United States

Highlights Portfolio Strategy The Fed’s extremely easy monetary backdrop along with easy fiscal policy remain the dominant macro themes, and they will continue to underpin the equity market. We remain constructive on the equity market’s prospects on a cyclical 9-12 month time horizon. While the path of least resistance remains higher for the S&P biotech index, we do not want to overstate our welcome and are putting it on downgrade alert and instituting a 5% rolling stop in order to protect profits. Relative supply/demand dynamics, social distancing, the pendulum swinging from renting to owing and enticing relative technicals and valuations, all signal that a long S&P homebuilders/short S&P REITs pair trade is primed to generate alpha.   Recent Changes Initiate a long S&P homebuilders/short S&P real estate trade, today. Table 1 Feature The SPX had a bumper week last week, but failed to pierce through the 200-day moving average. A flare up in the US/China trade war, a barrage of positive coronavirus vaccine news and Jay Powell’s 60 minutes interview brought back some volatility in trading, however, the VIX remains in a steady downturn. Importantly, investors are nowhere near as complacent as during the 2018/19 or early 2020 SPX peaks, judging by VIX futures positioning (net speculative positions shown inverted, Chart 1). Chart 1Positioning Is Far... In other words, there is still room for equities to rise before sentiment reaches greedy levels. A number of other indicators we track confirm that recent SPX trading is associated more with panic than with euphoria. Namely, Chart 2 shows that our Complacency-Anxiety, Capitulation and Equity Sentiment Indicators, all corroborate that investor confidence is far from previous exuberant peaks, and signal that there is scope for additional equity gains on a cyclical 9-12 month time horizon.  Delving deeper into investor psyche, our sense is that there are three distinct camps of investors at the current juncture, two of which are fiercely battling it out in the stock market. Chart 2…From Complacent First there are the pessimists that we call “second wavers” that are more often than not also “Fed non-believers” or “Fed fighters”. They argue that stocks are extremely expensive and if a second wave of the corona virus hits, then stocks are going to plunge anew given the lack of a valuation cushion, as all the money in the world (Fed QE5) cannot cure the virus (top panel, Chart 3). Second, there are the optimists that are hopeful that a vaccine/drug cocktail discovery is looming to effectively eradicate the coronavirus. These investors also believe in the smooth reopening of the economy. But, even if there were a second wave, their thinking goes that our societies/governments/health care systems are all going to be more prepared and effective to deal with a second viral outbreak in the fall. In addition, they are in the “do not fight the Fed” camp. Finally, there are the more moderate investors that lie somewhere in between these two camps. They sat tight and held on to their stock positions during the 36% peak-to-trough SPX drawdown and have likely been on the sidelines lately (bottom panel, Chart 3) awaiting a catalyst to either deploy fresh capital or raise some cash. We are in the more optimistic camp and while a vaccine may be months away, we will have to figure out a way as a society to more effectively protect the elderly that are most at risk from the virus and continue to live on, as we first posited in the March 23rd Weekly Report when we outlined 20 reasons to buy stocks and reprint here: "20. Social-distancing measures in the West will ultimately break the Epidemic Curve first derivative and arrest the panic. Even if COVID-19 comes back in force, the fact is that most of the patients who succumb to it are elderly. In Italy, the average age of death is 80 years old. As such, the final circuit-breaker ahead of a GFC would be desensitization by the population, as selective quarantines – targeting the elderly cohorts – get implemented in order to allow other people to return to work. Furthermore, two “silver bullet” solutions remain as tail risks to the bearish narrative. First, a biotech or pharmaceutical company may make a breakthrough in the fight against COVID-19. Not necessarily a vaccine, but a treatment. Finally, upcoming warm weather in the northern hemisphere may also help the fight against the virus."1 Chart 3Cash Hoarding Is Associated With Market Troughs Chart 4Loose Monetary Policy… Moreover, we definitely refrain from fighting the Fed as we outlined in our recent “Fight Central Banks At Your Own Peril” Weekly Report2 and reiterate that view today (Chart 4). While some investors were surprised by Jay Powell’s 60 Minutes interview remarks on the way the Fed digitally creates money, Ben Bernanke in another 60 Minutes interview in March 20093 made a similar comment that we cited in our March 23 Weekly Report (please refer to reason number 6 to buy equities).4 Importantly, we felt that Jay Powell’s demeanor was more like “please test our resolve Mr. Market if you reckon the FOMC is out of ammunition”. As a reminder, the Fed is in a position of strength: devaluing a currency is easy, revaluing/defending a currency is difficult and at times impossible as FX (and gold) reserves eventually run dry. In sum, the Fed’s extremely easy monetary backdrop along with easy fiscal policy (Chart 5) remain the dominant macro themes, and they will continue to underpin the equity market. Eventually, a liquidity handoff to growth will take root, and the SPX will no longer require the immense fiscal and monetary supports. As a result we continue to believe that stocks will be higher in the coming 9-12 months. Chart 5…And Easy Fiscal Policy Are Underpinning Stocks Biotech Delivers We have been overweight the S&P biotech index and adding alpha to our portfolio in the double digits, however we do not want to overstate our welcome and are putting it on downgrade alert and instituting a 5% rolling stop in order to protect profits. While a few technology sectors and subsectors have come close to vaulting to fresh all-time highs, none other than the S&P biotech index has managed such an impressive feat. The stealthy advance in biotech stocks has been earnings driven and is not only confined to the narrow based Big-Pharma lookalike S&P biotech index (Chart 6). The broader-based NASDAQ biotech index comprising 209 stocks has also quietly sprang to uncharted territory. True, relative share prices have yet to make the all-time high leap, but have bested the market roughly by 30% year-to-date irrespective of the biotech index or ETF tracked (Chart 6). Importantly, growth stocks in general and biotech stocks in particular perform exceptionally well in a disinflationary growth environment. Therefore biotech stocks are the primary beneficiaries of the Fed’s QE5 and NIRP policies at a time when inflation is missing in action (top panel, Chart 7). Chart 6Earnings-Led Advance This goldilocks backdrop is also evident in the US bank credit impulse that has gone parabolic. When there is flushing liquidity and growth is scarce and declining, investors flock to any growth they can get their hands on (bottom panel, Chart 7). Chart 7Goldilocks Backdrop US dollar based liquidity, also underpins biotech stocks. In recent research, we have been highlighting that the Fed is indirectly targeting the debasing of the greenback. All this excess US dollar liquidity will eventually boost global growth, and reflate corporate earnings via the export relief valve. Biotech stocks will also get a fillip from a depreciating US dollar (Chart 8). Our overweight thesis in biotech was predicated – among other things – upon Big Pharma taking out biotech players and acquiring their coveted drug pipelines. We continue to side with the