilities Telecommunication Services (Neutral) Telecom services relative performance is positively correlated with the dollar, similarly to its defensive sibling, the utilities sector. In fact, telecom carriers go neck-in-neck with utilities as the former is the second worst performing sector during dollar bear markets (Table 2). A softening dollar has proven to be fatal to the industry’s relative pricing power beyond intra industry competition. In fact, industry selling prices are slated to head south anew if history at least rhymes (Chart 13, middle panel). Importantly, this defensive sector is in a structural downtrend and is trying to stay relevant and avoid becoming a “dumb pipeline” with the eventual proliferation of 5G. Worrisomely, telecoms only manage to claw back some of their severe losses during recessions. But, the latest iteration is an aberration as this safe haven sector has failed to stand up to its defensive stature likely owing to the heavy debt load. We are currently neutral the niche S&P telecom services index that now hides underneath the S&P communication services sector. Chart 13Telecom Services Telecom Services Telecom Services REITs (Underweight) Surprisingly, US REITs enjoy an overall negative correlation with the dollar, especially since 1993, and in fact lead the greenback by about 18 months (Chart 14). Our hypothesis would have been a positive correlation courtesy of the landlocked nature of this sector i.e. no export exposure. Granted, in the three periods of dollar bear markets we examined, REITs slightly outperformed the market by 2.5% on a median basis. While the causal link (if any) is yet to be established and the correlation may be spurious, our sense is that forward interest rate differentials are at work and more than offset the domestic nature of this index. REITs have a high dividend yield and thus outperform when the competing risk free asset the 10-year Treasury yield is falling and vice versa (except during recessions). As a result, REITs outperformance is more often than not synonymous with a depreciating currency as lower Treasury yields would exert downward pressure on the USD ceteris paribus.  We are currently underweight the S&P REITs index. Chart 14REITs REITs REITs   Appendix Chart A1Appendix: Technology Appendix: Technology Appendix: Technology Chart A2Appendix: Materials Appendix: Materials Appendix: Materials Chart A3Appendix: Energy Appendix: Energy Appendix: Energy Chart A4Appendix: Industrials Appendix: Industrials Appendix: Industrials Chart A5Appendix: Health Care Appendix: Health Care Appendix: Health Care Chart A6Appendix: Consumer Discretionary Appendix: Consumer Discretionary Appendix: Consumer Discretionary Chart A7Appendix: Consumer Staples Appendix: Consumer Staples Appendix: Consumer Staples Chart A8Appendix: Financials Appendix: Financials Appendix: Financials Chart A9Appendix: Utilities Appendix: Utilities Appendix: Utilities Chart A10Appendix: Telecommunication Services Appendix: Telecommunication Services Appendix: Telecommunication Services Chart A11 landscapeAppendix: REITs Appendix: REITs Appendix: REITs   Footnotes 1    Please see BCA US Equity Strategy Weekly Report, “The Bottomless Punchbowl” dated May 11, 2020, available at uses.bcaresearch.com. 2    https://us.spindices.com/indexology/djia-and-sp-500/sp-500-global-sales 3    https://www.cbo.gov/system/files/2020-05/56351-CBO-interim-projections.pdf 4    Please see BCA US Equity Strategy Weekly Report, “Gauging Fair Value” dated April 27, 2020, available at uses.bcaresearch.com.  

Software: The Crown Jewel Software: The Crown Jewel Overweight While we are neutral the S&P tech sector, we continue to employ a defensive over aggressive tech strategy and prefer software and services to hardware and equipment. The S&P software index in particular has proven its resilience during the COVID-19 sell-off and recovery and has now broken out to fresh all-time highs both in absolute and relative terms. Upbeat profit fundamentals underpin software buoyancy. Relative capex spending remains in a secular uptrend, spring-boarding the share price ratio. Our relative macro earnings growth model is also gaining steam highlighting that the earnings driven outperformance phase has staying power. Bottom Line: Stay overweight the S&P software index.  

Highlights Social distancing must persist to prevent dangerous super-spreading of COVID-19. The jobs recovery will be much weaker than the output recovery, because the sectors most hurt by social distancing have a very high labour intensity. This will force a prolonged period of ultra-accommodative monetary policy… …structurally favour T-bonds and Bonos over Bunds and OATs… …growth defensives such as tech and healthcare… …and the S&P 500 over the Euro Stoxx 50. Stay overweight Animal Care (PAWZ). Working from home has generated a puppy boom. Fractal trade: short gold, long lead. Feature As economies reopen, economists and strategists are quibbling about the shape of the output recovery: U, V, W, square root, or even ‘swoosh’. But for the furloughed or displaced worker, the more urgent question is, what will be the shape of the jobs recovery? Unfortunately, the jobs recovery will be much weaker than the output recovery – because the sectors most hurt by social distancing have a very high labour intensity (Chart Of The Week). Chart Of The Week 1ALeisure And Hospitality Makes A Large Contribution To Jobs Relative To Output A Jobless V-Shape Recovery, And A Puppy Boom A Jobless V-Shape Recovery, And A Puppy Boom Chart Of The Week 1BFinance Makes A Small Contribution To Jobs Relative To Output A Jobless V-Shape Recovery, And A Puppy Boom A Jobless V-Shape Recovery, And A Puppy Boom Output Might Snap Back, But Jobs Will Not The sectors most hurt by social distancing make a huge contribution to employment but a much smaller contribution to economic output. This is true for Europe and all advanced economies, though the following uses US data given its superior granularity and timeliness. The leisure and hospitality sector generates 11 percent of jobs, but just 4 percent of output. Retail trade generates 10 percent of jobs, but just 5 percent of output. It follows that if both sectors are operating at half their pre-coronavirus capacity, output will be down by 4.5 percent, but employment will collapse by 10.5 percent. Conversely, sectors which are relatively unaffected by social distancing make a small contribution to employment but a much bigger contribution to economic output. Financial activities generate just 6 percent of jobs, but 19 percent of economic output. Information technology generates just 2 percent of jobs, but 5 percent of output (Table I-1). Table I-1Sectors Hurt By Social Distancing Have A Very High Labour Intensity A Jobless V-Shape Recovery, And A Puppy Boom A Jobless V-Shape Recovery, And A Puppy Boom If economies are reopened but social distancing persists – either via government policy or personal choice – then output can rebound in a V-shape, but employment cannot (Chart I-2). Forcing a prolonged period of ultra-accommodative monetary policy, with all its ramifications for financial markets. Chart I-2UK Unemployment Is Set To Surge If The US Is Any Guide UK Unemployment Is Set To Surge If The US Is Any Guide UK Unemployment Is Set To Surge If The US Is Any Guide This raises a key question. Must social distancing persist? To answer, we need to pull together our latest understanding of COVID-19. COVID-19: What We Know So Far Many people argue that coronavirus fears are disproportionate. The mortality rate seems comfortingly low, at well below 0.5 percent (Chart 3). Yet this argument misses the point. Chart I-3The COVID-19 Mortality Rate Is Not High A Jobless V-Shape Recovery, And A Puppy Boom A Jobless V-Shape Recovery, And A Puppy Boom COVID-19 is dangerous not because it kills, but because it makes a lot of people seriously ill. It has a low mortality rate, but a high morbidity rate. According to the World Health Organisation, around one in six that gets infected “develops difficulty in breathing”. Moreover, The Lancet points out that many recovered COVID-19 patients suffer pulmonary fibrosis, a permanent scarring of the lungs that impairs their breathing for the rest of their lives. Hence, while COVID-19 is highly unlikely to kill you, it could damage your health forever1 (Figure I-1). Figure 1COVID-19 Is Unlikely To Kill You, But It Could Permanently Damage Your Lungs A Jobless V-Shape Recovery, And A Puppy Boom A Jobless V-Shape Recovery, And A Puppy Boom The most famous COVID-19 victim to date is British Prime Minister Boris Johnson who spent several days recovering in intensive care. By his own admission, Johnson’s only pre-existing conditions are that he is overweight and “drinks an awful lot”. But those pre-existing conditions could apply to a large swathe of the population. COVID-19 is virulent. But we now know that most infections are the result of so-called ‘super-spreaders’ – a small minority of virus carriers who infect tens or hundreds of other people. We also know that talking loudly, singing, or chanting tends to eject higher doses of the virus, and in an aerosol form that can linger in enclosed spaces. This creates the perfect conditions for one infected person to infect scores of others very quickly.  Based on this latest knowledge, the good news is that economies can reopen. The bad news is that, until an effective vaccine is developed, social distancing must persist. Specifically, people must avoid forming the crowds, congregations, and loud gatherings that can generate very dangerous super-spreading events. Hence, the sectors that are most hurt by social distancing – leisure and hospitality and retail trade – will continue to operate well below capacity for many months, at a minimum. And as these sectors have a very high labour intensity, there will be no V-shape recovery in jobs. Without Higher Bond Yields, European Equities Struggle To Outperform Social distancing is set to persist, which will create heaps of slack in advanced economy labour markets. This will force central banks to push the monetary easing ‘pedal to the metal’ – though in many cases, the pedal is already at the metal. In turn, this will force bond yields to stay ultra-low and, where they can, go even lower. One immediate takeaway is to stay overweight positively yielding US T-bonds and Spanish Bonos versus negatively yielding German Bunds and French OATs. Depressed bond yields must also compress the discount rate on competing long-duration investments that generate safely growing cashflows. Meaning, growth defensive equities such as technology and healthcare. Now comes the part that is conceptually difficult to grasp because it is novel to this unprecedented era of ultra-low bond yields. Take some time to absorb the following few paragraphs. For growth defensives, both components of the discount rate – the bond yield and the equity risk premium (ERP) – compress together. This is because the ERP is a tight function of the difference in equity and bond price ‘negative asymmetries’, defined as the potential price downside versus upside. When bond yields converge to their lower limit, bond prices converge to their upper limit, which increases the potential price downside versus upside. The result is that the difference in equity and bond negative asymmetries converges to zero, forcing the ERP to converge to zero. As the discount rate on growth defensives such as tech and healthcare collapses towards zero, the net present value must increase exponentially. This exponentially higher valuation of tech and healthcare is a mathematical consequence of the novel risk relationship between growth defensive equities and bonds at ultra-low bond yields. The unprecedented phenomenon has a major implication for European equity relative performance. The Euro Stoxx 50 is heavily underweight technology and healthcare, and this defining sector fingerprint is the key structural driver of European equity market relative performance (Chart I-4). Meanwhile, the relative performance of technology and healthcare is just an inverse exponential function of the bond yield (Chart I-5). The upshot is that European equities tend to outperform other regions only when bond yields are heading higher and the growth defensives are underperforming (Chart I-6). Chart I-4The Euro Stoxx 50's Underweight In Tech Drives Its Relative Performance The Euro Stoxx 50's Underweight In Tech Drives Its Relative Performance The Euro Stoxx 50's Underweight In Tech Drives Its Relative Performance Chart I-5Tech Outperforms When The Bond Yield Declines... Tech Outperforms When The Bond Yield Declines... Tech Outperforms When The Bond Yield Declines... Chart I-6...Hence, Without Higher Bond Yields The Euro Stoxx 50 Struggles To Outperform ...Hence, Without Higher Bond Yields The Euro Stoxx 50 Struggles To Outperform ...Hence, Without Higher Bond Yields The Euro Stoxx 50 Struggles To Outperform Some commentators are calling the higher valuations in tech and healthcare a new bubble. But it is a bubble only to the extent that bond yields are in a ‘negative bubble’, meaning that ultra-low yields are unsustainable. However, with social distancing set to leave heaps of slack in the advanced economy labour markets, ultra-low bond yields are here to stay and could go even lower. Moreover, as shown earlier, tech and healthcare demand and output are immune to social distancing. They may even benefit from social distancing. Hence, on a one-year horizon and beyond, stay overweight the growth defensive tech and healthcare sectors. And stay overweight the tech and healthcare heavy S&P 500 versus Euro Stoxx 50. A Puppy Boom We finish on a very positive note for animal lovers. The shift to working from home has generated a puppy boom. The Association of German Dogs claims that “the demand for puppies is endless” and the UK Kennel Club says that “there is unprecedented demand.” In the era of social distancing, the waiting list for puppies has quadrupled, and prices of easy to look after crossbreeds such as cockapoos have more than doubled. The demand for pet food and equipment is also very strong. Dogs make excellent companions for the socially isolated, which describes how many people are now feeling. Furthermore, with millions of people now working from home or on extended furlough, a growing number of households can fulfil the dream of owning a dog. We have recommended a structural overweight to the Animal Care sector based on the ‘humanisation’ of pets and the structural uptrend in spend per pet, especially on veterinary costs (Chart I-7). Animal Care has outperformed by 50 percent in the past two and a half years, but the shift to working from home will add impetus to the structural uptrend (Chart I-8). Chart I-7Animal Care Prices Are Rising... Animal Care Prices Are Rising... Animal Care Prices Are Rising... Chart I-8...And The Animal Care Sector Is Strongly Outperforming ...And The Animal Care Sector Is Strongly Outperforming ...And The Animal Care Sector Is Strongly Outperforming Stay overweight Animal Care. The ETF ticker, appropriately enough, is called PAWZ.  Fractal Trading System This week’s recommended trade is to short gold versus lead, given that the relative performance recently reached a fractal resistance point that has successfully identified four previous turning points. Set the profit target and symmetrical stop-loss at 13 percent. In our other open trades, five are in profit and one is in loss. The rolling 1-year win ratio now stands at 64 percent. Gold Vs. Lead Gold Vs. Lead When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated  December 11, 2014, available at eis.bcaresearch.com.   Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1    https://www.thelancet.com/journals/lanres/article/PIIS2213-2600(20)30222-8/fulltext Fractal Trading System   Cyclical Recommendations Structural Recommendations Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields   Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields     Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations     Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations    

