Valuations

Highlights Chinese stocks have outperformed global benchmarks by a wide margin. We are taking profits on our overweight position, and downgrading our tactical call on Chinese stocks to neutral. In absolute terms, Chinese stocks have failed to buck the trend in a global selloff of risk assets. This suggests Chinese stocks are not immune to worldwide panics. Investors should wait for a peak in the global pandemic before going long on Chinese equities. Chinese stocks have become less cheap relative to global benchmarks. The size of Chinese stimulus is also less impressive compared with other major economies such as the US. Therefore, in order to maintain an overweight stance on Chinese risk assets in a global portfolio, Chinese stocks need to either offer a better price entry point, or a more upside potential in earnings outlook relative to their global peers. Feature Chart I-1Chinese Stocks Have Significantly Outperformed Global Benchmarks... Chinese Stocks Have Significantly Outperformed Global Benchmarks... Chinese Stocks Have Significantly Outperformed Global Benchmarks... In the current pandemic environment, economic fundamentals mean little to panicked investors who have mostly ignored the unprecedented degree of monetary and fiscal stimulus pouring into the global economy. Investors are looking for clear signs that the COVID-19 crisis can be brought under control, but medical experts have been unable to predict the timing of a peak in the pandemic. Policymakers around the world are beginning to address investors’ concerns that substantial and timely fiscal policy supports are needed to offset the knock-on effects on businesses and individuals.1 However, until the number of new infections in major economies peaks, the erratic trading behavior among global investors will persist. Given the lack of near-term certainty, we are downgrading our tactical stance on Chinese stocks from overweight to neutral. Chart 1 highlights since we upgraded our tactical call to overweight in end-2019, Chinese stocks have significantly outperformed global stocks. This outperformance has been passive in nature; Chinese stocks are down about 10% year-to-date in US$ terms, versus a 23% decline in global stocks. We are also closing 7 of our 10 high-conviction investment calls from our trade book, for reasons cited here and then detailed in the next sections. Of the 10 active trades in our book, 7 have generated a positive return since their inceptions, including 3 that have recorded double-digit gains.2 Investors should wait for clarity on the peak of the global pandemic before going long on risk assets. Investors should wait for more signs of an upside potential in earnings and/or a better price entry point to go long on Chinese stocks. China Is Not Immune To A Global Pandemic Chart I-2...But Their Prices Have Also Plunged In Absolute Terms ...But Their Prices Have Also Plunged In Absolute Terms ...But Their Prices Have Also Plunged In Absolute Terms Chinese equities have not been immune from the gyrations in the global financial markets, which have not responded to monetary and fiscal stimulus measures in either a customary or predictive manner. Unlike the 2008 global recession triggered by a financial crisis, public health crises damage the economy by reducing human activity and, therefore, erode both supply and demand. A return to normalcy depends almost entirely on whether the pandemic can be contained. Even though Chinese business activities are gradually resuming, Chinese stocks failed to buck the worldwide trend of a liquidation in risk assets. While Chinese stocks have outperformed global benchmarks by a wide margin, the relative gains have mostly been passive since early March. In absolute terms, Chinese domestic stocks have lost all their gains from February and investable stock prices have fallen back to their November 2018 level (Chart 2). Chart I-3Number Of Imported Cases Now On The Rise Investing During A Global Pandemic Investing During A Global Pandemic China is not immune to a second COVID-19 wave. China has been reporting zero-to-low single-digit numbers of locally transmitted cases since mid-March, but it is now experiencing an increase in imported cases from overseas travelers (Chart 3). The mounting numbers have led the Chinese government to shut its borders to non-Chinese citizens.3 This indicates that it is still too early to claim a victory in China’s virus containment efforts.  Given that China’s domestic businesses are open, the trajectory of new cases also remains unknown. These lingering doubts will slow the pace in the resumption of Chinese production (Chart 4).   Chart I-4Chinese Companies Operating At 80% Capacity Investing During A Global Pandemic Investing During A Global Pandemic Moreover, China is not immune to qualms about the depth and duration of a global recession. China has the political will and policy room to stimulate its economy, and the country’s dominant domestic demand makes the economy relatively insulated from a global recession. However, when more than 40% of China’s trading partners (including Europe and the US) remain under lockdown, a collapse of external demand will weigh on China’s economic and corporate profit recovery in the next quarter or two. Therefore, short-term risks on Chinese stocks are tilted to the downside. Bottom Line: Chinese stocks have failed to buck the trend in the global pandemic and the tsunami selloff in risk assets. Investors should wait for a peak in the outbreak before going long on Chinese equities. Chinese Stocks Have Become Less Cheap Relative To Global Benchmarks Chart I-5Outperformance In Chinese Stocks Seems Quite Extended Outperformance In Chinese Stocks Seems Quite Extended Outperformance In Chinese Stocks Seems Quite Extended Chinese stocks, particularly in the domestic market, are no longer priced at deep discounts compared with global equities (Chart 5). The recent outperformance of Chinese stocks has brought the relative performance trend in both investable and domestic stocks back close to late-2017/early-2018 levels. That was before the US-China trade war began, and at a point where China’s economy was close to peak strength for the cycle. Although a passive outperformance does not automatically warrant an underweight stance on Chinese stocks, investors will demand a higher upside potential in Chinese corporate earnings to justify an overweight position in Chinese equities. Therefore, we will watch for the following signs before buying Chinese stocks: a strengthening in China’s economy and corporate profits outpacing recoveries in other major economies, and/or a near-term drop in Chinese stock prices outsizing the decline in global stock prices. Given the exceedingly strong policy responses from G20 economies (particularly the US), China’s stimulus will need to be amplified so that investors are confident that the rate of Chinese corporate profit recovery will surpass their global counterparts.4 In a recent Politburo meeting, Chinese policymakers signaled their willingness to expand stimulus, including much larger fiscal deficits and local-government special bond issuance quotas in 2020, along with further interest rate cuts.5 An escalation in policy support will probably bring China’s stimulus in line with that extended in the 2008-2009 global financial crisis. However, the size of the stimulus package will be determined at the National People’s Congress (NPC) meeting, which is delayed to end-April or early May. In the near term, the selloff in Chinese stocks will likely persist as financial markets continue to price in bad news in the global economy. Chinese investable stock prices continue to be priced at a discount relative to global benchmarks, although the discount is much smaller than it was three months ago. In absolute terms, Chinese investable stock prices have not reached their technical support levels.  The offshore market historically rebounds when prices approach a major defense line, measured by a 12-year moving average. This technical support for the MSCI China Index is currently 65, still about 13% below the March 30 close (Chart 6). Chart I-6Investable Stock Prices Not Yet At Their Long-Term Support Investable Stock Prices Not Yet At Their Long-Term Support Investable Stock Prices Not Yet At Their Long-Term Support The prices in Chinese domestic stocks have reached their 12-year moving average, although A-share prices are not decisively in a structural “cheap” territory yet (Chart 7).  Investors should wait on the sidelines for now, since the full effects of any enhanced stimulus in China will be felt in the real economy with a time lag. China’s production supply side is only operating at about 80% of normal capacity, and demand has yet to catch up (Chart 4 and Chart 8).  This suggests the rebound in economic activities in Q2 will likely be gradual, and corporate profits are likely to remain depressed. Chart I-7Domestic Stock Prices Approaching A Structural "Cheap" Territory Domestic Stock Prices Approaching A Structural "Cheap" Territory Domestic Stock Prices Approaching A Structural "Cheap" Territory Chart I-8Demand In Manufacturing Remains Sluggish Demand In Manufacturing Remains Sluggish Demand In Manufacturing Remains Sluggish Bottom Line: Chinese stocks have become less cheap against the backdrop of a massive liquidation of global equities. Chinese existing stimulus also appears moderate compared with other major economies. Therefore, in order for investors to overweight Chinese risk assets in a global portfolio, Chinese stocks either will have to offer a better entry price point or more upside corporate earnings potential. Both are currently missing. Investment Conclusions Investors should stay neutral on Chinese stocks in the next 3 months, and we are closing 7 out of the 10 active positions in our trade book. These trades are especially vulnerable to a protracted global recession and more selloffs in the domestic stock market. We will look for opportunities to incrementally add new trades to our book in the coming months. Here are our reasons for retaining or closing some of our positions: Long China Onshore Corporate Bonds (Maintain): The trade has yielded a handsome return of 16% since its inception in June 2017, (Chart 9). Although the spread in Chinese onshore corporate bond yields has widened sharply in the past few weeks, it has been the result of an indiscriminate global selloff of financial assets rather than the market pricing in any China-centric credit risks (Chart 10). In the next 6 to 12 months, corporate credit spreads should normalize as we expect monetary policies in major economies to remain ultra-loose, the global economy to recover and investors’ risk sentiment to improve. Chinese onshore corporate bonds will likely continue to offer a better risk-reward profile relative to other economies, with a higher risk premium and relatively stable default rate. Chart I-9Chinese Onshore Corporate Bonds Remain Attractive Chinese Onshore Corporate Bonds Remain Attractive Chinese Onshore Corporate Bonds Remain Attractive Chart I-10Corporate Credit Spreads Should Narrow Over A 12-Month Horizon Corporate Credit Spreads Should Narrow Over A 12-Month Horizon Corporate Credit Spreads Should Narrow Over A 12-Month Horizon     Long MSCI China Energy Stocks (Close): This trade has had the worst performance among our positions due to consistently falling oil prices since October 2018 (Chart 11). Although BCA’s commodity strategists expect Brent prices to average $36/barrel in 2020, $3 higher than the average oil prices in March, it is still at a 50% discount from the $70 price tag just 3 months ago. Such a minor improvement in the price outlook does not offer enough upside potentials to offset downside risks in earnings in the next 9 months. Therefore, we would rather cut the losses. Long China Domestic Consumer Discretionary Equities Versus Benchmark and Long China Domestic Consumer Discretionary Equities/Short China Domestic Consumer Staples Equities (Close): As explained in the previous sections, we think there will be better entry price points for Chinese stocks as well as cyclical stocks. Besides, discretionary consumption in China has yet to show signs of a meaningful rebound. In the near term, we will also look for opportunities to go long position in domestic consumer staple stocks because we think that food and beverage price inflation will persist well into the second half of this year (Chart 12).  Chart I-11Depressed Oil Prices Lead To Significant Underperformance In Energy Stocks Depressed Oil Prices Lead To Significant Underperformance In Energy Stocks Depressed Oil Prices Lead To Significant Underperformance In Energy Stocks Chart I-12Consumer Staple Stocks Should Benefit From Stubbornly High Food Prices Consumer Staple Stocks Should Benefit From Stubbornly High Food Prices Consumer Staple Stocks Should Benefit From Stubbornly High Food Prices   Long MSCI China Index, Long MSCI China Onshore Index, Long MSCI China Growth Index/ Short MSCI All Country World (Close): We will need to see more stable sentiment in the global financial markets, a better entry price point for Chinese stocks and a sure sign of outsized Chinese stimulus before reinitiating a long position on Chinese stocks. Jing Sima China Strategist jings@bcaresearch.com   Appendix Table 1Massive Stimulus In Response To Pandemic Investing During A Global Pandemic Investing During A Global Pandemic Footnotes 1  Please see Table 1 in the Appendix. 2  Please see the trade table at the end of the report. 3  https://www.bloomberg.com/news/articles/2020-03-26/china-to-suspend-foreigners-entry-starting-saturday?mc_cid=1bdcd29ddd&mc_eid=9da16a4859 4  The stimulus package announced in the US amounts to 9% of the country’s 2019 GDP, whereas China’s stimulus would be about 3% of its 2019 GDP. 5  http://www.xinhuanet.com/politics/leaders/2020-03/27/c_1125778940.htm Cyclical Investment Stance Equity Sector Recommendations

Highlights Investment Grade: Investors should overweight investment grade corporate bonds relative to a duration-matched position in Treasury securities, with a particular focus on bonds that are eligible for the Fed’s purchase programs. High-Yield: Caution is still warranted in the high-yield market. At current levels, spreads do not adequately compensate investors for the coming default cycle. We would recommend buying high-yield if the average index spread rises to a range of 1075 bps – 1290 bps. Fed Purchases: Fed corporate bond purchases will cause investment grade spreads to tighten, particularly out to the 5-year maturity point. However, the program won’t stop the coming onslaught of ratings downgrades. High-Yield Sectors: The Energy, Transportation, Capital Goods, Consumer Cyclical and Consumer Noncyclical sectors are all highly exposed to the looming default cycle. Financials and Utilities look like the best places to hide out. Feature Chart 1Will The Fed's Corporate QE Mark The Top In Spreads? Will The Fed's Corporate QE Mark The Top In Spreads? Will The Fed's Corporate QE Mark The Top In Spreads? The COVID pandemic and associated recession have already caused turmoil in financial markets and prompted a policy response from the Federal Reserve that is unprecedented in its aggressiveness. US investment grade and high-yield corporate spreads widened 280 bps and 764 bps, respectively, to start the year. Then, they tightened by 78 bps and 179 bps, respectively, after the Fed announced it is stepping into the corporate bond market for the first time (Chart 1). Clearly, this is a challenging time for corporate bond investors. But sifting through all the noise, we think there are three key questions to stay focused on: How will the Federal Reserve’s support for the corporate bond market impact spreads? At what level do spreads fully discount the looming default cycle? What sectors within the corporate bond market are most/least at risk of experiencing large-scale defaults? What Can The Fed Hope To Accomplish By Buying Corporate Debt? As part of its package of monetary policy stimulus measures to combat the US COVID-19 recession, the Fed has undertaken a dramatic new step to try and lower borrowing costs for US businesses – the outright buying of US investment grade corporate bonds. The main details of these new programs are as follows: The Fed will purchase investment grade corporate bonds, loans and related exchange-traded funds (ETFs) as part of these programs. Bonds can be purchased in the primary (newly-issued) and secondary markets. The purchases will not be held on the Fed’s balance sheet. Instead, two off-balance sheet Special Purpose Vehicles (SPVs), one for primary market purchases and one for secondary market purchases, will buy the bonds. Both SPVs are initially funded by the US Treasury and will be levered up via loans from the Fed. The primary market SPV will buy newly-issued bonds with credit ratings as low as BBB- and maturities of four years or less.  Eligible issuers are US businesses with material operations in the United States; that list of companies may be expanded in the future. Eligible issuers do not include companies that are expected to receive direct financial assistance from the US government (i.e. no buying of bonds from companies getting bailout funds). The secondary market SPV will buy bonds with maturities of up to five years and credit ratings as low as BBB-, with a buying limit of 10% of the entire stock of eligible debt of any single company. This secondary market SPV will also buy investment grade bond ETFs, up to 20% of the outstanding shares of any single ETF. Through the primary market facility, any eligible company can “borrow” from the Fed, through bond purchases or direct loans, an amount greater than its maximum outstanding debt (bonds plus loans) on any day over the past twelve months. Specifically: 140% of all debt for AAA-rated issuers, 130% for AA-rated issuers, 120% for A-rated issuers and 110% for BBB-rated issuers. Since those percentages are all greater than 100, this effectively means that the Fed will allow eligible companies to potentially roll over their entire stocks of debt through this program, plus some net new borrowing. With the primary market facility, issuers can even defer interest payments on the funds borrowed from the Fed for up to six months, with the interest payments added to the final repayment amount (any company choosing this option cannot do share buybacks or make dividend payments). These programs are set to run until September 30 of this year, with an option to extend as needed. The Fed’s new initiatives represent a new step for the central bank, providing direct lending to any company that needs it. The Fed had to do this through off-balance-sheet SPVs, since direct buying of corporates is not permitted under the Federal Reserve Act. With this structure, it is technically the US Treasury department that bears the initial credit risk through its seed funding of each SPV. The BoJ was the first of the major central banks to start buying corporate bonds. This structure is different than the recent corporate bond QE programs of the European Central Bank (ECB), Bank of England (BoE) and Bank of Japan (BoJ), where the credit risk was directly taken onto the central bank balance sheets. But from an investment perspective, the difference in structure between the Fed’s corporate bond buying program and that of other central banks is nothing more than a technicality. It is still worthwhile to see if any lessons can be learned from these other countries.     