potential M&A targets, rather than the acquirers. The number of industry M&A deals has reached fever pitch and deal premia are still averaging over 60% (Chart 9). Chart 8Dollar Flooding Is A Boon For Biotech Equities Currently, the global race to find a coronavirus vaccine has further propelled biotech stocks. Indeed, investors are voting with their feet and are betting on a vaccine breakthrough. Thus, the allure of biotech stocks has also increased a notch as the possibility of a vaccine makes their earnings streams even more valuable and desirable to Big Pharma. A mega M&A deal in the space would not take us by surprise. Chart 9M&A Activity Will Remain Robust A few words are in order on the earnings, valuation and technical fronts. While relative share price momentum is galloping higher, it is moving in lockstep with rising earnings estimates (second panel, Chart 10). We would be extremely concerned if this were a multiple expansion driven relative share price advance. In fact, the biotech forward P/E trades both below the historical mean and at a 39% discount to the broad market hovering near an all-time low (Chart 10). Even on a dividend yield basis, biotech stocks are cheap sporting a higher (and safer) dividend yield than the SPX (bottom panel, Chart 10). Chart 10Biotech Stocks Are As Cheap As They Have Ever Been Chart 11Earnings Hurdle Remains Low Finally, relative long-term profit growth euphoria reaching astronomical levels, preceded previous S&P biotech index peaks: three times in the past two decades biotech stocks were projected to surpass SPX profit growth by roughly 10%. The current reading has plunged to negative 1.2% (Chart 11). Netting it all out, the global race for a coronavirus vaccine, robust earnings growth, ample US dollar liquidity and generationally low interest rates suggest that the path of least resistance remains higher for the S&P biotech index.   Bottom Line: Stay overweight the S&P biotech index, but put it on downgrade alert and set a 5% rolling stop in order to protect profits. The ticker symbols for the stocks in this index are: BLBG: S5BIOT – ABBV, ALXN, AMGN, BIIB, GILD, INCY, REGN, VRTX. Intra-Real Estate Trade Idea There is an exploitable trade opportunity in the real estate market, preferring residential real estate to commercial real estate (CRE). The cleanest way to play this is via a long S&P homebuilders/short S&P REITs pair trade, and we recommend initiating such a market-neutral trade today. Relative performance remains below the upward sloping time trend and at least a mini overshoot phase is in the cards in the coming quarters (Chart 12). One of the key drivers for this pair trade is the ebb and flow of owning versus renting and the current message is positive for homebuilders at the expense of REITs (Chart 13). Chart 12Looming Overshoot Phase Chart 13Own Versus Rent Upswing Is Bullish For The Pair Trade Home ownership has suffered a setback and never reclaimed its pre GFC highs. However, there is pent up demand for single family homes, especially given the recent drubbing of interest rates which should bring first time home buyers back into the market. Millennials up to now have been more of a renter generation, but as household formation increases for the largest cohort in the US, homeownership will make a comeback. One can argue that both real estate segments are interest rate sensitive and that they should benefit from lower rates. However, banks are more willing to lend to consumers in order to buy a home rather than to investors for CRE properties/projects by a factor of 2:1 according to the latest Federal Reserve Senior Loan Officer survey.5 Similarly, whereas demand for CRE loans has collapsed according to the same survey in April, demand for residential real estate loans spiked (top panel, Chart 14). In times of coronavirus-induced social distancing there is a lot more risk associated with CRE versus residential properties. Apartment REITs for example have an element of density-related risk versus the allure of a single family home in the suburbs. Likely social distancing will place a premium on single family homes in coming quarters at the expense of living in high rises in the city. This backdrop bodes well for home prices, but ill for CRE prices which according to Green Street Advisors contracted by 9% in April.6 Keep in mind that residential real estate price only very recently surpassed their 2006 zenith whereas CRE price are still hovering at one standard deviation above the previous peak (Chart 14). Debt deflation is a real threat for CRE prices and given that REITs are at the bottom of this levered asset’s capital structure it is last to collect.  Also the long-term ramifications to demand on CRE are grave compared with residential real estate. On the office REIT segment as an example, we deem that corporations will rethink their often expensive downtown office space requirements and likely downsize, as working from home has become mainstream. The unintended consequence of this realization is that demand for (larger) single family homes will also increase as workers opt to set up more comfortable working spaces at suburban homes. Chart 14Homebuilders Have The Upper Hand Shopping mall REITs are under relentless attack from the Amazonification of the economy and now have to contend with social distancing. The retail shopping experience will never be the same again sustaining the threat of extinction for shopping centers. On the construction front, single family housing starts are breaking ground at the historical mean and way below the 2006 peak run-rate, however, multi-family supply has gone parabolic (Chart 15). These diverging supply conditions are a harbinger of rising relative share prices. Finally, with regard to technicals and valuations homebuilders have the upper hand. Our Technical Indicator is in the neutral zone and relative valuations have collapsed near all-time lows offering a compelling entry point to the pair trade (Chart 16). Chart 15Supply Dynamics Favor Homebuilders Chart 16Relative Pessimism Is Contrarily Positive Netting it all out, relative supply and demand dynamics, social distancing, the pendulum swinging from renting to owing and enticing relative technicals and valuations, all signal that a long S&P homebuilders/short S&P REITs pair trade is primed to generate alpha.  Bottom Line: Initiate a long S&P homebuilders/short S&P REITs pair trade today. The ticker symbols for the stocks in the S&P homebuilding and S&P REITs indexes are: BLBG: S5HOME – LEN, PHM, NVR, DHI, and BLBG: S5REITS – AMT, PLD, CCI, EQIX, DLR, SBAC, PSA, AVB, EQR, WELL, ARE, O, SPG, ESS, WY, MAA, VTR, DRE, PEAK, BXP, EXR, UDR, HST, REG, IRM, VNO, FRT, AIV, KIM, SLG, respectively.   Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com     Footnotes 1     Please see BCA US Equity Strategy Weekly Report, “The Darkest Hour Is Just Before The Dawn” dated March 23, 2020, available at uses.bcaresearch.com 2     Please see BCA US Equity Strategy Weekly Report, “Fight Central Banks At Your Own Peril” dated April 14, 2020, available at uses.bcaresearch.com. 3    https://www.cbsnews.com/news/ben-bernankes-greatest-challenge/2/ 4    Please see BCA US Equity Strategy Weekly Report, “The Darkest Hour Is Just Before The Dawn” dated March 23, 2020, available at uses.bcaresearch.com 5    https://www.federalreserve.gov/data/sloos/sloos-202004.htm 6    https://www.greenstreetadvisors.com/insights/CPPI             Current Recommendations Current Trades Strategic (10-Year) Trade Recommendations Size And Style Views June 3, 2019 Stay neutral cyclicals over defensives (downgrade alert)  January 22, 2018 Favor value over growth May 10, 2018 Favor large over small caps (Stop 10%) June 11, 2018 Long the BCA  Millennial basket  The ticker symbols are: (AAPL, AMZN, UBER, HD, LEN, MSFT, NFLX, SPOT, TSLA, V).