The COVID-19 induced recession has accelerated several paradigm shifts that were already afoot. Populism, anti-immigrant sentiment, deglobalization, and fiscal profligacy were replete – particularly in the US – even before the pandemic. For the first time since WWII, the US budget deficit significantly expanded for three years running at a time when the unemployment rate was declining, late in the cycle. We fear that the Washington Consensus – a catchall term for fiscal prudence, laissez-faire economics, free trade, and unfettered capital flows – is being replaced by economic populism, by a Buenos Aires Consensus, as our geopolitical strategists have posited in the past. Buenos Aires Consensus is our catchall term for everything that is opposite of the Washington Consensus: less globalization, fiscal stimulus as far as the eyes can see, erosion of central bank independence, and a dirigiste (as opposed to laissez-faire) approach to economics that seeks to protect “state champions,” stifles innovation, and ultimately curbs productivity growth. The most important long-term consequence of the Buenos Aires Consensus will be higher inflation. And we are not talking just the asset price kind – which investors have enjoyed over the past decade – but of the more traditional flavor: consumer price inflation (Chart 1). Chart 1Inflation Is Coming Inflation Is Coming Inflation Is Coming A profligate US government where $3 trillion + fiscal packages are passed with a strong bipartisan consensus, rising odds of increased defense and infrastructure spending, a renewed focus on protecting America’s industrial champions from competition (foreign or domestic), and a robust protectionist agenda (again, on both sides of the aisle), are all inherently inflationary and negative for bonds, ceteris paribus. A whiff of inflation would be a positive for the broad equity market, further fueling the “risk on”, liquidity-driven, melt-up phase. However, historically when inflation has entered the 3.7%-4% zone in the past, the broad equity market has stumbled (Chart 2). Despite these powerful longer-term inflationary forces, our working assumption is that, in the next 9-12 months, headline CPI inflation will only renormalize, rather than surge, as the coronavirus-induced deficient demand and excess supply dynamic will take time to reach a new equilibrium (Chart 3). Chart 2Only A Whiff Of Inflation Is Good For Stocks Only A Whiff Of Inflation Is Good For Stocks Only A Whiff Of Inflation Is Good For Stocks Importantly, the magnitude of the economic damage, the likelihood that a “second wave” requires renewed lockdowns, and a new steady state of the apparent “square root” type of recovery remain unknown. This means that “deflationistas” may continue to have an upper hand on the “inflationistas”, as witnessed by the subdued inflation expectations (Chart 3). Chart 3In The Near-Term Disinflation Looms In The Near-Term Disinflation Looms In The Near-Term Disinflation Looms The Federal Reserve’s Function As The Lender Of Last Resort What is certain is the Fed’s resolve to keep things gelled together and allow businesses and the economy enough time to heal and overcome the coronavirus shock. Simply put, there are high odds that the Fed will remain accommodative and take inflation risk “sitting down” for quite some time, certainly for the next year, and likely longer (Chart 4). While early on, the Powell-led Fed had been ambivalent, the FOMC’s swift and immense response to the coronavirus calamity with unorthodox monetary policies has been appropriate and unprecedented (Chart 5). Clearly, the sloshing liquidity cannot cure the coronavirus, but providing the credit needed in parts of the financial markets and select business sectors that had completely dried up was the proper policy response. The Fed acted promptly as a lender of last resort. Unlike the difficulty in defeating deflation – look no further than Japan – ending inflation is easy. The great Paul Volcker has taught the Fed and the world how to break the back of inflation. The Fed, therefore, has the credible tools to deal with a possible inflationary impulse. Chart 4Do Not Fight The Mighty Fed Do Not Fight The Mighty Fed Do Not Fight The Mighty Fed Chart 5Joined At The Hip Joined At The Hip Joined At The Hip Until economic growth regains its footing and climbs to its post-GFC steady 2-2.5% real GDP growth profile, the probability is high that the Fed will take some inflation risk (Chart 6). Chart 6The Fed Can Afford To Take Inflation Risk The Fed Can Afford To Take Inflation Risk The Fed Can Afford To Take Inflation Risk This is especially the case given that political risk in the US is tilted to the downside. With income inequality at nose bleeds levels, US policymakers (both fiscal and monetary authorities) will hesitate to act on the inflation mandate with gusto and objectivity (Chart 7). Chart 7The Apex Of Globalization And Income Inequality The Apex Of Globalization And Income Inequality The Apex Of Globalization And Income Inequality The Fed will therefore not rush to abruptly tighten monetary policy, a view confirmed by the bond market: fed funds futures are penciling a negative fed funds rate in mid-2021 and ZIRP as far as the eye can see (Chart 8). A sustainable breakout in bond yields would require inflation (and to a lesser extent real GDP growth) to significantly surprise to the upside, which would compel the Fed to aggressively raise the fed funds rate. But that is not on the immediate horizon especially given the recent coronavirus-related blow to unit labor costs (please see Appendix below). Even if there were an inflationary backup in longer term Treasury yields, yield curve control is a tool the Fed is considering, something it first tried on the Treasury’s orders during and following WWII for a nine year period. Chart 8ZIRP As Far As The Eye Can See ZIRP As Far As The Eye Can See ZIRP As Far As The Eye Can See Dollar And The Inflationary Valve Importantly, the US dollar’s direction will be critical in determining whether any lasting inflation acceleration occurs. The top panel of Chart 9 shows that inflation accelerates during U.S. dollar bear markets. A depreciating greenback greases the wheels of the global financial system and also serves as a global growth locomotive given that trade is largely conducted in US dollars (bottom panel, Chart 9). Thus, the Fed’s recent US dollar swap lines to other Central Banks, along with its FIMA facility, were instrumental in unclogging the global financial system. Sloshing US dollar liquidity restored a semblance of normality to asset prices (Chart 10). Chart 9Inversely Correlated Inversely Correlated Inversely Correlated Chart 10Ample Liquidity To Debase The Greenback Ample Liquidity To Debase The Greenback Ample Liquidity To Debase The Greenback As we highlighted in our December 16 Special Report titled “Top US Sector Investment Ideas For The Next Decade” ,1 there are rising odds that a US dollar bear market takes root this decade. Eventually, the steeper the greenback’s fall, the higher the chance of a longer lasting inflationary spurt as US import price inflation will rear its ugly head (Chart 11). Chart 11US Dollar Bear Markets Are Synonymous With Inflation US Dollar Bear Markets Are Synonymous With Inflation US Dollar Bear Markets Are Synonymous With Inflation So What? While, in the near-term, accelerating inflation is a negligible risk owing to excess economic slack, in the intermediate-term, it is a rising probability outcome. BCA’s long-held de-globalization theme,2 the US/Sino trade war that is here to stay irrespective of the next electoral outcome and excessive US government fiscal largesse will likely, in the next two-to-three years, swing the global deflation/inflation pendulum toward sustained inflation (Chart 12). For investors that are worried about the prospect of higher inflation, the purpose of this Special Report is to serve as an equity sector positioning roadmap, especially if inflationary pressures become more acute sooner than we anticipate. Chart 12Deglobalization Will Result In Inflation Deglobalization Will Result In Inflation Deglobalization Will Result In Inflation Historically, inflation has been synonymous with an aggressive Fed and hard asset outperformance, suggesting that deep cyclical sectors would be the primary beneficiaries. Table 1 shows that over the last six major inflationary cycles, energy, materials, real estate and health care have been consistent outperformers. On the flip side, utilities, tech and telecom have been clear underperformers. The remaining sectors have been a mixed bag. Table 1S&P 500 Sector Performance During Inflationary Periods Revisiting Equity Sector Winners And Losers When Inflation Climbs Revisiting Equity Sector Winners And Losers When Inflation Climbs With the exception of real estate, our portfolio will benefit from an accelerating inflationary backdrop. However, our early- and late-cyclical preference to defensives is a consequence of the current stage of the cycle: when in recession it pays to have a cyclical portfolio bent (please see Charts 6 and 7 from our mid-April Weekly Report).3 Ultimately, we expect relative profit trends to dictate relative performance on a cyclical investment horizon, and are not rushing to further shift our portfolio in order to benefit from accelerating inflation. What follows is a one page per sector analysis of the impact of inflation on pricing power and performance. Sectors are ranked by their average returns (largest to smallest) in the six inflationary cycles we studied as shown on Table 1.   Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com Health Care Health care stocks have consistently outperformed during the six inflationary periods we examined. Over the long haul, it has paid to overweight this sector given the structural uptrend in relative share prices. Spending on health care services is non-cyclical and demand for such services is on a secular rise around the globe most recently further catalyzed by the COVID-19 pandemic: in the developed markets driven largely by the aging population and in the emerging markets by the accelerating adoption of health care safety nets and higher standards. Chart 13Health Care Health Care Health Care Health care pricing power is expanding at a healthy clip, outshining overall CPI. Importantly, recent geopolitical uncertainty had cast a shadow on the sector’s pricing power prospects that suffered from a constant derating. Now that political uncertainty has lifted as Biden is a more moderate Democratic President candidate than either Sanders or Warren, a rerating looms. Finally, demand for health care goods and services will not only remain robust, but also get a boost from the recent coronavirus pandemic as governments around the globe beef up their health care response systems. Chart 14Health Care Health Care Health Care Energy The energy sector comes out on top of the median relative return results in times of inflation, and second best in average terms (Table 1 above). Oil price surges are typically synonymous with other forms of inflation. During the six inflationary periods we analyzed, all but one period were associated with relative share outperformance. Oil producers in particular benefit from the increase in the underlying commodity almost immediately (assuming little to no hedging), which also serves as an excellent inflation hedge. Chart 15Energy Energy Energy Relative energy pricing power collapsed during the COVID-19 accelerated recession plumbing multi-decade lows. Saudi Arabia’s decision in early-2020 to refrain from balancing the oil market triggered a plunge in WTI crude oil prices to negative $40/bbl. While global demand remains deficient, this breakdown in oil prices has brought some much needed supply discipline in global oil producers including US shale. As the reopening of economies takes hold oil demand will recover and absorb excess oil inventories. While base effects will push crude oil inflation to the stratosphere in Q1/2021, eventually a more balanced global oil market will pave the way to a sustainable rebound in oil prices. Chart 16Energy Energy Energy Real Estate REITs have outperformed the overall market during the five inflationary periods we analyzed, exemplifying their hard asset profile. While the 1976-81 iteration skewed the mean results, REITs still come out with the third best showing among the top eleven sectors even on median return basis (Table 1 above). Real estate prices tend to appreciate when inflation is accelerating, because landlords have consistently raised rents at least on a par with inflation. Chart 17Real Estate Real Estate Real Estate Following the GFC trough, REITs pricing power has outpaced the overall CPI. CRE selling prices had been on a tear since the GFC, but the ongoing recession has short-circuited this hard asset’s near uninterrupted price appreciation; according to Green Street Advisors, average CRE prices contracted by roughly 10% in April. Worrisomely the persistent multi-family construction boom and the “amazonification” of the economy will act as a restraint to the apartment REIT and shopping center REIT segments, respectively. Tack on the longer-term knock-on effects of the work-from-home wave that has staying power and even office REITs may suffer a demand-related deflationary shock. Chart 18Real Estate Real Estate Real Estate Materials Materials equities have a tight positive correlation with accelerating inflation. Resource-related stocks are the closest representation of hard assets, given their ability to store value among the eleven GICS1 sectors. As inflation takes root and commodity prices rise, materials sales and EPS growth get a boost with relative share prices following right behind. Chart 19Materials Materials