The Corporate Bond Buying Experience Of Other Central Banks The BoJ was the first of the major central banks to start buying corporate bonds, in a program that began in February 2009 and continued until October 2012. The program initially involved only the purchase of very high-quality corporate debt (rated A or higher) and only for maturities up to one year. The pool of eligible bonds was later increased to allow for lower credit quality (rated BBB or higher) and longer maturities (up to three years). The BoJ ended up buying a total of 3.2 trillion yen (US$30 billion) of bonds during that program, representing nearly 50% of total Japanese investment grade nonfinancial debt (Chart 2). Credit spreads tightened modestly over the life of the program, particularly for the shorter maturity debt that the BoJ was directly buying.1 Research from the BoJ concluded that the corporate bond buying did improve liquidity for the bonds that were eligible for the program, although there was no discernable pickup in overall Japanese corporate bond issuance.2 The BoE started its Corporate Bond Purchase Scheme (CBPS) in August 2016, as part of a package of stimulus measures to cushion the economic blow from the UK’s stunning vote to leave the European Union. The CBPS bought £10bn of UK nonfinancial investment grade corporate bonds over a period of 18 months, with ratings as low as BBB-. This was a relatively modest share of all eligible nonfinancial bonds (4.7%), but UK credit spreads did tighten over the life of the program (Chart 3). The BoE’s own research has determined that the spread tightening was due to lower downgrade/default risk premiums, and that the program triggered a surge in investment grade issuance in the weeks and months following its launch.3 Chart 2The BoJ's Corporate Bond Buying Experience The BoJ's Corporate Bond Buying Experience The BoJ's Corporate Bond Buying Experience Chart 3The BoE's Corporate Bond Buying Experience The BoE's Corporate Bond Buying Experience The BoE's Corporate Bond Buying Experience The ECB announced its Corporate Sector Purchase Program (CSPP) in March 2016, with the actual bond purchases beginning three months later. This was an expansion of the ECB’s overall Asset Purchase Program that had previously been focused on government debt. Like the BoJ and BoE programs, only nonfinancial debt of domestic euro area companies rated BBB- or higher was eligible. The ECB did buy bonds across a wide maturity spectrum of 1-30 years. The ECB’s purchases in the first 18 months of the CSPP were sizeable, between €60-80bn per month, reaching a cumulative total of nearly 20% of the stock of eligible bonds (Chart 4). This not only drove credit spreads tighter for bonds in the CSPP, but also pushed spreads lower for bonds that were not directly purchased by the ECB, like bank debt. The ECB described this as evidence of a strong “portfolio balance effect”, where investors who sold their bonds to the central bank ended up redeploying the proceeds into other parts of the euro area corporate bond market.4  One major difference between the ECB CSPP and the BoJ and BoE programs was that the ECB could conduct the necessary purchases in the primary market, if necessary. This represented a major new source of funding for smaller euro area companies that did not previously issue corporate bonds, preferring to get most of their debt financing through bank loans. As evidence of this, the year-over-year growth rate of euro area corporate bond issuance soared from 2.5% to 10% in the first year of the CSPP (Chart 5). Chart 4The ECB's Corporate Bond ##br##Buying Experience The ECB's Corporate Bond Buying Experience The ECB's Corporate Bond Buying Experience Chart 5ECB Primary Market Buying Spurred A Boom In Issuance ECB Primary Market Buying Spurred A Boom In Issuance ECB Primary Market Buying Spurred A Boom In Issuance Investment Conclusions Applying these lessons to the US, the first conclusion we reach is that Fed corporate bond purchases will tighten spreads for eligible securities. In this case, eligible securities include all investment grade rated US corporate bonds with maturities less than five years. In effect, the Fed’s primary market facility could be thought of as adding an agency backing to these eligible bonds since the Fed has effectively guaranteed that this debt can be rolled over and that bond investors will be made whole. It’s noteworthy that last week saw a record amount of new investment grade corporate bond issuance as firms rushed to take advantage of the program.    Second, we should see some positive knock-on effects on spreads of ineligible investment grade securities, i.e. investment grade corporate bonds with maturities greater than five years. The impact will not be as large as for eligible securities, but since many of the same issuers operate at both ends of the curve, long-maturity spreads will benefit at the margin from any reduction in interest expense for the issuer. Third, any trickle-down effects to high-yield spreads will be much smaller. No high-yield issuers can benefit from the program, and while the Fed could eventually open up its facilities to include high-yield debt, we wouldn’t count on it. We suspect the moral hazard of “bailing out the junk bond market” would simply be a step too far for the Federal Reserve. We should see some positive knock-on effects on spreads of ineligible securities. In sum, we would advocate an overweight allocation to US investment grade corporate bonds today – especially on securities eligible for the Fed’s programs. We do not recommend a similar overweight stance on US high-yield, where spreads will continue to fluctuate based on the fundamental default outlook (see section titled “Assessing The Value In High-Yield” below). Can The Fed Re-Steepen US Credit Spread Curves And Prevent Ratings Downgrades? Prior to the Fed’s announcement of the new programs, the US investment grade corporate spread curve had become inverted, with shorter maturity spreads exceeding longer maturity ones. This has historically been a harbinger of increased investment grade downgrades and high-yield defaults (Chart 6). With the Fed’s new programs focusing on bonds with maturities of up to five years, the Fed’s buying can potentially lead to a re-steepening of the investment grade spread curve by driving down shorter maturity spreads. Chart 6Inverted US Credit Spread Curves Are Flashing An Ominous Message Inverted US Credit Spread Curves Are Flashing An Ominous Message Inverted US Credit Spread Curves Are Flashing An Ominous Message Already, the investment grade spread curve has begun to disinvert in the first week of the Fed’s programs (Chart 7). At the same time, the bond rating agencies are moving aggressively to adjust credit opinions in light of the US recession. Already, downgrades from Moody’s and S&P are outpacing upgrades by a 3-1 ratio year-to-date – a pace not seen since the depths of the financial crisis, according to Bloomberg.5  Chart 7The Fed's New Programs Are Already Helping Disinvert Investment Grade Spread Curves The Fed's New Programs Are Already Helping Disinvert Investment Grade Spread Curves The Fed's New Programs Are Already Helping Disinvert Investment Grade Spread Curves The Fed’s actions should be successful at re-steepening the investment grade credit curve. However, we doubt that they will have much impact on ratings decisions. While the Fed can reduce borrowing costs and prevent default by rolling over maturing debt for investment grade issuers, this has a relatively minor impact on corporate balance sheet health. In fact, the Fed's programs will only improve balance sheet health for firms that just roll over existing debt loads and don’t take on any new debt. Any firm that takes on new debt during this period will come out of the crisis with more leverage than when it entered. All else equal, that should warrant a downgrade. Bottom Line: Fed corporate bond purchases will cause investment grade spreads to tighten, particularly out to the 5-year maturity point. However, the program won’t stop the coming onslaught of ratings downgrades. Assessing The Value In High-Yield What Kind Of Default Cycle Is Already “In The Price”? High-yield debt may not benefit from the Fed’s corporate bond-buying programs. But, as in every other cycle, there will come a time when spreads discount the full extent of future default losses. At that point it will be appropriate to increase allocations to the sector. Our Default-Adjusted Spread will guide us as we make that determination. Our Default-Adjusted Spread is the excess spread available in the Bloomberg Barclays High-Yield index after subtracting realized default losses. Specifically, we calculate the Default-Adjusted Spread as: Index OAS – [Default Rate x (1 – Recovery Rate)] The default and recovery rates apply to the 12-month period that follows the index spread reading. For example, the Default-Adjusted Spread for January 2019 uses the index OAS from January 2019 and default losses incurred between February 2019 and January 2020. Table 1 shows that there is a strong link between the Default-Adjusted Spread and excess High-Yield returns relative to duration-matched Treasuries. Specifically, we see that losses are a near certainty if the Default-Adjusted Spread is negative and that return prospects are poor for spreads below 150 bps. A Default-Adjusted Spread above its historical average of 250 bps is an obvious buying opportunity, while a spread above 400 bps virtually guarantees strong returns. Table 1The Default-Adjusted Spread & High-Yield Excess Returns Trading The US Corporate Bond Market In A Time Of Crisis Trading The US Corporate Bond Market In A Time Of Crisis This helps clarify the task at hand. We must make an assumption about what the default and recovery rates will be for the next 12 months, then apply those assumptions to the current index spread. The resulting Default-Adjusted Spread will tell us if High-Yield bonds are worth a look. Table 2 shows the Default-Adjusted Spread that results from different combinations of default and recovery rates.6 For example, a 10% default rate and 35% recovery rate together imply a Default-Adjusted Spread of 271 bps, suggesting an attractive buying opportunity. Table 2Default-Adjusted Spread (BPs) Given Different Assumptions For Default And Recovery Rates Trading The US Corporate Bond Market In A Time Of Crisis Trading The US Corporate Bond Market In A Time Of Crisis What Sort Of Default Cycle Should We Expect? To answer this question we turn to Table 3. Table 3 lists periods since the mid-1980s when the default rate rose above 4%, along with several factors that influence the level of default losses: The magnitude of the economic downturn, proxied by the worst year-over-year real GDP growth reading recorded during that timeframe. The duration of the economic downturn, measured as the number of quarters from the peak to trough in real GDP. Nonfinancial corporate leverage – measured as total debt divided by book value of equity – at the cycle peak. Table 3A Brief History Of Default Cycles Trading The US Corporate Bond Market In A Time Of Crisis Trading The US Corporate Bond Market In A Time Of Crisis Alongside these determining factors, the table also shows the peak 12-month default rate seen during the cycle and the recovery rate that occurred alongside it. First, we notice a strong relationship between the magnitude of the economic shock and the peak default rate. Meanwhile, corporate leverage does a better job explaining the recovery rate. Notice that recoveries were greater in 2008 than in 2001, despite 2008’s larger economic shock. Turning to the current situation, our base case assumption is that we will see severe economic contraction in Q1 and Q2 of this year followed by some recovery in the third and fourth quarters. All told, 2020 annual GDP growth could be close to the -3.9% seen in 2008, though the duration of the peak-to-trough economic shock will be only two quarters instead of six.7 Based on the historical comparables listed in Table 3, this sort of economic shock could generate a peak default rate somewhere between 11% and 13%. As for recoveries, nonfinancial corporate leverage is currently higher than during any of the prior episodes in our study. It follows that the recovery rate will be very low, perhaps on the order of 20%-25%. Turning back to Table 2, we see that our default and recovery rate assumptions imply a Default-Adjusted Spread somewhere between -119 bps and +96 bps. This is too low to be considered a buying opportunity. A Default-Adjusted Spread above its historical average of 250 bps is an obvious buying opportunity, while a spread above 400 bps virtually guarantees strong returns. Table 4 flips this analysis around and shows the option-adjusted-spread on the Bloomberg Barclays High-Yield index that would generate a Default-Adjusted Spread of 250 bps based on different assumptions for the default and recovery rates. Recall that we consider a Default-Adjusted Spread of 250 bps or above as a buying opportunity. Using the aforementioned default and recovery rate assumptions, we would see a buying opportunity in high-yield if the average index spread rose to a range of 1075 bps – 1290 bps, or above. As of Friday’s close, the index option-adjusted spread was 921 bps. Table 4High-Yield Index Spread (BPs) That Would Imply A Buying Opportunity* In Different Default Loss Scenarios Trading The US Corporate Bond Market In A Time Of Crisis Trading The US Corporate Bond Market In A Time Of Crisis Bottom Line: High-yield spreads do not discount the full extent of the looming default cycle and will not benefit from the Fed’s asset purchase programs. Investors should stay cautious on high-yield for now and look to increase allocations when the average index spread moves into a range of 1075 bps to 1290 bps. Which High-Yield Sectors Are Most Exposed? Even during a period of large-scale defaults, sector and firm selection are vital in the high-yield bond market. In fact, you could argue that sector selection becomes even more important during a default cycle, as some sectors bear the brunt of default losses while others skate through relatively unscathed. To wit, Chart 8plots the 12-month trailing speculative grade default rate alongside a diffusion index that shows the percentage of 30 high-yield industry groups – as defined by Moody’s Investors Service – that have a trailing 12-month default rate above 4%. Even at the peaks of the default cycles during the last two recessions, only 47% and 63% of industry groups experienced significant default waves. Chart 8Sector Selection Is Vital In A Default Cycle Sector Selection Is Vital In A Default Cycle Sector Selection Is Vital In A Default Cycle To help identify which sectors are most at risk during the current default cycle, we consider how the 10 main high-yield industry groups, as defined by Bloomberg Barclays, stack up on three crucial credit metrics: The share of firms rated Caa Growth in par value of debt outstanding since the last recession Change in the median firm’s net debt-to-EBITDA ratio since the last recession8 Charts A1-A10 in the Appendix show how the three credit metrics for each industry group have evolved over time. In the remainder of this report we compare the sectors against each other across each of the above three dimensions. Note that Box 1 provides a legend for the sector name abbreviations used in Charts 9, 10 and 11. Box 1Sector Abbreviations Trading The US Corporate Bond Market In A Time Of Crisis Trading The US Corporate Bond Market In A Time Of Crisis Chart 9OAS Versus Share Of Caa-Rated Debt Trading The US Corporate Bond Market In A Time Of Crisis Trading The US Corporate Bond Market In A Time Of Crisis Chart 10OAS Versus Debt Growth Trading The US Corporate Bond Market In A Time Of Crisis Trading The US Corporate Bond Market In A Time Of Crisis   Chart 11OAS Versus Net Debt-To-EBITDA Trading The US Corporate Bond Market In A Time Of Crisis Trading The US Corporate Bond Market In A Time Of Crisis Share Of Caa-Rated Debt Even during a large default cycle the bulk of default losses will be borne by firms rated Caa and below. In Chart 9, we see that if we ignore the outlying Technology, Transportation and Energy sectors, there is a fairly linear relationship between credit spreads and the share of firms rated Caa in each sector. Transportation and Energy currently trade at very wide spreads because those sectors’ revenues are heavily impacted by the current crisis. Technology spreads remain low because, despite the high percentage of Caa-rated debt, the sector has one of the lower net debt-to-EBITDA ratios (see Chart A6). All in all, Chart 9 suggests that Capital Goods, Communications, Consumer Cyclicals and Consumer Noncyclicals all carry a large proportion of low-rated debt. In contrast, Financials and Utilities appear much safer. Debt Growth Another good way to assess which sectors are most likely to experience defaults is to look at which sectors added the most debt during the economic recovery (Chart 10). On that note, the rapid levering-up of the Energy sector clearly sticks out. Beyond that, Capital Goods, Consumer Noncyclicals and Technology also added significant amounts of debt during the recovery. In contrast, the Utilities sector actually reduced its debt load. Change In Net Debt-to-EBITDA Finally, it’s important to note that simply adding debt does not necessarily put a sector at greater risk of default if earnings are rising even more quickly. For this reason we also look at recent trends in net debt-to-EBITDA (Chart 11). Here, we see that wide spreads in Energy and Transportation are justified by large increases in net debt-to-EBITDA. Conversely, Financials and Communications have seen improvement. Bottom Line: Based on a survey of three important credit metrics: The Energy, Transportation, Capital Goods, Consumer Cyclical and Consumer Noncyclical sectors are all highly exposed to the looming default cycle. In contrast, Financials and Utilities look like the best places to hide out. Appendix Chart A1Basic Industry Credit Metrics Basic Industry Credit Metrics Basic Industry Credit Metrics Chart A2Capital Goods Credit Metrics Capital Goods Credit Metrics Capital Goods Credit Metrics Chart A3Consumer Cyclical Credit Metrics Consumer Cyclical Credit Metrics Consumer Cyclical Credit Metrics Chart A4Consumer Non-Cyclical Credit Metrics Consumer Non-Cyclical Credit Metrics Consumer Non-Cyclical Credit Metrics Chart A5Energy Credit Metrics Energy Credit Metrics Energy Credit Metrics Chart A6Technology Credit Metrics Technology Credit Metrics Technology Credit Metrics Chart A7Transportation Credit Metrics Transportation Credit Metrics Transportation Credit Metrics Chart A8Communications Credit Metrics Communications Credit Metrics Communications Credit Metrics Chart A9Utilities Credit Metrics Utilities Credit Metrics Utilities Credit Metrics Chart A10Financial Institutions Credit Metrics Financial Institutions Credit Metrics Financial Institutions Credit Metrics     Ryan Swift US Bond Strategist rswift@bcaresearch.com Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Jeremie Peloso Senior Analyst jeremiep@bcaresearch.com Footnotes  1 The March 2011 earthquake and tsunami in Japan created a lot of short-term credit spread volatility, but even then, shorter-maturity bonds saw less spread widening than the overall index. 2 https://www.imes.boj.or.jp/research/papers/english/18-E-04.pdf 3  https://www.bankofengland.co.uk/quarterly-bulletin/2017/q3/corporate-bond-purchase-scheme-design-operation-and-impact 4 The ECB described this effect in a 2018 report that can be accessed here: https://www.ecb.europa.eu/pub/pdf/other/ecb/ebart201803_02.en.pdf 5  https://www.bloomberg.com/news/articles/2020-03-26/s-p-moody-s-cut-credit-grades-at-fastest-pace-since-2008-crisis 6 Calculations are based on the index spread as of market close on Friday March 27. 7 For more details on BCA’s assessment of the economic outlook please see Global Investment Strategy Second Quarter 2020 Strategy Outlook, “World War V”, dated March 27, 2020, available at gis.bcaresearch.com 8 Median net debt-to-EBITDA is calculated from our bottom-up sample of high-yield firms that consists of all the firms in the Bloomberg Barclays High-Yield index for which data are available. Data are retrieved on a quarterly basis and the sample is adjusted once per year based on changes in the composition of the Barclays indexes. As of Q2 2019, this sample includes 354 companies.