Highlights Duration: The easing of shelter-in-place restrictions and resultant improvement in economic growth will cause US bond yields to rise somewhat during the next couple of months. However, the magnitude of economic improvement will be modest, and the Fed’s dovish rate guidance will temper the severity of any yield back-up. Municipal Bonds: The less-than-generous pricing offered through the Fed’s Municipal Liquidity Facility will not help push muni yields lower from current levels. However, very attractive valuations and the expectation of federal government relief justify an overweight allocation to the sector. Inflation & TIPS: We are not worried about significant inflation pressures any time soon. But equally, we don’t see 12-month headline CPI falling much below zero this year. This means that TIPS are cheap relative to nominal Treasuries. Treasury Yield Outlook Chart 1Taking A Breather Bond yields have been relatively stable since early April, and the Treasury index has performed roughly in-line with cash for most of the second quarter. This of course follows on the heels of massive outperformance in Q1 (Chart 1). Nonetheless, the recent stabilization in yields raises the question of whether bond returns are approaching a cyclical peak, or merely experiencing a temporary lull. Yields Are Biased Higher In The Near-Term … Our view is that a modest bond sell-off is likely during the next couple of months for four reasons. First, high-frequency global growth indicators are finally starting to hook up (Chart 2). Specifically, we like to track the CRB Raw Industrials commodity price index, emerging market currencies and the relative performance of cyclical versus defensive US equities. All three indicators track bond yields closely, and all three are showing signs of bottoming. Chart 2High-Frequency Global Growth Indicators Second, FLASH PMI estimates for May showed broad-based improvement compared to the April lows. Specifically, FLASH Manufacturing PMIs for the United States, Euro Area and United Kingdom all increased compared to April (Chart 3A). Of countries that have FLASH PMI estimates, only Japan saw a continued decline in May. If these numbers are to be believed, they suggest that April might indeed represent the global economic trough. We are still waiting for May data from China and the rest of the emerging world, important economic blocs that together account for 47% of the Global Manufacturing PMI. But China’s PMI, at least, has already rebounded off its February low (Chart 3B). China’s number will likely pressure the global index higher when it is released next week. Chart 3APMI Estimates For May Chart 3BChina's PMI Is Close To Neutral Third, high-frequency US economic data are consistent with an economy that is close to, or perhaps already passed, its economic trough. Initial jobless claims are still very high but have printed successively lower since peaking seven weeks ago. Similarly, the New York Fed’s Weekly Economic Index remains at its all-time low but is no longer in free fall (Chart 4).1   Chart 4US Economic Indicators Finally, but also most importantly, the slightly better data noted above are the result of economies that are slowly starting to re-open as daily new COVID cases roll over. This is particularly the case in Europe and North America (Chart 5). Restrictions will probably continue to ease during the next couple of months, meaning that both the economic data and bond yields are biased higher. Chart 5Global COVID-19 Cases … But Don’t Expect Anything More Than A Modest Sell-Off Chart 6Fed's Forward Guidance Quickly Dampened Vol However, there are also a few reasons to not get too bearish on US bonds. First, it is entirely possible – and even likely – that COVID cases will start to increase as shelter-in-place restrictions are lifted. If these second waves of the infection aren’t adequately suppressed via testing and contact tracing then restrictions could be re-instated by the fall, putting renewed downward pressure on bond yields. Also, while new COVID cases are declining in many parts of Europe and North America, several large emerging markets are still seeing cases accelerate. Brazil and India, for example, have yet to see a peak in new cases, while Russia’s new cases have just started to roll over (Chart 5, bottom 2 panels). Together, Brazil, Russia and India account for 8% of the Global Manufacturing PMI. Slow growth in those nations will significantly dampen any global economic recovery. On top of uncertainty surrounding the speed of any nascent global economic recovery, bond yields will also be held down by the Fed’s highly credible zero-lower-bound interest rate guidance. As we discussed in last week’s report, large bond sell-offs are almost always associated with a significant hawkish shift in monetary policy.2 This will not occur any time soon. In fact, the New York Fed’s latest Survey of Market Participants, taken just prior to the April 28-29 FOMC meeting, reveals that the median market participant expects the fed funds rate to stay at its current level at least until the end of 2022!3 On the one hand, such depressed expectations suggest scope for a massive re-pricing at some point in the future, but this will not occur until inflation forces the Fed to act. We agree with the survey respondents that this is a long way off. While new COVID cases are declining in many parts of Europe and North America, several large emerging markets are still seeing cases accelerate. It’s also interesting to note the speed at which the market has bought into the Fed’s zero-lower-bound rate guidance during the past two months. Chart 6 shows that after the Fed first cut rates to zero in December 2008, it still took several years for implied interest rate volatility to reach historically low levels. That is, the market was not initially convinced that rates would stay at zero for the long haul. In contrast, interest rate volatility has plunged dramatically since the Fed cut rates to zero on March 15. This time around, the market has been quick to buy into the Fed’s dovish message. Bottom Line: The easing of shelter-in-place restrictions and resultant improvement in economic growth will cause US bond yields to rise somewhat during the next couple of months. However, the magnitude of economic improvement will be modest, and the Fed’s dovish rate guidance will temper the severity of any yield back-up. Additionally, we can’t rule out the resumption of lockdown restrictions in the fall, should COVID cases rise during the summer. In terms of strategy, nimble investors may want to position for higher yields in the near-term. However, given the risks involved, we prefer to keep portfolio duration close to benchmark while implementing duration-neutral curve steepeners that will profit from rising yields. Specifically, we recommend going long the 5-year note and short a duration-matched barbell consisting of the 2-year and 10-year notes.4 Munis Carry Some Risk, But Offer A Lot Of Value Chart 7Munis Cheap Versus Treasuries Our spread product investment strategy during the recession has been to favor those sectors that: a)  Offer attractive yields/spreads b)  Benefit from one or more of the Fed’s emergency lending facilities Municipal bonds check both of those boxes. In terms of value, Aaa-rated municipal bond yields are consistently above Treasury yields across the entire maturity spectrum (Chart 7), a yield advantage that becomes especially pronounced when you factor in munis’ tax-exempt status. There is even a strong case for tax-exempt municipal bonds relative to corporate bonds. Table 1A shows the yield differential between tax-exempt municipal bonds and corporate bonds that carry the same credit rating and maturity. Not surprisingly, municipal bond yields are below corporate yields in most cases, with A-rated yields and longer-maturity Baa-rated yields being glaring exceptions. To put those yield differentials in context, Table 1B shows the breakeven effective tax rate for each muni/corporate combination. For example, the breakeven effective tax rate between Aaa-rated 5-year municipal and corporate bonds is 23%. This means that an investor will earn more after-tax yield in the municipal bond if his effective tax rate is above 23%, and less if it is below. It is apparent that breakeven effective tax rates are quite low, especially at the bottom-end of the credit spectrum. Table 1ASpread Between Municipal Bonds & Credit Index Yields* (BPs) Table IBMuni/Credit Breakeven Effective Tax Rate* (%) As for our second criterion, the municipal sector clearly benefits from the Fed’s Municipal Liquidity Facility (MLF). Through this facility, the Fed lends directly to eligible state & local governments for up to three years.5 However, there is a problem with the MLF: The cost. The Fed recently revealed that it will charge a rate of OIS + 150 bps for new loans taken out by Aaa-rated issuers through the MLF. That fixed spread rises as the issuer’s credit rating declines. Aa2 issuers are charged OIS + 175 bps, A2 issuers are charged OIS + 250 bps, etc…6 Chart 8MLF Pricing Doesn't Help Muni Investors For each credit rating, the rate available through the MLF is significantly higher than the actual market yield (Chart 8). This means that the MLF currently places a cap on how high municipal yields can rise, but it doesn’t actively pressure them lower. This stands in stark contrast to the rates offered through the Term Asset-Backed Securities Loan Facility (TALF) that are considerably below market yields on Aaa-rated CMBS and similar to market yields on Aaa-rated consumer ABS. Uncharitable MLF pricing structure aside, we think there are several reasons to remain overweight municipal bonds within US fixed income portfolios. First, the Fed is already facing criticism about the MLF rates and it could lower them in the near future. It has already shown a willingness to alter its facilities in response to market pressure. The MLF initially only made loans with maturities of 2 years or less, now it offers loans of up to 3 years. Second, direct federal aid to state & local governments was the centerpiece