Materials Our relative materials pricing power gauge is currently contracting, but encouragingly it is showing some signs of stabilization. The drubbing in Chinese GDP in Q1 has dealt a blow to commodities-related demand and thus prices as infrastructure projects ground to a halt. As the Chinese economy has restarted slightly ahead of developed markets a return to normalcy is a high probability outcome in the back half of the year. Keep in mind that the delayed effect of stimulus spending should also hit in Q3 and Q4 likely further tightening commodity markets. Chart 20Materials Materials Materials Consumer Discretionary While the overall trend in consumer discretionary stocks has been higher since the mid-1970s, relative performance mostly declines during inflationary times. Consumer spending takes the backseat as a performance driver when interest rates rise on the back of higher inflation. In addition, previous inflationary periods have also coincided with surging energy prices, representing another source of diminishing consumer discretionary purchasing power. Chart 21Consumer Discretionary Consumer Discretionary Consumer Discretionary Consumer discretionary selling prices are expanding relative to overall wholesale price inflation, and are on a trajectory to hit double digit growth. Deflating energy prices, ultra-loose monetary conditions and the $3tn fiscal stimulus have kept the US consumer afloat. As Washington and the Fed are providing a lifeline to the economy during the recession, the reopening of the economy has the potential to turbo-charge consumer discretionary spending as pent up demand will get unleashed. Chart 22Consumer Discretionary Consumer Discretionary Consumer Discretionary Financials Financials relative returns are neither hot nor cold when inflation rears its ugly head. In fact they sit in the middle of the pack in terms of relative median and mean returns. This lack of consistency reflects different factors that exerted significant influence in some of these inflationary periods. Moreover, Chart 23 shows that relative share prices have been mean reverting since the 1960s, likely blurring the inflation influence. Ultimately, the yield curve, credit growth and credit quality determine the path of least resistance for the relative share price ratio of this early cyclical sector. Chart 23Financials Financials Financials Financials sector pricing power has jumped by about 450bps since the 2019 trough and have exited deflation. Given the recent steepening of the yield curve that is typical at the depths of the recession, the odds are high that sector pricing power will remain firm via rising net interest margins. Any easing in the regulatory backdrop even temporary could also provide a fillip to margins and offset the large precautionary provisioning that banks are taking to combat the looming recession-related losses. Chart 24Financials Financials Financials Industrials The industrials sector tends to outperform during inflationary periods. In fact, relative share prices have risen 50% of the time since the mid-1960s when inflation was accelerating. The two oil shocks in the 1970s raised the profile of all commodity-related sectors as investors were scrambling to find reliable inflation hedges. Chart 25Industrials Industrials Industrials Following a three-year period in the deflation zone, industrials relative pricing power is steadily rising, likely as a consequence of decreasing supplies, CEO discipline and the ongoing US/Sino trade war. The previously expansionary mindset has given way to retrenchment, as the scars from the late-2015/early 2016 manufacturing recession remain fresh. However, infrastructure spending is slated to increase at some point in late-2020 as China revs its economic engine and bolster the demand prospects for this deep cyclical sector. Chart 26Industrials Industrials Industrials Consumer Staples Similar to the health care sector, consumer staples stocks have been stellar outperformers over the past 55 years. The sector’s track record during the six inflationary periods we studied is split down the middle. Most consumer staples companies are global conglomerates and their efforts have been focused on building global consumer brands, allowing them to implement a stickier pricing strategy. As a result, overall inflation/deflation pressures are more benign. Chart 27Consumer Staples Consumer Staples Consumer Staples Relative consumer staples pricing power has slingshot higher and is flirting with the upper bound of the past three decade range near the 10% mark. The current recession has augmented the status of consumer staples. While the lockdowns has dealt a blow to select discretionary purchases, demand for staples has actually increased according to recent retail sales and inflation data releases. Tack on falling commodity input costs and the implication is that consumer staples manufacturers will likely continue to enjoy widening profit margins. Chart 28Consumer Staples Consumer Staples Consumer Staples Tech Technology stocks have underperformed every time inflation has accelerated with two exceptions, in the mid-to-late 1960s and mid-to-late 1970s. Creative destruction forces in the tech industry are inherently deflationary. As a result, tech business models have evolved to thrive during disinflationary periods. Moreover, tech stocks have become more mature than is typically perceived, generating enormous amounts of free cash flow. Cash flow growth is also steadier than in the past and has served as a catalyst to embark on shareholder friendly activities. Chart 29Tech Tech Tech Tech companies are constantly mired in deflation. While relative pricing power has been in an uptrend since 2016, it has recently soared as tech companies preserved their pricing power, but overall wholesale inflation has suffered a sizable setback. Importantly, demand for tech goods and services has remained resilient during the current recession, further adding to the allure of the tech sector. Chart 30Tech Tech Tech Utilities Utilities relative returns during inflationary bouts are the second worst among the top eleven sectors on an average basis and dead last on a median return basis (Table 1 above). In five out of the six inflationary phases we examined, utilities stocks suffered a setback. The industry’s lack of economic leverage and fixed income attributes anchor the relative share price ratio during inflationary times. Chart 31Utilities Utilities Utilities Our utilities sector pricing power proxy has sprung to life recently moderately outpacing overall inflation. Natural gas prices, the industry’s marginal price setter, have risen 18% since the early-April trough, signaling that recent utility pricing power gains have more upside. Nevertheless, as the economy is gradually reopening, soft data will stage a V-shaped recovery bolstering the odds of a selloff in the bond market. Such a backdrop will dampen the demand for high-yielding defensive equities, including pricey utilities. Chart 32Utilities Utilities Utilities Telecom Services Relative telecom services performance and inflation appear broadly inversely correlated since the early 1970s, underperforming 60% of the time when core PCE prices accelerate. Importantly, in two of the periods we studied (during the late-70s and the TMT bubble) the drawdowns were massive, skewing the mean results portrayed in Table 1 above. This fixed income proxy sector tends to suffer in times of inflation as competing assets dilute its yield appeal and vice versa. Chart 33Telecom Services Telecom Services Telecom Services Telecom services pricing power has been on a recovery mode since February 2017 when Verizon surprised investors and embarked on a price war by reinstating its unlimited plans in order to defend its market share. Importantly, earlier in the year telecom carriers relative selling prices exited deflation coinciding with the completion of the T-Mobile/Sprint deal. Intra-industry M&A is over as now only three major wireless providers are left raising the threat of monopolistic power. Nevertheless, the ongoing 5G deployment is of the utmost importance for telecom carriers and a foray further into cable/media/content services is inevitable so that the telecom incumbents move beyond being “dumb pipelines”. Chart 34Telecom Services Telecom Services Telecom Services Appendix Chart A1 CHART A1 CHART A1 Chart A2 CHART A2 CHART A2 Chart A3 CHART A3 CHART A3 Chart A4 CHART A4 CHART A4 Chart A5 CHART A5 CHART A5 Chart A6 CHART A6 CHART A6     Footnotes 1     Please see BCA US Equity Strategy Special Report, “Top US Sector Investment Ideas For The Next Decade” dated December 16, 2019, available at uses.bcaresearch.com 2     Please see BCA Geopolitical Strategy Special Report, “The Apex Of Globalization - All Downhill From Here” dated November 12, 2014, available at gps.bcaresearch.com 3    Please see BCA US Equity Strategy Weekly Report, “Fight Central Banks At Your Own Peril” dated April 14, 2020, available at uses.bcaresearch.com.

An analysis on Turkey is available below.   Highlights Due to the sizable stimulus announced by the NPC, we are upgrading our outlook for Chinese growth for this year. Nevertheless, in terms of investment strategy, we are reluctant to chase China-related plays higher at the moment. Rising geopolitical tensions between the US and China will likely produce a pullback in China-related risk assets, providing a better entry point in the months ahead. The RMB is set to depreciate dragging down emerging Asian currencies. There is evidence that the equity rally from late-March lows has been driven or supercharged by retail investors worldwide. Such retail-driven manias never end well, though they can last for a while. Feature Emerging market equities are facing a critical technical resistance. Chart I-1 shows that over the past decade, EM share prices often found support at the horizontal line during selloffs. The latter could now become a resistance point. In turn, the Australian dollar and the S&P 500 have climbed to their 200-day moving averages (Chart I-2). Chart I-1EM Stocks Are Facing A Technical Resistance EM Stocks Are Facing A Technical Resistance EM Stocks Are Facing A Technical Resistance Chart I-2S&P 500 And AUD Are At Critical Technical Juncture S&P 500 And AUD Are At Critical Technical Juncture S&P 500 And AUD Are At Critical Technical Juncture   Having rallied strongly in the past two months, it is reasonable to expect that global risk assets will take a breather as investors assess the economic and geopolitical outlooks. China: Aggressive Stimulus… China has embarked on another round of aggressive stimulus. The government program approved by the National People’s Congress (NPC) last week laid out the following macro policy objectives: Stabilize employment. The NPC has pledged to create more than 9 million new jobs in urban areas. Although this is lower than last year’s target of more than 11 million new jobs, it is very ambitious given the number of layoffs that have occurred year-to-date. Chart I-3China: Money/Credit Is Set To Re-Accelerate China: Money/Credit Is Set To Re-Accelerate China: Money/Credit Is Set To Re-Accelerate Significantly accelerate the growth rate of broad money supply and total social financing relative to last year. Indeed, broad money growth accelerated in April and will continue to move higher (Chart I-3). Lending to enterprises and households as well as overall bank asset growth have all accelerated (Chart I-3, bottom two panels). Boost aggregate government spending (budgetary and quasi-fiscal) growth to 13.2% in 2020 versus 9.5% last year.   Local government’s special bond quotas have been set at RMB 3.75 trillion yuan, compared with RMB 2.15 trillion last year. The central government will issue special bonds in the order of 1 trillion yuan. The proceeds will be transferred to local governments to support tax and fee reductions, as well as to boost consumption and investment.  Support SMEs. The government will extend its beneficial loan-repayment policy for SMEs until March 2021. It will extend exemptions for SMEs on social security contributions, VAT and other fees and taxes through to the end of this year. The government estimates a total of RMB 2.5 trillion in tax and fee reductions for companies in 2020. Table I-1 details potential scenarios for the credit and fiscal spending impulse (CFI). In our baseline scenario, the CFI will rise to 15.5% of GDP by year-end (Chart I-4). In short, in 2020 the CFI will likely be larger than it was in 2015-’16 and closer to its 2012 level. However, it will still fall short of the 2009-2010 surge. Table I-1Simulation On Credit And Fiscal Spending Impulse For 2020 EM Stocks Are At A Critical Resistance Level EM Stocks Are At A Critical Resistance Level Chart I-4Our Projections For The Credit And Fiscal Spending Impulse Our Projections For The Credit And Fiscal Spending Impulse Our Projections For The Credit And Fiscal Spending Impulse In summary, it is fair to say that for now, the authorities have abandoned their deleveraging objective and are encouraging a substantial acceleration of both debt and credit. However, it will take time before the stimulus filters through the economy and boosts growth. This will be the case because of the following persistent headwinds: First, the reduced willingness of households and enterprises to spend. The top panel of Chart I-5 reveals that consumers’ marginal propensity to spend is falling. Enterprises’ willingness to invest continues to trend lower. Historically, companies’ willingness to invest has been a good indicator for industrial metals prices. So far it has not validated the advance in base metals (Chart I-5, bottom panel). The rationale for this correlation is that Chinese companies account for 50-55% of global industrial metals demand. Second, the COVID-19 economic downturn in China was much worse than previous downturns, and the financial health of companies and households is considerably poorer than before. This is why it will take very large amounts of stimulus to produce even a moderate recovery. In particular, a portion of the credit expansion will go toward plugging operating cash flow deficits at companies rather than to augment investment. For example, in the US, commercial and industrial loan growth surged in 2007/08 and this year (Chart I-6). In all of those cases, the underlying cause for credit acceleration was companies drawing on their credit lines to close their negative operating cashflow gaps. Chart I-5China: Households And Enterprises Are Less Willing To Spend China: Households And Enterprises Are Less Willing To Spend China: Households And Enterprises Are Less Willing To Spend Chart I-6US Loan Growth Spikes In Recessions US Loan Growth Spikes In Recessions US Loan Growth Spikes In Recessions The same phenomenon is presently occurring in China. This entails more credit origination will be required in China in this cycle before we witness a revival in capital spending. Third, geopolitical tensions between the US and China will escalate further in the months ahead. We elaborate on this in more detail below. As far as China’s growth outlook is concerned, rising geopolitical tensions with the US will weigh on both consumer and business confidence. On the whole, due to the sizable stimulus announced by the NPC, we are upgrading our outlook for Chinese growth for this year. Nevertheless, in terms of investment strategy, we are reluctant to chase China-related plays higher at the moment. Rising geopolitical tensions will likely produce a pullback in China-related risk assets, providing a better entry point in the months ahead. Chart I-7Chinese Economy: Still Very Weak Chinese Economy: Still Very Weak Chinese Economy: Still Very Weak In addition, the mainland economy is still undergoing post-lockdown normalization – not recovery. Both capital spending and household consumption are still in recession (Chart I-7).    