Dear client, Next Monday instead of sending you a Weekly Report we will be hosting a live webcast at 10am EST, addressing the recent market moves and discussing the US equity market outlook.  Kind Regards, Anastasios Highlights Portfolio Strategy The passing of the mega fiscal package, turning equity market internals, the collapse in net earnings revisions all underscore that we may have already seen the recessionary equity market lows. Investors with higher risk tolerance and a cyclical 9-12 month time horizon will be handsomely rewarded. Firming operating metrics, the defensive nature of tech services at a time when macro data are about to nosedive, compel us to boost the S&P data processing index to overweight. Grim macro data, the rising threat of a debt deflation spiral, poor operating metrics and lofty valuations, all warn that the path of least resistance is lower for REITs. Recent Changes Boost the S&P data processing index to overweight today. Last week we obeyed our rolling stops in our cyclically underweight position in the S&P homebuilders index and cyclically overweight positions in the S&P hypermarkets and S&P household products indexes for gains of 41%, 26% and 5%, respectively.1 Feature The SPX had a streak of three green days last week as congress finally passed a $2tn fiscal easing bill. In fact the last time the S&P 500 had two consecutive green days was right before its February 19 peak. Our view remains that the risk/reward tradeoff for owning equities is favorable for investors with higher risk tolerance and a cyclical 9-12 month time horizon, as we highlighted last Monday in our “20 reasons to start buying equities” part of our Weekly Report.2 As a reminder, during the Great Recession, equities troughed 20 days after the American Recovery and Reinvestment Act of 2009 took effect on February 17, 2009. Thus if history rhymes, an equity market bottom is likely near if not already behind us.  Does this mean the SPX has definitively troughed? Not necessarily, but our playbook/roadmap calls for a retest and hold of the recent lows as we have been highlighting in recent research.3 Keep in mind that S&P 500 futures (ES) have fallen over 36% from peak to trough. This is similar to the median fall during recession bear markets dating back to the Great Depression. Most importantly, comparing the two most recent iterations is instructive in attempting to figure out what is baked in the cake. Namely, in the 9/11 catalyzed recession and subprime mortgage collapse catalyzed recession, EPS got halved. Similarly, equities fell 50% from their respective peaks. If we use that assumption – i.e. a recessionary equity bear market fall predicts the eventual profit drubbing – then what the ES futures clocking in at 2174 discounted is that trailing EPS will fall from $162 to $104 and forward EPS from $177 to $113 (Chart 1). Chart 1Joined At The Hip Joined At The Hip Joined At The Hip While we have no real visibility on EPS, our sense is that we will not fall further than what was already discounted in the broad market. If we are offside and a GFC or Great Depression ensues, then profits will get halved to $81 and the SPX will fall to 1700. Another simple way of looking at the EPS drawdown is by considering $162 as trend EPS. Then for every month that the economy is shut down roughly $13.5 get shaved off EPS. Thus, triangulating both approaches, a $104 EPS level has discounted a shutdown lasting 4 months and 10 days. This is a tall order and we would lean against such extreme pessimism. Meanwhile, analysts are scrambling to cut estimates the world over. Not only SPX net earnings revisions (NER) are at the lowest point since the GFC, but so is the emerging market NER ratio. The Eurozone and Japan are following close behind (Chart 2). Once again the speed of this downward adjustment suggests that a lot of bad news is already priced in now depressed NER. Chart 2Bad News Is Priced In Bad News Is Priced In Bad News Is Priced In Chart 3Market Internals Ticking Higher Market Internals Ticking Higher Market Internals Ticking Higher Moreover, equity market internals underscore that we may have already seen the recessionary equity market lows. Chart 3 shows that hypersensitive small caps have been outperforming their large cap peers of late, chip stocks are sniffing out a reflationary impulse and even emerging markets are besting the SPX. Finally, the best China proxy out there, the Aussie dollar, corroborates the bullish signal from all these indicators and suggests that this mini “risk-on” phase can last a while longer (third panel, Chart 3). Nevertheless, the spike in the TED spread (Treasury-EuroDollar spread, gauging default risk on interbank loans) was quite unnerving last week. While we have shown in the past that equity volatility and credit risk are joined at the hip, this parabolic move in the, up to very recently calm, TED spread disquieted us. We will keep on monitoring it closely as the coronavirus pandemic continues to unfold (Chart 4). Chart 4Disquieting Disquieting Disquieting Another significant risk that this crisis has exposed is the massive non-financial business debt uptake that has taken root during the ten-year expansion (top panel, Chart 5). We deem investors will be more mindful of debt saddled companies going forward, despite the government’s sizable looming bailout of select severely affected industries from the coronavirus pandemic. Stock market reported data also corroborate the national accounts’ debt deterioration data (bottom panel, Chart 5). Chart 5Watch The Debt Burden… Watch The Debt Burden… Watch The Debt Burden… The yield curve has already forewarned that a significant default cycle is looming (Chart 6) and this time is not different. Chart 6…A Default Cycle Looms …A Default Cycle Looms …A Default Cycle Looms Importantly, both the equity and bond markets have been sending these debt distress signals for quite some time now (Chart 7). Chart 7Distress Signals Sent A long Time Ago Distress Signals Sent A long Time Ago Distress Signals Sent A long Time Ago What interest us most from a US equity sector perspective is identifying weak spots that may come under intense pressure in the coming weeks as the economy remains shut down likely until Easter Sunday. Chart 8 shows the current level of net debt-to-EBITDA for the overall non-financial equity market, and the 10 GICS1 sectors (we use telecom services instead of communications services and exclude financials). In more detail, the bar represents the 25 year range of net debt-to EBITDA and the vertical line the current reading for each sector (Appendix 1 below showcases the net debt-to-EBITDA time series for the GICS1 sectors). Chart 8Mind The… What Is Priced In? What Is Priced In? Chart 9 goes a step further and juxtaposes EV/EBITDA with net debt-to EBITDA on a two dimensional map. Real estate and utilities clearly stand out as the most debt burdened sectors, with a pricey valuation (For completion purposes Appendix 2 below delves deeper into sectors and shows net debt-to-EBITDA for the GICS2 sectors). Chart 9…Outliers What Is Priced In? What Is Priced In? Frequent US Equity Strategy readers know that we believe the excesses this cycle have been in the commercial real estate (CRE) segment of the economy, where prices are one standard deviation above the previous peak and cap rates have collapsed to all-time lows fueled by an unprecedented credit binge (Chart 10). This week we reiterate our underweight stance in the S&P real estate sector and boost a defensive tech services index to an overweight stance. Chart 10CRE: The Epitome This Cycle’s Excesses CRE: The Epitome This Cycle’s Excesses CRE: The Epitome This Cycle’s Excesses Reality Bites We continue to recommend investors avoid the S&P real estate sector. For investors seeking defensive protection we would recommend hiding in the S&P health care sector instead, as we highlighted in our mid-March report.4 Chart 11 shows a disturbing breakdown in the inverse correlation between the relative share price ratio and the 10-year Treasury yield. While it makes intuitive sense that this fixed income proxy sector (i.e. high dividend yielding) should move in the opposite direction of the competing risk free yielding asset, at times of tumult this correlation reverts to positive (top panel, Chart 11). In other words, fear grips investors and they frantically shed REITs despite the fact that interest rates collapse. Why? Because these are highly illiquid assets that these REITs are holding and investors demand the “return of” their capital instead of a “return on” their capital when volatility and credit risk soar in tandem (see TED spread, Chart 4). While CRE prices remain extended and vulnerable to a deflationary shock (bottom panel, Chart 11), there is no real price discovery currently as no landlord would dare put any properties for sale in this market starved for liquidity. With the exception of distressed sales, we deem that the “mark to model” mantra will make a comeback, eerily reminiscent of the GFC. Using an example of how all this may play out in the near-term is instructive. As the economy remains shut down, a tenant may forego a rent payment to a landlord and if the landlord is levered and starved of cash, he/she in turn may miss a debt payment to the outfit that holds his mortgage, typically a bank. Chart 11Breakdown Breakdown Breakdown At first sight this may not seem as a big problem on a micro level as the bank may have enough liquidity to withstand a delinquent borrower’s no/late payment. If, however, the bank is itself scrambling for cash, it will foreclose and then put this asset for sale in order to recover some capital. This will put downward pressure on the underlying asset’s price that all borrowing was based upon and a debt deflation spiral ensues (Chart 12). Chart 12Debt Deflation Warning Debt Deflation Warning Debt Deflation Warning The biggest problem however arises from the bond market. If these deflating assets are all in a CLO or concentrated in a select REIT, then our current financial system setup is not really equipped to handle a failure/delay of payment. This is especially true if some bond holders have hedged their bets and bought CDS on these bonds and demand payment as a “default clause” will in practice get triggered.  The longer the economy remains shut down, the higher the credit, counterparty and default risks will rise. Therefore, given that the real estate sector has an extremely high reading on a net debt-to-EBITDA basis (Chart 8), we are concerned about the profit prospects of this niche sector in the coming months. Moreover, the economy is in recession and the recent Markit services PMI is a precursor of grim data to follow. Historically, REITs move in the opposite direction to the PMI services survey and the current message is to expect a catch down phase in the former (Chart 13). Adding insult to injury, the supply response especially on the multi-family construction side is perturbing. In fact, multi-family housing starts have gone parabolic hitting 619K recently, the highest reading since 1986! Such a jump in supply is deflationary and will weigh on the relative share price ratio (multi-family starts shown inverted, bottom panel, Chart 13). Chart 13Tiiimber Tiiimber Tiiimber Finally, lofty valuations warn that if our bearish thesis pans out in the coming months, there is no cushion left to absorb a significant profit shock that likely looms (Chart 14). Chart 14No Valuation Cushion No Valuation Cushion No Valuation Cushion In sum, grim macro data, the rising threat of a debt deflation spiral, poor operating metrics and lofty valuations, all warn that the path of least resistance is lower for REITs.   Bottom Line: Shy away from the S&P real estate sector. The ticker symbols for the stocks in this index are: BLBG: S5RLST – CCI, AMT,  PLD, EQIX, DLR, PSA, SBAC, AVB, EQR, FRT, SPG, WELL, ARE, CBRE, O, BXP, ESS, EXR, DRE, PEAK, HST, MAA, UDR, VTR, WY, AIV, IRM, PEG, VNO, SLG. Boost Data Processing To Overweight We have been offside on the data processing tech sub-index and today we are booking losses of 39% and boosting exposure to overweight. Data processing stocks are a services-based defensive tech index that typically thrive in deflationary and recessionary environments, according to empirical evidence (Chart 15). We are currently in recession, thus a deflationary impulse will grip the economy and investors will flock to defensive tech stocks when growth is scarce. Tack on the spike in the greenback, and the disinflationary backdrop further boosts the allure of these tech services stocks (third panel, Chart 15). Beyond the recessionary related tailwinds, data processing stocks should also enjoy firming relative demand. While the two bellwether stocks, V and MA, will suffer from the decrease in consumption that requires physical visits and from select services outlays that are severely affected by the coronavirus, online spending by households and corporations should at least serve as a partial offset. Chart 15Time To Buy Defensive Tech Time To Buy Defensive Tech Time To Buy Defensive Tech Chart 16What’s not To Like? What’s not To Like? What’s not To Like? Already, industry pricing power gains have been accelerating at a time when overall inflation has been tame. This will boost revenues – and given high operating leverage and high and rising profit margins – that will flow straight through to profits (Chart 16). While relative profit growth and sales estimates may appear uncharacteristically high and unrealistic to attain, this is what usually transpires in recessions: sell side analysts trim SPX profit and revenue forecasts more aggressively than they do for the defensive data processing index (Chart 17). In fact, given that we are still in the early stages of recession, we expect a further surge in relative EPS and sales estimates in the coming months. Chart 17Seeking Growth When Growth Is Scarce Seeking Growth When Growth Is Scarce Seeking Growth When Growth Is Scarce Chart 18Risk: Lofty Valuations Risk: Lofty Valuations Risk: Lofty Valuations However, there is a key risk to our bullish stance in this tech service index: valuations. Relative valuations are still pricey despite the recent fall from three standard deviations above the historical mean to half that, according to our relative valuation indicator. Technicals have also corrected from an extremely overbought reading, but a cleansing washout has yet to occur (Chart 18). Netting it all out, firming operating metrics and the defensive nature of tech services at a time when macro data are about to nosedive, compel us to boost the S&P data processing index to overweight.   Bottom Line: Boost the S&P data processing index to overweight today from previously underweight for a loss of 39% since inception. The ticker symbols for the stocks in this index are: BLBG: S5DPOS – ADP, V, MA, PYPL, FIS, FISV, GPN, PAYX, FLT, BR, JKHY, WU, ADS.   Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com   Appendix 1 Chart A1Appendix A1 Appendix A1 Appendix A1 Chart A2Appendix A2 Appendix A2 Appendix A2   Appendix 2 Chart A3 What Is Priced In? What Is Priced In? Chart A4 What Is Priced In? What Is Priced In? Footnotes 1     Please see BCA US Equity Strategy Daily Report, “Housekeeping” dated March 26, 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 Daily Report, “Gravitational Pull” dated March 12, 2020, available at uses.bcaresearch.com. 4    Please see BCA US Equity Strategy Weekly Report, “Inflection Point” dated March 16, 2020, available at uses.bcaresearch.com.   