Valuations

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

Highlights Q1/2020 Performance Breakdown: Our recommended model bond portfolio underperformed the custom benchmark by -40bps during the first quarter of the year – a number that would have been far worse if not for the changes in exposures for duration (increased) and spread product (decreased) made in early March. Winners & Losers: Underperformance was concentrated in sovereign debt, US Treasuries in particular (-94bps), as yields plummeted. This detracted from the outperformance in spread product (+51bps) led by US investment grade corporates (+34bps) and emerging markets (+20bps). Scenario Analysis For The Next Six Months: Given the ongoing uncertainty over when the COVID-19 pandemic and economy-crushing global lockdown will end, we are sticking close to benchmark on overall duration and spread product exposure. Instead, we recommend focusing more on country allocation and spread product relative value to generate outperformance, favoring markets where there is direct involvement from central banks. Feature Global bond markets were roiled in the first quarter of 2020 by the economic fallout from the COVID-19 pandemic. Government bond yields crashed to all-time lows while volatility reached extremes across both sovereign debt and credit. The quick, coordinated policy response from global monetary and fiscal authorities – which includes unprecedented levels of direct central bank asset purchases, both in terms of size and the breadth across markets and counties - has helped stabilize global credit spreads and risk assets, more generally. The outlook remains highly uncertain, however, with many governments worldwide looking to reopen their collapsed economies, risking the potential resurgence of a virus still lacking effective treatment or a vaccine. We are focusing more on relative value between counties and sectors. In this report, we review the performance of the BCA Research Global Fixed Income Strategy (GFIS) model bond portfolio during the eventful first quarter of 2020. We also present our updated recommended positioning for the portfolio for the next six months. The main takeaway there is that we are focusing more on relative value between counties and sectors while staying close to benchmark on both overall global duration and spread product exposure versus government bonds (Table 1). Table 1GFIS Model Bond Portfolio Recommended Positioning For The Next Six Months GFIS Model Bond Portfolio Q1/2020 Performance Review & Current Allocations: Traversing The Turmoil GFIS Model Bond Portfolio Q1/2020 Performance Review & Current Allocations: Traversing The Turmoil Chart 1Q1/2020 Performance: Lagging, But It Could Have Been Much Worse Q1/2020 Performance: Lagging, But It Could Have Been Much Worse Q1/2020 Performance: Lagging, But It Could Have Been Much Worse As a reminder to existing readers (and to new clients), the model portfolio is a part of our service that complements the usual macro analysis of global fixed income markets. The portfolio is how we communicate our opinion on the relative attractiveness between government bond and spread product sectors. This is done by applying actual percentage weightings to each of our recommendations within a fully invested hypothetical bond portfolio. Q1/2020 Model Portfolio Performance Breakdown: A Missed Rally In Sovereigns, Outperformance In Credit The total return for the GFIS model portfolio (hedged into US dollars) in the first quarter was -0.1%, underperforming the custom benchmark index by -40bps (Chart 1).1 That relative underperformance came from the government bond side of the portfolio, while our spread product allocation outperformed the benchmark. US Treasuries underperformed the most (-91bps) with losses concentrated in the +10 year maturity bucket. (Table 2). After US Treasuries, euro area high-yield corporates were the second worst performer, underperforming the benchmark by -10bps. Outperformance in spread product was driven by US investment grade industrials (+22bps) and EM credit (+20bps). Table 2GFIS Model Bond Portfolio Q1/2020 Overall Return Attribution GFIS Model Bond Portfolio Q1/2020 Performance Review & Current Allocations: Traversing The Turmoil GFIS Model Bond Portfolio Q1/2020 Performance Review & Current Allocations: Traversing The Turmoil The potential losses to our model portfolio were greatly mitigated by changes in positioning during the quarter. Our decision to raise overall global duration exposure to neutral at the beginning of March helped shield the portfolio as yields plummeted.2 We followed this by upgrading sovereign debt in the US and Canada, both higher-beta countries, to overweight while moving to an underweight stance on US high-yield debt, euro area investment-grade and high-yield debt, and emerging market (EM) USD-denominated sovereign and corporate debt.3 In an environment of rampant uncertainty, these allocation changes helped prevent catastrophic losses in the model portfolio that had previously been positioned for a pickup in global growth. The potential losses to our model portfolio were greatly mitigated by changes in positioning during the quarter. In terms of the specific breakdown between the government bond and spread product allocations in our model portfolio, the former generated -91bps of underperformance versus our custom benchmark index while the latter outperformed by +51bps. The bar charts showing the total and relative returns for each individual government bond market and spread product sector are presented in Charts 2 and 3. Chart 2GFIS Model Bond Portfolio Q1/2020 Government Bond Performance Attribution GFIS Model Bond Portfolio Q1/2020 Performance Review & Current Allocations: Traversing The Turmoil GFIS Model Bond Portfolio Q1/2020 Performance Review & Current Allocations: Traversing The Turmoil Chart 3GFIS Model Bond Portfolio Q1/2020 Spread Product Performance Attribution By Sector GFIS Model Bond Portfolio Q1/2020 Performance Review & Current Allocations: Traversing The Turmoil GFIS Model Bond Portfolio Q1/2020 Performance Review & Current Allocations: Traversing The Turmoil The most significant movers were: Biggest Outperformers Overweight US investment grade industrials (+22bps) Underweight euro area investment grade corporate bonds (+16bps) Underweight EM USD-denominated corporates (+12bps) Overweight US investment grade financials (+10bps) Underweight Japanese government bonds with maturity greater than 10 years (+8bps) Biggest Underperformers Underweight US government bonds with maturity greater than 10 years (-36bps) Underweight US government bonds with maturity of 3-5 years (-17bps) Underweight US government bonds with maturity of 5-7 years (-16bps) Underweight US government bonds with maturity of 1-3 years (-13bps) Underweight US government bonds with maturity of 7-10 years (-12bps) Chart 4 presents the ranked benchmark index returns of the individual countries and spread product sectors in the GFIS model bond portfolio for Q1/2020. The returns are hedged into US dollars (we do not take active currency risk in this portfolio) and are adjusted to reflect duration differences between each country/sector and the overall custom benchmark index for the model portfolio. We have also color-coded the bars in each chart to reflect our recommended investment stance for each market during Q1/2020 (red for underweight, dark green for overweight, gray for neutral).4 Ideally, we would look to see more green bars on the left side of the chart where market returns are highest, and more red bars on the right side of the chart were returns are lowest. Predictably, government debt performed the best in Q1/2020 as global bond yields fell and monetary authorities raced to support economies and inject liquidity. UK, US, and Canadian government debt delivered the best returns this quarter. While we started the year neutral or underweight those assets, we moved to an overweight allocation in March, which helped salvage some returns. Also worth noting is that Australian government debt, where we have maintained a structural overweight stance, was one of the top performing markets during the first quarter. The deepest losses were sustained in EM USD-denominated sovereign and corporate debt, and euro area high-yield. Although it seems a distant memory at this point, we did start this quarter on an optimistic note and expected spreads on these products to narrow as global growth picked up. However, we were able to shield our portfolio against excessive losses in these products by moving to an underweight stance in March once the severity of the COVID-19 global economic shock become apparent. Bottom Line: Our recommended model bond portfolio underperformed the custom benchmark index during the first quarter of the year. The underperformance was concentrated in government bonds, which rallied on the back of the global pandemic. However, the portfolio outperformed the benchmark in spread products, where the combination of massive fiscal/monetary easing and direct central bank asset purchases have brought credit spreads under control. Future Drivers Of Portfolio Returns Typically, in these quarterly performance reviews of our model bond portfolio, we attempt to make return forecasts for the portfolio based off scenario analysis and quantitative predictions of various fixed income asset classes. In the current unprecedented economic and financial market environment, however, we are reluctant to rely on model coefficients and correlations to estimate expected returns. Instead, in this report, we will focus on discussing the logic behind our current model portfolio positioning and how those allocations should expect to contribute to the overall portfolio performance over the next six months. Looking ahead, the performance of the model bond portfolio will be driven by three main factors: Our recommended overweight stance on US spread product that is backstopped by the Fed—US investment grade corporates, Agency CMBS, and Ba-rated high-yield; Our recommended overweight stance on relatively higher-yielding sovereigns like the US and Italy; Our recommended underweight stance on EM USD-denominated corporates and sovereigns, where the specter of defaults and liquidity crunches looms. In terms of specific weightings in the GFIS model bond portfolio, we have moderated our stance on global spread product since our previous review of the portfolio.5 While the monetary liquidity backdrop is highly bullish, with central banks aggressively buying bonds and keeping policy rates at the zero lower bound, it is still unclear if and when economies will be able to successfully reopen and put an end to the COVID-19 recession. We are now recommending only a small relative overweight of two percentage points for spread product versus the benchmark index (Chart 5), leaving room to add more should the news on the virus and global growth take a turn for the better. Chart 5Overall Portfolio Allocation: Slightly Overweight Credit GFIS Model Bond Portfolio Q1/2020 Performance Review & Current Allocations: Traversing The Turmoil GFIS Model Bond Portfolio Q1/2020 Performance Review & Current Allocations: Traversing The Turmoil We also remain neutral on overall portfolio duration exposure. Our Global Duration Indicator, which contains growth data like our global leading economic indicator and the global ZEW expectations index, has plunged and is signaling bond yields will stay depressed over the next six months (Chart 6). Yet at the same time, yields in most countries have been unable to hit new lows after the panic-driven bond rally in late February and early March, even as global oil prices have collapsed and inflation expectations remain depressed, suggesting that yields already discount a lot of bad news. Chart 6Our Duration Indicator Is Signaling Government Bond Yields Will Stay Low Our Duration Indicator Is Signaling Government Bond Yields Will Stay Low Our Duration Indicator Is Signaling Government Bond Yields Will Stay Low We do not see much value in taking a big directional bet on yields through overall duration exposure at the present time. We also think it is far too early to contemplate reducing duration – even with many global equity and credit markets having rallied sharply off the lows – given the persistent uncertainty over the timing of a recovery in global growth. Thus, we are maintaining a neutral overall portfolio exposure (Chart 7). Chart 7Overall Portfolio Duration: At Benchmark Overall Portfolio Duration: At Benchmark Overall Portfolio Duration: At Benchmark Chart 8Country Allocation: Favor Those With Higher Betas To Global Yields Country Allocation: Favor Those With Higher Betas To Global Yields Country Allocation: Favor Those With Higher Betas To Global Yields Within the government bond side of the model bond portfolio, we recommend focusing more on country allocation to generate outperformance. That means concentrating exposures in relatively higher yielding markets like the US, Canada and peripheral Europe while maintaining underweights in core Europe and Japan, where yields have relatively little room to fall. That allocation also lines up with the sensitivity of each market to changes in the overall level of global bond yields, i.e. the yield beta (Chart 8). By favoring those higher beta markets, the model portfolio would still benefit from a renewed leg down in global bond yields, while still maintaining an overall neutral level of portfolio duration. By favoring those higher beta markets, the model portfolio would still benefit from a renewed leg down in global bond yields. Turning to spread product allocations, we recommend focusing more on policymaker responses to the COVID-19 recession rather than the downturn itself. Yes, the earlier widening of global high-yield spreads is forecasting a sharp plunge in global growth and rising unemployment rates (Chart 9, top panel). At the same time, the now double-digit year-over-year growth in global central bank balance sheets - a measure that has led global high-yield bond excess returns by one year in the years after the Global Financial Crisis (bottom panel) – is pointing to a period of improved global corporate bond market performance over the next 6-12 months. Chart 9Global Corporate Performance Should Benefit From Global QE Global Corporate Performance Should Benefit From Global QE Global Corporate Performance Should Benefit From Global QE In other words, we are focusing on global QE rather than global recession, while maintaining a modest recommended overall weighting