Bottom Line: China is yet again resorting to aggressive fiscal and credit stimulus. Mainland growth is bound to improve over the remainder of the year. However, financial markets have run a bit ahead of themselves, and we will wait for a pullback before recommending China-related plays.  …But Geopolitics Is A Major Risk Despite an improving growth outlook, Asian and China-related risk assets could struggle in the months ahead due to escalating geopolitical tensions between the US and China. On the surface, the COVID-19 crisis seems to be the culprit behind rising tensions between the two nations. However, the pandemic has only accelerated an otherwise unavoidable confrontation between the existing superpower and the rising one. BCA’s Geopolitical Strategy team has been writing about cumulating tensions and the potential for them to boil over in the months before the US election. The contours of the rise in geopolitical tensions will be as follows: President Trump’s chances of re-election have declined, with the recession gripping the US economy and unemployment surging. There is little doubt that he will use external foes to rally the nation behind the flag. Blaming China for the pandemic and acting tough is probably the only way for Trump to switch his campaign’s nucleus from the economy to foreign policy, which will raise the odds of his election victory. The US administration will not resort to import tariffs this time around. Going forward, the administration’s goal will be cutting China’s access to foreign technology. Technology in general and semiconductors in particular will be the key battleground in this new cold war. The US will also step up its pressure on multinationals to move production out of China. The broader idea is to impede China’s technological advance. Even though the US rhetoric on China’s policies toward Hong Kong will be tough, there is little the US can do or will do regarding Hong Kong. Rather, the more important battleground will be Taiwan and its semiconductor industry. Finally, China’s political leadership cannot tolerate being perceived as weak domestically in the face of US pressures. They will retaliate against the US. One form of retaliation against Trump could be pushing North Korea to test its strategic military weapons that could undermine Trump’s foreign policy credibility in the US. Another form of retaliation could be tolerating moderate currency depreciation. The latter will challenge Trump’s claims that he has been victorious in dealing with China. The latest decision to ban US and foreign companies from accepting orders from Huawei and the slide in the value of the RMB are consistent with these narratives. To our surprise, however, financial markets in general and Asian markets in particular have not sold off meaningfully in response to the US ban on Huawei and renewed RMB depreciation. Critically, China is the world’s largest consumer of semiconductors, accounting for 35% of global semiconductor demand. Restricting Chinese purchases would be negative for global semiconductor producers. China has been aware of the risk of US restrictions on its imports of semiconductors and has been ramping up its semi imports since 2018. Semi imports have been booming even though smartphone sales had been shrinking (Chart I-8). This is a sign of large semiconductor restocking in China which has helped global semi sales in general and TSMC sales in particular in the past 18 months. In brief, major semi restocking by China in the past 18 months along with the ban on sales to Huawei all but ensure that global semiconductor sales will be weak this year. It does not seem that global semi stocks in general and Asian ones in particular are pricing in this outcome. Global semiconductor stocks are a hair below their all-time highs, and their trailing P/E ratio is at 21. Specifically, given Huawei is the second-largest customer of TSMC, the latter’s sales will be negatively affected (Chart I-9). Chart I-8Has China Been Stockpiling Semiconductors? Has China Been Stockpiling Semiconductors? Has China Been Stockpiling Semiconductors? Chart I-9TSMC Has Benefited From China Stockpiling Semiconductors TSMC Has Benefited From China Stockpiling Semiconductors TSMC Has Benefited From China Stockpiling Semiconductors Finally, both DRAM and NAND prices are falling anew (Chart I-10). Further, DRAM revenue proxy correlates with Korean tech stocks and points to lower share prices (Chart I-11). Chart I-10Semiconductor Prices Have Begun Falling Semiconductor Prices Have Begun Falling Semiconductor Prices Have Begun Falling Chart I-11Semiconductor Prices Are Still Deflating DRAM Revenue Proxy And Korean Tech Stocks Semiconductor Prices Are Still Deflating DRAM Revenue Proxy And Korean Tech Stocks Semiconductor Prices Are Still Deflating DRAM Revenue Proxy And Korean Tech Stocks Crucially, Chinese, Korean and Taiwanese stocks account for 60% of the MSCI EM equity market cap. Hence, a selloff in these bourses will weigh on the EM equity index. Chart I-12 shows that the latest drawdown in these North Asian equity markets was relatively small compared to the drop in the rest of the EM equity universe. Hence, Chinese, Korean and Taiwanese share prices are not discounting a lot of bad news making them vulnerable to the geopolitical risks that lie ahead. Financial markets in Asia are very complacent to mounting geopolitical risks stemming from the US-China confrontation. The RMB is set to depreciate dragging down emerging Asian currencies. Chart I-12North Asian Stocks Versus The Rest Of EM North Asian Stocks Versus The Rest Of EM North Asian Stocks Versus The Rest Of EM Bottom Line: Financial markets in Asia are very complacent to mounting geopolitical risks stemming from the US-China confrontation. The RMB is set to depreciate dragging down emerging Asian currencies. The large share of Chinese, Korean and Taiwanese stocks in the MSCI EM equity index implies significant downside risks to the EM equity benchmark. The Global Economic Outlook As economies around the world open, the level of economic activity will certainly begin to rise. The opening of shops, offices and various other facilities will result in a partial normalization and an increase in economic activities.  However, we cannot call this a recovery. Rather it is just a snapback from the lockdowns which both equity and credit markets have already fully priced in. The outlook for global share prices and credit markets depends on what happens to the global economy following this post-lockdown snapback. Will the snapback be followed by an actual recovery or will the level of activity stagnate at low levels? For now, our sense is that following the initial snapback a U-shaped recovery is the most likely global scenario. This does not exclude the possibility that activity in some sectors/countries will follow a square root trajectory.  From a global macro perspective, we have the following observations to share: Certain industries will likely experience stagflation. Due to social distancing measures, they will be forced to limit their output/capacity and compensate for their increased costs by charging higher prices. In this group, we would include airlines, restaurants, and other service sector businesses. The short-term outlook for consumer spending is contingent on fiscal stimulus. A material reduction in fiscal support for households will weigh on their spending capacity. Capital spending will remain subdued outside China’s stimulus-driven local government and SOE investment outlays, and outside the technology sector, generally. Critically, economic activity in many countries and industries will remain below pre-pandemic levels until late this year. This implies that despite the snapback, some businesses will still be operating below or close to their breakeven points. This will have ramifications on their ability to service debt and on their willingness to invest and hire. Any rise in government bond yields worldwide will be limited as central banks in both DM and EM will cap yields by augmenting their purchase of government and in some cases corporate bonds. We discussed EM QE programs in detail in last week’s report. Bottom Line: It is tempting to interpret the post-lockdown snapback in economic activity as a recovery. However, the nature and depth of this recession is unique. Investors should consider both the direction of economic indicators and the level of economic activity in relation to a company’s breakeven point. This is an extremely difficult task. And that is in addition to gauging the odds of a second wave of COVID-19 infections later this year. In the context of such complexities facing investors, there is astonishing evidence that the recent equity rally has been driven by unsophisticated retail investors. A Retail-Driven Equity Rally There is growing evidence that the equity rally from late-March lows has been driven or supercharged by retail investors, worldwide. There is growing evidence that the equity rally from late-March lows has been driven or supercharged by retail investors, worldwide. Such retail-driven manias never end well, though they can last for a while. The following articles corroborate the worldwide phenomenon that retail investors have been opening broker accounts en masse and investing in stocks: Bored Day Traders Locked at Home Are Now Obsessed With Options Frustrated sports punters turn to US stock market Coronavirus spawns new generation of Japanese stock pickers Stuck at Home, More Filipinos Try Luck at Stock Investing It is fair to assume that retail investors do very little fundamental analysis. Not surprisingly, since March global share prices have decoupled from profit expectations. Although some professional investors have no doubt also played the rally, surveys of asset managers and traders suggest that generally they have stayed lukewarm on stocks. Specifically, the net long position of asset managers and leveraged funds in various US equity index futures remains very low (Chart I-13). Chart I-14 shows that US traders’ and professional individual investors’ sentiment on US stocks are at multi-year lows. Only US investment advisors have become fairly bullish again (Chart I-14, bottom panel). Chart I-13Fund Managers Have Stayed Lukewarm On Stocks Fund Managers Have Stayed Lukewarm On Stocks Fund Managers Have Stayed Lukewarm On Stocks Chart I-14Professional Investors’ Sentiment On Stocks Have Been Subdued Professional Investors Sentiment On Stocks Have Been Subdued Professional Investors Sentiment On Stocks Have Been Subdued Who will capitulate first: retail or professional investors? It is hard to predict the behavior of investors but, if we had to guess, our take could be summed up as follows:  If geopolitical tensions escalate much more or the number of COVID-19 inflections in some large countries rises anew, retail investors will likely sell before professional investors step in. In this scenario, share prices will drop considerably. In the case of an absence of geopolitical tensions or a new wave of infections, it is hard to see how economic data that is improving could lead to a substantial drawdown in equities even if the level of activity remains very depressed. In this case, corrections will be small and short-lived. Investment Strategy Chart I-15Beware Of Breakdowns Beware Of Breakdowns Beware Of Breakdowns For global equity portfolios, we continue recommending underweighting EM stocks. Regardless of the direction of global share prices, EM will continue underperforming DM (Chart I-15, top panel). The basis for this is rising geopolitical tensions in China and weakness in the RMB will spill over into other emerging Asian currencies (Chart I-15, bottom panel). We continue recommending short positions in the RMB and KRW versus the US dollar. In terms of the absolute performance of EM equities and credit markets, as well as EM currencies versus the greenback, we recommend being patient. Global and EM financial markets are presently at a critical juncture, as illustrated in Charts 1 and 2 on pages 1 and 2. If these and some other markets meaningfully break above current levels of resistance, we will upgrade our stance on EM stocks and credit markets and close our short positions in EM currencies versus the US dollar. If they fail to do so, a considerable selloff is likely to follow. As to EM local currency bonds, we are long duration but cautious on EM currencies. For the full list of our recommendations for EM equity, credit, local fixed-income and currency markets, please refer to pages 18 and 19.   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Lin Xiang, CFA Research Analyst linx@bcaresearch.com     Turkish Lira: Facing A Litmus Test The Turkish lira has rolled over at its resistance level on a total return (including carry) basis (Chart II-1). The spot rate versus the US dollar is at its 2018 low. In short, the exchange rate is facing a litmus test. The culprit of a potential downleg in the lira is an enormous monetary deluge. Chart II-2 reveals that broad money supply growth has accelerated to 35% from a year ago. Local currency money supply is skyrocketing because the central bank and commercial banks are engaged in rampant money creation and public debt monetization. Chart II-1Turkish Lira (Including Carry): A Good Point To Short Turkish Lira (Including Carry): A Good Point To Short Turkish Lira (Including Carry): A Good Point To Short Chart II-2Turkey’s Broad Money: The Sky Is The Limit Turkey's Broad Money: The Sky Is The Limit Turkey's Broad Money: The Sky Is The Limit While such macro policies could benefit economic growth in the short term, they also herald growing inflationary pressures and currency devaluation. First, Turkish commercial banks have been on a government bonds buying binge since 2018 (Chart II-3, top panel). They presently own 62% of total local currency government bonds, up from 45% in early 2018. In addition, the central bank is de-facto engaging in government debt monetization. The Central Bank of Turkey (CBT) has bought TRY 40 billion of government bonds in the secondary market since March (Chart II-3, bottom panel). When a central bank or commercial bank buys a local currency asset from a non-bank, a new local currency deposit is created in the banking system and the money supply expands.  