Current Recommendations Current Trades Strategic (10-Year) Trade Recommendations What Is Priced In? What Is Priced In? 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 Wells Fargo’s path, before and after deregulation, has been similar to every other SIFI bank’s: It began by serving a single area in a single state, expanded within the state, and then pieced together its regional and national footprint via combinations. A review of 50 years of Wells Fargo’s financials offers multiple insights into the way that banking has evolved at the regional and SIFI bank level: Several community banks are at risk amidst the economy’s unprecedentedly sudden stop, but the overall banking system’s health turns on the condition of the regional banks and the SIFIs. Larger banks are far less reliant on lending than they used to be, … : Net interest income has contributed just 53% of Wells Fargo’s revenues since 2009. The banks would prefer wider net interest margins, but narrow ones won’t wreck their earnings power. … have considerably more capital, and are holding more cash, Treasury and agency securities to stabilize the asset side of the balance sheet: The big banks have two sources of additional ballast: more equity capital to absorb losses, and more stable asset portfolios to limit them in the first place. Feature We are top-down researchers at BCA, using macro data to make conclusions about how financial markets will fare against the economic backdrop they’ll face in the future. We also occasionally glean macro insights from micro data, which we are happy to incorporate into our process when it helps augment our understanding. Wells Fargo is a good proxy for the SIFIs and regional banks which make up the heart of the banking system, because it traveled the same serial acquisition path as its peers once prohibitions on interstate banking began to be eased in the mid-‘80s, and were wiped away for good in 1994. Wells Fargo makes all of its annual reports since 1969 available on its website, and their balance-sheet and income-statement detail fills in some gaps in the system-wide data available from the FDIC and the Fed. We will dig into the system-wide data in next week’s second installment of our examination of banking system vulnerability. This week, we focus on five decades of Wells Fargo data for insight into how banks have fared during the last seven recessions, and how they’re positioned heading into the current one. Banking, Then And Now A time-traveling visitor who worked in banking between the New Deal and the beginning of bank deregulation in the late seventies would find that banks fulfill the same two primary functions as they did in his/her day. They still promote financial intermediation by turning savers’ deposits into fuel for investment and accelerated consumption via loans to businesses and households, and they still administer the payments system. S/he might be unfamiliar with many of the ways they carry out those duties, however, and especially surprised at the way that lending and maturity transformation have been eclipsed. The biggest banks have become far less reliant on lending over the last 50 years, and they no longer engage in maturity transformation, ... At the largest banks, lending is no longer the be-all and the end-all, as revenue from fees has very nearly caught up to net interest income (Chart 1). After adjusting net interest income for loan-loss provisions, lending accounted for just 44% and 48% of Wells Fargo’s revenues in the 2000s in the 2010s, respectively. On that basis, fee revenue exceeded net interest income every year from 2007-2013, inclusive. The rise of fee income has made bank earnings more stable and bank capital levels less dependent on borrower fitness. Chart 1Lending Is No Longer The Only Game In Town Lending Is No Longer The Only Game In Town Lending Is No Longer The Only Game In Town Banks also no longer engage in maturity transformation, or borrowing short to lend long, which placed them at the mercy of the yield curve. When it inverted, profitability was squeezed as new deposit-taking-and-lending activity became less lucrative. When the curve shifted out, even if it remained upward-sloping, there was a risk that interest expense on new short-term borrowings would exceed interest income on legacy portfolio assets. The latter is what killed the savings and loans, which were chartered expressly to channel household savings into 30-year fixed-rate home mortgages. ... so investors shouldn't obsess over the yield curve's every wiggle. There is no doubt that bank stocks have closely followed moves in the 10-year Treasury yield for the last several years, and the correlation makes some sense. With deposit rates stuck at zero, the spread between the rate banks pay for funds and the rate at which they lend them out (net interest margin), should move with long yields. Over the last two decades, however, Wells Fargo’s profitability (Chart 2, top panel) has largely detached from net interest margins (Chart 2, bottom panel). It and other banks would welcome higher long yields, but equity investors’ fixation on them is misplaced in a banking industry which has rigorously matched the duration of its assets and liabilities for decades. Chart 2NIM's Influence Has Faded NIM's Influence Has Faded NIM's Influence Has Faded Bank Balance Sheets Have Become Considerably More Conservative In the wake of the 2008-9 crisis, Wells Fargo and other banks have been managed much more cautiously. The share of Wells Fargo’s assets held in cash, Treasury and agency securities is at its highest level in the last 50 years (Chart 3). Its loan-to-deposit ratio is around 50-year lows, indicating that sticky core deposits1 are amply capable of funding its loan book (Chart 4). Wells’ overall leverage,2 or the value of assets supported by each dollar of common equity, is also way down (Chart 5). All banks have de-levered from their peaks, as mandated by regulators after the 2008-9 crisis, making the banking system safer, if less profitable. Mitigating some of the drag on profits brought about by lessened leverage, banks have become considerably more efficient since the early ‘70s. The ATM has reduced the need for physical branches and staff, check processing has been streamlined, and online banking is continuing to help push costs even lower. Chart 3Playing It Safe Playing It Safe Playing It Safe Chart 4Not Anywhere Close To Extended Not Anywhere Close To Extended Not Anywhere Close To Extended Chart 5Safety First Safety First Safety First Credit Costs: The Elephant In The Room The main concern for bank stability, profitability and capital adequacy is the effect of the economic sudden stop on credit performance. Credit performance is acutely sensitive to the business cycle, and banks have headed into this recession, as always, with very low loan-loss reserve balances (Chart 6, top panel). Loan-loss provisions, which reduce net income and chip away at capital positions, are bound to rise, suddenly and significantly (Chart 6, middle panel). (Please see the Box, below, for a brief description of the mechanics of accounting for credit impairments.) Chart 6Banks Have A Lot Of Catching Up To Do Banks Have A Lot Of Catching Up To Do Banks Have A Lot Of Catching Up To Do Box: Accounting For Lending Losses Every business that makes sales on credit maintains an allowance for doubtful accounts to reflect the fact that not every bill will be paid in full. That allowance reduces the carrying value of its accounts receivable to something below their aggregate face value. Using a loan-loss reserve account, banks apply the same principle to loan repayments. The loan-loss reserve is increased by provisions for loan losses, projections of future loan losses that are immediately recognized as an expense. At the time that a bank provisions for future losses, it does not map the as-yet unrealized losses to individual loans. The value of the loans that are not going to be fully repaid are marked down once they reveal themselves, and the sum of all of the individual write-downs is aggregated as a net charge-off. Identifying individual loan impairments reduces the pool of unspecified loan-loss reserves represented by the reserve account. Net charge-offs do not have any direct impact on bank earnings or bank capital, but by consuming existing reserves, they herald a rebuild of the reserve buffer. Table 1 shows the accounting entries involved in recognizing credit losses, demonstrating the underlying rules. Provisions increase reserves and charge-offs reduce them, triggering a need for more provisions, and ensuring a continuing drain on income and equity capital. Table 1Loan-Loss Accounting How Vulnerable Are US Banks? Part 1: A 50-Year Bottom-Up Case Study How Vulnerable Are US Banks? Part 1: A 50-Year Bottom-Up Case Study The current recession, emerging from the widespread shutdown of economic activity to counter COVID-19, will mark the sharpest downturn since the Great Depression. The sudden stop in activity, and borrowers’ revenue streams, should induce a high level of defaults. Perhaps Wells Fargo’s loan-loss reserves as a share of outstanding loans will ultimately exceed their 1993 peak of nearly 6.5%, following the 1990-91 recession, which wreaked particular havoc on real estate, and in California, where the bank conducted substantially all of its business. Banks would be in a tricky spot if the economy were left to face the coronavirus crisis by itself, but policymakers are doing their utmost to support it. Chart 7There's Nothing Unusual About Credit Line Exposures There's Nothing Unusual About Credit Line Exposures There's Nothing Unusual About Credit Line Exposures Wells Fargo barely broke even in 1991, and its book value declined by 6%. Investors seem to fear that it, and other banks, are at risk of net losses and book value declines in 2020. With nearly $1 trillion of outstanding loans, and an annual earnings run rate of around $20 billion, Wells Fargo would appear to be at risk of a nasty capital hit if the economic effects were left alone to play themselves out. The CARES Act coronavirus relief measure, however, clearly signals that the federal government is not going to leave the economy on its own to face the recession’s ravages. As a part of the act, banks were granted the option of delaying the implementation of CECL, the new credit loss recognition standard, which would have had the effect of speeding up the recognition of losses, until the virus emergency passes. The act also provided relief from a loan modification rule, thereby encouraging banks to work out new, easier terms to prevent defaults, and allowed community banks to operate with a reduced minimum equity capital cushion. The $850 billion dedicated to supporting small business borrowers ($350 billon) and other borrowers, including airlines and companies deemed critical to national security ($500 billion) will also benefit their creditors. It is clear to us that forbearance, which will help debtors and creditors weather the social-distancing storm, has been established as a guiding principle for managing through the crisis. Policymakers are out to help banks, not to clip their wings. Investors should also recognize that a lot of lending to small businesses and industrial borrowers has migrated away from banks. They do not stand as squarely in the path of the default storm as they would have in the ‘70s, ‘80s and ‘90s. Direct-lending funds sprung up in the wake of the 2008-9 crisis like mushrooms after the rain, and publicly-traded business development companies (BDCs) have steadily grown their SMID lending share. The biggest industrial borrowers are much more likely to turn to the bond market than they are to call on a syndicate of banks. Finally, the existence of unused loan commitments has occasioned concern among commentators and investors over the last several weeks. If corporate borrowers were to tap their credit lines en masse, would banks find themselves significantly more leveraged? Not at Wells Fargo, where total unfunded lending commitments are about at the middle of their range over the past 25 years (Chart 7, top panel), and its commitments to corporate borrowers are at the low end of their range (Chart 7, second panel). Credit card borrowers may be more inclined to max out their capacity (Chart 7, bottom panel), but that may not be a bad thing for bank profits. Interest on unpaid card balances produces juicy returns, and the 2005 bankruptcy overhaul makes it more difficult to discharge credit card debt. Bullish Or Bearish? Based on what we know now, we do not expect that the SIFI banks will pose a systemic threat to the financial system. Entire industries are at risk, and a multitude of small businesses are reeling, but banks have less exposure than they have in the past, and the Fed and Congress are on a war footing to try to protect the most vulnerable parts of the economy. The looming hit to the banks may be less severe than markets expect. Banks are especially exposed to the business cycle, and the market rule is to avoid them ahead of recessions. From a fundamental perspective, though, the last seven recessions have not been so bad for Wells Fargo. Its per-share book value managed to rise in all of them except the ’90-’91 recession3 (Chart 8). The stock slid in recessions because its book value multiple was slashed (Chart 9). Chart 8Book Value Doesn't Suffer Too Much In Recessions, ... Book Value Doesn't Suffer Too Much In Recessions, ... Book Value Doesn't Suffer Too Much In Recessions, ... Chart 9... But Multiples Are Regularly Crushed ... But Multiples Are Regularly Crushed ... But Multiples Are Regularly Crushed Wells Fargo’s multiple has been slashed again; as of Friday’s close, using its December 31st book value, it had fallen by 44%, from 1.33 to 0.75, and it had been more than halved as of last Monday. It trades at just 90% of its year-end tangible book value. On our first day on an equity trading desk, an old-timer told us that you “buy ‘em at one [times book], and sell ‘em at two.” He was talking about the investment banks, but Wells Fargo’s history suggests the maxim applies to commercial banks, too. In our view, SIFI banks offer an appealing margin of safety to investors who buy them at or below their tangible book value. The degree to which individual banks’ book values fall in this quarter and beyond depends on the size of their loan-loss provisions, but the selloff appears extreme. We noted the appeal of writing out-of-the-money puts on the SIFI banks last week, when the VIX was in the high 70s. Selling those options has lost some appeal after the S&P 500’s 10% surge last week, but writing them could again be alluring if the SIFIs revisit their lows in the coming days and weeks.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 Loans that exceed deposits, or very nearly match them, are a sign of potential instability because banks often rely on “hot-money” flows to fund them by offering above-market interest rates on instruments like CDs. A bank must continue to pay above-market rates to retain these flows, which are prone to leave the bank for higher interest rates elsewhere. Loan-to-deposit ratios well below 100% can be funded entirely with core deposits, like checking and savings accounts, or market-rate CDs placed with core banking customers who are unlikely to move their business. 2 A bank’s leverage is calculated by dividing its total assets by its common shareholders’ equity. 3 Book value would have shrunk in 2008 if not for the purchase of Wachovia Bank at a significant discount.