on global spread product. Chart 10Credit Allocation: Buy What The Central Banks Are Buying Credit Allocation: Buy What The Central Banks Are Buying Credit Allocation: Buy What The Central Banks Are Buying That allocation could be larger, but we suggest picking the lowest hanging fruit in the credit universe rather than going for the highest beta credit markets. That means concentrating spread product allocations on the parts of global credit markets where central banks are directly buying (Chart 10). We are focusing on global QE rather than global recession, while maintaining a modest recommended overall weighting on global spread product. In the US, that means overweighting US investment grade corporate bonds (particularly those with maturities of less than five years), US Ba-rated high-yield that the Fed is now allowed to hold in its corporate bond buying program, and euro area investment grade corporate bonds (excluding bank debt) that the ECB is also buying in its increased bond purchase programs. Chart 11Stay Underweight EM Credit Stay Underweight EM Credit Stay Underweight EM Credit One new change we are making this week is upgrading US agency commercial mortgage-backed securities (CMBS) to overweight, funding by a reduction in US agency residential mortgage-backed securities (MBS) to underweight. While the Fed is still buying agency MBS debt in its new QE programs, MBS spreads have already compressed substantially and are now exposed to potential refinancing risk as eligible US homeowners look to take advantage of the recent plunge in US mortgage rates. We prefer to increase the allocation to agency CMBS, which the Fed can now buy within its expanded QE programs and which offer more attractive spreads than agency MBS (middle panel). One part of the spread product universe where we continue to recommend an underweight stance is USD-denominated EM corporate and sovereign debt. The time to buy those markets will be when the US dollar has clearly peaked and global growth has clearly bottomed. Neither of those conditions is in place now, with the price momentum in both the EM currency index and the trade-weighted US dollar still tilted towards a stronger greenback. That backdrop is unlikely to change in the next few months, suggesting a defensive stance on EM credit is still warranted (Chart 11). A defensive stance on EM credit is still warranted. Model bond portfolio yield and tracking error considerations The selective global government bond and credit portfolio we have just outlined does not come without a cost. While we are currently overweight countries with higher-yielding government bonds, our underweight positions on riskier spread product like EM debt and lower-rated US junk bonds bring the yield of our model portfolio down to 1.8%, –15bps below the yield of the model portfolio benchmark index (Chart 12). We feel that is an acceptable level of “negative carry” given the still heightened levels of uncertainty over global growth. This leads us to focus more on relative value between countries and sectors to generate outperformance that we expect to offset the impact of underweighting the highest yielding credit markets. Chart 12Portfolio Yield: Moderately Below Benchmark Portfolio Yield: Moderately Below Benchmark Portfolio Yield: Moderately Below Benchmark Chart 13Portfolio Volatility: Currently High, But Expected To Fall Portfolio Volatility: Currently High, But Expected To Fall Portfolio Volatility: Currently High, But Expected To Fall Finally, turning to the risk budget of the model portfolio, we are aiming for a “moderate” overall tracking error, or the gap between the portfolio’s volatility and that of the benchmark index. However, given our pro-risk positioning in the first two months of 2020, combined with the extreme volatility in markets during the first quarter, the realized portfolio tracking error blew through our self-imposed ceiling of 100bps (Chart 13). We expect this to settle down in the coming months as the recent changes in our positioning start to be reflected in the trailing volatility of our portfolio. Bottom Line: Given the ongoing uncertainty over when the COVID-19 pandemic and economy-crushing global lockdown will end, we are sticking close to benchmark on overall duration and spread product exposure. Instead, we recommend focusing more on country allocation and spread product relative value to generate outperformance, favoring markets where there is direct involvement from central banks.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Shakti Sharma Research Associate shaktis@bcaresearch.com Footnotes 1 The GFIS model bond portfolio custom benchmark index is the Bloomberg Barclays Global Aggregate Index, but with allocations to global high-yield corporate debt replacing very high quality spread product (i.e. AA-rated). We believe this to be more indicative of the typical internal benchmark used by global multi-sector fixed income managers. 2 Please see BCA Global Fixed Income Strategy Weekly Report, "What Bond Investors Should Do After The 'Great Correction'", dated March 3 2020, available at gfis.bcaresearch.com. 3 Please see BCA Global Fixed Income Strategy Weekly Report, "The Train Is Empty", dated March 10, 2020, available at gfis.bcaresearch.com. 4 Note that sectors where we made changes to our recommended weightings during Q1/2020 will have multiple colors in the respective bars in Chart 4. 5 Please see BCA Research Global Fixed Income Strategy Weekly Report, "2019 GFIS Model Bond Portfolio Performance Review: Praise Credit & Blame Duration", dated January 14, 2020, available at gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index GFIS Model Bond Portfolio Q1/2020 Performance Review & Current Allocations: Traversing The Turmoil GFIS Model Bond Portfolio Q1/2020 Performance Review & Current Allocations: Traversing The Turmoil Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Portfolio Strategy Our conservative dividend growth assumptions especially for the next three years – largely mimicking the GFC experience – result in an SPX 3,000 fair value target. Relative performance already reflects the jump in demand for packaged foods. A firm US dollar and an ongoing profit margin squeeze at a time when relative valuations have returned to the historical mean compel us to downgrade the S&P packaged foods index to neutral. An upward trending demand profile, a fortress of a balance sheet, exemplary recession resilience, and sustained M&A activity, all warrant an overweight stance in the S&P software index. Recent Changes Trim the S&P packaged foods index to neutral today, which pushes the S&P consumer staples sector to a benchmark allocation. Boost the S&P software index to overweight today, which lifts the S&P tech sector to a benchmark allocation. Table 1 New SPX Target New SPX Target Feature The SPX jumped to a five-week high last week, on the back of news that the economy will gradually reopen next month. In other news, GILD’s remdesivir drug showed some positive early signs in fighting off the coronavirus, sparking an impressive late-week rally in the SPX. From a macro perspective, flush monetary liquidity and extremely easy fiscal policy remain the dominant market forces. While we remain confident that equities will be higher on a 9-12 month cyclical time horizon, we believe that the easy money since the March 23 lows has already been made and a consolidation phase now looms. Thus, monetizing some of these gains would make sense at the current juncture. Keep in mind that the SPX, junk spreads and the CBOE’s put/call ratio have returned to their respective means since 2018 (horizontal lines denote the historical averages, Chart 1). Tack on the stiff resistance that the S&P 500 will face near the 50-day and 100-week moving averages, and a lateral move is likely in the coming weeks. Meanwhile, in our seminal report “SPX 3,000?” on July 10, 2017 we introduced our SPX dividend discount model (DDM) when we first came up with the SPX 3,000 target.1 It is now custom to update our DDM every April when the previous year’s annual S&P 500 dividend payment is finalized from the Standard & Poor’s. Chart 1Consolidation Mode Consolidation Mode Consolidation Mode Chart 2Dividends Rule Dividends Rule Dividends Rule As a reminder, we have been and remain very conservative in our DDM assumptions. Again this year we assume that no buybacks will occur, a long held assumption of ours, i.e. we pencil in a steady divisor in the coming five-year time frame. 2025 is our terminal year when dividend growth settles at 6.6%, 60bps below the long-term average (bottom panel, Chart 2). Our 8.2% discount rate mirrors the corporate junk bond yield historical average. This year we use two different dividend growth approaches: our own estimates and alternatively the S&P 500 dividend futures derived growth. In the spirit of conservatism, we pick the lowest point hit in early April across the different dividend futures expirations. Tables 2 & 3 summarize the results. In the dividend futures derived approach, SPX fair value is close to 2,110. Granted, such dividend contractions for two years running (33% in 2020 and 14% in 2021, Table 2) are extreme and highly unlikely. Moreover, dividend futures have since rebounded violently. However, we stick with them to derive our worst case SPX value. Table 2SPX Dividend Discount Model: Using S&P Dividend Futures Growth Assumptions New SPX Target New SPX Target Our own dividend growth estimates result in an SPX 3,000 fair value target (Table 3). While our assumptions are not as dire as the nadir in dividend futures, they are slightly more conservative than the GFC experience. As a reminder, in the aftermath of the GFC dividends contracted by 20% in 2009 and then recovered rising by 1% and 16% in 2010 and 2011, respectively (please click here if you would like to receive our DDM and insert your own assumptions). Table 3SPX Dividend Discount Model: Using USES Dividend Growth Assumptions New SPX Target New SPX Target Building up on this analysis, we want to identify sectors that are at risk of a dividend cut, and thus pose the greatest threat to our SPX dividend projections. Table 4 shows the 2019 sectorial dividends, profits, and the payout ratio along with indebtedness. While during the Great Recession financials cut their handsome dividends, the current recession is not a financial crisis and we doubt the financials sector will cut their dividends, at least not as aggressively as in the GFC (Table 5). Table 4S&P 500 GICS1 Sector Dividend Analysis New SPX Target New SPX Target Table 5The GFC S&P 500 GICS1 Sector Dividend Experience New SPX Target New SPX Target Energy is a clear standout, but neither XOM nor CVX will forego their dividend aristocrat status (minimum 25 consecutive years of rising dividends) and chop their dividends. In other words, these Oil Majors will do everything in their power including raising debt to ever so modestly increase their dividends and maintain their aristocrat status. Thus, $24bn of energy sector related dividends are safe or 55% of the overall energy sector’s dividend. Keep in mind that the energy sector increased their dividends in the GFC (Tables 4 & 5). Industrials (GE is no longer a big dividend payer), materials, real estate and select consumer discretionary are sore spots, but not large enough to undermine the SPX (Table 4). Tech, health care and consumer staples are in excellent shape and judging by JNJ’s and COST’s recent dividend hikes, these sectors that enjoy mostly pristine balance sheets may even increase their payouts as they did during the GFC (Tables 4 & 5). While utilities and telecom services are debt saddled, their defensive stature and stable cash flow streams along with their history of steady dividend payments also do not pose a real threat to the SPX’s dividend (Tables 4 & 5). This leaves financials as the key sector to monitor for a possible large inflicted wound to the SPX dividend. In the most adverse scenario where the Fed instructs banks to eliminate their dividends, as the BoE and the ECB recently did in Europe, then the SPX dividend will contract, but only by 15%, ceteris paribus. This is because last year the tech sector had the highest dividend weight in the SPX and also because the financials sector’s dividend weight has fallen from 30% in 2007 to 15% in 2019 (Tables 4 & 5). Netting it all out, we are comfortable with our dividend growth assumptions especially for the next three years – largely mimicking the GFC experience – and resulting in an SPX 3,000 fair value target. The path of least resistance for the SPX remains higher on a 9-12 month cyclical time horizon. However, given that the easy SPX gains from the March 23, 2020 lows – when we turned cyclically bullish2 – have been made, opportunistic/nimble investors could monetize at least a part of these massive one-month returns. As aforementioned the SPX may face resistance near the 50-day moving average where it attempts to consolidate its recent gains. This week we are downgrading a defensive group to neutral and boosting a deep cyclical group to an above benchmark allocation. Turning Stale Following up from last week’s report, we heed the message from our research to be wary of staples stocks at the depth of the recession and downgrade the S&P packaged foods index to neutral. This move also pushes the S&P consumer staples sector down to a benchmark allocation from previously overweight. While this defensive index had been severely bruised from the accounting scandal at Kraft/Heinz, it has really flexed its safe haven muscles year-to-date. We use this opportunity to trim exposure down to neutral as we deem that this relative advance has run out of steam, despite the once in a lifetime jump in a number of key demand indicators. Chart 3 shows that food & beverage store retail sales now garner 17% of total retail sales a percentage last hit in the early 1990s. Impressively, not only did industry sales rise in absolute terms, but also overall retail sales suffered a severe setback accentuating last month’s spike. Similarly, food output hit a high mark last month, outpacing overall industrial production that came to a standstill. Food products resource utilization also soared, outpacing overall capacity utilization by 10% (bottom panel, Chart 3). As a result, relative share price momentum came close to accelerating by triple digits on a short-term rate of change basis (Chart 4). While such euphoria is warranted, we reckon that most if not all the good news is already reflected in prices, especially given