of the relief bill that recently passed through the House of Representatives. That bill will not get through the Senate in its current form, but another federal government relief package is forthcoming and it will almost certainly include money for state & local governments. There is even a strong case for tax-exempt municipal bonds relative to corporate bonds. Third, despite the massive challenges ahead, state governments entered the present crisis with relatively strong budget positions and well stocked rainy day funds (Chart 9). State & local governments will obviously be forced to make some tough budget decisions in the coming months, but there is no doubt that they are in a better position to do so than they were prior to the last two recessions. Chart 9State Rainy Day Funds Bottom Line: The less-than-generous pricing offered through the Fed’s Municipal Liquidity Facility will not help push muni yields lower from current levels. However, very attractive valuations and the expectation of federal government relief justify an overweight allocation to the sector. Deflation A Bigger Risk Than Inflation, But TIPS Still Make Sense Chart 10Energy Inflation May Have Troughed April’s CPI report saw year-over-year headline inflation fall to 0.4%, the lowest level since 2015. Deflation is clearly a bigger risk than inflation this year, but we would argue that TIPS prices are so beaten down that the sector still offers value. This is true over investment horizons as short as one year. We calculate that headline CPI inflation would have to come in below -0.85% over the next 12 months for a hold-to-maturity position in TIPS to underperform a similar position in nominal Treasuries (Chart 10). Could we actually see that much deflation during the next 12 months? It is possible, but we’d bet against it. First, the collapse in oil prices and energy inflation has been an important driver of falling inflation during the past couple of months (Chart 10, panel 2). But with oil prices having already dipped into negative territory and massive production cuts about to come on board, energy inflation may have already troughed for the year.7 At the very least, with oil prices already so low there is much less room for them to decline and thus less scope for further energy CPI deceleration. Second, the Great Financial Crisis (GFC) was the last time that headline CPI inflation went significantly below zero. Year-over-year core inflation had to get to 0.6% for that to happen. This year, 12-month core CPI dropped to 1.4% in April from 2.1%, but the trimmed mean measure only fell from 2.4% to 2.2% (Chart 10, bottom panel). During the GFC, both core and trimmed mean inflation fell in tandem. This gives us some reason to doubt the persistence of core CPI’s recent drop. Headline CPI inflation would have to come in below -0.85% over the next 12 months for a hold-to-maturity position in TIPS to underperform a similar position in nominal Treasuries. Finally, shelter accounts for roughly one third of headline inflation. Year-over-year shelter CPI troughed at -0.6% during the GFC. It also dropped sharply in April – from 3.0% to 2.6% – but it still has a long way to go to get back to GFC levels (Chart 11). We don’t think that shelter inflation will move back into negative territory, and without that drag it is hard to see 12-month headline CPI falling much below zero. Chart 11Shelter Is One Third Of CPI Rental vacancies are the number one driver of shelter CPI. The rental vacancy rate has only been updated through the end of March, and April’s data will definitely show a spike. However, the vacancy rate is starting from below 7%. The vacancy rate needed to spend several years hovering around 10% or higher before shelter CPI saw its big drop in 2008/09 (Chart 11, panel 2). The National Multifamily Housing Council (NMHC)’s Apartment Market Diffusion Index also does a good job predicting shelter inflation. Shelter inflation tends to fall when the index is below 50 and rise when it is above 50 (Chart 11, bottom panel). The Diffusion Index experienced a massive drop in April, back to GFC levels. However, it remains to be seen whether it will recover rapidly or remain below 50 for ten consecutive quarters like it did between 2007 and 2010. In fact, there is some reason to believe that the recovery might be fairly quick. Other data released by the NMHC show that as of May 20 2020, 90.8% of renters had made their monthly payments for May. In April 2020, 89.2% of renters had made their monthly payments by the 20th of the month. Unsurprisingly, both of these figures are below what was seen last year: In 2019, about 93% of renters had made their April and May monthly payments by the 20th of the month. But the fact that May 2020 data show a small increase compared to April indicates that the situation is not worsening, and it may in fact be getting better. Bottom Line: We are not worried about significant inflation pressures any time soon. But equally, we don’t see 12-month headline CPI falling much below zero this year. This means that TIPS are cheap relative to nominal Treasuries. We recommend overweighting TIPS versus nominal Treasuries across the entire maturity spectrum. We also recommend implementing TIPS curve steepeners.8 Appendix - Buy What The Fed Is Buying The Fed rolled out a number of aggressive lending facilities on March 23. These facilities focused on different specific sectors of the US bond market. The fact that the Fed has decided to support some parts of the market and not others has caused some traditional bond market correlations to break down. It has also led us to adopt a strategy of “Buy What The Fed Is Buying”. That is, we favor those sectors that offer attractive spreads and that benefit from Fed support. Right now, that means we are overweight corporate bonds rated Ba and higher, Aaa-rated Agency and non-agency CMBS, Aaa-rated consumer ABS and municipal bonds. We are underweight residential mortgage-backed securities and corporate bonds rated B and lower. The below Table tracks the performance of these different bond sectors since the Fed’s March 23 announcement. We will use this Table to monitor bond market correlations and evaluate our strategy's success. Table 2Performance Since March 23 Announcement Of Emergency Fed FacilitiesRyan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 The Weekly Economic Index is a composite of 10 daily and weekly indicators of real economic activity. For more details on its construction please see https://www.newyorkfed.org/research/policy/weekly-economic-index 2 Please see US  Bond Strategy Weekly Report, “The Treasury Market Amid Surging Supply”, dated May 12, 2020, available at usbs.bcaresearch.com 3  https://www.newyorkfed.org/medialibrary/media/markets/survey/2020/apr-2020-smp-results.pdf 4 For more details on our recommended yield curve positioning please see US Bond Strategy Weekly Report, “Life At The Zero Bound”, dated March 24, 2020, available at usbs.bcaresearch.com 5 For more details on the MLF and the Fed’s other emergency lending facilities please see US Investment Strategy/US Bond Strategy Special Report, “Alphabet Soup: A Summary Of The Fed’s Anti-Virus Measures”, dated April 14, 2020, available at usbs.bcaresearch.com 6 For full pricing details please see https://www.federalreserve.gov/newsevents/pressreleases/files/monetary20200511a1.pdf  7 For more details on BCA’s outlook for oil prices please see Commodity & Energy Strategy Weekly Report, “US Politics Will Drive 2H20 Oil Prices”, dated May 21, 2020, available at ces.bcaresearch.com 8 For more details on our recommendation for TIPS curve steepeners 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 Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Economic conditions are quite bad, … : Stay-at-home orders have decimated economic activity, giving rise to massive layoffs. … but policy makers embarked on a mighty initial effort to limit the longer-run effects: Mixing emergency GFC programs with bold new initiatives, the Fed has kept markets functioning and restrained defaults. Congress did its part with the CARES Act, opening the fiscal taps full blast to ease the burden on struggling households and businesses. Now the key question is if they’ll have the stomach to do more: Several businesses will not reopen, and it will be some time before nonfarm payrolls regain their peak. Successive waves of monetary and fiscal accommodation may be required to prevent longer-term scarring. Feature If we could have just one data series to assess the health of the economy, we would choose the monthly employment situation report. Though employment is only a coincident indicator, it is a powerfully self-reinforcing series, influencing consumption (Chart 1), fixed investment and future hiring. The unemployment rate also drives most household credit performance models, thereby influencing banks’ willingness to make auto, credit card and mortgage loans. The ripple effects of job losses can lead to a broader tightening of financial conditions, exacerbating downturns. Chart 1As Goes Employment, So Goes Consumption The April release was grim. The headline unemployment rate leaped by ten percentage points to 14.7%, its highest level since the Depression, but it failed to convey the full picture. With greater than 2% of the labor force having been laid off in each of the two weeks following the survey cut-off date, we estimate that the unemployment rate at the end of April was another four percentage points higher. There is a sizable gap between the 38.6 million workers who have filed for unemployment since mid-March and the 17.3 million newly unemployed captured in the March and April household surveys. The labor market data will get worse before it gets better, and we assume that the unemployment rate will peak above 20%. Astonishing numbers of jobs have been lost in the blink of an eye.  