Chart II-3Turkey: Public Debt Monetization In Full Force Turkey: Public Debt Monetization In Full Force Turkey: Public Debt Monetization In Full Force Chart II-4Turkey: Loan Growth Exceeds 30% Turkey: Loan Growth Exceeds 30% Turkey: Loan Growth Exceeds 30% Second, the commercial banks’ local currency loan growth has surged to 32% (Chart II-4). Government lending schemes and newly introduced regulations are incentivizing commercial banks to continue lending in order to boost domestic demand. In particular, state owned banks are providing loans at interest rates well below both the policy and inflation rates. The most likely outcome from such policies is rampant capital misallocation and an increase in non-performing loans. The former will weigh on productivity in the long turn. Third, the central bank has been providing enormous amounts of liquidity to commercial banks (Chart II-5, top panel). The latter’s local currency excess reserves – which are exclusively created out of thin air by the central bank - have surged (Chart II-5, bottom panel). In fact, the effective policy rate has been hovering below the actual policy rate, suggesting that there is an excess liquidity overflow in the banking system. In a nutshell, the central bank has been providing fuel to commercial banks to expand money supply via the purchases of local currency government bonds and loan origination. Fourth, an overly loose monetary stance will lead to higher inflation and currency devaluation. Moreover, wages continue to expand at an annual rate of 15-20%, confirming the fact that inflationary pressures are genuine and broad within this economy (Chart II-6). Higher inflation, and the consequent loss of purchasing power, is leading residents to switch their holdings of liras to foreign currencies. Chart II-5Central Banks' Liquidity Provision To Banks Central Banks' Liquidity Provision To Banks Central Banks' Liquidity Provision To Banks Chart II-6Turkey: A Sign Of Genuine Inflation Turkey: A Sign Of Genuine Inflation Turkey: A Sign Of Genuine Inflation Higher inflation, and the consequent loss of purchasing power, is leading residents to switch their holdings of liras to foreign currencies. Finally, Turkey’s current account deficit is set to widen, and the central bank’s net foreign currency reserves are non-existent at best. Booming credit growth will keep domestic demand and imports stronger than they otherwise would be. In the meantime, the complete collapse in tourism revenues and Turkey’s large foreign debt obligations, estimated at $160 billion over the next six months, entail negative balance of payment dynamics. Barring capital controls, Turkey will not be able to preclude further currency depreciation. Investment Implications Short the Turkish lira versus the US dollar. We recommend dedicated equity investors underweight Turkish equities and credit relative to their respective EM benchmarks. Also, we are reiterating our short Turkish banks / long Russian banks position. Local currency yields will offer little protection against currency depreciation. As such, investors should underweight domestic bonds.   Andrija Vesic Associate Editor andrijav@bcaresearch.com   Footnotes Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

    Highlights Risk assets continue to ignore the dire state of the economy. “Don’t fight the Fed” will dictate investment policy for the coming months. Populism and supply-chain diversification will shape the world after COVID-19. Global stimulus will result in higher long-term inflation when the labor market returns to full employment. Asset prices are not ready for higher inflation rates. Precious metals, especially silver, will offer inflation protection. Stocks should structurally outperform bonds, even if they generate lower returns than in the past. Tech will continue to rise for now, but this sector will suffer when inflation turns higher. Feature Despite the continued collapse in economic activity, the S&P 500 remains resilient, bolstered by the largesse of the Federal Reserve and US government, and generous stimulus packages in other major economies. Stocks will likely climb even higher with this backdrop, but a violent second wave of COVID-19 infections may derail the scenario in the near term. The biggest risk, which is long-term in nature, is rising inflation. Public debt ratios will skyrocket in the G-10 and many emerging markets. Private debt loads, which are elevated in most countries, will also increase. Add rising populism and ageing populations into this mix and the incentive to push prices higher and reduce real debt loads becomes too enticing. Long-term investors must be wary. For the time being, overweight equities relative to bonds, but the specter of rising inflation suggests that growth stocks (e.g. tech) will not offer attractive long-term returns. Investors with an eye on multi-year returns should use the ongoing surge in growth stocks to strategically switch their portfolios toward small-cap equities, traditional cyclicals and precious metals. Economic Freefall Continues Most economic indicators paint a dismal picture for the US. Industrial activity is suffering tremendously. In April, industrial production collapsed by 15%, a pace matching the depth of the Great Financial Crisis (GFC). The ISM New Orders-to-Inventories ratio remains extremely weak with no glimmer of a rebound in IP in May. The numbers for trucking activity and railway freight are equally poor. Chart I-1A Worried Consumer Saves A Worried Consumer Saves A Worried Consumer Saves The US labor market has not been this ill since the 1930s. 20.5 million jobs vanished in April and the unemployment rate soared to 14.7%, despite a 2.5 percentage point decline in the participation rate. The number of employees involuntarily working in part-time positions has surged by 5.9 million, which has hiked up the broader U-6 unemployment rate to 22.8%. Wage growth has rebounded smartly to 7.7%, but this is an illusion. Average hourly earnings rose only because low-wage workers in the leisure and hospitality fields bore the brunt of the pain, accounting for 37% of layoffs. The worst news is that the Bureau of Labor Statistics (BLS) classifies any worker explicitly fired due to COVID-19 as temporarily laid off, but without a vaccine it is highly unlikely that employment in the leisure, hospitality or airline sectors will normalize anytime soon. Unsurprisingly, lockdowns have limited the ability of households to spend. Americans have boosted their savings rate to 13.1%, the highest level in 39 years, as they worry about catching a potentially deadly illness, losing their jobs, watching their incomes fall, or all of the above (Chart I-1). This double hit to both employment and consumer confidence sparked a 22% collapse in retail sales on an annual basis in April, the worst reading on record. Putting it all together, real GDP contracted at a 4.8% quarterly annualized rate in Q1 2020 and the Congressional Budget Office expects second-quarter annual growth to plummet to -37.7%. The New York Fed’s Weekly Economic Index suggests a more muted contraction of 11.1% (Chart I-2), which would still represent a post-war record. Investors must look beyond the gloom. The economic weakness is not limited to the US. In Europe and in emerging markets, retail sales and auto sales are disappearing at an unparalleled pace. Industrial production readings in those economies have been catastrophic and manufacturing PMIs are still in deeply contractionary territory. As a result, our Global Economic A/D line and our Global Synchronicity indicator continues to flash intense weakness (Chart I-3). Chart I-2The Worst Is Still To Come The Worst Is Still To Come The Worst Is Still To Come Chart I-3Dismal Growth, Everywhere Dismal Growth, Everywhere Dismal Growth, Everywhere   Chart I-4China Leads The Way China Leads The Way China Leads The Way Investors must look beyond the gloom. China’s experience with COVID-19 is instructive despite questions regarding the number of cases reported. China was the first country to witness the painful impact of COVID-19 and the quarantines needed to fight the disease. It was also the first country to control the virus’s spread and, most importantly, to escape the lockdown, along with being the first to enact economic stimulatory measures. The results are clear: industrial production, domestic new orders, and to a lesser extent, retail sales, are all experiencing V-shaped recoveries (Chart I-4). Even Chinese yields are rising, despite interest rate cuts by the People’s Bank of China. Accommodative Policy Matters Most The global policy “put option” is still in full force, which is boosting asset prices. A 41% rally in the median US stock reflects both a massive amount of funds inundating the financial system and a recovery that will take hold in the coming 12 months in response to this stimulus and the end of lockdowns. Global monetary policies have been even more aggressive than after the GFC. Interest rates have fallen as quickly and as broadly as they did around the Lehman bankruptcy. Moreover, unorthodox policy measures have become the norm (Chart I-5). Chart I-5Easy Policy, Everywhere Easy Policy, Everywhere Easy Policy, Everywhere In China, credit generation is quickly accelerating and has reached 28% of GDP, the highest in 2 years. Moreover, policymakers are emphasizing the need to create 9 million jobs in cities and keep the unemployment rate at 6%. Consequently, the recent rebound in construction activity will continue because it is a perfect medium to absorb excess workers. The ever-expanding quotas for local government special bonds to CNY3.75 trillion will also ensure that infrastructure spending energizes any recovery. Therefore, we expect Chinese imports of raw materials and machinery to accelerate into the second half of the year. The country’s orders of machine tools from Japan have already bottomed, which bodes well for overall Japanese orders (Chart I-6). Europe has also moved in the right direction. Government support continues to expand and combined public deficits will reach EUR 0.9 trillion, or 8.5% of GDP. Governmental guarantees have reached at least EUR1.4 trillion. Meanwhile, the European Central Bank’s balance sheet is swelling more quickly than during either the GFC or the euro area crisis (Chart I-7). Unsurprisingly, European shadow rates have collapsed to -7.6% and European financial conditions are the easiest they have been in 8 years. Chart I-6Will China's Rebound Matter? Will China's Rebound Matter? Will China's Rebound Matter? Chart I-7The ECB Is Aggressive The ECB Is Aggressive The ECB Is Aggressive   More importantly, COVID-19 has broken the taboo of common bond issuance in Europe. Last week, Chancellor Merkel, President Macron and EC President von der Leyen hatched a plan to issue common bonds that will finance a EUR 750 billion recovery fund as part of the European Commission Multiannual Financial Framework. The EC will then allocate EUR 500 billion of grants (not loans) to EU nations as long as they adhere to European principles. The unified front by the three most senior European politicians reflects elevated support for the EU among all European nations and an understanding that economic ruin in the smaller nations could capsize the core nations (Chart I-8). Hence, fiscal risk-sharing will increasingly become the norm in Europe. Unsurprisingly, Italian, Spanish, Portuguese and Greek bond spreads all narrowed significantly following the announcement. Chart I-8The Forces That Bind The Forces That Bind The Forces That Bind Chart I-9Negative Rates Are Here, Sort Of Negative Rates Are Here, Sort Of Negative Rates Are Here, Sort Of US policymakers have abandoned any semblance of orthodoxy. The Fed’s programs announced so far have lifted its balance sheet by $2.9 trillion and could generate an expansion to $11 trillion by year-end. Moreover, Fed Chair Jerome Powell has highlighted that there is “no limit” to what the Fed can do with its unconventional policy apparatus. The nature of the US funding market makes negative rates very dangerous and, therefore, highly doubtful in that country. Nonetheless, the Fed is willing to buy more paper from the public and private sectors to push the shadow rate and real interest rates further into negative territory (Chart I-9). Moreover, the Federal government has already bumped up the deficit by $3 trillion and the House has passed another $3 trillion in spending. Senate Republicans will pass some of this program to protect themselves in November. According to BCA Research’s Geopolitical Strategy service, a total escalation in the federal deficit of $5 trillion (or 23% of 2020 GDP) is extremely likely this year. Chart I-10The Fed Is Monetizing The Deficit The Fed Is Monetizing The Deficit The Fed Is Monetizing The Deficit Combined fiscal and monetary policy in the US will have a more invigorating impact on the recovery than the measures passed in 2008-09. They represent a larger share of output than during the GFC (10.5% versus 6% of GDP for the government spending and 15.2% versus 8.3% for the Fed’s balance sheet expansion). Moreover, the Fed is buying a much greater percentage of the Treasury’s issuance than during the GFC (Chart I-10). Therefore, the Fed is much closer to monetizing government debt than it was 11 years ago. The combined monetary and fiscal easing should result in a larger fiscal multiplier because the private sector is not financing as much of the government’s largesse. Thus, the increase in the private sector’s savings rate should be short-lived and the current account deficit will widen to reflect the greater fiscal outlays. Low real rates and a larger balance-of-payments disequilibrium should weaken the dollar which will ease US financial conditions further. A Trough In Inflation Maintaining incredibly easy monetary and fiscal conditions as the economy reopens will lead to higher inflation when the labor market reaches full employment. Core CPI has collapsed to 1.4% on an annual basis and to -2.4% on a three-month annualized basis, the lowest reading on record. The breakdown of the CPI report is equally dreadful (Chart I-11). However, CPI understates inflation because the basket measured by the BLS includes many areas of commerce currently not frequented by consumers. Items actually purchased by households, such as food, have experienced accelerating inflation in recent months. Fiscal risk-sharing will increasingly become the norm in Europe. Beyond this technicality, the most important factor behind the anticipated structural uptick in inflation is a large debt load burdening the global economy. Total nonfinancial debt in the US stands at 