the early signs of a possible reopening of the US economy some time next month. Importantly, sell side analyst optimism has climbed to a similar height observed in late-2015/early-2016 when industry 12-month forward EPS were slated to outshine the broad market by over 10% (bottom panel, Chart 4). Chart 3Demand Boost… Demand Boost… Demand Boost… Chart 4…Is Already Baked In …Is Already Baked In …Is Already Baked In Worrisomely, despite the rising demand profile, operating margins have been drifting lower over the past decade and a further profit margin squeeze remains a high probability outcome (Chart 5). Finally, on the food export front, the rising US dollar is warning that volumes will remain in check in coming quarters (greenback shown inverted, middle panel, Chart 6). All of this is reflected in valuations that have returned to the 25-year mean with packaged food manufacturers now trading at a 9% forward P/E premium to the broad market (bottom panel, Chart 6). Chart 5Margin Trouble Margin Trouble Margin Trouble Chart 6Past Expiry Date Past Expiry Date Past Expiry Date In sum, relative performance already reflects the jump in demand for packaged foods. A firm US dollar and an ongoing profit margin squeeze at a time when relative valuations have returned to the historical mean compel us to downgrade the S&P packaged foods index to neutral. Bottom Line: Trim the S&P packaged foods index to neutral, today for a loss of 20% since inception. This downgrade also pushes the S&P consumer staples sector to neutral for a loss of 11% since inception. The ticker symbols for the stocks in this index are: BLBG: S5PACK – MDLZ, SJM, KHC, CPB, MKC, CAG, TSN, GIS, HSY, HRL, K, LW. Boost Software To Overweight We recently monetized over 50% relative gains in our overweight in the S&P software index, but today we are compelled to lift this heavyweight tech sub-index back to an overweight stance. One key reason for our renewed bullishness is that for the second time in the past 15 months, software stocks managed to eke out relative gains when the broad market fell peak-to-trough 20% and 35% in late-2018 and in Q1/2020, respectively (Chart 7). This resilience on the way down confirms both the defensive stature of this services tech subgroup and simultaneously our long held belief that when growth is scarce investors will flock to secular growth stocks. Chart 7Recession Proof Recession Proof Recession Proof As a result and following up from our recent data processing upgrade, another defensive services tech group, we are compelled to augment exposure to the S&P software index to overweight. Last week we showed that the tech sector (along with financials and consumer discretionary) best the broad market from the recessionary troughs onward, signaling that the key software sub group will likely lead the recovery.3 Software investment is on a multi decade upward trajectory and is slated to rise further in coming quarters as overall spending takes the back seat, but defensive software capex remains resilient (Chart 8). Not only do corporate executives upgrade software in downturns as these upgrades yield near instantaneous return on investment and are immediately productivity enhancing, but also the push to cloud-based services will only accelerate during the ongoing recession (bottom panel, Chart 8). Tack on that the global coronavirus social distancing measures are also boosting demand for remote working services specifically, and software sales will continue to grind higher (Chart 9). Chart 8Capex Market Share Gains Capex Market Share Gains Capex Market Share Gains Chart 9Rising Demand Buoys Sales Rising Demand Buoys Sales Rising Demand Buoys Sales Meanwhile, industry M&A remains robust and both the number of deals are still rising at a brisk rate and the premia paid remain near historically high levels (Chart 10). Contrary to a slew of corporations that have announced dividend cuts and equity buyback suspensions, pristine software balance sheets underscore that shareholder friendly activities will remain in place, if not accelerate, during the current recession (bottom panel, Chart 10). Chart 10What’s Not To Like? What’s Not To Like? What’s Not To Like? Chart 11Model Says Buy Model Says Buy Model Says Buy Our macro-based software EPS growth model does an excellent job in capturing all these moving forces and it is signaling that industry profits will continue to expand at a healthy pace for the rest of the year, in marked contrast to the broad market’s expected profit contraction (Chart 11). Adding it all up, an upward trending demand profile, a fortress of a balance sheet, exemplary recession resilience, and sustained M&A activity, all bode well for an earnings-led outperformance phase in the S&P software index. Bottom Line: Boost the S&P software index to overweight, today. This upgrade also lifts the S&P tech sector to neutral for a loss of 5% since inception. The ticker symbols for the stocks in this index are: BLBG: S5SOFT – MSFT, ADBE, CRM, ORCL, INTU, NOW, ADSK, ANSS, SNPS, CDNS, FTNT, PAYC, CTXS, NLOK.   Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com       Footnotes 1     Please see BCA US Equity Strategy Weekly Report, “SPX 3,000?” dated July 10, 2017, available at uses.bcaresearch.com. 2     Please see BCA US Equity Strategy Weekly Report, ““The Darkest Hour Is Just Before The Dawn”” dated March 23, 2020, available at uses.bcaresearch.com. 3    Please see BCA US Equity Strategy Weekly Report, “Fight Central Banks At Your Own Peril” dated April 14, 2020, available at uses.bcaresearch.com.     Current Recommendations Current Trades Strategic (10-Year) Trade Recommendations New SPX Target New SPX Target 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 Banks have an unmatched perspective on the entire economy, … : BCA began by tracking money flows through the banking system to gain advance notice of the direction of markets and the economy. … so we review the five largest banks’ earnings calls every quarter to augment our standard macro analysis: We’re looking for insight into borrower performance, lender willingness, consumer behavior, business sentiment and the condition of the banking system. The biggest banks are bearish on the economic outlook, but bullish on their ability to get through it, … : No management teams are looking for a V-bottom, and their expectations about the duration of the downturn sound a good bit more pessimistic than most investors’. They all expressed confidence in their institutions’ preparedness, however, citing sizable capital buffers and high-quality loan portfolios. … and we agree with their self-assessment: Analysts were skeptical that the banks have adequately reserved for coming loan losses, but we take the more optimistic view that their earnings power will allow them to absorb repeated iterations of reserving while barely scuffing book value. Follow The Money The big banks reported their first quarter earnings last week, and equity investors were decidedly unimpressed, knocking the stocks down 15-19% through Thursday’s close while the S&P 500 was flat. We listen to the calls to hear banks’ observations about households’ and businesses’ financial activity and glean some insight into where lending might be headed. This time we also wanted to use what we heard to inform our investment view on their stocks. We have long been of the view that post-GFC regulatory reforms left the SIFI banks overcapitalized. Even staring down the barrel of the current downturn, it was our sense that the SIFIs had ample capital buffers to withstand a severely adverse scenario, and the sharp de-rating they’ve been subjected to was excessive. With the potential range of credit outcomes so wide, however, it was hard to assess how much their per-share book values might fall, and so we couldn’t state with conviction whether or not the SIFIs’ stocks were as cheap as they appeared to the naked eye. The uncertainty remains, but we heard enough on the calls to conclude that book values are likely to remain resilient. 4Q19 Big Bank Beige Book As a group, the banks offered a pretty grim take on the economy. JPMorgan Chase built its in-house economists’ late-March forecast of a 25% decline in 2Q GDP and an unemployment rate above 10% into its model for calculating its 1Q loan-loss reserve, only to have them revise their forecasts lower, to -40% and 20%, respectively, after the bank closed its books. The rest of the banks, which offered directional GDP and unemployment views instead of point forecasts, uniformly called for weakness well into 2021. The banks were downbeat on the economy, but confident in their ability to manage through it, and not a single one has any intention of cutting its dividend. On the bright side, every bank cited its sizable capital buffer when arguing that it is in a better position than it was in 2008. The banks’ contention that the mix and quality of their loan books makes them safer than they were then didn’t seem to get much traction. The mortgages they hold today were much more carefully underwritten than the ones they held in 2008, but the quality of the banks’ overall loan books won’t be known until the recession has run its course. Many business borrowers are weaker credits that they were when their loans were extended, though the record-low growth in bank lending in the expansion just concluded suggests that the banks committed fewer excesses in this cycle than they normally do (Chart 1). Chart 1An Expansion Without Bank Lending Excesses An Expansion Without Bank Lending Excesses An Expansion Without Bank Lending Excesses Businesses drew down their credit lines at a frenzied pace over the last two weeks of March (Chart 2), a sure sign that they feared that liquidity would be in short supply. Since many of the banks saw the funds return to them as deposits (Chart 3), it seems that the draws were precautionary, rather than emergency, measures. It is entirely possible that the lines will be paid down once businesses replace them with forgivable 1% loans from the Paycheck Protection Program (PPP) funded by the SBA,1 though legislative attempts to replenish the PPP's rapidly consumed initial resources are currently in limbo. Chart 2Corporate Borrowers Drew Down Their Credit Lines With Stunning Speed, ... Corporate Borrowers Drew Down Their Credit Lines With Stunning Speed, ... Corporate Borrowers Drew Down Their Credit Lines With Stunning Speed, ... Chart 3... Only To Put It Back In The Bank ... Only To Put It Back In The Bank ... Only To Put It Back In The Bank Every bank asserted that it had the capacity to continue to pay its dividend, and pledged to do so as long as conditions didn’t deteriorate dramatically. Operationally, the banks were largely able to perform their standard functions without interruption, despite having the majority of their employees working from home. Successful remote operations bode well for future productivity and profitability as they may herald a future in which banks are able to reduce their costly branch footprints. They also suggest that their ongoing IT investments are paying dividends. A Sudden Stop In Household Spending (Chart 4) And Borrowing Chart 4Sudden Stop Sudden Stop Sudden Stop [I]n March, we saw a rapid decline in spend initially in travel and entertainment, which then spread to restaurants and retail as social distancing protocols were implemented more broadly. … [W]e did see an initial boost to supermarkets, wholesale clubs and discount stores as people stocked up on provisions, but even that is now starting to normalize. (Piepszak, JPM CFO) [Credit card] spend in aggregate was down 13% in the month of March, year-over-year, and we are seeing trends like that continue here in April. (Piepszak, JPM) Consumer spend is down over 25% year-over-year this past week with food and drug increasing and other spend down significantly. (Scharf, WFC CEO) March 2020 [card] volumes declined approximately 15% from March 2019. (Shrewsberry, WFC CFO) [Our customers’] … overall spending … seems to have stabilized in the last few weeks. During mid-April, we’re seeing [weekly] spending running about a low $50 billion average level compared to $60 billion … before the crisis. (Moynihan, BAC CEO) [T]he last week of March, the card spend activity just broadly for us was down about 30%. … [W]e would expect there to be continued pressure on purchase sale volumes through most of the second quarter. (Mason, C CFO) A Sharp Rise In Credit Line Utilization, … C&I loans were up 26% [year-on-year] as revolver utilization increased to 44%, which is an all-time high. … [E]arly here in the second quarter, we have seen a pause on revolver draws but … we are assuming … that we will see [them] continue in the second quarter, albeit at lower levels than the first quarter. (Piepszak, JPM) [The draws] really have flattened out, and they have been negligible for the last several days, more than a week. And so they probably peaked at the end of the third week of March, and then came right back down. … It’s worth noting that the high rate of [utilization] growth … has backed off since credit markets have reopened. (Shrewsberry, WFC) The draw activity was pretty normal through the first week of March, but ramped up in the second week before peaking in the third. The requests have come down in every one of the last three weeks. (Moynihan, BAC) [C]oming into the second quarter, we’ve actually seen really de minimis draws on the facilities and … we don’t see or feel that [drawdown] pressure now. (Corbat, C CEO) [T]he drawdowns were high in the third and fourth week in March and started to level out in early April. So I think we saw the peak already occurring. (Dolan, USB CFO) … Accompanied By A Surge In Deposits [A]bout half of [the increase in deposits came] from clients drawing on their credit lines and holding their cash with us as they look to secure liquidity. (Piepszak, JPM) It’s worth noting [that] ... we saw many of those draws come back … as deposits. [T]he 75% of loan draws [that] were not used for other paydowns ended up as deposits with [us]. (Moynihan, BAC) The Current Situation Is Unprecedented, … [T]here is no model that [has] dealt with GDP down 40%, unemployment growing that rapidly. … [There are] no models that ever dealt with a government which is doing a PPP program which might be ... $550 billion, unemployment where it looks like 30-40% [of those unemployed will have] higher income than before they went on unemployment, … or that the government is going to make direct payments to people. So what does that mean for credit