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

Highlights Portfolio Strategy We have identified 20 reasons to start buying equities. We highlight positive catalysts that should underpin the equity market as the pandemic progresses. Investors with higher risk tolerance should continue to layer in slowly and put cash to work with a cyclical 9-12 month time horizon. Consumer staples in general and hypermarkets and household products in particular are defensive areas where we are comfortable to deploy fresh longer-term oriented capital. Recent Changes Erratic trading compelled us to close out all our high-conviction calls for the year last Friday, booking handsome gains for our portfolio.1 Table 1 "The Darkest Hour Is Just Before The Dawn" "The Darkest Hour Is Just Before The Dawn" Feature Equities oscillated violently last week and remain mostly rudderless (Chart 1). While the relentless COVID-19 news bombardment kept on feeding the bears, on the flip side monumental monetary easing and fiscal packages the world over emboldened the bulls. This tug of war is far from over, but it is becoming crystal clear that both monetary and fiscal authorities will throw the proverbial kitchen sink at it until the hemorrhaging stops. Last week we showed that it takes a median two full years for the SPX to make fresh all-time highs following a bear market.2 This week we highlight the median and mean profile of the bear market recoveries since WWII (Chart 2). Crudely put, if history at least rhymes the SPX will not make any fresh all-time highs until early 2022. Chart 1Rudderless Rudderless Rudderless Chart 2Profile Of A Bear Profile Of A Bear Profile Of A Bear As a reminder, our equity market roadmap for the next few months is a drawn out consolidation phase leaving investors ample time to shift portfolios and put cash to work. This bottoming roadmap is something akin to the 1987, 2011, 2015/16 or early-2018 episodes.3 We cannot rule out further downside to equities. Moreover, we can neither time the tops nor the bottoms. However, the same way we were cautioning investors not to chase this market higher – as we were not willing to risk 100-200 points of SPX upside for a potential 1000 point drawdown – we are now compelled to nibble on the way down. Turning over to volatility, the VIX hit 85.47 intraday last week and clocked its highest close since the history of the data. Its sibling the VXO (volatility on the OEX or S&P 100) that predated the VIX hit an intraday high of 172.79 on Tuesday, following Black Monday, October 20, 1987, and clearly warns that if another crash takes root the VIX will explode higher.4 Importantly, vol at 85 translates into a 25% move in the SPX, in either direction, in the next 30 days. Chart 3 shows that actual SPX realized volatility jumped to 103 last week, trumping the VIX’s spike. Historically, when realized volatility trumps the VIX, it is time to sell the VIX; the opposite is also true. Given that we still do not expect a repeat of the GFC, or a depression, we recommend investors with higher risk tolerance start to deploy long-term oriented capital in the equity market. Chart 3Realized Versus Implied Vol Realized Versus Implied Vol Realized Versus Implied Vol Below are 20 reasons to start buying equities. We highlight positive catalysts that should underpin the equity market as the pandemic progresses. We are already in recession. Markets trough in recessions and historically offer enticing risk/reward return profiles. China’s manufacturing PMI and other hard data fell below the GFC lows. As a general rule of thumb investors should buy stocks when the global PMI is well below 50 (Chart 4). Cupboards are bare. A drawdown in inventories is usually followed by a jump in production. That is one of the reasons to be bullish staples. As for durables, pent-up demand due to delayed purchases will eventually be violently unleashed, especially given zero rates. Consumers will benefit from the oil market carnage and the super low mortgage refinancing rates. The Fed cut rates to zero, did QE5, and brought back the alphabet soup of programs like CPFF, PDCF and MMLF from the GFC, more will likely follow (Chart 5). Chart 4Time To Buy Time To Buy Time To Buy Chart 5The Fed Put The Fed Put The Fed Put The DXY has gone from 95 on March 9 to 103 on Friday. King dollar will soon have to reverse course and provide some much-needed relief globally as the Fed’s US dollar swap lines aim to alleviate the shortage of US dollars (Chart 6). Keep in mind what Dr. Bernanke told Scott Pelley in a 60 Minutes interview with regard to money creation: “PELLEY: Is that tax money that the Fed is spending? BERNANKE: It's not tax money. The banks have accounts with the Fed, much the same way that you have an account in a commercial bank. So, to lend to a bank, we simply use the computer to mark up the size of the account that they have with the Fed (emphasis ours). So it's much more akin to printing money than it is to borrowing.”5 Other global Central Banks are cutting rates and doing QE. Beyond Christine Lagarde’s recent €750bn bazooka, the ECB has the OMT ready from previous crises. Already last week the ECB intervened in Italian BTPs via Banca d’Italia. Germany has hinted that it would not be opposed to a “Covid-bond” A mega US fiscal package looms near the $1tn mark.6 The recession-related automatic stabilizers and government spending will soar. China’s fiscal response will likely be as large as in late 2008 (as a reminder in Q4/2008 the Chinese fiscal spending announcement equated “to 12.5% of China’s GDP in 2008, to be spent over 27 months”7). Germany and a slew of other countries have already pledged fiscal spending. Spain has announced a 20% of GDP package. Countries will bid-up the size of the bailout. IMF announced a $1tn bailout package. Nibbling at stocks when the VIX is at 85 makes sense versus when the VIX is at 12 (Chart 7). Chart 6Greenback Falls And Rates Rise When The Fed Does QE Greenback Falls And Rates Rise When The Fed Does QE Greenback Falls And Rates Rise When The Fed Does QE Chart 7Compelling Entry Point Compelling Entry Point Compelling Entry Point   The yield curve slope is steepening (Chart 8). Chart 8The Yield Curve Always Leads Stocks The Yield Curve Always Leads Stocks The Yield Curve Always Leads Stocks The 10-year real Treasury yield hit a low of -50bps that indicator has also priced in recession (Chart 7). Chart 9Recession Nearly Fully Priced In Recession Nearly Fully Priced In Recession Nearly Fully Priced In Equity market internals have fully priced recession, small caps and weak balance sheet stocks in particular (Chart 9). Sentiment is washed out as per our Capitulation, Sentiment and Complacency-Anxiety Indicators (Chart 9). Bernie Sanders has lost his bid to become the nominee of the Democratic Party. Buffett will either bailout a company or two or buyout a company he likes. Jamie Dimon and/or other prominent CEOs (insiders) will start buying their own company stock. Social-distancing measures in the West will ultimately break the Epidemic Curve first derivative and arrest the panic. Even if COVID-19 comes back in force, the fact is that most of the patients who succumb to it are elderly. In Italy, the average age of death is 80 years old. As such, the final circuit-breaker ahead of a GFC would be desensitization by the population, as selective quarantines – targeting the elderly cohorts – get implemented in order to allow other people to return to work. Furthermore, two “silver bullet” solutions remain as tail risks to the bearish narrative. First, a biotech or pharmaceutical company may make a breakthrough in the fight against COVID-19. Not necessarily a vaccine, but a treatment. Finally, upcoming warm weather in the northern hemisphere may also help the fight against the virus.   Nevertheless, there are some risks we are closely monitoring. First, if we are offside and this turns into a GFC, another big down-leg will ensue. One reason for this would be a Spanish Flu parallel where the second wave of deaths trounced the first wave. In that case, the GDP contraction will be longer-lived and SPX EPS will suffer a long-lasting setback. Second, a credit crunch can cause a credit event, which is a big risk as we have been highlighting recently. Counter party as well as bank insolvency risks will also come into play. Third, non-financial non tech corporate net debt-to-EBITDA is at all-time highs according to company reported data and non-financial corporate debt as a percent of GDP is at all-time highs according to national accounts (Chart 10). Finally, while lower rates are helpful in the long run, a long era of low rates in Japan and more recently the euro area have not helped equities in the longer-term. The NIKKEI 225 is still down 58% from the December 1989 all-time highs and the MSCI Eurozone index is down 46% from the March 2000 all-time highs (Chart 11). Chart 10Risk: Too Much Indebtedness Risk: Too Much Indebtedness Risk: Too Much Indebtedness Chart 11Japan And The Euro Area Are Scary ZIRP Parallels Japan And The Euro Area Are Scary ZIRP Parallels Japan And The Euro Area Are Scary ZIRP Parallels Netting it all out, following a nine-month cyclical period of being in the bearish camp, we are now selectively nibbling on stocks with a 9-12 month time horizon, as we deem the potential positive catalysts will overwhelm the few risks that we are closely monitoring. This week we reiterate our overweight stance in the second largest defensive sector – the S&P consumer staples index – and two of its key sub-components. Continue To Favor Defensive Staples… Consumer staples stocks have caught on fire lately as investors have been seeking refuge in defensive equities during the current “risk off” phase. Behind health care (15.6% of the SPX weight), their safe haven siblings, staples are the second largest defensive sector comprising 8.5% of the S&P 500, and we reiterate our overweight stance in this sector. Historically, staples equities thrive in recessions and in deflationary/disinflationary environments. The reason is the allure of their stable cash flows especially in times of duress when growth is really hard to come by, a staples company growing revenues 5%/annum is sought after aggressively. Currently, relative share prices have troughed near the GFC bottom, and are probing to break out of the one standard deviation below the historical time trend mean (Chart 12), offering a compelling entry point to deploy new capital. Chart 12Bouncing Bouncing Bouncing Last week’s jump in unemployment insurance claims to 281,000 is a small precursor of things to come as more parts of the US get locked down (middle panel, Chart 13). This recessionary backdrop, coupled with the surging VIX, which will take months to die down to 20 near the historical average, and investors hiding in Treasurys all argue that it pays to stay with defensive staples stocks (top & bottom panels, Chart 13). Two of our preferred vehicles to continue to explore an overweight in the consumer staples sector are via above benchmark allocation in both hypermarkets and household products stocks. Chart 13Sticks With Staples Sticks With Staples Sticks With Staples …Stick With Hypermarkets… Last summer, following our recession thought experiment report8 we upgraded the S&P hypermarkets index to overweight preparing our portfolio for the inevitable recession.9 Since then, hypermarket stocks have bested the SPX by over 36%. While a consolidation phase looms that will allow hypermarkets to build a base before vaulting higher, today we are instituting a rolling 10% stop from the highs in order to protect handsome gains for our portfolio. The savings rate more than trebled from the GFC lows as the once in a generation Great Recession scared consumers. The savings rate has remained elevated ever since and is primed to rise further in the current recession as consumers tighten their purse strings. Historically, relative share prices and the savings rate have been positively correlated as even wealthier consumers opt for rock bottom selling price points. The current message is to expect a durable bidding up phase of hypermarket equities (Chart 14). Chart 14When The Going Gets Tough, Buy Hypermarkets When The Going Gets Tough, Buy Hypermarkets When The Going Gets Tough, Buy Hypermarkets The soaring greenback is underpinning these pricing strategies from Big Box retailers as it keeps import prices in deflation, allowing retailers to pass these on to the consumer (fourth & bottom panels, Chart 15). The recent drubbing in oil prices is an added catalyst to boost hypermarket equities as lower prices at the pump will translate into more cash in consumers’ wallets (top panel, Chart 15). Keep in mind that WMT is the number one grocery store in the US with near 25% market share – COST is also a large mover of US groceries – thus the coronavirus pandemic will not deal a blow to their demand profile. Chart 15Defense Is… Defense Is… Defense Is… The 10-year Treasury yield recently melted to 0.31%, fully discounting ZIRP, QE5 and recession. Last week’s Philly Fed survey made for grim reading, a harbinger of acute economic pain in the weeks to come. Tack on the 40% jump in weekly unemployment insurance claims, and things are falling into place for additional gains in relative share prices (Chart 16). Finally, overall tighter financial conditions and the more than doubling in the junk spread also corroborate that the path of least resistance remains higher for hypermarket equities (second & middle panels, Chart 15). Bottom Line: We reiterate our overweight stance in the S&P hypermarkets index. Today, we are also instituting a risk management metric in order to protect profits: we are implementing a rolling 10% stop from the highs in order to protect gains. The ticker symbols for the stocks in this index are: BLBG: S5HYPC – WMT, COST. Chart 16…The Best Offense …The Best Offense …The Best Offense   …And Overweight Household Products Household products stocks have recently bounced off of long-term support and have sling shot higher (Chart 17). While we continue to recommend an above benchmark allocation of this safe haven index, we are also obliged to initiate a 5% rolling stop in order to protect our recent explosive gains. We reckon that the COVID-19 experience will scar consumers and alter behaviors with long lasting effects. We doubt this sanitization craze will completely subside following the passing of the pandemic. Our sense is that use of disinfectants and cleaning products in general will experience a parallel shift higher in the demand curve. Chart 17Held The Line Held The Line Held The Line Therefore, consumer outlays on household products will continue to gain share from the overall spending pie and underpin relative share prices (top panel, Chart 18). US household products exports are another important source of demand for the industry. Exports recently ticked higher and the coronavirus pandemic underscores that US manufacturers that are held in high regard abroad especially sanitation household products will struggle to meet export demand (bottom panel, Chart 18). Domestically, overall grocery store level wholesale selling prices are expanding smartly paving the way for a similar trajectory for household products pricing power (second panel, Chart 18). Importantly, given the recent consumer behavior, shortages all but assure that non-durable goods factories will be humming at a time when almost all other industries will grind to a halt (third panel, Chart 18). Moreover, household products are part of consumer goods that have a fairly inelastic demand profile and really shine during recessions. The recent collapse of the Philly Fed survey heralds a durable outperformance phase for household products equities (Chart 18). While relative valuations appear expensive, relative forward EPS and revenues are slated to trail the market in the coming 12 months. If our thesis pans out then household products stocks will grow into their pricey valuations as profits will overwhelm (Chart 19). Chart 18Demand Driven Advance Demand Driven Advance Demand Driven Advance In fact, our macro based S&P household products sale per share growth model does an excellent job in capturing all these drivers and signals that top line growth will continue to accelerate for the rest of the year (Chart 20). Chart 19Low Bar To Surpass Low Bar To Surpass Low Bar To Surpass Chart 20Macro Model Says Buy Macro Model Says Buy Macro Model Says Buy Bottom Line: Stick with the S&P household products index, but institute a 5% rolling stop from the highs in order to protect profits. The ticker symbols for the stocks in this index are: BLBG: S5HOPRX – PG, CL, KMB, CLX, CHD. Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com   Footnotes 1     Please see BCA US Equity Strategy Daily Report, “Closing Out All High-Conviction Calls” dated March 20, 2020, available at uses.bcaresearch.com. 2     Please see BCA US Equity Strategy Weekly Report, “Inflection Point” dated March 16, 2020, available at uses.bcaresearch.com. 3    Please see BCA US Equity Strategy Daily Report, “Gravitational Pull” dated March 12, 2020, available at uses.bcaresearch.com. 4    http://www.cboe.com/products/vix-index-volatility/vix-options-and-futures/vix-index/vix-historical-data 5    https://www.cbsnews.com/news/ben-bernankes-greatest-challenge/2/ 6    Please see BCA US Equity Strategy Daily Report, “Don’t Be A Hero” dated March 11, 2020, available at uses.bcaresearch.com. 7     https://www.oecd.org/gov/budgeting/Public%20Governance%20Issues%20in%20China.pdf 8    Please see BCA US Equity Strategy Weekly Report, “A Recession Thought Experiment” dated June 10, 2019, available at uses.bcaresearch.com. 9    Please see BCA US Equity Strategy Weekly Report, “Divorced From Reality” dated July 15, 2019, available at uses.bcaresearch.com. Current Recommendations Current Trades Strategic (10-Year) Trade Recommendations "The Darkest Hour Is Just Before The Dawn" "The Darkest Hour Is Just Before The Dawn" 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).