254% of GDP, 262% in the euro area, 380% in Japan, 301% in Canada, 233% in Australia, 293% in Sweden and 194% in emerging markets (Chart I-12). Historically, the easiest method for policymakers to decrease the burden of liabilities is inflation; the current political climate increases the odds of that outcome. Chart I-11Weak Core Weak Core Weak Core Chart I-12Record Debt, Everywhere Record Debt, Everywhere Record Debt, Everywhere   Households in the G-10 and emerging markets are angry. Growing inequalities, coupled with income immobility, have created dissatisfaction with the economic system (Chart I-13). Before the GFC, US households could gorge on debt to support their spending patterns, and inequalities went unnoticed. After the crisis revealed weakness in the household sector, banks tightened their credit standards and consumption slowed, constrained by a paltry expansion of the median household income. As a consequence, the American public increasingly supports left-wing economic policies (Chart I-14). Chart I-13Inequalities + Immobility = Anger June 2020 June 2020 Chart I-14The US Population's Shift To The Left June 2020 June 2020 COVID-19 is exacerbating the population’s discontent and highlighting economic disparities. The recession is hitting poor households in the US harder than the general population or highly skilled white-collar employees who can easily telecommute. Millennials, the largest demographic group in the US, are also irate. Their lifetime earnings were already lagging that of their parents because most millennials entered the job market in the aftermath of the GFC.1 Their income and balance sheet prospects were beginning to improve just as the pandemic shock struck. Finally, in response to the lockdowns and school closures caused by COVID-19, young families with children have to juggle permanent childcare and daily work demands from employers, resulting in a lack of separation between home and office.2  Economic populism will generate a negative supply shock, which will push up prices (Diagram I-1). BCA has espoused the theme of de-globalization since 20143 and COVID-19 will accelerate this trend. Firms do not want fragile supply chains that fall victim to random shocks; instead, they are looking to diversify their sources (Chart I-15). Additionally, workers and households want protection from foreign competition and perceived unfair trade practices. This sentiment is evident in a lack of trust toward China (Chart I-16). China-bashing will become a mainstay of American politics and rising tariffs will continue to increase the cost of doing business (Chart I-17). Last year’s Sino-US trade war was a precursor of events to come. Diagram I-1The Inflationary Impact Of A Stifled Supply Side June 2020 June 2020 Chart I-15COVID-19 Accelerates The Desire To Repatriate Production June 2020 June 2020 Chart I-16China As A Political Piñata June 2020 June 2020 Chart I-17The Cost Of Doing International Business Will Rise The Cost Of Doing International Business Will Rise The Cost Of Doing International Business Will Rise Chart I-18A Problem For Productivity A Problem For Productivity A Problem For Productivity The rate of capital stock accumulation does not bode well for the supply side of the economy. Productivity trails the path of capex, with a long time lag. The 10-year moving average of non-residential investment in the US bottomed three years ago. Its subsequent uptick should enhance average productivity. However, the growth of the real net capital stock per employee remains weak and will not strengthen because companies are curtailing spending in the recession. Moreover, the efficiency of the capital stock is well below its long-term average and probably will not mend if supply chains are made less efficient. These factors are negative for productivity and thus, the capacity to expand the supply side of the economy (Chart I-18). Finally, a significant share of capital stock is stranded and uneconomical. The airline industry is a good example. Going forward, regulations will keep the middle row seats empty. Fewer filled seats imply that the capital stock has lost significant value, which creates a negative supply shock for the industry. To break even, airlines will have to raise the price of fares. IATA estimates that fares will increase by 43%, 49% and 54% on North American, European and Asian routes, respectively (Table I-1). The same analysis can be applied to restaurants, hotels, cinemas, etc. – industries that will have to curtail their supplies and change their practices in response to COVID-19. Table I-1The Inflationary Impact Of Supply Cuts June 2020 June 2020 Chat I-19Pandemics Boost Wages June 2020 June 2020 While rising populism will hurt the supply side of the economy, it will also hike demand. Redistribution is an outcome of populism. Corporate tax hikes hurt rich households that receive more than 50% of their income from profits. High marginal tax rates on high earners will also curtail their disposable income. Shifting a bigger share of national income to the middle class will depress the savings rate and boost demand. It is estimated that the middle class’s marginal propensity to spend is 90% compared with 60% for richer households. In fact, in the past 40 years, the shift in income distribution has curtailed demand by 3% of GDP. Pandemics also increase real wages. Òscar Jordà, Sanjay Singh, and Alan Taylor demonstrated that European real wages accelerated following pandemics (Chart I-19). Fewer willing workers contributed to the climb in real wages by decreasing the supply of labor. Higher real wages are positive for consumption. China-bashing will become a mainstay of American politics and rising tariffs will continue to increase the cost of doing business. Populism will also put upward pressure on public spending. Governments globally and in the US are bailing out the private sector to an even larger extent than they did after the GFC. Discontent with expanding inequalities and the perceived lack of accountability of the corporate sector4 will push the government to be more involved in economic management than it was after 2008. Moreover, the post-2008 environment showed that austerity was negative for private sector income growth and the economic welfare of the middle class (Chart I-20). Thus, government spending and deficits as a share of GDP will be structurally higher for the coming decade. Higher deficits mechanically boost aggregate demand which is inflationary if the advance of aggregate supply is sluggish. Chat I-20Austerity Hurts June 2020 June 2020 Central banks will likely enable these inflationary dynamics. The Fed knows that it has missed its objective by a cumulative 4% since former Chairman Ben Bernanke set an official inflation target of 2% in 2012. Thus, it has lost credibility in its ability to generate 2% inflation, which is why the 10-year breakeven rate stands at 1.1% and not within the 2.3%-2.5% range that is consistent with its mandate. Moreover, the Fed is worried that the immediate deflationary impact of COVID-19 will further depress inflation expectations and reinforce low realized inflation. This logic partly explains why the Fed currently recommends more stimulus and the Federal Open Market Committee will be reluctant to remove accommodation anytime soon. Inflation will likely move toward 4-5% after the US economy regains full employment. Central banks may fall victim to growing populism. Both the Democrats and Republicans want control over the US Fed. If Congress changes the Fed’s mandate, there would be great consequences for inflation. Prior to the Federal Reserve Reform Act of 1977, the Fed’s mandate was to foster full employment conditions without any explicit mention of inflation. Therefore, the Fed kept the unemployment rate well below NAIRU for most of the post-war period. This tight labor market was a key ingredient behind the inflationary outbreak of the 1970s. After the reform act explicitly imposed a price stability directive on top of the Fed’s employment mandate, the unemployment rate spent a much larger share of time above NAIRU, which contributed to the structural decline in inflation after 1982 (Chart I-21). Chat I-21The Fed's Mandate Matters The Fed's Mandate Matters The Fed's Mandate Matters Finally, demographics will also feed inflationary pressures. The global support ratio peaked in 2014 as the number of workers per dependent decreased due to ageing of the population in the West and China (Chart I-22). A declining support ratio depresses the growth of the supply side of the economy because the dependents continue to consume. In today’s world, dependents are retirees, who have higher healthcare spending needs. This healthcare spending will accrue additional government spending. Moreover, it will continue to push up healthcare inflation, which will contribute to higher overall inflation (Chart I-23). Chat I-22Demographics: From Deflation To Inflation Demographics: From Deflation To Inflation Demographics: From Deflation To Inflation Chat I-23Aging Will Feed Healthcare Inflation Aging Will Feed Healthcare Inflation Aging Will Feed Healthcare Inflation   Bottom Line: COVID-19 has highlighted inequalities in the population and will accelerate a move toward populism that started four years ago. Consequently, the supply side of the economy will grow more slowly than it did in prior decades, while greater government interventions and redistributionist policies will boost aggregate demand. Additionally, monetary policy will probably stay easy for too long and demographic factors will compound the supply/demand mismatch. Inflation will likely move toward 4-5% after the US economy regains full employment, but will not surge to 1970s levels. Investment Implications Chat I-24Breakevens Will Listen To Commodities Breakevens Will Listen To Commodities Breakevens Will Listen To Commodities Extremely accommodative economic policy and a shift to higher inflation will dominate asset markets for the next five years or more. Breakevens in the G-10 are pricing in permanently subdued inflation for the coming decade, which creates a large re-pricing opportunity if inflation troughs when the labor market reaches full employment. Investors cannot wait for inflation to turn the corner to bet on higher breakevens. After the GFC, core CPI bottomed in October 2010, but US breakevens hit their floor at 0.15% in December 2008. Instead, a rebound in commodity prices and a turnaround in the global economic outlook may signal when investors should buy breakevens (Chart I-24). Chat I-25Deleterious US Balance Of Payments Dynamics Deleterious US Balance Of Payments Dynamics Deleterious US Balance Of Payments Dynamics A repricing of inflation expectations will depress real rates. Central banks want to see inflation expectations normalize towards 2.3%-2.5% before signaling an end to accommodation. Moreover, political pressures and high debt loads will likely loosen their reaction functions to higher breakeven. As a result, real interest rates will decline because nominal ones will not rise by as much as inflation expectations. This is exactly what central banks want to achieve because it will foster a stronger recovery. Our US fixed-income strategists favor TIPS over nominal Treasurys. The dollar will probably depreciate in the post-COVID-19 environment. As we wrote last month, the US is the most aggressive reflator among major economies. The twin deficit will expand while US real rates will remain depressed. This is very negative for the USD, especially in an environment where the US money supply is outpacing global money supply (Chart I-25).5 Additionally, Chinese reflation will stimulate global industrial production, which normally hurts the dollar. EM currencies are cheap enough that long-term investors should begin to bet on them (Chart I-26), especially if global inflation structurally shifts higher. Precious metals win from the combination of higher inflation, lower real rates and a weaker dollar. However, silver is more attractive than gold. Unlike the yellow metal, it trades at a discount to the long-term inflation trend (Chart I-27). Moreover, silver has more industrial uses, especially in the solar panel and computing areas. Thus, the post-COVID-19 recovery and the need to double up supply chains will boost industrial demand for silver and lift its price relative to gold. Our FX strategists recommend selling the gold-to-silver ratio.6 Chat I-26Cheap EM FX Cheap EM FX Cheap EM FX Chat I-27Silver Is The Superior Inflation Hedge Silver Is The Superior Inflation Hedge Silver Is The Superior Inflation Hedge   Chat I-28Still Time To Favor Stocks Over Bonds Still Time To Favor Stocks Over Bonds Still Time To Favor Stocks Over Bonds Investors should favor stocks over bonds. This statement is more an indictment of the poor value of bonds and their lack of defense against rising inflation than a structural endorsement of stocks. The equity risk premium is elevated. To make this call, we need to account for the lack of stationarity of this variable and adjust for the expected growth rate of earnings. Nonetheless, once those factors are accounted for, our ERP indicator continues to flash a buy signal in favor of equities at the expense of bonds (Chart I-28). Moreover, bonds tend to underperform stocks when inflation trends up for a long time (Table I-2).   Table I-2Rising Inflation Flatters Stocks Over Bonds June 2020 June 2020 Chart I-29Bonds Are Prohibitively Expensive Bonds Are Prohibitively Expensive Bonds Are Prohibitively Expensive In absolute terms, G-7 government bonds are also vulnerable, both tactically and structurally. They are overbought and currently trade at their greatest premium to fair value since Q4 2009 and Q1 1986, two periods followed by sharp rebounds in yields (Chart I-29). Moreover, the previous experience with QE programs shows that even if real rates diminish, the reflationary impact of aggressive monetary policy on breakeven rates is enough to increase nominal interest rates (Chart I-30). Additionally, as our European Investment Strategy team indicates, bond yields are close to their practical lower bound, which creates a negative skew to their return profile.7 This asymmetric return distribution destroys their ability to hedge equity risk going forward, making this asset class less appealing to investors. This problem is particularly salient in Europe and Japan. A lower dollar, which is highly reflationary for global growth, will likely catalyze the rise in yields.   