card [performance]? (Dimon, JPM CEO) The economy is in an unprecedented situation, but not all of the unknowns are bad. The monetary and fiscal stimulus programs will undoubtedly help at the margin, and they may dramatically reduce the second-round effects of the social distancing measures that have strangled activity. We all know we haven’t seen anything like this before. There is no clear path … with a narrow range of outcomes. And so [I just have a very hard time] making an analogy of what this environment is to other environments. Having said that, … we feel like the portfolios that we have are stronger than they were at other downturns as I think they certainly are in many banks out there. (Scharf, WFC) I would just [dis]courage anyone from imagining that at this point in time that any bank has got perfect clairvoyance about … the future …, and whether it gets better or … worse. (Shrewsberry, WFC) Obviously there are many unknowns including how government fiscal and monetary actions will impact the outcome and how our own deferral programs will impact losses, or perhaps the biggest unknown is how long economic activity and conditions will be significantly impacted by the virus. (Donofrio, BAC CFO) … But Credit Performance Might Not Be Horrendous The real question will ultimately be how long this shutdown actually continues, … but in addition to that, how our actions, … the things that we’re doing very actively to help our clients, and the huge amount of government intervention, whether those things will … bridge individuals and small businesses and larger corporations to the other side of this. (Scharf, WFC) It wouldn’t surprise me to continue to have to add to reserves, … [b]ut … what we know is, we’re strong and the industry is strong to be able to handle this. (Scharf, WFC) For years now, we have been focused on client selection. As you all know, what really impacts banks in recession is not the loans put on your books during stress, but rather the quality of your portfolio booked during the years leading up to the stress. (Donofrio, BAC) [T]his isn’t a financial crisis, it’s a public health crisis with severe economic ramifications. … [W]e entered [it] in a very strong position from capital, liquidity and balance sheet perspective. We have the resources we need to serve our clients without jeopardizing our safety and soundness. … I feel confident in our ability to manage through whatever scenario comes to pass. (Corbat, C) I think, generally speaking, all banks are in a good position right now, which is why we’re all able to help our customers while protecting employees. (Cecere, USB CEO) Today we received the first major distribution of the direct payments in terms of the $1,200 stimulus payment. We’re seeing now the unemployment benefits, the extra $600 … coming through. [T]hose programs are just barely hitting the general consumer, general business, et cetera. And so … the stimulus they’ll provide is actually going to be from now on, not from now backwards, because this is a program that didn’t exist literally three weeks ago. (Moynihan, BAC) [T]hese [fiscal and monetary] programs … are extraordinary and should have an extraordinary impact. (Piepszak, JPM) Buy The Banks? The uncertainty around loan losses remains extremely high. No one knows how long the economy will remain locked down, or how long it will take to restart the economy once the most restrictive social distancing measures begin to be relaxed. No one knows how large the package of fiscal and monetary assistance will become, or how effective it will ultimately be. Analysts were clearly skeptical that the amounts the banks set aside in the first quarter as reserves against future losses will be sufficient. They were concerned about the gaps between current reserve levels and the losses the banks realized in the global financial crisis, and the cumulative losses projected under the severely adverse scenario of the 2019 iteration of the Fed’s annual stress tests (Table 1). If the virus drag on the economy persists into the third quarter, as our base-case scenario projects, the banks will likely have to step up their reserving activity aggressively. Given that they were able to do so in the first quarter without impairing their book values (Table 2), however, we think they can handle it. Table 1Loan Loss Reserves Vs. Stress Test Projections The Big Bank Beige Book, April 2020 The Big Bank Beige Book, April 2020 Table 2Big Bank Book Values The Big Bank Beige Book, April 2020 The Big Bank Beige Book, April 2020 The bull case, as BAC’s CEO put it on the call, rests on the idea that the banks’ quarterly pre-tax pre-provision net revenue – their earnings power – is large enough to absorb the gathering tide of writedowns. After seeing the first quarter results, and believing that monetary and fiscal policy will be able to reduce the overall level of credit losses and spread them out across several quarters, provided the shutdown doesn’t last more than six months, we subscribe to it. We are a buyer of the largest banks on the view that the monetary and fiscal support will reduce and stretch out the inevitable writedowns enough to allow the banks to earn their way through them without suffering meaningful book-value declines. Let’s go back to the beginning on the pre-tax PPNR[.] [W]e feel [that earnings power] has us in good stead in terms of [our] ability to absorb whatever circumstances play out here. The reality is how much earnings capacity [we] have to keep generating capital and … earnings that [we] can offset whatever comes at [us] and that’s what we feel good about. (Moynihan, BAC) Table 3A Solid Month's Work The Big Bank Beige Book, April 2020 The Big Bank Beige Book, April 2020 The SIFI put options we flagged four weeks ago have expired worthless, yielding a tidy 9% one-month gain for investors who wrote them (Table 3). That call was founded on the interaction between low book-value multiples and astronomical implied volatilities, but didn’t fully embrace the banks. We are ready to take the next step now because we believe pre-provision earnings will match or exceed the somewhat attenuated stream of credit losses, allowing investors to buy the biggest banks at a price-to-tangible-book multiple with a margin of safety that would comfort Benjamin Graham. We recommend overweighting the largest banks in US equity portfolios.2   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 Please see the April 14, 2020 US Investment Strategy/US Bond Strategy Special Report, "Alphabet Soup: A Summary Of The Fed’s Anti-Virus Measures," available at usis.bcaresearch.com. 2 Our US Equity Strategy service rates the S&P 500 banks group overweight, albeit with a downgrade alert.

Highlights Stay tactically neutral to equities. The market may meet some short-term resistance, especially as a slew of poor earnings are released in the coming weeks. The long-term threat to equities comes from the pandemic’s lasting after-effects, such as financial and corporate distress, and/or a political backlash against the private sector. Long-term investors should prefer equities over bonds, with the caveat that the threat does not materialise. Long-term equity investors should avoid oil and gas and European banks at all costs… …but healthcare, European personal products, and European clothes and accessories should all form core long-term holdings. Fractal trade: long nickel / short copper. Feature Chart of the WeekSales Per Share Must 'Catch Down' With GDP, Just Like In 2008 Sales Per Share Must 'Catch Down' With GDP, Just Like In 2008 Sales Per Share Must 'Catch Down' With GDP, Just Like In 2008 The sharp snapback rally in stock markets has reached an important resistance point – the critical Fibonacci level of a 38.2 percent proportionate retracement of the sell-off.1 Technical analysts define the sell-off in terms of the most recent peak to trough. But we define it differently. We define it in terms of the longest time horizon of investors that capitulated at the sell-off. The market may meet some short-term resistance. The longest time horizon of investors that capitulated at the sell-off’s climax on March 18 was a seven-quarter horizon. Hence, we define the sell-off as the seven-quarter decline to March 18. On that basis, and using the DAX as our benchmark, we would expect the index to meet resistance at around a 21 percent retracement rally from the March 18 low. Which is pretty much where the DAX stands right now (Chart I-2).2 Chart I-22020 Low: A Seven-Quarter Capitulation Followed By A Fibonacci Retracement 2020 Low: A Seven-Quarter Capitulation Followed By A Fibonacci Retracement 2020 Low: A Seven-Quarter Capitulation Followed By A Fibonacci Retracement After A Sharp Snapback Rally What Happens Next? The maximum length of investment horizons that capitulated on March 18 was unusually long at seven quarters. This should comfort long-term investors because of an important investment identity: Financial markets have fully priced a downturn when the longest time horizon of investors that have capitulated = the length of the downturn. So, the good news is that the March 18 bottom should hold if the downturn does not last longer than seven quarters. In this regard, the main risk of a protracted downturn comes not from the pandemic itself. Even if the pandemic returns in second and third waves, any economic shutdowns, full or partial, should last considerably less than seven quarters. Instead, the main risk comes from lasting after-effects, such as financial and corporate distress, and/or a political backlash against the private sector. The long-term threat comes from the pandemic’s after-effects on economic and political systems. But a protracted downturn of what? As we are focussing on the stock market, the downturn is not of GDP per se but its stock market equivalent: sales per share. In the long run, sales per share and GDP advance at the same rate. But the sector compositions of the stock market and GDP are not the same, so over shorter periods sales per share can underperform or outperform GDP. In which case, sales per share must catch up or catch down (Chart of the Week). In 2008, sales per share had to catch down. As a result, world sales per share declined for seven quarters through 2008-10, considerably longer than the decline in GDP (Chart I-3). Hence, the stock market found its bottom in early March 2009 when the longest time horizon of investors that had capitulated had reached seven quarters (Chart I-4). Chart I-32008-10: Sales Per Share Fell For Seven Quarters 2008-10: Sales Per Share Fell For Seven Quarters 2008-10: Sales Per Share Fell For Seven Quarters Chart I-42009 Low: A Seven-Quarter Capitulation Followed By A Fibonacci Retracement 2009 Low: A Seven-Quarter Capitulation Followed By A Fibonacci Retracement 2009 Low: A Seven-Quarter Capitulation Followed By A Fibonacci Retracement From this March 2009 bottom, the Fibonacci retracement equated to a 35 percent advance, which the market achieved by early June 2009. Thereafter, stocks met short-term resistance and gave back some of the snapback rally. Fast forward to 2020. Having likewise reached the Fibonacci retracement, the market may meet some short-term resistance, especially as a slew of poor earnings are released in the coming weeks. Assuming no lasting after-effects from financial distress or political backlash, the next sustained advance will happen later this year. Valuations Flatter Equities, But They Still Beat Bonds Turning to long-term investors the three most important things are: valuation, valuation, and valuation. Our favourite valuation measure is price to sales, which has been a good predictor of 10-year prospective returns going back to at least the 1980s (Chart I-5). Chart I-5Price To Sales Might Over-Estimate Prospective Returns In 2020, Just Like In 2008 Price To Sales Might Over-Estimate Prospective Returns In 2020, Just Like In 2008 Price To Sales Might Over-Estimate Prospective Returns In 2020, Just Like In 2008 But the predictive power depends on a crucial underlying assumption – that the past is a good guide to the future. Specifically, today we must assume that the pandemic causes just a brief blip in the multi-decade uptrend in stock market sales and profits. To repeat, the main long-term threat to stock markets comes not from the pandemic itself. The long-term threat comes from the pandemic’s after-effects on economic and political systems – such as crippled banking systems or large-scale nationalisations of the private sector. Furthermore, price to sales will err in its prediction if sales per share have deviated from GDP – implying either a future catch up or catch down. In the 1990s sales per share had underperformed GDP, so future returns outperformed the valuation prediction. However, in 2008 sales per share had outperformed GDP, so future returns underperformed the prediction. Today, just as in 2008, sales per share have become overstretched relative to GDP, so there will be a catch down. Which will weigh down prospective returns relative to what valuations appear to imply. Still, even adjusting for this, equities are likely to produce annualised nominal returns in the mid-single digits, comfortably higher than the yields on long-term government bonds. Hence, with the caveat that the pandemic does not generate lasting after-effects for economic and political systems, long-term investors should prefer equities over bonds. What Not To Buy, And What To Buy If a stock, sector, or stock market maintains a structural uptrend in sales and profits, then a big drop in the share price provides an excellent buying opportunity for long-term investors. In this case, the lower share price is stretching the elastic between the price and the up-trending profits, resulting in an eventual snap upwards. However, if sales and profits are in terminal decline, then the sell-off is not a buying opportunity other than on a tactical basis. This is because the elastic will lose its tension as profits drift down towards the lower price. In fact, despite the sell-off, if the profit downtrend continues, the elastic may be forced to snap downwards! Do not buy sectors whose profits are in major downtrends. This leads to a somewhat counterintuitive conclusion for long-term investors. After a big drop in the stock market, do not buy everything that has dropped. And do not buy the stocks and sectors that have dropped the most if their profits are in major downtrends. Specifically, the profits of oil and gas and European banks are in major structural downtrends (Chart I-6 and Chart I-7). Long-term equity investors should avoid these sectors at all costs. Chart I-6Oil And Gas Profits In A Major ##br##Downtrend Oil And Gas Profits In A Major Downtrend Oil And Gas Profits In A Major Downtrend Chart I-7European Banks Profits In A Major Downtrend European Banks Profits In A Major Downtrend European Banks Profits In A Major Downtrend Conversely, the profits of healthcare, European personal products, and European clothes and accessories are all in major structural uptrends (Chart I-8 - Chart I-10). As such, all three sectors should be core holdings for all long-term equity investors. Chart I-8Healthcare Profits In A ##br##Major Uptrend Healthcare Profits In A Major Uptrend Healthcare Profits In A Major Uptrend Chart I-9European Personal Products Profits In A Major Uptrend European Personal Products Profits In A Major Uptrend European Personal Products Profits In A Major Uptrend Chart I-10European Clothing Profits In A Major Uptrend European Clothing Profits In A Major Uptrend European Clothing Profits In A Major Uptrend Fractal Trading System* Given the outsized moves in markets over the past month, all assets have become highly correlated making it more difficult to find candidates for trend reversals. Chart I-11Nickel Vs. Copper Nickel Vs. Copper Nickel Vs. Copper However, we find that some relative moves within the commodity complex have not correlated with risk on/off. Specifically, the underperformance of nickel versus copper is technically stretched, so this week’s recommended trade is long nickel / short copper, setting a profit target of 11 percent with a symmetrical stop-loss. The rolling 1-year win ratio now stands at 67 percent. 