To avoid getting caught up in the unemployment rate’s technicalities, we are focusing on the change in employment. The establishment survey’s nonfarm payrolls series1 shrank by 21 million in March and April, or 14% from its February peak. To put the current episode into context, the 6.3% peak-to-trough decline in payrolls that played out over 25 months from February 2008 through February 2010 was previously the worst of the postwar era, dwarfing the typical recessionary payroll contraction of 1.5-3% (Chart 2). Chart 2Payrolls Have Never Shrunk Anything Like This Before Readers who’ve had their fill of the word “unprecedented” can call the employment contraction breathtaking. One mitigating factor, cited by economists inside and outside of the Fed, is that four-fifths of the layoffs have been characterized as temporary (Chart 3). That is certainly a positive, and we don’t doubt that nearly all bars, restaurants, gyms, hotels and concert venues would like to reopen. They surely planned to when stay-at-home orders were initially implemented, but things have changed over the ensuing ten weeks, and a new research paper suggests that only about three-fifths of laid-off workers will be recalled.2 Chart 3Nearly Every Laid-Off Worker Expects To Be Recalled For most of the postwar era, it took about 18 to 24 months for employment to recover its pre-recession peak. With the onset of the twenty-first century’s “jobless recoveries,” however, employment has rebounded much more slowly across cycles. After the dot-com bust and the global financial crisis, it took four and six years, respectively, to make new highs (Chart 4). The combination of manufacturing outsourcing and the ongoing automation of white-collar tasks is likely to make the slower pace of employment recovery the rule. Investors should anticipate that unemployment will linger at elevated levels through 2021 even in the event of an optimistic scenario. Chart 4Employment Doesn't Rebound Like It Used To Congress Versus The Data When employment falls, the virtuous circle in which changes in employment feed into further changes in employment becomes a vicious circle. Falling employment doesn’t just directly weigh on activity via less consumption and fixed investment; it also leads to reduced credit availability via tighter lending standards. With COVID-19 looming as a massive shock to consumer credit performance, Congress rushed to prop up the income streams of households in harm’s way. It began by sending $1,200 checks to more than 60% of taxpayers (single filers with less than $75,000 of adjusted gross income, and married couples with less than $150,000). One-off $1,200 payments could help strapped households, but the CARES Act’s more significant measure provided for a weekly $600 supplement to state unemployment benefits through the end of July. Weekly state-level benefits average about $400. When coupled with the federal supplement, unemployed workers will receive around $1,000 per week, slightly above the average weekly wage. After applying the stimulus check, the average worker will earn 10% more over his/her first three months of joblessness than s/he did when working full time. Why leave the couch when sitting in front of the TV is more lucrative than venturing outside? The Fed is deliberately aiming to keep households and businesses from defaulting. The direct payments3 and the supplemental unemployment benefits could prevent spending from falling, and consumer loan performance from weakening, as much as they otherwise would given the scale of layoffs. The Department of Labor has tracked the share of the average worker’s income that is replaced by unemployment benefits (the replacement rate) since the late nineties. During the two recessions covered by that sample period, laid-off workers received benefits amounting to just 40% of their previous income (Chart 5). Not surprisingly, consumer loan defaults surged (Chart 6). We are hopeful that credit performance through July, the expiration date of the supplemental benefit program, will be much better than simple regression analyses based on the unemployment rate would project, leaving ample room for a positive surprise. Chart 5Unemployment Benefits Typically Replace Just 40% Of Average Income ... Chart 6... But Consumer Borrowers Might Be Able To Stay Current When They Exceed It Powell Versus The Data In his 60 Minutes interview broadcast on May 17th, Fed Chair Jay Powell repeatedly indicated that the Fed is also pursuing a finger-in-the-dike strategy. Early in the interview, after lamenting the seriousness of the COVID-19 shock, he noted, “the good news is that we have policies that can go some way toward minimizing those [hysteresis-like] effects. And that’s by keeping people and businesses out of insolvency just for maybe three or six more months while the health authorities do what they can do. We can buy time with that.” He came back to the short-term-stimulus-to-prevent-long-term-impairment theme toward the end, explicitly referencing credit performance. “[W]e have tools to try to minimize the longer-run damage to the supply side of the economy. And these tools just involve keeping people solvent, keeping them in their homes, keeping them paying their bills just for maybe a few more months. And the same thing with businesses. Keeping them away from Chapter 11 if it’s available.” It seems reasonable to assume that the worst of the public health news will have passed by the fall. If employment were to rebound in line with re-opening measures, six months of active fiscal and monetary support, from March to September, ought to be enough to stave off long-run damage. As the massive scale of the job losses is revealed, however, we are beginning to rethink our own assumptions about when the economy will truly be able to stand on its own. As Chart 4 suggests, it may be unrealistic to think that the US can return to full employment by 2022, especially as the lockdowns may have given businesses lots of ideas about where they can permanently reduce headcount. The Fed is prepared for such a contingency, to hear the Chair tell it: It may well be that the Fed has to do more. It may be that Congress has to do more. And the reason we’ve got to do more is to avoid longer-run damage to the economy. [W]e’re not out of ammunition by a long shot. No, there’s really no limit to what we can do with these lending programs that we have. So there’s a lot more we can do to support the economy, and we’re committed to doing everything we can as long as we need to. Powell’s take did not come as news to markets, even if it helped stocks romp higher the day after the interview was broadcast. The Fed moved with dizzying speed in March, and its measures have been effective. Taking the corporate bond market as an example, spreads narrowed sharply after the primary- and secondary-market corporate credit facilities were announced on March 23rd (Chart 7) and have fallen to a level consistent with a run-of-the-mill recession (Chart 8). Corporate bond issuance set an all-time monthly record in March, then broke it in April, all without the Fed buying a single bond until mid-May. Chart 7The Fed Tamed The Corporate Bond Market Without Firing A Shot ... Chart 8... And Spreads Are Now At Levels Consistent With A Ho-Hum Recession Investment Implications Investors can count on the Fed’s whatever-it-takes pledge, but they shouldn’t expect the Fed to defend the economy from monumental job losses all by itself. States, cities and towns need cash grants to avoid laying off wide swaths of their workforces, and only Congress and the administration can issue them. Despite their public wavering, we do not think that Republicans will want to spurn masses of unemployed voters and their teachers, police and firefighters ahead of the election. Bailout fatigue and deficit worries will make succeeding iterations of aid packages less generous, though. A wave of defaults and business failures would complicate the near-term recovery playbook. Independent of longer-run effects, financial markets will fare better over the next year if fiscal and monetary policy continue to focus on limiting avoidable busts. We think they will, however begrudgingly, but financial markets already discount this benign outcome. Jay Powell is singing the SIFI banks' song. The combination of Fed support and low valuations makes them especially attractive. Relentlessly accentuating the positive leaves risk assets vulnerable in the near term. We continue to expect some sort of an equity correction and have no appetite for anything but the BB-rated top tier of high yield corporates. Over the tactical 0-to-3-month timeframe, we continue to recommend that multi-asset investors maintain a benchmark equity weighting, while underweighting bonds and overweighting cash. We recommend overweighting equities, underweighting bonds and equal-weighting cash over the cyclical 3-to-12-month timeframe. Within bonds, we are underweight Treasuries and high yield, and overweight investment grade, over both timeframes. The SIFI banks will benefit most directly if policymakers are able to limit consumer and business defaults. Chair Powell’s 60 Minutes refrain should have been music to their management teams’ and stockholders’ ears. They are the rare prominent segment of the market that is viewing the glass as half-empty. Investors have a considerable margin of safety buying them at or near their book value and they continue to be our favorite long idea.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 The employment situation report is compiled from a survey of households (used to calculate the size of the labor force and the unemployment rate) and a survey of business establishments (used to calculate net employment gains, hours worked and earnings). The foregoing unemployment discussion referenced the household survey; the subsequent discussion and charts reference the establishment survey. 2 Barrero, Jose Maria, Nicholas Bloom and Steven J. Davis, 2020. "COVID-19 Is Also a Reallocation Shock," NBER Working Paper No. 27137. Accessed May 21, 2020. Using historical data samples analyzed by other researchers, and the responses to the Survey of Business Uncertainty, the authors estimate that only 58% of pandemic-induced layoffs will prove to be temporary. 3 Another round of direct payments is being debated on Capitol Hill as we go to press.