Chart I-30QE Will Lift Breakevens And Yields QE Will Lift Breakevens And Yields QE Will Lift Breakevens And Yields As long as real rates remain under downward pressure, the window to own stocks remains open, even if stocks continue to churn. Equities are expensive, but when yields are taken into consideration, their adjusted P/E is in line with the historical average (Chart I-31). Moreover, periods of weak growth associated with lower real interest rates can foster a large expansion in multiples (Chart I-32). Chart I-31Low Bond Yields Allow High Stock Multiples Low Bond Yields Allow High Stock Multiples Low Bond Yields Allow High Stock Multiples Chart I-32Multiples Will Rise Further As The Fed Floods The World With Low Rates Multiples Will Rise Further As The Fed Floods The World With Low Rates Multiples Will Rise Further As The Fed Floods The World With Low Rates Whether to have faith in stocks in absolute terms on a long-term basis is complicated by our view on inflation and populism. Strong inflation will increase nominal rates. Moreover, low productivity coupled with higher real wages, less-efficient supply chains and higher taxes will accentuate the margin compression that higher inflation typically creates. Thus, equities are expected to generate poor real returns over the long term, even if they beat bonds. Chart I-33Tech EPS Leadership Tech EPS Leadership Tech EPS Leadership Tech stocks are another structural problem for equities. Including Amazon, Google and Facebook, tech stocks account for 41% of the S&P 500’s market cap. As our US Equity Strategy service explains, wherever tech goes, so does the US market.8 Tech stocks are the current market darling. Today, the tech sector is the closest thing to a safe-haven in the mind of market participants, because a post-COVID-19 environment will favor tech spending (telecommuting, e-commerce, cloud computing, etc.). The problem for long-term investors is that this view is the most consensus view. Already, investors expect the tech sector to generate the highest EPS outperformance relative to the rest of the S&P 500 in more than 15 years (Chart I-33). Moreover, in a low-yield environment, investors are particularly willing to bid up the multiples of growth stocks such as tech equities because low interest rates result in muted discount factors for long-term cash flows. When should investors begin betting against the tech sector? Backed by a powerful narrative, tech stocks are evolving into a mania. Yet, contrarian investors understand, being too early to sell a mania can be deadly. Bond yields should not be relied on to signal an end to the bubble. During most of the 1990s, tech would outperform the market when Treasury yields declined. However, when the tech outperformance became manic, yields became irrelevant. From the fall of 1998 to the beginning of 2000, 10-year yields rose from 4.2% to 6.8%, yet the tech sector outperformed the S&P 500 by 127%. More recently, yields rose from 1.33% in the summer of 2016 to 3.25% in November 2018, but tech outperformed the broader market by 39%.   Investors should favor stocks over bonds. Instead, higher inflation will be the key factor to end the tech sector’s infallibility. Since the 1990s, higher core inflation has led periods of tech underperformance by roughly six months. This relationship also held at the apex of the tech bubble in the second half of the 1990s (Chart I-34). Relative tech forward EPS suffers when core inflation rises, as the rest of the S&P 500 is more geared to higher nominal GDP growth. In essence, if nominal growth is less scarce, then the need to bid up growth stocks diminishes. Moreover, the dollar will likely be the first early signal because it leads nominal GDP. As a result, a weak dollar leads to a contraction in tech relative multiples by approximately 9 months (Chart I-35). Chart I-34Tech Hates Inflation... Tech Hates Inflation... Tech Hates Inflation... Chart I-35...And A Soft Dollar ...And A Soft Dollar ...And A Soft Dollar   We recommend long-term investors shift their portfolios toward industrial equities when inflation turns the corner. As a corollary, the low exposure of European and Japanese stocks to the tech sector suggests these cheap bourses will finally reverse their more-than-a-decade-long underperformance at the same time. This strategy means that even if the S&P 500 generates negative real returns during the coming decade, investors could still eke out positive returns from their stock holdings. Higher inflation will be the key factor to end the tech sector’s infallibility. Chart I-36The Time For Commodities Is Coming Back The Time For Commodities Is Coming Back The Time For Commodities Is Coming Back Finally, commodities plays are also set to shine in the coming decade. Commodities are very cheap and oversold relative to stocks (Chart I-36). Commodities outperform equities in an environment where inflation rises, real rates decline and the dollar depreciates. Consequently, materials and energy stocks may be winners. As a corollary, Latin American and Australian equities should also reverse their decade-long underperformance when inflation and the dollar turn the corner. This month's Section II Special Report is an in depth study of the Spanish Flu pandemic, written by our colleague Amr Hanafy and also published in BCA Research’s Global Asset Allocation service. Amr thoroughly analyses the evolution of the 100-year old pandemic and which measures mattered most to contain the virus and allow a return to economic normality. Mathieu Savary Vice President The Bank Credit Analyst May 28, 2020 Next Report: June 25, 2020 II. Lessons From The Spanish Flu What Can 1918/1919 Teach Us About COVID-19?   “Those who cannot remember the past are condemned to repeat it” George Santayana – 1905 Chart II-1Coronavirus: As Contagious But Not As Deadly As Spanish Flu June 2020 June 2020 Today’s economy is very different to that of 100 years ago. Many countries then were in the middle of World War I (which ended in November 1918). The characteristics of the Spanish Flu which struck the world in 1918 and 1919 were also different to this year’s pandemic. COVID-19 is almost as contagious as the Spanish Flu, but it is much less deadly (Chart II-1). Healthcare systems and treatments today are far more advanced than those of a century ago: many people who caught Spanish flu died of complications caused by bacterial pneumonia, given the absence of antibiotics. Influenza viruses tend to mutate rapidly: the influenza virus in 1918 first mutated to become far more virulent in its second wave, and then to become much milder. Coronaviruses have a “proofreading” capacity and mutate less easily.9  Nevertheless, an analysis of the pandemic of 100 years ago provides a number of insights into the current crisis, particularly now that policymakers are easing social-distancing rules to help the economy, even at the risk of more cases and deaths. Among the lessons of 1918-1919: Non-pharmaceutical interventions (NPIs) do lower mortality rates. The speed at which NPIs are implemented and the period of implementation are as important as the number of measures taken. Removing or relaxing measures too early can lead to a renewed rise in mortality rates. It is hard to compare current fiscal and monetary policies to those taken during the 1918 pandemic, since policy in both areas was already easy before the pandemic as a result of the world war. However, a severe pandemic would certainly call for a wartime-like fiscal and monetary response. The economy was negatively impacted by the pandemic in 1918-19 but, despite the shock to industrial activity and employment, the economy subsequently rebounded quickly, in a V-shaped recovery. Introduction Predicting how the economy will react to the COVID-19 pandemic is hard. Governments and policymakers face multiple uncertainties: How effective are different containment measures? Will cases and deaths rebound quickly if lockdown measures are eased? When will the coronavirus disappear? When will a vaccine be ready? With an event unprecedented in the experience of anyone alive today, perhaps there are some lessons to be learned from history. For this Special Report, we attempt to draw some parallels between the current situation and the 1918-19 Spanish flu. We focus on the different containment efforts implemented, the role that fiscal and monetary policies played, the impact on markets and the economy, and whether history can throw any light on how the COVID-19 crisis might pan out. The 1918 Spanish Flu Chart II-2The Spanish Flu Hit The World In Three Waves The Spanish Flu Hit The World In Three Waves The Spanish Flu Hit The World In Three Waves The 1918 influenza pandemic was the most lethal in modern history. Soldiers returning from World War I helped spread the pandemic across the globe. The first recorded case is believed to have been in an army camp in Kansas. While there is no official count, researchers estimate that about 500 million people contracted the virus globally, with a mortality rate of between 5% and 10%. The pandemic occurred over three waves in 1918 and 1919 – the first in the spring of 1918, the second (and most deadly) in the fall of 1918, and the third in spring 1919 (Chart II-2). In the US alone, official data estimate that around 500,000 deaths (or over 25% of all deaths) in 1918 and 1919 were caused by pneumonia and influenza.10 The pandemic moved swiftly to Europe and reached Asia by mid-1918, but became more lethal only towards the end of the year (Map II-1).11 Map II-1The Spread Of Influenza Through Europe June 2020 June 2020 Initially, scientists were puzzled by the origin of the influenza and its biology. It was not until a decade later, in the early 1930s, that Richard Shope isolated the particular influenza virus from infected pigs, confirming that a virus caused the Spanish Flu, not a bacterium as most had thought. Many of those who caught this strain of influenza died as a result of their lungs filling with fluid in a severe form of pneumonia. In reporting death rates, then, it is considered best practice to include deaths from both influenza and pneumonia. The first wave had almost all the hallmarks of a seasonal flu, albeit of a highly contagious strain. Symptoms were similar and mortality rates were only slightly higher than a normal influenza. The first wave went largely unnoticed given that deaths from pneumonia were common then. US public health reports show that the disease received little attention until it reappeared in a more severe form in Boston in September 1918.12 Most countries did not begin investigating and reporting cases until the second wave was underway (Chart II-3). Chart II-3Most Countries Began Reporting Only When The Second Wave Hit June 2020 June 2020 This second wave – which was more lethal because the virus had mutated – had a unique characteristic. Unlike the typical influenza mortality curve – which is usually “U” shaped, affecting mainly the very young and elderly – the 1918 influenza strain had a “W”-shaped mortality curve – impacting young adults as well as old people (Chart II-4). This pattern was evident in all three waves, but most pronounced during the second wave. The reason for this was that the infection caused by the influenza became hyperactive, producing a “cytokine storm” – when mediators secreted from the immune system result in severe inflammation.13 Simply put, as the virus became virulent, the body’s immune system overworked to fight it. Younger people, with strong immune systems, suffered most from this phenomenon. Chart II-4A Unique Characteristic: Impacting Younger Adults June 2020 June 2020 By the summer of 1919, the pandemic was over, since those who had been infected had either died or recovered, therefore developing immunity. The lack of records makes it difficult to assess if “herd immunity” was achieved. However, some historical accounts and research – particularly for army groups in the US and the UK – suggest that those exposed to the disease in the first mild wave were not affected during the second more severe wave.14 The failure to define the causative pathogen at the time made development of a vaccine impossible. Nevertheless, some treatments and remedies showed modest success. These varied from using a serum – obtained from people who had recovered, who therefore had antibodies against the disease – to simple symptomatic drugs and various oils and herbs. The Effectiveness Of Non-Pharmaceutical Interventions (NPIs) Chart II-5Travel Slowed...Just Not Enough Travel Slowed...Just Not Enough Travel Slowed...Just Not Enough What we today call “social distancing” showed positive effects during the 1918-19 pandemic. These included measures very similar to those applied today: school closures, isolation and quarantines, bans on some sorts of public gatherings, and more. However, there were few travel bans. The number of passengers carried during the months of the pandemic did noticeably decline though (Chart II-5). Table II-1, based on research by Hatchett, Mecher and Lipsitch, breaks down NPIs by type for 17 major US cities. Most cities implemented a wide range of interventions. But it was not only the type of NPIs implemented that made a difference, but also the speed and length of implementation. Further research by Markel, Lipman and Navarro based on 43 US cities shows that the median number of days between the first reported influenza case and the first NPI implementation was over two weeks. The median period during which various NPIs were implemented was about six weeks (Table II-2). Table II-1Measures Applied Then Are Very Similar To Those Applied Today June 2020 June 2020 Table II-2NPIs Were Implemented Only For Short Periods June 2020 June 2020 Markel, Lipman and Navarro's findings show that a rapid public-health response was an important factor in reducing the mortality rate by slowing the rate of infection, what we now refer to as “flattening the curve.” There were major differences in cities’ policies: both the speed at which they implement NPIs, and the length of the implementation period. Chart II-6 shows that: Cities that acted quickly to implement NPIs slowed the rate of infections and deaths (Chart II-6, panel 1) Cities that acted quickly had lower mortality rates from influenza and pneumonia (Chart II-6, panel 2) Cities that implemented NPIs for longer periods had fewer deaths (Chart II-6, panel 3) Chart II-7 quantifies the number of NPIs taken, the time it took to implement the measures, and the length of NPIs to gauge policy strictness. Cities with stricter enforcement had lower death rates than those with laxer measures. Chart II-6Fast Response And Longer Implementation Led To Fewer Deaths... June 2020 June 2020 Chart II-7...So Did Policy Strictness June 2020 June 2020     For example, Kansas City, less than a week after its first reported case, had implemented quarantine and isolation measures. By the second week, schools, churches, and other entertainment facilities closed. Schools reopened a month later (in early November) but quickly shut again until early January 1919. While we do not have definitive dates on when each NPI was lifted, some sort of protective measures in Kansas City were in place for almost 170 days. By contrast, Philadelphia, one of the cities hardest hit by Spanish Flu, took more than a month to implement any measures. Its tardiness meant that it reached a peak mortality rate much more quickly: in 13 days compared to 31 days for Kansas City. Even after the first reported case, the Liberty Loans Parade was still held on September 28, 1918 – with the knowledge that hundreds of thousands of spectators might be vulnerable to infection.15,16 It was not until a few days later that institutions were closed and a ban on public gatherings was imposed. Many other cities also held a Liberty Loans Parade, including Pittsburgh and Washington DC, but Philadelphia’s was the deadliest. Studies also show that relaxing interventions too early could be as damaging as implementing them too late. St. Louis, for example, was quick to lift restrictions and suffered particularly badly in the second wave as a result. It later reinstated NPIs up until end of February 1919. Other cities that eased restrictions too early (San Francisco and Minneapolis, for example) also suffered from a second swift, albeit milder, increase in weekly excess death rates from pneumonia and influenza (Chart II-8). Chart II-8Relaxing Lockdown Measures Too Early Can Lead To A Second Rise In Deaths... June 2020 June 2020 Chart II-9...And So Can Highly Effective Measures June 2020 June 2020 Of course, NPIs cannot be implemented indefinitely. A recent research paper by Bootsma and Ferguson raises the point that suppressing a pandemic may not be the best strategy because it just leaves some people susceptible to infection later. They argue that highly effective social distancing measures, which allow a susceptible pool of people to reintegrate into society when the measures are lifted, are likely to lead to a resurgence in infections and fatalities in a second peak (Chart II-9).17 They suggest an optimal level of control measures to reduce R (the infection rate) to a value that makes a significant portion of the population immune once measures are lifted.  