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 0.382 = 1- phi. Where phi is the Golden Ratio, defined as the ratio of successive Fibonacci numbers in the limit. Alternatively, phi =1 / (1 + phi). 2 The seven-quarter sell-off in the DAX (capital only) to March 18 2020 was 39.4 percent, so a full retracement rally equals 65.1 percent, and a 0.382 geometric retracement equals 21.1 percent. Fractal Trading System   Cyclical Recommendations Structural Recommendations Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields   Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations  

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

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

Highlights Oil prices are up strongly from their lows, but conditions for a durable bottom may not yet be in place. The main hiccup is that an air pocket will likely remain under global oil demand until most social-distancing measures are lifted. That said, most petrocurrencies offer a significant valuation cushion, making them attractive for longer-term investors. We will look to buy a basket of petrocurrencies on further weakness. The Asian economies that were closer to the epicenter of the epidemic are likely to recover faster than the West. Transport and electricity energy demand should pick up in these economies faster. AUD/CAD and AUD/EUR should benefit from this dynamic. CAD/USD is likely to weaken in the short term as Canadian crude remains trapped in Alberta, but then strengthen as the global economy recovers. Feature Chart I-1Massive Liquidation In Crude Oil Massive Liquidation In Crude Oil Massive Liquidation In Crude Oil Just over a decade ago, the price of crude oil was firmly above $100 per barrel. Fast forward to today and many blends are trading south of $20 (Chart I-1). The extraordinary drop has sent many petrocurrencies, including the Norwegian krone, Mexican peso, and Canadian dollar, into freefall. The oil industry has been hit by multiple tectonic shocks, including a sudden stop in economic activity, a fallout from the OPEC cartel, divestment from ESG funds, and falling oil intensity in many economies. Meanwhile, the trading of petrocurrencies is also complicated by a shifting production landscape among many oil producers. For investors, three key questions will determine whether petrocurrencies are a buy: Have we approached capitulation lows in oil prices? If so, what will be the velocity and magnitude of the demand recovery? Will the correlation between oil and petrocurrencies still hold once the dust settles? Have We Approached Capitulation Lows? In terms of magnitude and duration, yes. Over the last two decades, oil price drawdowns have tended to last between 8 and 20 months before a durable rally ensues. The oil price collapse from July 2008 to February 2009 lasted around 8 months. The decline from June 2014 to February 2016 was much longer, around 20 months. Given the October 2018 peak in oil prices, we should be very close to the bottom in terms of duration. Remarkably, in all episodes, the peak-to-trough decline in the West Texas Intermediate (WTI) blend has been around 75% (Chart I-2).   However, since the 1970s, oil has moved in a well-defined pattern of a 10-year bull market, followed by a 20-year bear market (Chart I-3). Assuming the bear market in oil began just after the global financial crisis, it does suggest that even if prices do recover, it will most likely be a bear-market rally. That said, history also suggests that these bear market rallies in oil can be quite powerful, with prices often doubling or trebling. As we go to press, oil prices are up a remarkable 18% from their lows Chart I-2Similar In Magnitude To Prior Oil Crashes Similar In Magnitude To Prior Oil Crashes Similar In Magnitude To Prior Oil Crashes Chart I-3Oil Prices Are Close To Capitulation Lows Oil Prices Are Close To Capitulation Lows Oil Prices Are Close To Capitulation Lows What is different this time? Aside from a breakdown in OPEC+, a few other factors are in play. This alters the timing and duration of an intermediate-term bottom: Any coordinated supply response will need to involve the US to be viable.1 The OPEC+ cartel, specifically the alliance between Russia and Saudi Arabia, is broken. Chart I-4 illustrates why. While being the stewards of global oil production discipline, there has been one sole benefactor – the US. In 2010, only about 6% of global crude output came from the US. Collectively, Canada, Norway and Mexico shared about 10% of the oil market. Meanwhile, OPEC’s market share sat just north of 40%. Fast forward to today and the US produces around 15% of global crude, having grabbed market share from many other countries. Chart I-4US Is The Big Winner From OPEC Cuts US Is The Big Winner From OPEC Cuts US Is The Big Winner From OPEC Cuts As we go to press, there are reports that Saudi Arabia and Russia have come to an agreement. However, the history of OPEC alliances suggests that it is fraught with broken promises.  Oil still trades above cash costs for many producing countries, meaning the incentive to boost production in times of a demand shock is quite strong (Chart I-5). Ditto if oil prices are recovering. Oil futures are in a massive contango, with WTI trading close to $40 per barrel two years out. This incentivizes players with strong balance sheets to keep the taps open. The oil curve needs to shift significantly lower, probably pushing some blends into negative spot territory, in order to force production discipline on some players.   Chart I-5Oil Still Trading Above Cost Of Production A New Paradigm For Petrocurrencies A New Paradigm For Petrocurrencies The dollar has been strong, meaning the local-currency revenues of oil producers have been cushioning part of the downdraft in oil prices. This could sustain production longer than would otherwise be the case, especially in a liquidation phase. The New York Fed’s model suggests that most of the downdraft in oil prices since 2010 has been due to rising supply (Chart I-6). Chart I-6Oil Downdraft Driven By Supply A New Paradigm For Petrocurrencies A New Paradigm For Petrocurrencies Both Saudi Arabia and Russia have low public debt and ample foreign exchange reserves. This buys them time in terms of dealing with a prolonged period of low prices. We know there will be massive economic pain from the oil price collapse (Chart I-7). The good news is that with the economic slowdown already in place, it may well be the catalyst needed to enforce any agreement put into effect. Chart I-7The Coming Economic Pain For Oil Producers The Coming Economic Pain For Oil Producers The Coming Economic Pain For Oil Producers While the positive correlation between oil prices and petrocurrencies has weakened in recent years, it has been re-established during the current downturn. More importantly, should production cuts be led by US shale producers, this will redistribute market share to OPEC and other non-OPEC members, allowing their currencies to benefit. Should production cuts be led by US shale producers, this will redistribute market share to OPEC and other non-OPEC members, allowing their currencies to benefit.  In statistical terms, petrocurrencies had a near-perfect positive correlation with oil around the time US production was about to take off (Chart I-8). Since then, that correlation has fallen from around 0.9 to about 0.3. Chart I-8Falling Correlation Between Petrocurrencies And The US Dollar Falling Correlation Between Petrocurrencies And The US Dollar Falling Correlation Between Petrocurrencies And The US Dollar Take the Mexican peso as an example. Since 2013, Mexico has become a net importer of oil, as the US moves towards becoming a net exporter (Chart I-9). This explains why the positive correlation between the peso and oil prices has weakened significantly in recent years. Put another way, rising oil prices benefit the US industrial base much more than in the past, while the benefits for countries like Canada and Mexico are slowly fading. Chart I-9A Shifting Export Landscape A Shifting Export Landscape A Shifting Export Landscape That said, in the case of Canada and Norway, petroleum still represents over 20% and 50% of total exports. For Russia, Saudi Arabia, Iran or Venezuela, the number is much higher. Therefore, it is easy to see why a big fluctuation in the price of oil can have deep repercussions for their external balances. Historically, getting the price of oil right was usually the most important step in any petrocurrency forecast. Bottom Line: Both the CAD and NOK remain positively correlated with oil. So do the Russian ruble and the Colombian peso. This correlation should remain in place if oil prices put in a definitive bottom, and it should strengthen if production cuts are led by the US. When Will Oil Demand Recover? Oil demand tends to follow the ebb and flow of the business cycle, with demand having slowed sharply on the back of a sudden stop in economic activity. Transport constitutes the largest share of global petroleum demand. Ergo the economic lockdowns have brought a lot of freighters, bulk ships, large crude carriers and heavy trucks to a halt. Encouragingly, passenger traffic in China has started to pick up as the number of new Covid-19 cases flattens, and the country is gradually reopening for business. There has also been an improvement in the manufacturing data. All eyes will be watching if the relaxation of measures in China lead to a second wave of infections. Otherwise, should the Western economies follow the Chinese recovery path, then the world will be open for business by the end of the summer (Chart I-10). One way to play an early restart in Asia relative to the West is to go long the Australian dollar, relative to a basket of the Canadian dollar and the euro.  Part of the slowdown in global demand is being reflected through elevated oil inventories. However, part of the inventory building has also been a function of refinery maintenance (Chart I-11). Chinese oil imports continue to hold up well, and should easier financial conditions continue to put a floor under the manufacturing cycle, overall consumption will follow suit. Chart I-10Some Optimism For The West Some Optimism For The West Some Optimism For The West Chart I-11Watch For A Peak In Inventories Watch For A Peak In Inventories Watch For A Peak In Inventories One way to play an early restart in Asia relative to the West is to go long the Australian dollar, relative to a basket of the Canadian dollar and the euro. There are three key reasons which support this trade: Liquefied natural gas will become the most important component of Australia’s export mix in the next few years (Chart I-12). As Beijing restarts its economy and electricity production picks up, Aussie exports will benefit. Beijing has a clear environmental push to shift its economy away from coal electricity generation and towards natural gas. The massive drop in pollution resulting from the shutdown will all but assure that this push occurs sooner rather than later. Chart I-12LNG Will Be A Game-Changer For Australia LNG Will Be A Game-Changer For Australia LNG Will Be A Game-Changer For Australia There was already pent-up demand in the Australian economy going into the crisis, given the destruction of the capital stock from the fires. With an economy that was already running well below capacity, construction activity should see a V-shaped rebound once social distancing measures are relaxed. As the currency of the now largest oil producer in the world, the US dollar is becoming a petrocurrency itself. In this new paradigm, a better strategy for playing oil upside is to be long a basket of energy producers versus energy consumers. AUD/EUR benefits from this. Chart I-13 shows that a currency basket of oil producers versus consumers has both had a strong positive correlation with the oil price and has outperformed a traditional petrocurrency basket. Rising oil prices are a terms-of-trade boost for oil exporters but lead to demand destruction for oil importers. Chart I-13Buy Oil Producers Versus Oil Consumers Buy Oil Producers Versus Oil Consumers Buy Oil Producers Versus Oil Consumers Eventually, a pickup in manufacturing activity will be a global phenomenon rather than localized within Asia. When this happens, other petrocurrencies will begin to benefit. This will especially be the case for producers where production is more landlocked. Bottom Line: A recovery in global transport will help revive oil demand. This should be positive for oil prices in general and petrocurrencies in particular. One way to play the recovery in Asia relative to the West for now is to go long AUD/CAD and AUD/EUR. On CAD, NOK, MXN, RUB And COP Chart I-14NOK Will Outperform CAD NOK Will Outperform CAD NOK Will Outperform CAD While Canadian crude is likely to remain trapped in the oil sands, North Sea crude will face less transportation bottlenecks in the near term. This suggests the path of least resistance for CAD/NOK is down (Chart I-14). We were stopped out of our short CAD/NOK trade, but still recommend this position as a play on this dynamic. We are already long the Norwegian krone versus a basket of the euro and dollar. CAD/USD has been displaying a series of higher lows since the March 18 bottom, but the double-top formation in place since then suggests we could see some weakness in the near term. Should CAD/USD retest its recent lows, driven by a relapse in oil prices, we will be buyers.  