Overweight In our April 14 Weekly Report we executed our upgrade alert and boosted the S&P internet retail index to overweight – a call that has since produced handsome relative gains of 14%. The most recent Advance Monthly Retail Trade (AMRT) report also suggests that the path of least resistance remains up for relative share prices. In fact, non-store retailers were the only category that reported an increase in activity on a month-on-month basis, while other categories such as clothing & accessories contracted nearly 80%. Bottom Line: We heed the message from the most recent AMRT report and continue to recommend an above benchmark allocation for the S&P internet retail index. The ticker symbols for the stocks in this index are: BLBG: S5INRE - AMZN, BKNG, EBAY, EXPE.

Special Report

Highlights China faces unprecedented socioeconomic challenges but its political response is rigid rather than flexible. The twin political goals of centralization and self-sufficiency bode ill for productivity. Communist Party elites have become more ideological and provincial, less cosmopolitan and technocratic. A global protectionist backlash adds to China’s woes. Over the long run, favor cyclical and commodity plays that benefit from China’s reflation but are distanced from its large and persistent political and geopolitical risks. Feature In ancient times Chinese emperors ruled with the “mandate of heaven.” As long as they could keep famine, rebellion, invasion, and plague from ravaging the nation, they were perceived as having divine sanction. Their dynasty would retain power and the people would be kept in awe (Table 1). Table 1Disease And The Fall Of Chinese Dynasties The COVID-19 pandemic and recession are highly unlikely to cause the downfall of General Secretary Xi Jinping and the Communist Party “dynasty.” But it is part of a string of recent challenges to the regime that are secular and structural in nature. The regime’s response, thus far, has been rigidity rather than flexibility – a warning sign that things may get worse before they get better. Investors should not view China as “fundamentally stable,” as has largely been the case for the past 20-30 years. Instead they should view it as fundamentally unstable and therefore a source of understated risk to the Chinese currency, equities, and corporate bonds. This is especially true relative to markets that benefit from Chinese reflation yet are distanced from its political and geopolitical risks. Political risks are more likely to manifest in China’s periphery in the short run. Mainland Chinese political risks are more likely to manifest over the long run. A Massive Reflationary Kick China convenes the National People’s Congress on May 21, after a two-month delay due to the extraordinary COVID-19 pandemic. The annual legislative session typically drives reflationary sentiment in the global economy and financial markets, especially in years of crisis such as 2009 and 2016. This year should be another such year, particularly viewed from a long-term perspective. Investors can count on massive Chinese stimulus because the spike in unemployment poses a threat to social stability. Chinese authorities are wheeling out the big guns for this crisis. The fiscal measures announced thus far should reach 10% of gross domestic product. The “quasi-fiscal” function of Chinese banks could push the total well above that when all is said and done. Investors can count on massive stimulus because the spike in unemployment poses a threat to social stability. The economy is contracting for the first time since the Cultural Revolution (Chart 1). Chart 1China's Rapid Growth, A Pillar Of Stability, Is Officially Gone Table 2The Great Chinese Boom, 1980-2020 Ever since that chaotic period, the Communist Party has based its legitimacy on economic growth and rising incomes. The results of China’s economic boom of 1980-2020 are well known. China’s share of global GDP has risen from 2% to 16%; its share of global capital stock from 3% to 21%; exports 1% to 13%; and military spending 1% to 14% (Table 2). In the future, with this economic pillar cracked, Beijing will have to devote even more attention to “stability maintenance” at home. Reflation Doesn’t Solve Structural Problems Household consumption is China’s only hope for developing sustainable economic growth in the wake of a boom driven by investment in export-manufacturing and construction. Cyclically, the virus threatens consumption by discouraging consumers from going anywhere other than work. However, China’s suppression of the virus is enabling consumers to resume activity gradually. Elsewhere, including Europe, economic expectations are also perking up, corroborating China’s data that consumers are increasingly willing to venture out of their homes (Chart 2). Still, China is vulnerable to subsequent outbreaks and is already instituting new lockdowns in the northeast. Structurally, China’s economy is susceptible to a series of historic shifts that were already taking place and that the pandemic has accelerated. The working-age share of the population is now declining rapidly. This coincides with a drop in the national savings rate (Chart 3) and a rapid rise in the dependency ratio – faster even than in Germany or Japan over the past two decades. Consumption will rise relative to investment. But if households are precautionary savers, as in Japan, then consumption will not grow fast enough to sustain overall GDP growth, forcing the government to spend more to shore up overall demand. Chart 2Chinese And Global Sentiment Recovering Chart 3China's Demographic Changes Portend Higher Cost Of Capital China no longer primarily channels its savings into export manufacturing. Instead it invests them at home. China’s total debt – public and private – has surpassed that of many developed nations despite the country’s lower level of development and wealth (Chart 4). China can manage this debt, given that it prints its own currency, keeps a closed capital account, and has shifted to a primarily domestic-oriented economy. But the debt is less manageable than before the crisis. Nominal growth has fallen beneath interest rates, implying that, in the midst of the crisis, debt cannot be serviced for the economy as a whole (Chart 5). Growth will revive, but it will likely run at lower rates than prior to the crisis. Debt servicing will be a recurrent problem for small or inefficient businesses. Chart 4China’s Indebtedness Will Continue To Surge Chart 5China Needs Growth To Service Debt Chart 6China Struggling To Avoid 'Twin Deficits' The whole problem is illustrated by China’s verging on “twin deficits” – an ever-widening budget deficit combined with a recent tendency to slip into current account deficit (Chart 6). Anglo-Saxon economies often run large twin deficits. But China is more comparable to Japan, which has never let itself run persistent current account deficits, since it would then become reliant on foreign sources of financing. Since China will run large budget deficits for the foreseeable future, it will either have to make its corporate sector more efficient (e.g. by depressing wages), or it will see downward pressure on the currency as a result of a weakening current account balance. The pandemic and recession will pass, thanks to massive stimulus. What will remain is China’s voyage into new territory. Prior to COVID-19 the concern was that China would grow old before it grows rich – that the transition to a low-growth consumer economy would occur at a much lower level of GDP per capita than it did with economies like Taiwan, Japan, and South Korea. Now, with a sudden downward shift in growth rates, it is possible that China will grow old without growing rich. This would be a huge risk to the regime in the long run. The Communist Party Returns To Its Roots Risk of economic stagnation – the so-called middle-income trap – is why policymakers at the National People’s Congress this weekend will lay so much emphasis on “reform and opening up,” even as they are forced by the pandemic to do the opposite for now and stimulate the economy via debt-financed fixed investment. China has pledged sweeping structural reforms, liberalization, and internationalization so many times now that it is common for western policymakers to complain of “promise fatigue.” The lack of verification is one reason foreign governments are increasingly willing to consider punitive measures in dealing with China. Today’s macro and geopolitical context do not favor liberal reforms, such as occurred in China in the late 1990s, but the changing characteristics of China’s elite political leaders reveal a more specific reason why policy has grown more statist, more “communist,” and less liberal, over the past decade. Members of the