The Impact Of The Spanish Flu On The Economy And Markets How did the Spanish Flu pandemic affect the economy? Many pandemic researchers ignore the official recession identified by the NBER during the months of the pandemic (between August 1918 and March 1919).18 The reason is that most of the evidence indicates that the economic effects of the 1918-19 pandemic were short-term and relatively mild.19 Disentangling drivers of the economy is, indeed, tricky given that WW1 ended in November 1918. However, it is easy to underestimate the negative impact of the pandemic since the war had such a big impact on the economy, as well as investor and public sentiment. Various research papers support the fact that, while the pandemic did indeed have an adverse effect on the economy, NPIs did not just depress mortality rates, but also sped the post-pandemic economic recovery.20 Research by Correia, Sergio, and Luck showed that the areas most severely affected by the pandemic saw a sharp and persistent decline in real economic activity, whereas cities that intervened earlier and more aggressively, experienced a relative increase in economic activity post the pandemic.21 Their findings are based on the increase in manufacturing employment after the pandemic compared to before it (1919 versus 1914). However, note that the rise of manufacturing payrolls in 1919 was high everywhere given the return of soldiers post-WWI. The researchers also note that those cities hardest hit by the pandemic also saw a negative impact on manufacturing activity, the stock of durable goods, and bank assets. Chart II-10Short-Term Price Impact Was Disinflationary Short-Term Price Impact Was Disinflationary Short-Term Price Impact Was Disinflationary Because Spanish flu disproportionately killed younger adults, many families lost their breadwinner. In economic terms, this implies both a negative supply shock and negative demand shock. If fewer employees are available to produce a certain good, supply will fall. The same reduction in employment also implies reduced income and therefore lower purchasing power. Both cases will result in a decrease in output. However, the change in prices depends on the decline of supply relative to demand. In 1918-19, the impact was disinflationary: demand declined by more than supply, and both spending and consumer prices fell during the pandemic (Chart II-10). US factory employment fell by over 8% between March 1918 and March 1919 – the period from the beginning of the first wave until the end of the second wave. It is important to note, however, that few businesses went bankrupt during the pandemic years (Chart II-11). Additionally, the November 1918 Federal Reserve Bulletin highlighted that many cities, including New York, Kansas City, and Richmond, experienced a shortage of labor due to the influenza.22 Factory employment in New York fell by over 10% during this period. The link between the labor shortages and the decline in industrial production is unclear. Industrial activity in the US peaked just before the second wave, contracting by over 20% during the second wave (Chart II-12). Various industries reported disruptions: automobile production fell by 67%, anthracite coal production and shipments fell by around 45%, and railroad freight revenues declined by over seven billion ton-miles (Chart II-12, panels 2, 3 & 4). However, some of this decline is attributed to falling defense production after the war. Chart II-11Loss Of Middle-Aged Adults = Loss Of Breadwinners Loss Of Middle-Aged Adults = Loss Of Breadwinners Loss Of Middle-Aged Adults = Loss Of Breadwinners Chart II-12Activity Slowed, But Rebounded Quickly Activity Slowed, But Rebounded Quickly Activity Slowed, But Rebounded Quickly   Chart II-13The War Had A Bigger Impact On The Stock Market Than The Pandemic The War Had A Bigger Impact On The Stock Market Than The Pandemic The War Had A Bigger Impact On The Stock Market Than The Pandemic Chart II-14Monetary Policy Was Easy...Even Before The Pandemic Started Monetary Policy Was Easy...Even Before The Pandemic Started Monetary Policy Was Easy...Even Before The Pandemic Started The equity market moved in a broad range in 1915-1919 and fell sharply only ahead of the 1920 recession (Chart II-13). Seemingly, stock market participants were more focused on the war than the pandemic. The lack of reporting of the pandemic could have contributed to this: newspapers were encouraged to avoid carrying bad news for reasons of patriotism and did not widely cover the pandemic until late 1918.23 The Federal Reserve played an active role in funding the government’s spending on the war, and so monetary policy was very easy during the pandemic – but for other reasons. The Fed used its position as a lender to the banking system to facilitate war bond sales.16 Interest rates were cut in 1914 and 1915 even before the US entered the war. The US economy had been in recession between January 1913 and December 1914. Policy rates remained low throughout 1916 and 1917 and slightly rose in 1918 and 1919. It was not until 1920 that Federal Reserve Bank System tightened policy rapidly to choke off inflation, which accelerated to over 20% in mid-1920 – rising inflation being a common post-war phenomenon (Chart II-14). The Lessons Of 1918-19 For The Coronavirus Pandemic Non-pharmaceutical interventions should continue to be implemented until a vaccine, effective therapeutic drugs, or mass testing is available. Relaxing measures prematurely is as damaging as a tardy reaction to the pandemic. Reacting quickly and imposing multiple measures for longer periods not only reduces mortality rates, but also improves economic outcomes post-crisis. The economy suffers in the short-term: supply and demand shocks lead to lower output. The demand shock however is larger leading to lower prices and disinflationary pressures, at least during and immediately after the pandemic.   Amr Hanafy Senior Analyst Global Asset Allocation III. Indicators And Reference Charts Last month, we maintained a positive disposition toward stocks, especially at the expense of government bonds. The global economy may be in the midst of its most severe contraction since the Great Depression, but betting against stocks is too dangerous when fiscal and monetary policy are both as easy as they are today. In essence, don’t fight the Fed. This view remains in place, even if the short-term risk/reward ratio for holding stocks is deteriorating. On a cyclical basis, the same factors that made us willing buyers of stocks remain broadly in place. Stocks are not as cheap as they were in late March, but monetary conditions have only eased further as real interest rates weakened. Additionally, our Speculation Indicator has eased, which indicates that contrary to many commentators’ perceptions, speculation is not rampant. Confirming this intuition, the equity risk premium remains elevated (even when one takes into account its lack of stationarity) and expected growth rates of earnings are still very low. Finally, our Revealed Preference Indicator is finally flashing a strong buy signal. Tactically, equities are still overbought. We have had four 5% or more corrections since March 23. More of them are in the cards. However, the most likely outcome for the S&P 500 this summer is a churning pattern, not a major downward move below 2700. The median stock is still 26% below its August 2018 low and only a fraction of equities on the NYSE trade above their 30-week moving average. These indicators do not scream that a major correction is on the horizon, especially when policy is as accommodative as it is today. We continue to recommend investors take advantage of the supportive backdrop for stocks by buying equities relative to bonds. In contrast to global bourses, government bonds are still massively overbought on a cyclical basis and trading at their largest premium to fair value since Q4 2008 and late 1985. Additionally, the vast sums of both monetary and fiscal stimulus injected in the economy should lift inflation expectations and thus, bond yields. The yield curve is therefore slated to steepen further. Since we last published, the dollar has not meaningfully depreciated, but the DXY is trying to breakdown while our composite technical indicator is making lower highs. It is too early to gauge whether the recent rebound in the IDR, the MXN, or the ZAR is anything more than an oversold bounce, but if it were to continue, it would indicate that the expensive greenback is starting to buckle under the weight of the quickly expanding twin deficit. The widening in the current account deficit that will result from extraordinarily loose fiscal policy means that the large increase in money supply by the Fed will leak out of the US economy. This process is highly bearish for the dollar. Ultimately, the timing of the dollar’s weakness will all boil down to global growth. As signs are building up that global growth is bottoming, odds are rising that the dollar will finally breakdown. Get ready for a meaningful downward move over the coming months. Finally, commodities seem to be gaining traction. The Continuous Commodity Index’s A/D line is quickly moving up and our Composite Technical Indicator is quickly rising from extremely oversold levels. Oil will hold the key for the broad complex. Oil supply has started to adjust lower and oil demand is set to improve starting June/July as the global economy re-opens, fueled with massive amounts of stimulus. As a result, inventories should start to meaningfully decline this summer, which will support the recent recovery in oil prices. If oil can rebound further, industrial commodities will follow. Finally, gold is a mixed bag in the near term. The dollar is set to weaken significantly and inflation breakevens to move higher, which will mitigate the negative impact of declining risk aversion. Silver is a superior play to gold as it will benefit from a recovery in global growth. 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 Reid Cramer et al., The Emerging Millennial Wealth Gap, Divergent Trajectories, Weak Balance Sheets, and Implications for Social Policy, New America, Oct 2019. 2 https://www.wsj.com/articles/new-normal-amid-coronavirus-working-from-home-while-schooling-the-kids-11584437400 3 Please see Geopolitical Strategy Special Report "The Apex Of Globalization - All Downhill From Here," dated November 12, 2014, available at gps.bcaresearch.com 4  Please see The Bank Credit Analyst Special Report "The Productivity Puzzle: Competition Is The Missing Ingredient," dated June 27, 2019, available at bca.bcaresearch.com 5  Please see The Bank Credit Analyst Monthly Report "May 2020," dated April 30, 2020, available at bca.bcaresearch.com 6 Please see Foreign Exchange Strategy Weekly Report "A Few Trades Amidst A Pandemic," dated May 22, 2020, available at fes.bcaresearch.com 7 Please see European Investment Strategy Weekly Report "European Investors Left Defenceless," dated May 21, 2020, available at eis.bcaresearch.com 8 Please see US Equity Strategy Special Report "Debunking Earnings," dated May 19, 2020, available at uses.bcaresearch.com 9 Please see the Q&A with immunologist and Nobel laureate Professor Peter Doherty, published by BCA Research April 1st 2020: BCA Research Special Report, “Questions On The Coronavirus: An Expert Answers,” available at bcaresearch.com 10 Please see “Leading Cause of Death, 1990-1998,” CDC Centers for Disease Control and Prevention. 11 Please see Ansart S, Pelat C, Boelle PY, Carrat F, Flahault A, Valleron AJ, “Mortality burden of the 1918-1919 influenza pandemic in Europe,” NCBI. 12 Please see Public Health Report, vol. 34, No. 38, Sept. 19, 1919. 13 Please see Qiang Liu, Yuan-hong Zhou, Zhan-qiu Yang Cell Mol Immunol. 2016 Jan; 13(1): 3–10. 14 Please see Shope, R. (1958) Public Health Rep. 73, 165–178. 15 The Liberty Loans Parade was intended to promote the sale of government bonds to pay for World War One. 16 Please see Hatchett RJ, Mecher CE, Lipsitch M (2007) "Public health interventions and epidemic intensity during the 1918 influenza pandemic,"PNAS 104: 7582–7587. 17 Please see Bootsma M, Ferguson N, “The Effect Of Public Health Measures On The 1918 Influenza Pandemic In U.S. Cities,” PNAS (2007). 18 Please see https://www.nber.org/cycles.html 19 Please see https://www.stlouisfed.org/~/media/files/pdfs/community-development/res…12               Please see https://libertystreeteconomics.newyorkfed.org/2020/03/fight-the-pandemic-save-the-economy-lessons-from-the-1918-flu.html. 20 Please see Correia, Sergio and Luck, Stephan and Verner, Emil, Pandemics Depress the Economy, Public Health Interventions Do Not: Evidence from the 1918 Flu (March 30, 2020). Available at SSRN: https://ssrn.com/abstract=3561560 or http://dx.doi.org/10.2139/ssrn.3561560. 21 Please see Board of Governors of the Federal Reserve System (U.S.), 1935- and Federal Reserve Board, 1914-1935. "November 1918," Federal Reserve Bulletin (November 1918). 22 Please see https://newrepublic.com/article/157094/americas-newspapers-covered-pandemic. 23 Please see https://www.federalreservehistory.org/essays/feds_role_during_wwi.