HighlightsPortfolio Strategy“There is blood in the streets”. Investors with higher risk tolerance should be buying into this weakness and start to deploy long-term oriented capital. S&P 500 futures fell to 2394 which is a whopping 1000 points below the February 19, 2020 high of 3393. We cannot time the bottom, but future returns will be handsome from current SPX levels.Stick with health care stocks as the coronavirus pandemic will boost demand for health care goods and services, at a time when investors will also seek the refuge of defensive equities as the economy is in recession.Surging demand for pharmaceuticals, firming operating metrics, cheap relative valuations, an appreciating greenback along with the drubbing in the global manufacturing PMI, all signal that an underweight stance is no longer warranted in pharma equities.    Recent ChangesLift the S&P pharmaceuticals index to neutral today. Table 1 Inflection Point Inflection Point  Feature"Be fearful when others are greedy, and greedy when others are fearful"- Warren Buffett"The time to buy is when there's blood in the streets"- Baron RothschildEquities were unhinged last week, as the trifecta of the corona virus becoming a pandemic, Saudi ripping the cord out of crude oil and the convulsing bond markets made for an explosive equity market cocktail. The result was two circuit breaker triggers at the -7% mark that (thankfully) worked as planned and brought some liquidity back into the markets.Our Complacency-Anxiety index plunged to a panic level that has marked previous equity market troughs (Chart 1A). CNN’s Fear & Greed Index fell from near 100 to 1. While it could fall further at least a reflex rebound is in order. The Monday and Thursday mini-crashes felt like a capitulation (Chart 1B). Whoever wanted to get out likely got out. Chart 1ATime To Buy Time To Buy Time To Buy   Chart 1BThere’s Is Blood In the Streets There’s Is Blood In the Streets There’s Is Blood In the Streets  Volumes in the SPX soared to the highest level since 2011 and the bullish percentage index1 fell to 1.4%2 below the low hit in 2008! Early last week six out of ten stocks in the broad-based Russell 3000 were down 30% or more from their 52-week highs. As a reminder, the SPX took the elevator down and erased 13 months of gains in a mere 13 trading days (Chart 2)! Chart 2Selling Is Overdone Selling Is Overdone Selling Is Overdone   Chart 3Our Roadmap Our Roadmap Our Roadmap  A big crack has now formed.Given the tremor we just experienced, we doubt a V-shaped recovery to fresh all-time highs is in store for stocks similar to the one following the 2018 Christmas Eve lows V-shaped advance. Instead, parallels with the early-2018, 2015/16, 2011 or 19873 market action are more apt (Chart 3).Historically, Table 2 shows that the median time it takes for the stock market to make fresh all-time highs following a minimum 20% bear market from the most recent highs is two years. Table 2Bear Markets Duration Inflection Point Inflection Point  In other words, this will likely be a prolonged troughing phase and a retest near last Thursday’s lows is a high probability event, at which point we think the market will hold those lows, and this will serve as a catalyst to definitively put cyclical-oriented capital to work.Our purpose here is not to scare investors when a number of markets are in duress and already in a bear market. We have been sending these warning shots4 since last summer5 all the way until the recent SPX February peak. Now that we have reached the proverbial “riot point” we would recommend taking a cold shower and keeping calm and collected in order to put things into perspective as one of our mentors would always do in tumultuous times.Importantly, investors with higher risk tolerance should be buying into this weakness and start to deploy long-term oriented capital. We cannot time the bottom, but future returns will be handsome from current SPX levels. As a reminder, S&P 500 futures fell to 2394 which is a whopping 1000 points below the February 19, 2020 high of 3393.This drubbing blew past our most bearish SPX estimate of 2544,6 pushing the SPX from overvalued to undervalued overnight. In fact, the forward P/E has fallen to one standard deviation below the historical time trend (Chart 4). Chart 4From Overvalued To Undervalued From Overvalued To Undervalued From Overvalued To Undervalued  Our sense is that we will avoid a GFC type collapse, and thus investors with higher risk tolerance should start putting long-term cash to work as “there is blood in the streets”.Recapping the sequence of recent events is instructive. Two Fed officials (Clarida and Evans) made a huge error in our view by relaying that the Fed should stand pat and refrain from cutting rates. This culminated in a Powell press release that the Fed is ready to act, basically canceling these misplaced statements from the two Fed officials.Following these communication whipsaws, G7 finance ministers and central bankers held a conference call and then, the Fed panicked and cut rates inter-meeting further fueling the blazing fire. Now the Fed is cornered and has to act anew and further cut the fed funds rate (FFR) on March 18 all the way down to the zero lower bound. As a reminder, the last time the markets fell roughly 20% in late-2018 it took the Fed seven months to cut rates, this time it happened a mere two trading days after the market had a near 16% decline from the February peak.All of this bred uncertainty and a bond market spasm. There is little doubt we are in recession. The 10-year US Treasury yield plunging below 0.4% has fully discounted a recession, 100bps of Fed cuts and QE5 in our view.Keep in mind that the bond market now knows the Fed will cut the FFR to zero and eventually resort to QE, so it really front runs the Fed. This is something the bond market never anticipated or discounted on the eve of the Great Financial Crisis.While it is definitely true that interest rate cuts and further QE will neither cure COVID-19 nor reverse work-related disruptions, the Fed has to act and cut interest rates and restart QE for three reasons:a) to instill confidence that it is doing something and it is not a bystander,b) to loosen financial conditions as the VIX at a recent high near 76 and a more than doubling in junk spreads are screaming “help” (Chart 5), andc)  to jawbone the US dollar lower.Our sense is that the fixed income market hit an inflection point for stocks when the 10-year US Treasury yield breeched the 1.5% mark: the correlation between stocks and bond yields quickly snapped from negative to positive. Based on recent empirical evidence, stocks cannot stomach a 10-year US Treasury yield above 3%, and suffer indigestion below 1.5% (Chart 2). Crudely put, while lower yields act as a shock absorber for equities (via lifting the forward P/E multiple), below a breaking point they warn of a deflationary shock. Thus, we would view an eventual return of the 10-year US Treasury yield near the 1.5% as a positive sign for stocks. Chart 5Watching Spreads Watching Spreads Watching Spreads  The other shock two weekends ago was the deflationary oil market spiral out of the OPEC meeting in Vienna where a fight apparently erupted between the Saudis and the Russians with regard to rebalancing the oil markets and resulted in $30/bbl oil. The timing could not have been worse. Oil related capex will fall off a cliff given the looming bankruptcies in the US shale oil patch (bottom panel, Chart 5) and that makes a fiscal package from the US even more pressing.We deem that only a mega fiscal package comparable to the $750bn TARP will definitively stop the hemorrhaging. A comprehensive fiscal package close to $1tn in order to deal with the aftermath of the corona virus would mark a bottom in the equity market.Health care stocks will benefit both from a fiscal package and from the corona virus pandemic automatic rise in demand for health care services and goods. Thus, this week we reiterate our overweight stance in the health care sector and make a small shift to our sub-sector positioning.Continue To Hide In Health Care…We recommend investors continue to take refuge in health care stocks within the defensive universe as the coronavirus pandemic unfolds. The S&P health care sector relative share price ratio recently bounced off the one standard deviation below the historical time trend line and is primed to vault higher in coming quarter (Chart 6). Chart 6Health Care Shines In Recessions Health Care Shines In Recessions Health Care Shines In Recessions  If severe government measures are a prerequisite to stop the spread of the virus then growth will suffer a massive setback. Were President Trump to take draconian measures similar to what the Italian Prime Minister imposed recently and effectively shut down the country, then PCE will collapse.In fact, PCE excluding health care will take a beating. Health care outlays will rise both in absolute terms and relative to overall spending (Chart 7). Given the safe haven status of the S&P health care index and the stable cash flows these businesses command, when growth is scarce, investors flock to any source of growth they can come by and health care stocks definitely fit that bill.Not only is firming demand reawakening health care stocks that have been trading at a discount to the broad market owing to political uncertainty, but also their defensive stature is a heavily sought after attribute during recessions (Chart 6). Chart 7Upbeat Demand Profile… Upbeat Demand Profile… Upbeat Demand Profile…   Chart 8…Will Boost Selling Prices And Sales …Will Boost Selling Prices And Sales …Will Boost Selling Prices And Sales  Inevitably, demand for health care goods and services will rise in the coming weeks straining the US health care system, as the number of infections increases. This will sustain industry selling price inflation and underpin revenue growth at a time when the world will be deflating (Chart 8).The implication is an earnings-led durable health care sector outperformance phase, a message that our relative macro EPS growth model is forecasting for the rest of the year (Chart 9).Importantly, such a rosy outlook is neither discounted in relative forward sales nor profit growth expectations for the coming year and we would lean against such pessimism (third panel, Chart 10). Chart 9Macro Profit Growth Model Says Buy Macro Profit Growth Model Says Buy Macro Profit Growth Model Says Buy   Chart 10Unloved And Under-owned Unloved And Under-owned Unloved And Under-owned  Finally, valuations and technicals are both flashing green. On a forward P/E basis health care stocks still trade at a 15% discount to the broad market and momentum is washed out offering a compelling entry point for fresh capital.In sum, in times of malaise investors flock to defensive health care stocks, that are currently direct prime beneficiaries of the ongoing coronavirus pandemic.Bottom Line: We reiterate our overweight recommendation in the largest market capitalization weighted defensive sector in the SPX, the S&P health care sector.Upgrade Pharma To NeutralLift the S&P pharmaceuticals index to neutral from underweight for a modest loss of -1% since inception.A structurally downbeat pricing power backdrop was the primary driver of our bearish call on the S&P pharma index as both sides of the political aisle were out to get Big Pharma (bottom panel, Chart 11). This portfolio position was up double digits since inception, but it has given back almost all the gains recently since the coronavirus pandemic took stage a few weeks ago.While our thesis has not changed, we do not want to be bearish any health care related equities in times of a health epidemic. In addition, there is a chance that one of these behemoths discovers a compound to beat the virus and could serve as a catalyst for a sharp reversal of the downtrend.Importantly, from an operating perspective, margins appear to have troughed following 15 years of declines (middle panel,Chart 11). Now that inadvertently demand for medicines will surge, sales and profits will expand smartly (third & bottom panels, Chart 12). Chart 11It No Longer Pays To Be Bearish It No Longer Pays To Be Bearish It No Longer Pays To Be Bearish   Chart 12Firming Demand Firming Demand Firming Demand  As a result of the coronavirus pandemic, we deem pharma factories will start to hum reversing the recent contraction in pharmaceutical industrial production (second panel, Chart 12).From a macro perspective, layoffs are inevitable from the coronavirus catalyzed recession and a softening labor market bodes well for defensive pharma profits (bottom panel, Chart 12).The collapse in the February global manufacturing PMI, primarily driven by China, is a window into what the future holds for developed market (DM) PMIs. DMs will feel the coronavirus aftermath in the current month and likely sustain downward pressure on the global manufacturing PMI print. Historically, relative forward profits and the global manufacturing PMI have been inversely correlated and the current message is to expect catch up phase in the former (global PMI shown inverted, middle panel, Chart 13).Moreover, the same rings true for the ultimate macro indicator, the US dollar. A rising greenback reflects global growth ills and a safe haven bid in times of duress as investors park their money in the reserve currency of the world. Therefore, defensive pharma relative forward EPS enjoy a positive correlation with the US dollar, and the path of least resistance remains higher (bottom panel, Chart 13).Finally, relative valuations are hovering near one standard deviation below the historical mean and technicals have returned back to the neutral zone underscoring that it no longer pays to be bearish pharma stocks (Chart 14). Chart 13Macro Backdrop Is Favorable Macro Backdrop Is Favorable Macro Backdrop Is Favorable   Chart 14Value Has Been Restored Value Has Been Restored Value Has Been Restored  Adding it all up, surging demand for pharmaceuticals, firming operating metrics, cheap relative valuations, an appreciating greenback along with the drubbing in the global manufacturing PMI, all signal that an underweight stance is no longer warranted in pharma equities.Bottom Line: Lift the heavyweight S&P pharma index to neutral today, for a modest loss of -1% since inception. The ticker symbols for the stocks in this index are: BLBG: BLBG: S5PHAR – JNJ, MRK, PFE, BMY, LLY, ZTS, AGN, MYL, PRGO. Anastasios Avgeriou US Equity Strategistanastasios@bcaresearch.com Footnotes1     https://school.stockcharts.com/doku.php?id=index_symbols:bpi_symbols2     https://schrts.co/IfrNQmIu3    Please see BCA US Equity Strategy Daily Report, “Gravitational Pull” dated March 12, 2020, available at uses.bcaresearch.com.4    Please see BCA US Equity Strategy Weekly Report, “A Recession Thought Experiment” dated June 10, 2019, available at uses.bcaresearch.com.5    Please see BCA US Equity Strategy Special Report, “What Goes On Between Those Walls? BCA’s Diverging Views In The Open” dated July 19, 2019, available at uses.bcaresearch.com.6    Please see BCA US Equity Strategy Weekly Report, “From "Stairway To Heaven" To "Highway To Hell"?” dated May 2, 2020, available at uses.bcaresearch.com.Current RecommendationsCurrent TradesStrategic (10-Year) Trade Recommendations Inflection Point Inflection Point Size And Style ViewsJune 3, 2019Stay neutral cyclicals over defensives (downgrade alert) January 22, 2018Favor value over growthMay 10, 2018Favor large over small caps (Stop 10%)June 11, 2018Long the BCA  Millennial basket The ticker symbols are: (AAPL, AMZN, UBER, HD, LEN, MSFT, NFLX, SPOT, TSLA, V).