Politburo Standing Committee (PSC), the most powerful decision-making body, have become more ideological, more authoritarian, less cosmopolitan, and less technocratic over the years (Chart 7). They are far less likely to have studied the hard sciences or engineering than their predecessors, who orchestrated China’s westernizing, capitalist reforms from the 1980s to early 2000s. Chart 7China’s Leadership Increasingly Provincial And Inward-Looking They lack experience running state-owned enterprises, which might seem like a plus, except that the alternative is being a career politician – a ruler of a province – and never having run any business at all. Leaders increasingly hail from rural provinces, as opposed to the wealthy, internationally savvy coasts. Chart 8China Will Miss Some Centennial Income Targets Essentially, the grassroots interior of the country – the base of the Communist Party – has been reclaiming the party from the corrupt, liberal, westernizing technocrats. And the party is about to grow even more reactionary. First, it is now officially failing to meet its own development goals. For several years the administration has talked of abandoning annual GDP growth targets as part of its push to prioritize quality rather than quantity of economic growth, but has not done so. Now it is not only the annual growth target that will be missed in 2020, but the party’s decade goals will have to be fudged (Chart 8). Moreover, if the economy does not recover as quickly as hoped then the highly symbolic 2021 centennial of the Communist Party will be marred. Replacing hard numerical targets is reasonable but will not change the party’s constant need to emphasize development goals to keep the people looking forward. And it will not remove the local-level incentive structures that cause economic distortions to meet central government goals. The takeaway is that massive stimulus is assured as the party cannot afford to suffer instability over this period of political milestones. Second, the administration’s difficulties open up at least some possibility of factional struggle within the party. Remember that Xi Jinping was supposed to step down in 2022 at the twentieth National Party Congress. This would have marked the end of his ten-year rule according to the rules that his two predecessors tried to establish. Xi altered this pattern in 2017 to pave the way to rule until 2035 or beyond. Thus while the market can look forward to stimulus this year and next to ensure the economy has stabilized by 2022 (Chart 9), there is potential for surprising political events to rattle China’s appearance of political stability and unity. Chart 9Xi Jinping Was Originally Slated To Step Down In 2022 Granted, Xi has shifted the party’s governance model from single-party rule to single-person rule. The most likely political shocks will come from Xi cracking down on his opponents to re-consolidate power, as he did in 2012-13 and 2017. Factional struggles could cause minor risk-off episodes in financial markets but they will say something more important, which is that the unity of the ruling party is a façade and stability cannot be assumed forever. Economic Targets: Centralization And Autarky In the coming years, Xi Jinping’s government will continue to centralize control over society and the economy as it has done throughout his term. This is the opposite of “reform” in the sense of former leader Deng Xiaoping, which meant decentralizing power and letting local governments and private business innovate. The Xi administration’s “reform” push was to cut industrial overcapacity and deleverage the corporate sector, as we highlighted in a series of reports from 2016-18. We argued then that these reforms would be abandoned as soon as major downside risks to growth returned – which is what occurred due to the trade war and now COVID-19. Thus the net effect of the Xi administration thus far has been to centralize the economy and pursue self-sufficiency. Centralization can be shown in the resurgence of the Communist Party, the central government in Beijing, and state-owned enterprises. Government debt has grown at the expense of private leverage (Chart 10), which faced a crackdown, while the state-owned share of corporate debt has grown from one-half to two-thirds since 2013. Xi formally pledged in 2017 to make state companies stronger, better, and bigger. His term has witnessed a major bull market in SOE equities relative to the broad market – and each phase of power consolidation adds a new rally to this trend (Chart 11). Chart 10Public Sector Encroaching On Private Sector … Before COVID-19 Chart 11SOE Bull Market Under Xi Jinping As for international trade, China has become far less reliant on foreign parts and components for its manufacturing sector over recent decades (Chart 12). It has also increasingly used state resources to pursue strategic self-sufficiency through technological acquisition, import substitution, and state-backed “indigenous innovation.” The attempt to make a new Great Leap Forward in advanced manufacturing and high-tech services has led to a direct clash with the US government, which is now actively expanding export controls. In the upcoming fourteenth Five Year Plan for the years 2021-25, Beijing is highly likely to double down on technological self-reliance. Chart 12China Closes Its Doors Chart 13Centralization And Closed Economy Harm Productivity Centralization and import substitution have harmed productivity, especially total factor productivity (Chart 13). Centralization is not necessarily bad for productivity – state-directed research and development can galvanize major improvements. But in China centralization is excessive and constricts the flow of information and ideas in civil society and academia, which discourages innovation and privileges quantity over quality of output. Closure to the outside world reinforces this point – particularly as a global protectionist backlash comes to affect China’s acquisition of tech and talent – and exacerbates the misallocation of capital at home. Social Unrest Will Grow China’s falling potential growth will generate social unrest over time, despite the appearance of perfect control in this authoritarian society. Table 3 shows our COVID-19 Social Unrest Index. Countries are ranked from best to worst, top to bottom. Obviously a high rank does not suggest a country is immune to unrest – all emerging markets are vulnerable. A poor score under “household grievances” – i.e., income inequality combined with the “misery index” of high inflation and unemployment – can engender unrest even in relatively well-governed states, as is happening in Chile. Table 3China Looks Stable On Paper: Our COVID-19 Social Unrest Index China ranks fourth overall, with poor governance indicators dragging down the total. However, household grievances will rise as the unemployment rate rises (and perhaps food and fuel inflation). Unemployment is much higher in China than officially reported. The government is also unfamiliar with how to deal with large surges in unemployment, having long utilized policy to minimize the unemployment rate at any cost (Chart 14). Chart 14AUnemployment Spike A Threat To Chinese Stability Chart 14BUnemployment Spike A Threat To Chinese Stability Chart 15Income Inequality In China Inequality is at extreme levels and will worsen as a result of COVID-19. Our China Investment Strategist shows that the bifurcation in wealth between the top 10% and the bottom 50% will widen as job losses hit low-skilled and labor-intensive sectors (Chart 15). The rural-urban disparity – an obsession of policymakers in recent years – will also grow amid the crisis (Chart 16). Two factors are aggravating these trends. First, the decline of the manufacturing sector alluded to above. China’s manufacturing sector was too large and it has been rapidly converging to the level of developed economies, meaning that as many as 10% of workers’ jobs are at risk in the coming years. A maturing economy and mercantilist geopolitical trends are accelerating this process (Chart 17). Beijing will have to confiscate wealth from the coastal provinces and power centers to reduce inequality and social grievances. Chart 16Regional Inequality In China Chart 17Large Manufacturing Sector Getting Purged Second, migrant workers are drifting home amid the COVID-19 crisis, just as in 2008. 