Many petrocurrencies, including the Mexican and Colombian pesos, have become quite cheap and are attractive on a longer-term basis (Chart I-15). Given the uncertainty surrounding the nearer-term outlook, we a placing a limit buy on a broad basket of these currencies at -5%. Should oil prices retest the lows in the coming weeks/months, it will imply an 18% drop. Given the correlation between petrocurrencies and oil of 0.3, this suggests a 5.3% move lower.  Chart I-15ASome Petrocurrencies Are Very Cheap Some Petrocurrencies Are Very Cheap Some Petrocurrencies Are Very Cheap Chart I-15BSome Petrocurrencies Are Very Cheap Some Petrocurrencies Are Very Cheap Some Petrocurrencies Are Very Cheap Bottom Line: Place a limit buy on a petrocurrency basket at -5%.    Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Please see Commodity & Energy Strategy Weekly Report, “The Birth Of WOPEC,” dated April 9, 2020, available at ces.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 Recent data in the US have been negative: The unemployment rate soared from 3.5% to 4.4% in March. Nonfarm payrolls recorded a total loss of 701K jobs, the first decline in payrolls since September 2010. The NFIB business optimism index plunged from 104.5 to 96.4 in March. Initial jobless claims surged by 6.6 million last week, higher than the expected 5.3 million. Michigan consumer sentiment declined to 71 from 89.1 in April. The DXY index fell by 0.7% this week. Risk assets have recovered, fueled by an extra USD $2.3 trillion stimulus from the Federal Reserve. The lesson we are learning is that the deeper the perceived slowdown, the more the Fed will do to assuage any economic damage. As for currencies, what matters is relative monetary policies. The key variable to stem the rise in the USD is that the liquidity crisis does not morph into a solvency one. Report Links: Capitulation? - April 3, 2020 The Dollar Funding Crisis - March 19, 2020 Are Competitive Devaluations Next? - March 6, 2020 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Recent data in the euro area have been mostly negative: Markit services PMI fell further to 26.4 in March from 28.4 the previous month. The Sentix investor confidence dived to -42.9 from -17.1 in April. Moreover, the Sentix current situation index fell from -15 to -66 in April, while the outlook index moved up slightly from -20 to -15. EUR/USD appreciated by 0.5% this week. The euro zone members failed to reach an agreement on the joint EU debt issuance. On the other hand, the ECB adopted an unprecedented set of collateral measures to mitigate the negative impacts from COVID-19 across the euro area, including easing collateral conditions for credit claims, reduction of collateral valuation haircut, and waiver to accept Greek sovereign debt instruments as collateral.  Report Links: On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 On Money Velocity, EUR/USD And Silver - October 11, 2019 Japanese Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data in Japan have been negative: Consumer confidence fell to 30.9 from 38.4 in March. Labor cash earnings grew by 1% year-on-year in February, but slowed from 1.2% in January. The Eco Watchers Survey current index fell from 27.4 to 14.2 in March. The outlook index also declined from 24.6 to 18.8. The Japanese yen fell by 1% against the US dollar this week. On Wednesday, the BoJ announced that it would scale back some non-urgent operations such as long-term research and studies for academic papers, following the government’s decision to declare a state of emergency. The Reuters poll forecasted the Q1 GDP to shrink by 3.7% quarter-on-quarter and Q2 by 6.1%. Report Links: The Near-Term Bull Case For The Dollar - February 28, 2020 Building A Protector Currency Portfolio - February 7, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data in the UK have been dismal: Markit construction PMI plunged to 39.3 from 52.6 in March. GfK consumer confidence crashed to -34 from -9 in March. Total trade balance (including EU) shifted to a deficit of £2.8 billion from a surplus of £2.4 billion in February. The goods trade deficit widened from £5.8 billion to £11.5 billion. GBP/USD rose by 0.6% this week. After being told to cut dividends last week, the UK banks are now pressuring the BoE on fresh capital relief to help fight the COVID-19. The BoE has also agreed to temporarily lend the government money, funded through money printing. The details suggest the operations are temporary, but the BoE might be the first central bank to formally step closer to MMT. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 A Few Trade Ideas - Sept. 27, 2019 United Kingdom: Cyclical Slowdown Or Structural Malaise? - Sept. 20, 2019 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Recent data in Australia have been negative: The AiG services performance index fell from 47 to 38.7 in March. Imports and exports both slumped 4% and 5% month-on-month respectively in February. The trade surplus narrowed from A$5.2 billion to A$4.4 billion.  The Australian dollar surged by 3.8% against the US dollar, making it the best performing G10 currency this week. The RBA held interest rate steady at 0.25% on Tuesday, while warning the country is in for a “very large” economic contraction. Lowe also suggested that the economy will “much depend on the success of the efforts to contain the virus and how long the social distancing measures need to remain in place”. Report Links: On AUD And CNY - January 17, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 A Contrarian View On The Australian Dollar - May 24, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 Recent data in New Zealand have been dismal: NZIER business confidence survey reported that a net 70% of firms expect general business conditions to deteriorate in Q1, compared to 21% in the previous quarter. Electronic card retail sales contracted by 1.8% year-on-year in March, down from 8.6% growth the previous month. The New Zealand dollar recovered by 1.7% against the US dollar this week. In addition to the NZ$30 billion purchases of central government bonds, the RBNZ is stepping up the QE program by offering to buy up to NZ$3 billion of local government bonds to support liquidity. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Place A Limit Sell On DXY At 100 - November 15, 2019 USD/CNY And Market Turbulence - August 9, 2019 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Recent data in Canada have been dismal: Bloomberg Nanos confidence fell further from 46.9 to 42.7 the week ended April 3. Housing starts increased by 195K year-on-year in March, down from 211K in February. Building permits contracted by 7.3% month-on-month in February. On the labor market front, the pandemic has caused the unemployment rate to rise sharply from 5.6% to 7.8% in March, higher than the expected 7.2%. Employment fell by more than one million (-1,011,000 or -5.3%). The Canadian dollar rose by 1.2% against the US dollar this week, supported by the tentative rebound in oil prices. The BoC spring Business Outlook Survey shows that business sentiment had softened even before COVID-19 concerns intensified in Canada. The overall survey indicator fell below 0 to -0.68 in Q1. Businesses tied to the energy sector were hit the most due to falling oil prices. Report Links: The Loonie: Upside Versus The Dollar, But Downside At The Crosses Updating Our Balance Of Payments Monitor - November 29, 2019 Making Money With Petrocurrencies - November 8, 2019 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Recent data in Switzerland have been negative: Total sight deposits were little changed at CHF 627 billion for the week ended April 3. The unemployment rate jumped from 2.5% to 2.9% in March, above expectations of 2.8%. The number of total unemployed increased by 15%, now reaching 136K. The Swiss franc appreciated by 0.6% against the US dollar this week. The Swiss government forecasted the output to slump 10% this year under the worst-case scenario, given the incoming data proved worse than expected. On the positive side, the government said it would gradually relax restriction measures later this month should the current situation improve. Report Links: On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 Portfolio Tweaks Before The Chinese New Year - January 24, 2020 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Recent data in Norway have been negative: The unemployment rate surged to 10.7% in March from 2.3%. Manufacturing output fell by 0.5% month-on-month in February. Headline inflation fell from 0.9% to 0.7% year-on-year in March, while core inflation remained unchanged at 2.1%.  The Norwegian krone rose by 2.8% against the US dollar this week, up 18% from its recent low three weeks ago. Norway will likely relax some restrictions later this month while the ban on public gatherings will still remain in place. The loosening of COVID-19 measures, together with oil prices recovering and cheap valuations all underpin the Norwegian krone in the long run. Please refer to our front section this week for more detailed analysis. Report Links: Building A Protector Currency Portfolio - February 7, 2020 On Oil, Growth And The Dollar - January 10, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1   Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2   Recent data in Sweden have been mixed: Industrial production fell by 0.2% year-on-year in February. Manufacturing new orders increased by 6% year-on-year in February. Household consumption increased by 2.3% year-on-year in February, up from 1.6% the previous month. The Swedish krona increased by 1% against the US dollar this week. The recent efforts in buying up bonds by the Riksbank to increase liquidity amid COVID-19 is likely to increase the debt burden in Sweden. The stock of Swedish Treasury bills held by the Riksbank is estimated to be SEK 300 billion by the end of this year, compared to only 55 billion in February. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019 Balance Of Payments Across The G10 - February 15, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights Chart 1Will Fed Purchases Mark The Top? Will Fed Purchases Mark The Top? Will Fed Purchases Mark The Top? Policymakers can’t do much to boost economic activity when the entire population is under quarantine, but they can take steps to contain the ongoing credit shock and mitigate the risk of widespread corporate bankruptcy. If most firms can stay afloat, then at least there will be jobs to return to when shelter in place restrictions are lifted. Are the steps taken so far by the Federal Reserve and Congress sufficient in this regard? We expect that the Fed’s announcement of investment grade corporate bond purchases will mark the peak in investment grade corporate bond spreads (Chart 1). However, the Fed is doing nothing for high-yield issuers and its purchases only lower borrowing costs for investment grade firms, they don’t clean up highly levered balance sheets. Similarly, much of Congress’ fiscal stimulus package comes in the form of loans instead of grants. As such, ratings downgrades will surge and high-yield spreads probably have more near-term upside. Investors should keep portfolio duration close to benchmark, overweight investment grade corporate bonds and remain cautious vis-à-vis high-yield. Investors should also take advantage of the attractive long-run value in TIPS. Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment grade corporate bonds underperformed the duration-equivalent Treasury index by 1040 basis points in March, dragging year-to-date excess returns down to -1268 bps. The average index spread widened 251 bps from the beginning of the month until the Fed announced its corporate bond purchase programs. It then tightened by 90 bps. It currently sits at 283 bps. Even after the recent tightening, investment grade spreads are extremely high relative to history. Our measure of the 12-month breakeven spread adjusted for changing index credit quality ranks at its 89th percentile since 1989 (Chart 2).1 This means that the sector has only been cheaper 11% of the time since 1989. As we wrote in last week’s Special Report, the Fed’s two new corporate bond purchase programs could be thought of as adding an agency guarantee to eligible securities (those with 5-years to maturity or less).2  We would also expect ineligible (longer maturity) securities to benefit from some knock-on effects, since many firms issue at both the short and long ends of the curve. As such, we recommend an overweight allocation to investment grade corporate bonds, with a preference for the short-end of the curve (5-years or less). The Fed’s purchases should lead to spread tightening, and a steepening of the spread curve (panel 4).  Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Containing The Credit Shock Containing The Credit Shock Table 3BCorporate Sector Risk Vs. Reward* Containing The Credit Shock Containing The Credit Shock High-Yield: Neutral Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield underperformed the duration-equivalent Treasury index by 1330 basis points in March, dragging year-to-date excess returns down to -1659 bps. The average index spread widened 600 bps from the beginning of the month until the Fed announced its corporate bond purchase programs. It then tightened by 158 bps. It currently sits at 942 bps. As we wrote in last week’s Special Report, the Fed’s corporate bond purchases will cause investment grade corporate spreads to tighten, but so far, high-yield has been left out in the cold.3 This means that we must view high-yield spreads in the context of what sort of default cycle we expect for the next 12 months. To do that, we use our Default-Adjusted Spread – the excess spread available in the index after accounting for default losses. At current spreads, our base case expectation of an 11%-13% default rate and 20%-25% recovery rate implies a Default-Adjusted Spread between -98 bps and +117bps (Chart 3). For a true buying opportunity, we would prefer a Default-Adjusted Spread above its historical average of 250 bps. This means that we would consider upgrading high-yield to overweight if the index spread widens to a range of 1075 bps – 1290 bps, in the near-term. Until then, junk investors should stay cautious. MBS: Underweight Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 22 basis points in March, dragging year-to-date excess returns down to -81 bps. The conventional 30-year zero-volatility spread widened 13 bps on the month, driven by a 16 bps widening of the option-adjusted spread that was offset by a 3 bps decline in expected prepayment losses (aka option cost). Like investment grade corporates, MBS spreads will benefit from aggressive Fed purchases for the foreseeable future. However, we prefer investment grade corporates over MBS because of much more attractive valuations. Notice that the option-adjusted spread offered by a Aa-rated corporate bond is 98 bps greater than that offered by a conventional 30-year MBS (Chart 4). Further, servicer back-log is currently keeping primary mortgage rates elevated compared to both Treasury and MBS yields (panels 4 & 5). This is preventing many homeowners from refinancing, despite the Fed’s dramatic rate cuts. However, we expect these homeowners will eventually get their chance. The Fed will be very cautious about raising rates in the future, and primary mortgage spreads will tighten as servicers add capacity. This means that there is a significant amount of refi risk that is not yet priced into MBS. Government-Related: Underweight Chart 5Government-Related Market Overview Government-Related Market Overview Government-Related Market Overview The Government-Related Index underperformed the duration-equivalent Treasury index by 574 basis points in March, dragging year-to-date excess returns down to -667 bps. Sovereign debt underperformed duration-equivalent Treasuries by 1046 bps in March, dragging year-to-date excess returns down to -1375 bps. Foreign Agencies underperformed the Treasury benchmark by 850 bps on the month, dragging year-to-date excess returns down to -1023 bps. Local Authority debt underperformed Treasuries by 990 bps in March, dragging year-to-date excess returns down to -948 bps. Domestic Agency bonds underperformed by 96 bps in March, dragging year-to-date excess returns down to -103 bps. Supranationals underperformed by 70 bps on the month, dragging year-to-date excess returns down to -63 bps. USD-denominated Sovereigns handily outperformed Baa-rated corporate bonds during last month’s market riot (Chart 5). But going forward, we prefer to grab the extra spread available in Baa-rated corporates, with the added bonus that the corporate sector now benefits from direct Fed purchases. The Fed’s dollar swap lines should remove some of the liquidity premium priced into sovereign spreads, but these swap lines only extend to 14 countries (Euro Area, Canada, UK, Japan, Switzerland, Australia, Brazil, Denmark, Korea, Mexico, Norway, New Zealand, Singapore and Sweden) and further dollar appreciation is possible until global growth recovers. One silver lining of last month’s indiscriminate spread widening is that some value has been created in traditionally low-risk sectors. Specifically, the Domestic Agency and Supranational option-adjusted spreads are at 46 bps and 31 bps, respectively (bottom panel). Both look like attractive buying opportunities. Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds underperformed the duration-equivalent Treasury index by a whopping 649 basis points in March, dragging year-to-date excess returns down to -755 bps (before adjusting for the tax advantage). In fact, Aaa-rated Municipal / Treasury yield ratios have blown out across the entire curve and have made new all-time highs, above where they were during the 2008 financial crisis (Chart 6). While the spread levels are alarming, it’s not hard to understand why muni spread widening has been so dramatic. State and local governments are not only shouldering massive expenses fighting the COVID-19 crisis, but will also see tax revenues plunge as economic activity grinds to a halt. This opens up a massive whole in state & local government budgets and municipal bond prices are reacting in kind. Support in the form of Fed municipal bond purchases and direct cash injections from the federal government is required to right the ship. So far, the Fed is only supporting municipal debt with less than six months to maturity and federal government aid has come in the form of grants directed at specific spending areas. Ideally, the Fed will start purchasing long-dated municipal bonds (as it is doing with corporates) and the federal government will provide more direct aid to fill budget gaps. We expect both of those policies to be launched in the coming weeks, and thus think it is a good time to buy municipal bonds on the expectation that the “policy put” will drive spreads lower. Treasury Curve: Buy 5-Year Bullet Versus 2/10 Barbell Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve underwent a massive bull-steepening in March, as the Fed cut rates by 100 bps, all the way back to the zero bound. The 2-year/10-year Treasury slope steepened 20 bps on the month. It currently sits at 39 bps. The 5-year/30-year Treasury slope steepened 22 bps on the month. It currently sits at 85 bps. One good thing about the fed funds rate being pinned at zero is that it greatly simplifies yield curve strategy. As we showed in a recent report, when the funds rate is at its lower bound the Treasury slope will trade directionally with yields.4 That is, the yield curve will steepen when yields rise and flatten when they fall. Therefore, if you want to put on a position that will profit from lower yields but that doesn’t increase the average duration of your portfolio, you can enter a duration-neutral flattener: long a 2/10 or 2/30 barbell and short the 5-year or 7-year bullet, in duration-matched terms. Or, if like us, you do not want to make a large duration bet but suspect that Treasury yields will be higher in 12 months, you can enter a duration-neutral steepener: long the 5-year bullet and short a duration-matched 2/10 barbell.5 In terms of value, the 5-year yield no longer trades deeply negative relative to the 2/10 and 2/30 barbells (Chart 7), though it remains somewhat expensive according to our models (see Appendix B). TIPS: Overweight Chart 8Inflation Compensation Inflation Compensation Inflation Compensation TIPS underperformed the duration-equivalent nominal Treasury index by 515 basis points in March, dragging year-to-date excess returns down to -735 bps. The 10-year TIPS breakeven inflation rate fell 55 bps on the month. It currently sits at 1.09%. The 5-year/5-year forward TIPS breakeven inflation rate fell 24 bps on the month. It currently sits at 1.39%. As we noted in a recent report, the market crash has created an extraordinary amount of long-run value in TIPS.6 For example, the 10-year and 5-year TIPS breakeven inflation rates have fallen to 1.09% and 0.78%, respectively. This means that a buy & hold position long the TIPS and short the equivalent-maturity nominal Treasury will make money if average annual inflation is greater than 0.78% for the next five years, or greater than 1.09% for the next ten (Chart 8). This seems like a slam dunk. Even on a 1-year horizon, we would argue that TIPS trades make sense. We calculate that the TIPS note maturing in April 2021 will deliver greater returns than a 12-month T-bill as long as headline CPI inflation is above -1.25% during the next 12 months (panel 4). Granted, the oil price collapse is a significant drag on CPI (bottom panel). But, we would also note that the worst year-over-year CPI print during the 2008 financial crisis was -2.1% and this included deflation in the shelter component. Shelter accounts for 33% of the CPI, compared to only 7% for Energy. ABS: Underweight  Overweight Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities underperformed the duration-equivalent Treasury index by 342 basis points in March, dragging year-to-date excess returns down to -317 bps. The index option-adjusted spread for Aaa-rated ABS soared 158 bps on the month. It currently sits at 163 bps, well above average historical levels (Chart 9). Aaa-rated consumer ABS were not immune to the recent sell-off, but we think today’s elevated spreads signal an opportunity to increase exposure to the sector. In addition to the value argument, the Fed’s re-launched Term Asset-Backed Securities Loan Facility (TALF) should cause Aaa-rated ABS spreads to tighten in the coming months. Through TALF, eligible private investors can take out non-recourse loans from the Fed and use the proceeds to purchase Aaa-rated ABS. In our view, the combination of elevated spreads and direct Fed support for the sector suggests a buying opportunity in Aaa-rated consumer ABS. Non-Agency CMBS: Neutral  Underweight Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-agency Commercial Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 786 basis points in March, dragging year-to-date excess returns down to -785 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS widened 133 bps on the month. It currently sits at 217 bps, well above typical historical levels (Chart 10). Despite wide spreads, we are hesitant about stepping into the sector. The Fed has so far not extended its asset purchases to non-agency CMBS. There are other sectors – such as consumer ABS, Agency CMBS, and investment grade corporate bonds – that also offer attractive spreads and are benefitting directly from Fed support. Agency CMBS: Overweight Agency CMBS underperformed the duration-equivalent Treasury index by 394 basis points in March, dragging year-to-date excess returns down to -361 bps. The average index spread for Agency CMBS widened 74 bps on the month. It currently sits at 121 bps, well above typical historical levels (panel 3). Unlike its non-agency counterpart, the Fed is buying Agency CMBS as part of its mortgage-backed securities purchase program. The combination of an elevated spread and direct Fed support makes the Agency CMBS sector a high conviction overweight. Appendix A: The Golden Rule Of Bond Investing With the federal funds rate pinned at its effective lower bound for the foreseeable future, yield volatility at the front-end of the curve will decline markedly. This means that the 12-month fed funds rate expectations embedded in the yield curve provide little useful information. As such, our Golden Rule of Bond Investing is not a useful framework for implementing duration trades when the fed funds rate is pinned at zero. We will therefore temporarily stop updating the Golden Rule tables that were previously shown in Appendix A of our monthly Portfolio Allocation Summary. The Golden Rule framework will return when the fed funds rate is close to lifting off from zero. Please feel free to contact us if you have any questions.     Appendix B: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of April 3, 2020) Containing The Credit Shock Containing The Credit Shock Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 5Butterfly Strategy Valuation: Standardized Residuals (As Of April 3, 2020) Containing The Credit Shock Containing The Credit Shock Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of 46 bps in the 5 over 2/10 cell means that we would only expect the 5-year to outperform the 2/10 if the 2/10 slope steepens by more than 46 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) Containing The Credit Shock Containing The Credit Shock Appendix C: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Chart 11Excess Return Bond Map (As Of April 3, 2020) The Golden Rule's Track Record The Golden Rule's Track Record   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 The 12-month breakeven spread is the spread widening required to deliver negative excess returns versus duration-matched Treasuries on a 12-month horizon. 2 Please see US Bond Strategy/Global Fixed Income Strategy Special Report, “Trading The US Corporate Bond Market In A Time Of Crisis”, dated March 31, 2020, available at usbs.bcaresearch.com 3 Please see US Bond Strategy/Global Fixed Income Strategy Special Report, “Trading The US Corporate Bond Market In A Time Of Crisis”, dated March 31, 2020, available at usbs.bcaresearch.com 4 Please see US Bond Strategy Weekly Report, “Life At The Zero Bound”, dated March 24, 2020, available at usbs.bcaresearch.com 5 The rationale for why barbell positions profit from curve flattening and bullet positions profit from curve steepening is found in US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation

Highlights The potential range of book value outcomes for large banks is enormous, … : Total credit losses will be a function of the virus’ persistence, the intensity and duration of the social distancing actions taken to combat it, and the efficacy of monetary and fiscal policy measures meant to mitigate the economic pain. … making it almost impossible to assess their equity valuations: With the uncertainty around each of the three independent variables, estimating default rates and recovery rates is a guessing game. This is the most sudden recession on record, … : Nearly 10 million people have filed initial jobless claims in the last two weeks, more than the average over the first 26 weeks of the last seven recessions. … but the biggest banks have entered it on more stable footing than they typically would, and they have a few things going for them: The biggest banks are nowhere near as extended as they typically are after expansions, with unusually conservative asset portfolios and a large stockpile of equity capital. Feature “It depends” is always the answer to quite a few questions in economics, but right now, it’s the answer to just about all of them. Global economic activity is hostage to the COVID-19 outbreak, and the social distancing measures that have been implemented in an attempt to impede its progress. No one can say for sure how long those measures will have to remain in place, though their impact has been starkly apparent on the broad swath of businesses that they have rendered unviable. Non-essential retailers, pro sports leagues, movie theaters, concert venues, gyms, barbers, nail salons, bars and restaurants have had their revenue streams cut off entirely. Nearly all of them have some fixed costs: rent if they don’t own their space; maintenance, mortgage payments and property taxes if they do. Table 1A Half-Year Of Jobless Claims In Two Weeks How Vulnerable Are US Banks? Part 2: It’s Complicated How Vulnerable Are US Banks? Part 2: It’s Complicated Monthly rent and mortgage obligations pose a thorny issue for the banking system, because they could lead to a surge of defaults among retailers and their landlords. The unprecedentedly rapid rise in unemployment (Table 1) could trigger a tsunami of home mortgage, credit card and auto loan delinquencies. Congress, the Fed, and various executive-branch departments and agencies are doing their best to protect the individuals and businesses sucked into the vortex, but the ultimate success of their efforts is uncertain. That uncertainty makes it impossible to project the SIFI banks’ credit losses within a reasonably useful confidence interval. To take an extreme example, what if the collateral securing auto loans were reduced to its scrap value because consumers developed an aversion to previously-owned vehicles? Getting less far-fetched, what if all used cars had to be marked down by 20 or 30% to entice drivers to swallow their discomfort, and the value of soon-to-be-vacant homes and apartments faced similar haircuts? Neither is our base-case scenario, but the fact that the markdown scenario is at least plausible illustrates the difficulty of estimating credit losses, and the challenge of coming up with decent estimates of SIFI banks’ earnings and capital adequacy. For the time being, we cannot say if the SIFI banks are better bought or sold at their current prices because we don’t know how 1Q loan-loss provisions will affect their March 31st book value, or what June 30th book might be. Our thinking has evolved in the week since we published Part 1 of this Special Report on the biggest US banks’ vulnerability. Initially, 50 years of Wells Fargo’s financials led us to believe that the SIFI bank de-rating over the last month and a half was excessive, and we concluded that buying SIFI banks at or below their December 31st tangible book value provided investors with a significant margin of safety. The chance to buy at or below tangible book would be a gift even in a bad recession, but the current episode threatens to go well beyond bad. Though we still lean to buying the SIFIs rather than selling them, we now recommend that investors watch and wait before committing, as they should with risk assets more generally. We hold to that bias because our review of system-wide data revealed ample instances of how the largest banks have entered this recession in better shape than normal. We also take heart from the idea that the Fed and elected officials will vigorously pursue policies that directly and indirectly benefit the banks. The banking system is considerably more solid than it was ahead of the 2007-8 crisis. It’s not immune to the shocks that are roiling the economy, but it will not be a driver of them. A Lack Of Banking Excesses Back in 2007, the last time that a recession/financial crisis was taking aim at the US, a bank-examiner-turned-analyst told us that, “Banks create value on the liability side of the balance sheet [via deposits], and destroy it on the asset side.” At the time, the destruction was centered on subprime mortgages and the securities they spawned, but the story plays itself out in every cycle. Bad loans are made in good times, as bankers let their guard down after an extended period of low defaults and market share takes precedence over lending standards. Banks exercised more restraint over the last 10-plus years than they have in any prior postwar expansion. 11 years of zero- and negative-interest-rate policy have promoted plenty of credit excesses, as many investors have gone far afield in search of yield. Bond covenants have been shredded, and corporate leverage has duly risen. Yet banks have largely stayed out of the fray. Bank lending grew at a markedly slower rate between July 2009 and February 2020 than it has in any other postwar expansion1 (Chart 1, top panel). Chart 1An Especially Restrained Expansion An Especially Restrained Expansion An Especially Restrained Expansion Total loan growth slid all the way to 3.8% annualized versus 9.7% in prior postwar expansions. While real estate lending slowed the most, following the frenzy that precipitated the 2007-8 crisis (Chart 1, bottom panel), C&I (Chart 1, second panel) and consumer lending (Chart 1, third panel) also fell well short of their postwar expansion pace, and only consumer lending failed to set a new postwar expansion low (Table 2). From the examiner-analyst’s perspective, banks behaved less self-destructively in the last ten-plus years than they have in any other postwar expansion. Regulatory efforts to curb banking excesses really did get some traction. Table 2Core Bank Lending Growth During Expansions How Vulnerable Are US Banks? Part 2: It’s Complicated How Vulnerable Are US Banks? Part 2: It’s Complicated Setting An Uncharacteristically Good Example Historically, the largest banks are at the center of the excesses that make the banking system vulnerable and help set the stage for crises. It wasn’t a community banker, after all, who smugly declared that countries don’t go bust after having plunged headfirst into lending to shaky Latin American governments. It has been the biggest players who have hatched dubious financial innovations and scaled them to the extremes that trigger systemic rumbles. Since the 2007-8 crisis, however, the biggest banks have demonstrated uncommon restraint. As we noted in Part 1, loan-to-deposit ratios around 100% and above are a sign of instability because they have to be funded with capital flows that are here today but gone tomorrow. Lower loan-to-deposit ratios hold down profits, but they buffer banks’ exposure to the business cycle, provided that deposit funding isn’t diverted to uses that are riskier than straightforward loans. The FDIC and the Fed maintain data series that offer insight into different-sized banks’ use of their lending capacity. The FDIC’s Quarterly Banking Profile, published since the mid-‘90s, breaks out total system loan-to-deposit ratios into categories based on the size of individual banks’ assets. Using its data, we were able to compare the largest banks’ activity with all other FDIC-insured banks’ activity since 1997. The comparison showed that the largest banks performed an about-face after the subprime crisis, going from operating with uniformly higher loan-to-deposit ratios than all other banks to operating with uniformly – and significantly – lower loan-to-deposit ratios (Chart 2). Chart 2The Biggest Banks Are Using Less Of Their Lending Capacity ... The Biggest Banks Are Using Less Of Their Lending Capacity ... The Biggest Banks Are Using Less Of Their Lending Capacity ... The Fed’s commercial bank balance sheet data covering large and small banks extend back another decade. The data do not align perfectly with the FDIC’s, as the Fed’s large-bank subset (the top 25 banks by assets) has been broader than the FDIC’s since 2016 (top 9 or 10 banks) and was narrower in prior years (the FDIC’s top subset included 66 to 119 banks). The Fed’s data do not show large banks making fuller use of their deposit capacity in the ‘90s and most of last decade, but they echo the post-2007-8 drop-off in the FDIC data (Chart 3). The biggest banks have operated with less risk under the Basel 3/Dodd-Frank/Volcker Rule regime, allocating less of their capacity to loans, and considerably more to Treasuries, agencies and cash (Chart 4). Chart 3... No Matter How They're Defined ... ... No Matter How They're Defined ... ... No Matter How They're Defined ... Chart 4... And They're Directing It To Safer, More Liquid Assets ... And They're Directing It To Safer, More Liquid Assets ... And They're Directing It To Safer, More Liquid Assets Banks Are Better Capitalized Than They Used To Be The overall banking system is operating with considerably less leverage than it did in the ‘80s or ‘90s, as equity capital now accounts for 12% of total assets (Chart 5). Wells Fargo’s leverage history as shown in Part 1 suggests that banks were even more thinly capitalized in the ‘70s. An increased proportion of equity capital makes a bank more resilient to loan losses and other operational stumbles. Critically for the stability of the system, the SIFI banks are forced to maintain additional capital buffers. The combination of increased equity capital and increased holdings of liquid assets with little to no credit risk like Treasury and agency securities has made all of the largest banks safer. Chart 5Increased Equity Financing Has Made Banks More Resilient Increased Equity Financing Has Made Banks More Resilient Increased Equity Financing Has Made Banks More Resilient Some Fears Seem Overblown We reiterate from Part 1 that larger banks do not borrow short to lend long, and have not for a long time. According to the latest Quarterly Banking Profile, barely a sixth of the 4,400 banks with assets of less than $1 billion report having any derivatives exposure. A considerable majority of community banks must therefore take their asset and liability maturity profiles as given, leaving them exposed to the vagaries of shifts in the yield curve. No management team at a decently-sized publicly traded bank would dare to run anything more than a very narrow mismatch in asset and liability duration, however, as evidenced by the gargantuan interest-rate swaps market. Bank stocks may trade with 10-year Treasury yields, but the slope of the curve has very little bearing on bank earnings.2 During recessions, banks usually encounter more customers trying to park money than businesses trying to borrow it.  Unused loan commitments have provoked much agita among investors in recent weeks. A floundering company, desperately trying to stay afloat, may well draw down all of its available credit lines. Line drawdowns could force banks to make good on loan commitments made in better times that now have little prospect of repayment. While they do not appear to have been a significant issue in the ’90-’91 or 2001 recessions, lines were drawn down sharply in 2007-8 (Chart 6). Chart 6Much Ado About Nothing? Much Ado About Nothing? Much Ado About Nothing? The positive news for banks is that their exposure to untapped commitments is considerably smaller than it was heading into the last recession. They may also be less likely to be drawn, thanks to multiple Fed initiatives aimed at ensuring the availability of credit, like its ambitious plan to backstop investment-grade corporate borrowers, and the CARES Act’s expansion of Small Business Administration funding and provision of loans and loan guarantees for ailing companies in industries related to national security. There are going to be considerably more strapped borrowers, but they will have more non-bank avenues to obtain funding than they have had in prior recessions. Banks know that line demand may spike soon after the business cycle peaks; they reserve for unused commitments and will not be caught entirely unawares. Finally, not all of the unused commitments are to suffering C&I borrowers that investors most fear; Wells Fargo’s commitment history suggests that the largest share of the outstanding commitments are to individual credit card borrowers. Despite rising distress, lending has increased at a fairly modest rate during recessions, as households and businesses broadly shrink from risk, while deposits have grown at a faster rate, as the safety of FDIC-insured accounts gains appeal (Table 3). We do not expect that increased consumption of credit line capacity will materially alter the banking system’s credit exposures. Table 3Core Bank Lending And Deposit Growth During Recessions How Vulnerable Are US Banks? Part 2: It’s Complicated How Vulnerable Are US Banks? Part 2: It’s Complicated Investment Implications The banking system, anchored by the SIFI banks, is in considerably better shape now than it was in 2007, and does not pose an active threat to the financial system this time around. The banking system is not only better capitalized than it has been in the past, but large banks have invested far more conservatively. We cannot assess how expensive SIFI stocks are without having a better handle on potential loan losses, however, and we need to get a sense at how successful the Fed’s and Congress’ interventions to stem the building economic distress will be. We hope for the best, but the last-mile issues are complicated, and we expect that the mitigation efforts will have to work out some kinks before they begin to get traction. Don't worry about the banks, but give it some time before buying them. Congress and the Fed are trying to perform challenging new routines, and it's unlikely they'll stick the landing on their first try. Table 4Comfortably In The Money How Vulnerable Are US Banks? Part 2: It’s Complicated How Vulnerable Are US Banks? Part 2: It’s Complicated Our no-rush-to-buy take on the broad market applies to the SIFI banks, as well. We have high conviction that Congress and the administration will do whatever it takes to shore up the most vulnerable parts of the economy as they reveal themselves, and the Fed has already moved to a war footing. Stocks can go lower as they climb the learning curve, and may have to do so to signal the need for further intervention. We would not be concerned in the slightest if the SIFI banks were to cut or suspend their dividends. Husbanding cash is a good idea in times of uncertainty, and a couple of quarters without dividends is far preferable to shareholders than a dilutive secondary equity offering or rights issue. To the extent that it may leave elected officials more favorably disposed to the banking sector, it would be a plus. One may as well stay on the good side of legislators doling out goodies. Finally, our newly increased sense of caution does not extend to the put-writing idea we detailed two weeks ago. If implied volatility in the SIFI banks’ stocks returns to the triple-digit level, investors selling put options would be generously compensated for assuming the inherent risks. Even though the SIFIs have stumbled over the last six sessions, time decay and the steep decline in the VIX have the contracts we highlighted well in the money (Table 4).   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 Until the NBER makes the official designation, our working assumption is that the recession began in March. 2 Please see the February 28, 2011 US Investment Strategy Special Report, "Banks And The Yield Curve," available at usis.bcaresearch.com.