Highlights The S&P 500 is in a bear market, and a recession appears to be inevitable, … : The longest bull market in S&P 500 history succumbed last week to the Saudi-Russia oil war, the relentless drumbeat of spreading COVID-19 disruptions and the realization that it will take even worse market conditions to prompt a meaningful fiscal response. … but it is BCA’s view that the recession will be short, if sharp: Although our conviction level is low, and our view is subject to change as more information becomes available, we expect that the recession is much more likely to produce a V-bottom than a U-bottom. Pent-up demand will be unleashed once the coronavirus runs its course, stoked by monetary and fiscal stimulus initiatives around the world. Are central banks out of bullets?: We are not yet ready to embrace the most provocative idea that came up at our monthly View Meeting last week, but the question highlights the uncertainty that currently pervades markets. First, do no harm: What should an investor do now? Watch and wait. It is too early to re-risk a portfolio, but safe-haven assets are awfully overbought. Cash is worth its weight in gold right now, and those who have it should remember that they call the shots. Feature The S&P 500 entered a bear market last Thursday, bringing down the curtain on the longest US equity bull market in recorded history at just under 11 years.1 We are duly chastened by the misplaced bravado we expressed in last week’s report, which crumbled under the force of the ensuing weekend’s oil market hostilities between Saudi Arabia and Russia. We see the plunge in oil prices, and the looming spike in oil-patch defaults, bankruptcies and layoffs, as the straw that broke the camel’s back, ensuring a 2020 recession. Now that it has slid so far, we expect that the S&P 500 will generate double-digit returns over the next twelve months, but we do not believe that investors should be in any rush to buy. Wild oscillations are a sign of an unhealthy market, and stocks don’t establish a durable bottom while they are still experiencing daily spasms. The Fundamental Take (For What It’s Worth) We nonetheless believe that the recession will be fairly brief, even if it is sharp. The global economy was clearly turning around before the virus emerged, and the US economy was as fit as a fiddle. Data releases across February were decidedly positive, on balance, and the year-to-date data, as incorporated in the Atlanta Fed’s GDPNow model, pointed to robust first quarter growth in an economy that was firing on all cylinders (Chart 1). We continue to believe that most of the demand that goes missing across the first and the second quarters will not be lost for good, but will simply be deferred to the second half of this year and the beginning of next year. The coronavirus has brought an end to the expansion, but the US economy was in rude health before it was infected, and we expect it will make a full and swift recovery. Chart 1The First Quarter Had Been Shaping Up Really Well March Sadness March Sadness Chart 2Old Faithful Old Faithful Old Faithful That pent-up demand will be goosed by abundant monetary and fiscal stimulus. We expect that China and the US will take the lead, and will have the most impact on global aggregate demand, but that policymakers in other major economies will also lend a hand. Central banks in Australia, Canada and England have all cut rates in the last two weeks, and British policymakers took the boldest step, pairing last week’s rate cut with an immediate 30-billion-pound infusion of emergency spending, and a pledge to spend 600 billion pounds on infrastructure upgrades between now and 2025.2 Australia announced a plan to inject fiscal stimulus equivalent to about 1% of GDP Thursday morning, and Germany’s ruling party indicated a willingness to run a budget deficit to combat the virus.3 Our China Investment Strategy team notes that the Chinese authorities are already supporting domestic demand via aid to threatened businesses and out-of-work individuals, and are poised to open the infrastructure taps (Chart 2). Global aggregate demand is also set to receive a boost from the oil plunge, although it will arrive with a lag. Energy sector layoffs and the tightening in monetary conditions from wider bond spreads and marginally tighter bank lending standards will exert an immediate drag on activity. Once that drag fades, however, the positive supply-shock effects will take hold, helping households stretch their paychecks and non-energy businesses expand their profit margins. Although the effect of falling oil prices is mixed for the US now that fracking has made it a heavyweight oil producer, more economies are oil importers than exporters, and global growth is inversely related to oil price moves. We are keenly aware that markets are paying no attention whatsoever to economic data releases right now. They are backward-looking, after all, and fundamentals are not the driving force behind current market moves anyway. The data are useful, however, for evaluating the fundamental backdrop once the non-stop selling abates, as it eventually will. When it becomes important to take the measure of the economy and where it’s headed, investors will be able to make a more informed judgment if they have a good read on how the economy was doing before it was exposed to the virus (Chart 3). Chart 3Layoffs Are Coming, But They Hadn't Started By Early March Layoffs Are Coming, But They Hadn't Started By Early March Layoffs Are Coming, But They Hadn't Started By Early March Investment Strategy The near-term equity view was cautious when we held our View Meeting Wednesday morning before the open. No one thought investors should be in any hurry to buy, and while not everyone shared the bleakest S&P 500 downside estimate of 2,400 (well within sight now), no one suggested that the index had already bottomed. One participant made the case for a negative 10-year Treasury yield, but we still have little appetite for Treasuries as a house. We expect the 10-year yield will be higher in twelve months than it is now, if perhaps only modestly. We like equities' 12-month prospects, but they may have to decline some more before Congress joins hands and puts a floor under them. For anyone expecting US fiscal stimulus to bail out the markets, our geopolitical team sounded a note of caution. A recession is kryptonite for incumbent presidential candidates, and the more the virus squeezes the economy, the greater the Democrats’ chances of capturing the White House and the Senate. Our Geopolitical Strategy service fully expects that Democrats will eventually agree to a sizable spending package, but only after allowing the situation to deteriorate some more. As long as they don’t look like they’re putting party concerns ahead of the nation’s welfare, they can dent the president’s re-election prospects by waiting to throw a lifeline to the economy and financial markets. The administration’s initial proposal, as alluded to in the president’s prime-time Oval Office address on Wednesday night, fell way short of what the market sought. Its small-bore items seemed woefully inadequate to stem the tide, and raised the unsettling prospect that the fiscal cavalry might fail to ride to the rescue because the administration didn’t think it needed to be summoned. The good news for markets is that governments get an almost unlimited number of do-overs.4 The first iteration’s failure ensures that the second will be more ambitious, and if that fails, the third iteration will be even bigger. Thank You, Sir, May I Have Another? News of disruptions to economic activity, and daily life, in the United States piled up last week. Colleges closed their gates en masse for what remains of the academic year; concerts and music festivals were cancelled; the NCAA basketball tournament was initially closed to fans, then cancelled altogether; and all of the major North American professional sports leagues have suspended their seasons. In many instances, city and state ordinances banning mass gatherings forced sports franchises’ and concert promoters’ hands. The relentless drumbeat of bad news did markets no favors, and it surely did not help business or consumer confidence as broadcasters, hotels, restaurants, bartenders, taxi drivers and arena staff totted up their lost income. Today’s pain may be tomorrow’s gain, however. While draconian measures weigh on peoples’ spirits and crimp economic activity in the immediate term, they increase the chances of limiting the virus’ spread and mitigating its ultimate effect. As our Global Investment Strategy colleagues have pointed out, there is a trade-off between health and growth. Bulking up health safeguards unfortunately involves some growth sacrifices. Are Central Banks Out Of Bullets? Chart 4If At First You Don't Succeed, ... If At First You Don't Succeed, ... If At First You Don't Succeed, ... The most provocative line of argument in last week’s firm-wide discussion was the idea that the coronavirus is a bit of a red herring, and that the true driver of the global market selloff is the failure of the policy put. That’s to say that the efficacy of, and the belief in, central banks’ ability to shore up markets and the economy has crumbled. So far, this round of emergency rate cuts has failed to stem the flow of red on Bloomberg terminals and television screens (Chart 4). Spending plans have underwhelmed as well, with British, Australian and Japanese equities all fizzling following the announcement of fiscal stimulus measures. The end of markets’ monetary policy era would mark a major inflection point, if not a full-on regime change. We are hesitant to make such a sweeping declaration now, however. As one of our colleagues put it in making the case for further declines in rates, the golden rule of investing is never to lean against a primary trend. Positioning for an end to central banks’ influence on markets would mean going against 33 years of history that began with the Fed’s post-Black Monday statement affirming its “readiness to serve as a source of liquidity to support the economic and financial system.” Central bankers are neither omniscient nor omnipotent, but there’s a reason why You can’t fight the Fed became a cherished truism. It affects the real economy when it turns its policy dials. If monetary stimulus is aligned with fiscal stimulus, as it just might be next week, it can make for a potent cocktail. A devotee of the Austrian School of Economics may grind his or her teeth to dust over the endless intervention in markets, but the results are popular with the public and elected officials, and we can expect that they’ll continue over most professional investors’ relevant timeframes. Public officials will let go of the Debt Supercycle controls only when they’re pried out of their cold, dead hands. What Now? It feels like it was a month ago, but just last week we were of the view that a correction was more likely than a bear market. As we wrote then: We remain constructive on risk assets because we think the selling has gotten overdone. There may well be more of it, and the S&P 500 could reach its 2,708.92 bear-market level before we can publish again next Monday, but we will be buying it in our own account all the way there. Compounding our embarrassment and regret, we actually did buy shares in a SIFI bank on Tuesday as they approached their tangible book value. Markets were unimpressed with the initial monetary salvo, but there's more where that came from (and some fiscal artillery, too). We have learned our lesson and will wait before committing any more capital. We have also learned our lesson about “overdone selling.” Despite the dramatic gap between the S&P 500 and its 200-day moving average (Chart 5), every single sale over the last three weeks has proven to be a good one. Cutting one’s losses is a deservedly celebrated portfolio management rule, and we cannot object to any client who wants to take some exposure off the table. Chart 5The Equity Selloff Has Become Extreme The Equity Selloff Has Become Extreme The Equity Selloff Has Become Extreme We have little love for the havens that have already spiked, like gold, Treasuries, utilities and makers and sellers of hand sanitizer, disinfectant wipes and surgical masks. Insurance in the form of index puts is bracingly expensive. Our preferred way of taking advantage of the massive market disruption (Chart 6 and Table 1) is to write out-of-the money puts on individual stocks at strike prices where we’d be happy to own them. With the VIX in the 50s, much less the 60s or 70s, an investor writing puts 10% out of the money on a range of S&P 500 constituents5 can get paid double-digit annualized returns in exchange for agreeing to get hit down 10% between now and March 20th or April 17th. Chart 6Selling Insurance Looks More Appealing Than Buying It Right Now Selling Insurance Looks More Appealing Than Buying It Right Now Selling Insurance Looks More Appealing Than Buying It Right Now Table 1One Week, Two Historic Declines March Sadness March Sadness We recognize that not every investor has discretion to write puts, and it is not something to be done lightly in any event. The compensation is so high because it is a contractual agreement to buy stock in a relentlessly falling market. (Options only confer a right to transact for their buyers; they’re an iron-clad obligation to transact for their sellers.) Our species’ cognitive biases being what they are, however, we like the strapped-to-the-mast feature of writing puts because it commits an investor to following through on a course of action s/he decided upon before price declines had a chance to shake his/her resolve. It is one thing to have said that one would buy a 35-dollar stock if it ever got to 18, and quite another to follow through now that it’s gone from 35 to 21 in short order.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 The bull market began on March 10, 2009, at 676.53, and ended February 19, 2020, at 3,386.15. Its 400% advance was achieved at an annualized rate of 15.8%. 2 Nominal 4Q19 UK GDP was about 560 billion pounds. 3 Believe it or not, this is kind of a big deal for Berlin. 4 As we were going to press, it looked as if House Democrats and the administration were nearing agreement on a package to protect vulnerable workers and small businesses, while the combined private- and public-sector efforts outlined in the Rose Garden suggested that the US might be capable of stemming the spread of the virus soon. 5 Type [ticker]-F8-PUT into Bloomberg for the full menu of maturities and strike prices for any given stock. The annualized return for writing the put is equal to the option premium divided by the strike price, multiplied by (360/the number of days until expiration). For near-month contracts, if the premium is around 1% of the strike, the annualized return on the notional capital committed is 10%.

Feature An analysis on Singapore is available below. The plunge in global risk assets is occurring at such a breathtaking pace that any economic analysis is pointless at this time. Economic growth forecasts have been reduced to moving targets. In our latest report published two days ago, we argued that we are witnessing the unravelling of the policy put. For now, monetary stimulus – both rate cuts and QE programs – are unlikely to halt the market riot. Fiscal stimulus is forthcoming but its actual impact on the real economy will not materialize until another several months. The only thing that investors can use to gauge market downside as of now are valuations and market technicals. This report presents the most important technical and valuations indicators that we are currently monitoring. All market prices are updated as of the close of Thursday, March 12, 2020. We are in a liquidation phase where fundamentals do not matter and markets often undershoot. Such indiscriminate liquidation also leads to major buying opportunities. We will book profits on the short EM stocks position when the MSCI EM equity index in USD hits 800. On Thursday March 12, the MSCI EM equity index closed at 880. Possibly, we will recommend accumulating EM stocks and will reverse our bearish bias on EM currencies and fixed-income markets if the EM MSCI Index reaches this level. Remarkably, the top chart on page 2 shows that major EM bear markets – in 1998, 2002, 2008 and 2015-16 – all bottomed when EM share prices hit their 24-year exponential moving average. This technical support for the MSCI EM stock index is currently 780, about 10% below yesterday’s close. Stay tuned. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com EM Stocks Are Approaching A Major Defense Line EM Stocks Are Approaching A Major Defense Line EM Stocks Are Approaching A Major Defense Line Global Material Stocks Are At A Long-Term Technical Support Line Global Material Stocks Are At A Long-Term Technical Support Line Global Material Stocks Are At A Long-Term Technical Support Line A Long-Term Perspective On Brazilian Stocks Technical And Valuation Charts That Matter Technical And Valuation Charts That Matter The Brazilian Real Is Not Yet Very Cheap The Brazilian Real Is Not Yet Very Cheap The Brazilian Real Is Not Yet Very Cheap Cyclically-Adjusted P/E Ratio For EM Equities Cyclically-Adjusted P/E Ratio For EM Equities Cyclically-Adjusted P/E Ratio For EM Equities Cyclically-Adjusted P/E (CAPE) Ratio For US Stocks Cyclically-Adjusted P/E Ratio For US Stocks Cyclically-Adjusted P/E Ratio For US Stocks Three Technical Support Levels For S&P 500 Three Technical Support Levels For S&P 500 Three Technical Support Levels For S&P 500 An Equal-Weighted Aggregate Stock Price Of Facebook, Apple, Amazon, Netflix, Google And Microsoft An Equal-Weighted Aggregate Stock Price Of Facebook, Apple, Amazon, Netflix, Google And Microsoft An Equal-Weighted Aggregate Stock Price Of Facebook, Apple, Amazon, Netflix, Google And Microsoft Is FAANGM A Bubble That Has Reached A Top? Is FAANGM A Bubble That Has Reached A Top? Is FAANGM A Bubble That Has Reached A Top? US Market Cap As % Of GDP Was Record High Last Month US Market Cap As % Of GDP Was Record High Last Month US Market Cap As % Of GDP Was Record High Last Month Global Stock-To-Bond Ratio, Commodities And EM Currencies Global Stock-To-Bond Ratio, Commodities And EM Currencies Global Stock-To-Bond Ratio, Commodities And EM Currencies Global Stock-To-Bond Ratio, Commodities And EM Currencies Global Stock-To-Bond Ratio, Commodities And EM Currencies Global Stock-To-Bond Ratio, Commodities And EM Currencies   Global Stock-To-Bond Ratio, Commodities And EM Currencies Global Stock-To-Bond Ratio, Commodities And EM Currencies Global Stock-To-Bond Ratio, Commodities And EM Currencies Global Stock-To-Bond Ratio, Commodities And EM Currencies Global Stock-To-Bond Ratio, Commodities And EM Currencies Global Stock-To-Bond Ratio, Commodities And EM Currencies   Singapore: Zero Interest Rates Ahead   Risk Of Debt Deflation… Singaporean businesses and consumers have been deleveraging in the past six years. That, along with the ongoing export slump1  and collapse in tourism revenues – 50% and 5% of GDP, respectively – have likely pushed real and nominal GDP into contraction in Q1 2020. Negative income growth risks turning this gradual deleveraging into debt deflation. Debt deflation occurs when prices fall and the real value of debt rises. Given the private sector is still heavily leveraged, deflation will trigger defaults. This scenario would be disastrous for Singapore’s credit sensitive property and banking sectors – the two key pillars of this economy. Singapore is not far from this tipping point as core and trimmed-mean consumer prices inflation measures as well as GDP deflator are flirting with deflation (Chart II-1). In order to ensure that this ongoing deleveraging does not enter a debt deflation spiral, both monetary and fiscal authorities need to stimulate more aggressively than they already have. Specifically, they should reduce interest rates to zero and provide substantial fiscal stimulus. … Warrants Zero Interest Rates Even though Singapore households and companies have been deleveraging, they remain highly indebted - total non-financial private sector credit stands at 173% of GDP (Chart II-2, top panel). Chart II-1Singapore: Deflation Is At The Door Singapore: Deflation Is At The Door Singapore: Deflation Is At The Door Chart II-2Singapore: Companies & Households Are Deleveraging Singapore: Companies & Households Are Deleveraging Singapore: Companies & Households Are Deleveraging   The middle and bottom panels on Chart II-2 illustrate company and household leverage, defined as the ratio of Singaporean banks domestic loans to non-financial businesses and households relative to corporate profits and employee compensation, respectively. Corporate profits and employee compensation are better measures because they are incomes available to corporates and households, while nominal GDP is not.  In brief, these measures gauge companies and households liabilities relative to their proper income. Critically, nominal GDP growth has dropped well below prime lending rates which stand at 5.25%. Besides, the prime lending rate in real (in inflation-adjusted) terms has risen as inflation dropped (Chart II-3). This is dangerous and nominal income growth is falling below the nominal interest rate, worsening borrowers’ ability to service their debt. Chart II-4 shows that the private sector’s interest rate payments on debt are elevated relative to GDP. This risks pushing the level of non-performing loans (NPLs) at commercial banks much higher. Chart II-3Singapore: Real Lending Rates Are High Singapore: Interest Payments Are Elevated Singapore: Interest Payments Are Elevated Chart II-4Singapore: Interest Payments Are Elevated Singapore: NPL Provisions And Bank Stocks Singapore: NPL Provisions And Bank Stocks   The non-performing loan (NPL) ratio at Singaporean commercials banks is bound to rise from the low NPL ratio of 2%. Moreover, the ratio of special-mention loans - loans that are stressed but are not yet officially recognized as non-preforming - are also set to climb meaningfully from 2%. Chart II-5Singapore: NPL Provisions And Bank Stocks Singapore: Rates Are Heading To New Lows Singapore: Rates Are Heading To New Lows Furthermore, Singaporean banks have extended a non-negligible amount of loans to Chinese and ASEAN businesses. With the indebted mainland economy struggling following the COVID-19 epidemics and ASEAN companies strained by weakness in their domestic demand, Singaporean banks will have to deal with rising NPLs emanating from China and ASEAN. Singapore’s commercial banks will be forced to raise their provisioning levels significantly, which will hurt their profits. Provisions of the three large MSCI-listed commercial banks  have been already rising. This has been historically negative for bank share prices2 (Chart II-5). As banks boost their provisioning, shareholders will push them to curtail credit origination to control risks. This will dampen economic and income growth. Without bold actions by the authorities, the banking sector and the real economy are facing a dire outlook. Interest Rates Are Heading To Zero Although the monetary and fiscal authorities have provided stimulus, it remains inadequate to fend off rising risks of debt deflation. The MAS (Monetary Authority of Singapore) conducts monetary policy by guiding the trade-weighted exchange rate. The MAS depreciates the trade-weighted SGD when it wants to ease and vice versa. Given the economy has become much more leveraged and, thereby, more sensitive to credit and interest rates, depreciating currency is not always sufficient to create a swift turnaround in domestic demand. This is especially true when global trade is shrinking, as it is today. The Singaporean economy needs much lower lending rates and a significant fiscal boost to avoid entering painful debt deflation. The odds are high that Singaporean bond yields and swap rates are heading to zero. In brief, currency depreciation will only augment the market share of exporters in world trade even though their exports will continue shrinking in absolute terms. Hence, currency depreciation will not promptly boost income and employment in the export industries amid the ongoing global trade contraction. At the current juncture, currency depreciation without a substantial decline in borrowing costs will have little spillover to domestic demand. Chart II-6 illustrates that Singapore’s central bank has already been injecting liquidity in the banking system in order to bring interbank/money market rates lower. However, interest rates remain relatively elevated compared with the US, the euro area and Japan (Chart II-7), as well as relative to what this indebted economy needs. Chart II-6Singapore: Rates Are Heading To New Lows Singapore: Real Lending Rates Are High Singapore: Real Lending Rates Are High Chart II-7Singapore Interest Rates Are Above G3 Singapore Interest Rates Are Above G3 Singapore Interest Rates Are Above G3     On the fiscal side, the government budget will barely turn expansionary this year: expenditures will rise from 3% currently to just 7%, which translates to a 1% rise relative to GDP. This will not do much to boost overall growth. If the pace of domestic loan growth drops from 2.4% to 1.4% (by 100 basis points), that would generate a negative 1.8% credit impulse of GDP, more than offsetting the rise in the fiscal spending impulse. Chart II-8Singapore: Cyclical Sectors Are Contracting Singapore: Cyclical Sectors Are Contracting Singapore: Cyclical Sectors Are Contracting Confirming the lingering growth downtrend, economic conditions were dire even before the COVID-19 outbreak. Manufacturing production volume is shrinking and sea cargo handled has been dropping (Chart II-8). Electronic exports are contracting from a year ago (Chart II-8, bottom panel). Finally, corporate profits are not growing. Consumer spending is extremely weak. Retail volume sales excluding vehicle sales are contracting 2% from last year (Chart II-9). The excess-mired property sector is slowing down anew. Housing loans are contracting which will trigger a material drop in residential property sales (Chart II-10, top panel). As the latter transpires, construction activity will also shrink (Chart II-10, bottom panel). Chart II-9Singapore: Consumer Are Not Spending Singapore: Consumer Are Not Spending Singapore: Consumer Are Not Spending Chart II-10Singapore Property Sector Is Struggling Singapore Property Sector Is Struggling Singapore Property Sector Is Struggling Bottom Line: The Singaporean economy needs much lower lending rates and a significant fiscal boost to avoid entering painful debt deflation. The odds are high that Singaporean bond yields and swap rates are heading to zero. Investment Recommendations The MAS will continue injecting more liquidity into the banking system to bring down interest rates further and devalue the currency. Exactly for these reasons, since June 8, 2018 we have been recommending shorting the SGD versus the JPY. This trade has so far produced a 7.3% gain with very low volatility (Chart II-11). Our target for this SGDJPY position is 70. Today we are booking profits on the short Hong Kong property developers / long Singapore property developers position because the Fed is about to cut rates to zero, which will reduce downside potential in Hong Kong real estate stocks. This recommendation has produced 21.5% profit since March 22, 2017 (Chart II-12). Chart II-11Stay With Short SGD / Long JPY Trade Stay With Short SGD / Long JPY Trade Stay With Short SGD / Long JPY Trade Chart II-12Book Profits On Our Long Singapore / Short Hong Kong Property Stocks Position Book Profits On Our Long Singapore / Short Hong Kong Property Stocks Position Book Profits On Our Long Singapore / Short Hong Kong Property Stocks Position   As to the overall stock market, we continue recommending a neutral allocation to Singapore within an EM dedicated equity portfolio. Ayman Kawtharani Editor/Strategist ayman@bcaresearch.com   Footnotes 1   Domestic exports, excluding re-exports. 2   DBS Bank, Overseas-Chinese Banking, United Overseas Bank.