51 million migrants vanished from employment rolls in the first quarter (Chart 18). The government’s model of household registration reform has focused not on making it easier for migrants to integrate into wealthy coastal provinces but rather on subsidizing activity in interior provinces and foisting workers back into their home provinces. This is a trigger of unrest. Will social unrest end up being politically significant? In most cases no. Beijing is prepared to quell protests and dissent – it has devoted massive resources to domestic security, even compared to its rapid military modernization (Chart 19). Chart 18Migrant Workers Cast Adrift Amid COVID-19 Chart 19‘Stability Maintenance’ Is A State Priority The Communist Party began prioritizing “social stability maintenance” across all dimensions of society in the wake of the global financial crisis in 2008. The abortive “Jasmine Revolution” in 2011, at the height of the Arab Spring, was literally swept away by street-cleaning trucks. The Wukan riots that same year were more persistent, flaring up again in 2016, but the siege was ultimately confined to a single city in the generally more restive south. Various shows of defiance in Wuhan and Hubei in the wake of COVID-19 have been snuffed out. Social unrest will not always be politically significant. State repression and mismanagement could turn any minor incident of unrest into a major incident. But as long as disturbances remain local, they will have limited political consequences. The risk for China is its pursuit of innovation and technological modernization. Greater connectivity will increase the potential for cross-border coordination. The running assumption is that China is an authoritarian state with sufficient police force to silence any discontent. But political activism does not have to be liberal – it could be nationalist, or simply based on quality of life issues that cannot easily be demonized. At any rate, the dislocation of the manufacturing sector and labor market in the context of a secular growth slowdown is a long-term tailwind for social and political challenges to the state. Political risk will grow, not fall, from here. Diversions From Domestic Unrest Beijing’s attempt to re-centralize power and reassert Communist Party control has sparked resistance in the Chinese periphery. Both Taiwan and Hong Kong have seen protest movements – consisting of middle class workers as well as youth – since 2013. These movements have not spread to the mainland – if anything they are a diversion from the mainland’s own problems. But they have prompted Beijing to crack down on the periphery, further polarizing opinion. While unrest in Hong Kong will heat up as Beijing attempts to impose even more direct control, ultimately Hong Kong has no alternative. Taiwan, on the other hand, is an island that already largely conceives of itself as an autonomous unit. The sense of Taiwanese identity – as opposed to Chinese – has exploded upward in recent years (Chart 20). There is a very high bar for war in the Taiwan Strait. And yet Chinese military hawks and strategists have begun to discuss it more openly. China’s military drills around the island are a measured but intimidating response to the rise of the popular, nominally pro-independence government since 2016. The US is making active but measured moves to shore up the diplomatic and military relationship with Taiwan. Given Washington’s renewed focus on China’s drive to achieve dominance in semiconductors, and America’s desire to secure supply chains that run through Taiwan and the mainland, we remain fully committed to our view that Taiwan is a major underrated geopolitical risk. Given the high bar for outright war on Taiwan, it should be no surprise that disputes over sovereignty and military positioning in the South China Sea should revive (Chart 21). This is a convenient outlet for Chinese nationalism. The sea is of vital strategic importance to all the major East Asian economies – not because of resources but because of supply security. Military actions in the sea have a direct bearing on cross-strait relations as well as Sino-Japanese relations, which are also liable to flare up during periods of economic distress. Chart 20Tensions In Chinese Periphery Set To Increase Chart 21South China Sea: Not Just A Distraction The US is pushing back in the seas as well, increasing the odds of a skirmish or incident. Recent reports that China will seek to establish an air defense identification zone (ADIZ) in the South China Sea have been dismissed by Taiwanese authorities, but an ADIZ is just one of many plausible scenarios that could escalate tensions overnight. Will The US Sabotage China? The US election has the potential to exacerbate China’s economic and political insecurities in the near term. The major constraint on US-China economic decoupling is well known: US allies, such as Europe and Japan, can and will continue to trade with China. Thus the US would suffer the most if it insisted on an outright blockade of trade or tech. The implication, however, is that President Trump will change strategy in any second term. There is a substantial risk to European industry that he could attempt a trade war with the EU as well as China. But the major constraint – that the US cannot take on China alone – means that his advisers across all parties and agencies will urge him to change his position. Whether he will listen is anybody’s guess. Meanwhile a Democratic victory will ensure a multilateral strategy is adopted, as was the case from 2008-16. The real political risk comes when Xi Jinping attempts to step down and pass the baton to a successor. In this regard it is essential to recognize that China’s progress up the manufacturing value chain is a threat to US allies independently of the United States (Chart 22). Chart 22China’s Manufacturing Rivals Advanced Nations Judging by China’s fastest growing export categories, Germany, South Korea, Taiwan, Japan, and Singapore have nearly as much to lose as the United States if China’s state-backed trade practices are not constrained (Chart 23). These include illegal tech transfer, hacking, and increasingly Russian-style disinformation campaigns. Chart 23US Not Alone In Concern Over China’s Manufacturing Machine Chart 24China's Rise Comes At Expense Of US Allies, Not Necessarily US In terms of overall geopolitical power, China’s rise has occurred at the expense of Japan and the EU as well as the United States, even though Europe is less threatened militarily (Chart 24). The implication is that if the US should make a concerted diplomatic effort to form a united front against China demanding verifiable reform and opening, it will eventually be able to bring its allies over to the cause. Xi Jinping’s Succession Crisis How would China respond to this external pressure, which threatens to pile onto its new domestic woes? China will resist US unilateral pressure tactics, so confrontation with a re-elected Trump could be very destabilizing. A “grand alliance” of the West that leaves open the path to economic cooperation could force China to capitulate and offer real concessions. But we are far from there today. Faced with outright confrontation or multilateral encirclement, China will double down on self-sufficiency. Thus geopolitics reinforces China’s internal political evolution and the macro backdrop outlined above. Centralization, Maoism, protectionism, and confrontation with the United States suggest that China faces serious trouble over the long run, especially when today’s massive stimulus wears off. Chart 25Markets Want Chinese Reforms And A Trade Deal Will the challenges be so great as to deprive Xi Jinping of the mandate of heaven? Not anytime soon. He sits at the helm of a wealthy authoritarian state and has the distinct advantage of having consolidated power, from 2012-17, prior to the onslaught of internal and external pressure. He enjoys popular support, despite the seeds of unrest identified in this report. The real political risk for the Communist Party comes when Xi Jinping attempts to step down and pass the baton to a successor. It was the succession after Chairman Mao Zedong’s death that occasioned the power struggles of the late 1970s. And it was Deng Xiaoping’s various attempts to set up a successor that led to unrest and party divisions in the 1980s, culminating at Tiananmen Square. The implication is that systemic regime instability is a long way off – yet still discernible. Chinese equities trade at a high risk premium. However, it may persist for some time. Political and geopolitical trends are not positive for China’s growth, productivity, private sector, or trade over the long run. Equity returns in USD terms over the course of the just-finished bull market compare very unfavorably to the previous bull market (Chart 25). On a 12-month and beyond investment horizon, we recommend investors seek cyclical and commodity plays that benefit from Chinese reflation yet are removed from its governance and geopolitical risks. These include industrial metals, Southeast Asian assets, and Japanese and European equities.   Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com