Highlights Bear markets occur in phases, and their narrative can mutate. What began as a selloff caused by the coronavirus outbreak could well mutate into an oil crash-led selloff, and then mutate again into a selloff due to policy omnipotence, or something else. We are reiterating our short positions in the EM equity index and a basket of EM currencies versus the US dollar as well as our defensive positioning in EM domestic bonds and credit markets. We are taking profits on our long gold/short oil and copper trade. Oil prices may stabilize, but risks are still skewed to the downside. We are also booking gains on our long Russian domestic bonds/short oil position. Feature Chart I-1A Record Low Currency VOL Is Followed By Major Market Disturbances A Record Low Currency VOL Is Followed By Major Market Disturbances A Record Low Currency VOL Is Followed By Major Market Disturbances Global financial markets are witnessing the unwinding of the policy put. For the past several years, the consensus in the global investment community was that risk assets could not go down because of policy puts from the Federal Reserve, the US Treasury and President Trump, the European Central Bank and the Chinese authorities. Similarly, crude oil prices had been supported by OPEC 2.0’s put from December 2016 until recently. The latest panic and broad-based liquidation of risk assets has been due not only to fear and uncertainty related to the rapid escalation in COVID-19 cases around the world, but also to investor realization that these policy puts are ineffectual. The Fed’s 50-basis-point intra-meeting rate cut proved incapable of stabilizing global risk assets. Investors have begun to doubt the efficacy of policy puts and have thrown in the proverbial towel. Crucially, the high-speed and intensity of the selloff was due to widespread complacency and overbought conditions in risk assets. In our January 23 report, we quoted Bob Prince, co-CIO of Bridgewater, who stated in Davos that “…we have probably seen the end of the boom-bust cycle.” This comment was consistent with prevalent complacency in global financial markets, reflected in very tight credit spreads worldwide, high US equity multiples and record-low implied volatility in various asset classes. In the same January 23 report, we wrote: “Any time an influential person has made a similar declaration in the past, it marked a major turning point in financial markets. Remarkably, implied volatility for the US dollar has plummeted to a record low, as it has for EM currencies and a wide range of equity markets. Chart I-1 illustrates the implied volatility for EM currencies and the US dollar. Such low levels of implied currency market volatility historically preceded major moves in currency markets and often led to a material selloff in broad EM financial markets.” In that same report , we recommended going long implied EM currency volatility. Since then JP Morgan’s EM currency volatility has risen from 6% to 10%. What began as a selloff caused by the coronavirus outbreak could well mutate into an oil crash-led selloff, and then mutate again into a selloff due to policy omnipotence, or something else. Consistent with this thesis, we reinstated our short EM equity index recommendation in the following week’s report – on January 30. The MSCI EM stock index is down 11% since then. Our target is 800, which is 18% below current levels (Chart I-2, top panel). Chart I-2EM Stocks: A Breakdown In The Making EM Stocks: A Breakdown In The Making EM Stocks: A Breakdown In The Making Market Narratives Mutate Chart I-3VIX Surge In Early 2018 Was A Trigger Not Cause Of Selloff VIX Surge In Early 2018 Was A Trigger Not Cause Of Selloff VIX Surge In Early 2018 Was A Trigger Not Cause Of Selloff Narratives of all large market moves are always expounded in retrospect. Only after a selloff is well-advanced do investors and commentators come up with reasons for it and build a plausible narrative describing it. Critically, bear markets occur in phases, and their narrative can evolve. What began as a selloff caused by the coronavirus outbreak could well mutate into an oil crash-led selloff, and then mutate again into a selloff due to policy omnipotence, or something else. For example, the early 2018 selloff in global equities and industrial commodities was at the time attributed to the spike in US equity volatility (Chart I-3, top and middle panels). In retrospect, January 2018 marked a major top in the global business cycle (Chart I-3, bottom line). Hence, the true reason for the late-January 2018 top in global stocks and industrial commodities was a downturn in global manufacturing and trade and not the surge in the VIX. The key question investors are currently wrestling with is the following: How deep will this selloff be, and how long will it last? Our view is that the selloff in EM and global risk assets is not yet over. As such, we are reiterating our short positions in the EM equity index and a basket of EM currencies versus the US dollar, as well as our defensive positioning in EM domestic bonds and credit markets. Gauging The Downside There is no doubt that global growth will be affected by the spread of COVID-19 and the precautionary measures taken by the authorities, companies and households around the world to contain the outbreak.   Further, growth visibility is extremely low, and that uncertainty is raising the risk premiums that investors demand. The latter is weighing on risk assets in general and global share prices in particular.  Presently, precise forecasts for GDP growth and a potential trajectory of COVID-19 cases are not credible, and hence cannot be relied upon to formulate a sound investment strategy. If the current bloodbath in risk assets persists, a market bottom could be reached well before bad economic data are released or COVID-19 infection cases peak. Given the uncertainty related to both the global growth trajectory and the Covid-19 epidemic, the only way for investors to gauge a market bottom is to continuously examine valuations, technicals and market internals. With respect to valuations and technicals, we have the following observations: The EM equity index seems to breaking below its major support lines. If this breakdowns transpires, there is an air pocket until the index reaches its next technical support, which is 18% below its current level (please refer to the top panel of Chart I-2 on page 3). If the EM MSCI equity index drops to this support range, it would be trading at 11 times its trailing earnings (please refer to the bottom panel of Chart I-2 on page 3). At those levels, the EM equity index would be discounting a lot of bad news, making it immune to dismal economic data and general uncertainty. For the S&P 500, if the current defense line – which held been during 2011, 2015 and 2018 selloffs – is violated, the next long-term technical support is around 2400-2500 (Chart I-4). Inflows to EM fixed-income funds were enormous in 2019. Meanwhile, EM corporate and sovereign spreads have broken out (Chart I-5). Provided this selloff commenced from very overbought and expensive levels, the odds are that liquidation forces will not abate right now and that the selloff in EM fixed income has further to go. Chart I-4S&P 500: Where Technical Support Lies? S&P 500: Where Technical Support Lies? S&P 500: Where Technical Support Lies? Chart I-5EM Sovereign And Corporate Spreads Have Broken Out EM Sovereign And Corporate Spreads Have Broken Out EM Sovereign And Corporate Spreads Have Broken Out   In a nutshell, we suspect that EM local currency bonds and credit markets received a lot of inflows from European investors in recent years because yields were negative across European fixed-income markets. A weak euro was a boon for European investors investing in EM. That, however, is reversing. Since the recent sharp appreciation in the euro and the nosedive in EM currencies, EM financial market returns in euros have collapsed. This will likely prompt an exodus of European investors from EM financial markets. Chart I-6A Major Breakdown In This Cyclical Indicator A Major Breakdown In This Cyclical Indicator A Major Breakdown In This Cyclical Indicator Even though the EM equity index is not expensive or overbought, rising EM USD and local currency bond yields herald lower share prices, as we discussed at length in last week’s report. Our Risk-On/Safe-Haven currency ratio1  has plummeted below its major technical support and the next level is significantly lower. In other words, this indicator is also in an air pocket (Chart I-6). Given it is extremely well-correlated with EM share prices, the latter will not bottom until this indicator stabilizes. Technical configurations of high-beta and cyclical segments of the global equity universe are consistent with failed breakouts. Such a profile is typically not followed by a correction, but by a major drawdown. These include the European aggregate equity index, the Nikkei, global industrials and US high-beta stocks (Chart I-7). Chart I-7AFailed Breakouts Are Often Followed By Large Drawdowns Failed Breakouts Are Often Followed By Large Drawdowns Failed Breakouts Are Often Followed By Large Drawdowns Chart I-7BFailed Breakouts Are Often Followed By Large Drawdowns Failed Breakouts Are Often Followed By Large Drawdowns Failed Breakouts Are Often Followed By Large Drawdowns Chart I-8The Global Stocks-To-Bonds Ratio Is Back To 2011 Levels The Global Stocks-To-Bonds Ratio Is Back To 2011 Levels The Global Stocks-To-Bonds Ratio Is Back To 2011 Levels Finally, the global stock-to-bond ratio has decisively broken below the upward sloping channel that has been in place since 2009 (Chart I-8). Typically, when a market or ratio experiences such a major breakdown, the recovery does not occur quickly and is unlikely to be V-shaped. In short, the structural breakdown in the global stocks-to-bond ratio suggests that global share prices will likely stay under downward pressure for some time. Bottom Line: Odds are that risk assets remain in a liquidation phase and investors should avoid catching a falling knife. The odds are also high that EM share prices in US dollar terms have another 18% downside. We reckon at those levels – where the MSCI EM equity index is around 800 – it would be safe to start accumulating EM equities, even if the global growth outlook remains mired in uncertainty. For now, we recommend playing EM on the short side. What To Do With Oil Plays Despite periodic spikes in crude prices over the past few years, we have held our conviction that oil is in a structural bear market. We doubted the sustainability of the OPEC 2.0 arrangement, arguing that Russia would not cooperate with Saudi Arabia in the long term. Russia did cooperate much longer than we had expected, temporarily supporting oil prices. Ultimately, Russian President Vladimir Putin abandoned the cartel late last week, and the Saudis have hit back with massive price discounts amid large output increases. Consequently, oil prices have crashed and are presently oversold (Chart I-9). Given the uncertainty related to both the global growth trajectory and the Covid-19 epidemic, the only way for investors to gauge a market bottom is to continuously examine valuations, technicals and market internals. However, there will be no rapprochement between the Saudis and the Russians for some time. Given the drop in demand amid sharp increases in supply, crude oil prices may well slide further. Since July 11, 2019, we have been recommending a long gold/short oil and copper trade (Chart I-10). This position has generated a large 40% gain. Today, we are taking profits on this trade. Instead, we are replacing it with a new position: long gold/short copper. Chart I-9A Long-Term Profile Of Oil Prices A Long-Term Profile Of Oil Prices A Long-Term Profile Of Oil Prices Chart I-10Book Profits On Long Gold / Short Oil And Copper Trade Book Profits On Long Gold / Short Oil And Copper Trade Book Profits On Long Gold / Short Oil And Copper Trade   Among oil plays, we have been overweight Mexico and Russia within EM, both in fixed income and equity universes. That said, for absolute return investors, we have not been recommending unhedged long positions in either Mexico or Russia because of our expectation of a drop in oil prices and the ensuing broad-based EM selloff. Regarding Russia, for investors who were looking to gain exposure to local currency bonds, we have been recommending that they hedge this position by shorting oil since November 14, 2019. This recommendation has paid off well, and we are closing this position with a 26% gain. We will be looking to buy Russian local bonds unhedged in the weeks ahead. Chart I-11Relative Performance Of Russian And Mexican Domestic Bonds Is Facing Near-Term Headwinds Relative Performance Of Russian And Mexican Domestic Bonds Is Facing Near-Term Headwinds Relative Performance Of Russian And Mexican Domestic Bonds Is Facing Near-Term Headwinds In Mexico, we have also been reluctant to recommend naked exposure to local currency or US dollar bonds because of our bearish view on oil and the risk of large outflows from EM that would hurt the peso. Indeed, the oil crash and outflows from EM have led to a plunge in the Mexican currency. Instead, in Mexico we have been recommending betting on yield curve steepening. The proposition has been that short rates are anchored by a disinflationary backdrop and tight fiscal policy in Mexico while the long end of the curve could sell off in a scenario of capital outflows from EM. As with Russia, we are monitoring Mexican markets and are looking to recommend buying domestic bonds without hedging the currency risk in the weeks or months ahead. Bottom Line: We are taking profits on our long gold/short oil and copper trade. Oil prices may stabilize, but risks are still skewed to the downside. In the near term, the relative performance of Mexican and Russian stocks and local currency bonds versus their respective EM benchmarks could be undermined by capital outflows from EM in general and these countries in particular (Chart I-11). Nevertheless, both nations’ macro fundamentals remain benign, and their fixed-income and equity markets will outperform their EM peers in the medium term. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Footnotes   1     Calculated as ratio of equal-weighted average of total return indices of cad, aud, nzd, brl, idr, mxn, rub, clp & zar relative to average of jpy & chf total returns (including carry); rebased to 100 at January 2000. Equities Recommendations Currencies, Credit And Fixed-Income Recommendations